to 85% when the public or when the Bitcoin market is down within the past year, the public market is likely to move up because there's a lot of leverage built into the system. And once the volatility kicks in, a lot of the investors are margin called and they have to get money out from the public market and that kind of feeds into a loop.
So, you're saying there's correlation and there may be feedback loops, Tom.
Sort of a related question. So, Mervyn King was in this room a couple hours ago and he was talking about in the '08 crisis two issues of trust. One where there was a counterparty trust issue. Banks, even though the overall derivatives market was even, banks didn't individually know which other bank was most at risk and so they wouldn't trade with each other or lend to one another. And then on the opposite side, the solution, the salvation was two people in a room trusting each other that the central bank, that the government would fund tens of billions of dollars to inject capital. And so, I wonder your thoughts on blockchain's role in addressing that first problem, of knowing your counterparty or at least being able to trust their position, and then the risk of eliminating the second chance of injection of capital into the financial system in a blockchain.
I had a question that's related to this.
I just wanted to see how you all voted.
But the question is this: if it does strike me that you only have a financial stability problem if people are relying on the value of people's Bitcoin holdings, for example, which is the bulk of crypto assets, right? The reason you have the problem during the crisis is you have all these banks, they're carrying these assets on their balance sheet and all of a sudden people don't know what they're worth. Right? Who, if anyone, is actually carrying the Bitcoin assets on a balance sheet that someone else is relying on? Or, put it differently, who's extending the leverage?
All right. So, let me get out of this system. Let me wrap these together. I think that what many central bankers and the Financial Stability Board would say at 200 billion versus 300 trillion, it's probably not that financially relevant at this point. Where it could get relevant is, as Ross has sort of suggested, is as if there's leverage behind it. If it's in a balance sheet, it's an asset on a balance sheet and there's a liability on the other side, and thus it could bring down that entity, whether it's a hedge fund, whether it's a bank, but something that's relying. To tie it back to the questions that Tom raised is, could blockchain lower systemic risk? Possibly, if it's a better database solution. If it answers what Mervyn King was speaking about, we also addressed in the late '90s. I remember quite well when Secretary Rubin called a number of us into his office and said, 'I don't understand. The banks can't tell us their exposure to Korea.' A number of countries, South Korea was about to — they didn't default on their debt, but they were coming close to defaulting on their debt. And of course, it was only a short while before other countries like Indonesia and Thailand were getting into that same debt challenge. But why couldn't banks tell the US Department of Treasury their exposures? Usually through derivatives. And derivatives, both in the late '90s and in the financial crisis, were often something that propagated risk through the system. Now, the numbers were larger. I mean, depending upon the time, the '90s was less than this, but it was 300, 400 trillion dollars of notional amount of derivatives. So, just the sheer notional size, even though the capital at risk in derivatives was much smaller. It was because the leverage of this big notional size and the transparency was pretty low. It wasn't zero, actually. It wasn't zero, but it was really low. And so, I think that's what Mervyn King would have been mentioning. And I do think blockchain can help in that transparency. But it takes a big collective action. And so, Europe, the US, and Asia, a lot of laws were passed to get more transparency in the derivative space. But I would say that there could be problems. And I've had conversations with elected leaders that say don't get lulled into the sense that it won't have financial stability issues. Because that was what happened in the 1980s and '90s when people said, 'Well, derivatives will not create instability because it's only the institutional investors, the sophisticated investors, the so-to-speak big boys or big girls, you know?' And I was part of those debates, that consensus that formed that it was only institutional and it wouldn't. But there was a lot of leverage and a lack of transparency when big leverage, multiple hundreds of trillions of dollars associated with it. That, of course, was part of the crisis, not the only part of the crisis, but any questions before we — Hugo?
Yeah, on the protecting the investing public front, I was just wondering like a lot of people are now using Robinhood and zero fee things like that to invest in the stock market. And companies like Robinhood, Vanguard often sell order book data to high frequency traders so that they can kind of know what's going on and maybe front run. So I was wondering how that fits in to what we were talking about last time where there's no transparency on many of the cryptocurrency exchanges. And then in addition to that, big institutional investors can I think buy like upwards of 5% of any stock and then wait a few days before they have to report on that. So that can also have a huge effect on like stock price and then they can afterwards dump on people. So like how is that different from what's going on in cryptocurrency exchanges?
So that's an investor protection one. Was there another one in the — Is this investor protection or?
No, it's a little different.
A little different. All right, any other investor protection because I'm going to collect them and then just enter.
So it's about former — I was a little bit, it was kind of abstract to me when you say the blockchain can help to stabilize the financial market.
And effective financial stability.
All right. Can I call it? Let me just answer Hugo's. It's investor protection one. So, all markets, not just crypto markets, all markets are susceptible to some forms of front running. In essence, if you have a client relationship and you get information from your client that might affect the market pricing, you might jump ahead of that client with their information. Their information might be a buy order, a sell order, or frankly, it might be some other information. But traditionally, if they have a buy order or sell order, you have information, and then you're sort of jumping ahead and, you know, saying, 'All right, I'll buy or sell in front of them.' That's the classic sort of front running, even though there's other methods. It's not supposed to happen. On regulated exchanges, you have some policing of it. Even before government stood in, you could have some policing of it in self-regulatory organizations. In the crypto world, there is, you know, Katie bar the door, anything can really happen. And it's my belief and understanding that many crypto exchanges, not all of them, not all of them, but many crypto exchanges are basically trading in front of their customers. And in fact, most crypto exchanges make markets as they are both market makers, meaning they are buying when you're selling and selling when you're buying. That's the nature of a market maker. It's very typical, very legal, very important function of market. But the exchanges are both market makers, and then they show order books. And so, it sort of helps them do front running. Not that a lot of people would necessarily agree with me. I think these markets would be better off if there were some forms of rules about front running and manipulation in markets and the like. When your 5% question, can we take it up in the office hours or something because it's sort of outside of crypto, but I'll be glad to talk about the SEC rules about the 5%. Is this investor protection? And then.
I think so. The reading that we had that talked about the fabric technology, it mentioned something about execute order validate. Did that mechanism tie into the way that front running would work?
All blockchain technology, whether it's permission like fabric or permissionless, can, if it was efficient and scalable, could help out because you could actually timestamp when did the order come in. When did the client's information get to the exchange and is somebody standing in front.
Sort of like a cascade that you can't necessarily pause when start.
Right. Right. So, if you look at the algorithms at the New York Stock Exchange right now, which are not blockchain, they're not permissioned, and they're not permissionless blockchain, but if you look at both the algorithms and the data flows, they have very good timestamping. I'm not going to say it's perfect, but they have very good timestamping to ensure when orders basically message timestamping, every message that comes in. And some order books, like the New York Stock Exchange, some order books are price and time priority. Price priority meaning high bid gets hit before the next bid or lowest offer gets lifted first. That's price priority. But they might also have time priority for any bid that has the same price and any offer that's the same price. So, they have to have very good timestamping. It's not — you could not use, I truly believe you could not use a blockchain solution for the New York Stock Exchange order book right now. Whether you can in 10 years, I'm not sure, but time latency is so relevant in the middle of those order books. You know, the nanoseconds that matter. I want to take this stability question. There are two stability and then we're going to move on to the rest of today's lecture. You're having fun now.
Can you explain a little bit more about like, well, say if blockchain can be a better database, so it can help like stabilize the financial market. I can give some examples?
So, how blockchain could possibly help you stabilize there? A lot of financial instability or beyond the financial markets instability is a question of resilience. And when things are centralized, you create single points of failure in any system. It really in a military or financial. You centralize something, you then thus you know what to attack. You can also maybe have higher walls or better moats, but you still know of something to attack. So, blockchain and its decentralized nature might be a more resilient database because even if half or two-thirds of it goes down, you still have the other third. I'm going to say something about the New York Stock Exchange again. Whether it's a New York Stock Exchange or London Stock Exchange or Chicago Mercantile Exchange, they all are required by their various local laws to have backup data centers. And there's backup data centers even have to be lots of miles away if God forbid a bomb comes and takes out the center. What's that? It's called — it's basically disaster recovery. So, maybe blockchain will be more resilient. I know I'm going to take two more questions and then get back to permission versus permissionless. Wait, back in the corner. Your first name again is Matt. Thank you, Matt. I should know that.
So, I'm kind of curious how like the essentially the nascency for lack of a better word.
Like the nascency, how kind of like new and this market is, how that affects policy because when you're shaping policy and you don't necessarily have like a bunch of years of knowing how people are going to react to that policy, I feel like it could almost be a chicken and egg.
Okay, I understand. Anybody else with the same theme? No. So, the question is how does it affect policymakers when a whole technology is new? And I would say we have a lot of history with this. We have a — whether it was railroads or the telegraph or the telephone or television, we have a lot of history. Technology and commercial applications move ahead of the public sector. I mean, you just — it's just inevitable. The official sector, the public sector, unless it just basically does what Mark Carney says and the choice is to isolate something. To sort of put up the moats of a society and says we can't use that technology here. Unless you have that, technology usually supersedes the markets and the markets and technology come before official sector. Depending upon the area can take single-digit years and sometimes decades for public sector to catch up. Literally, but let's take the internet. The internet was being worked on for 15-ish years. But the protocol layer that helped take off was the World Wide Web in 1991 or '92. And then the security protocols in '96. Just taking financial regulation, the SEC was asked in 1995 could bulletin boards — there were electronic bulletin boards listing stocks and bonds be exempted from being considered stock exchanges. Well, the people that were asking that were the people putting up the bulletin boards. They didn't want to be regulated. The New York Stock Exchange that was fully regulated and NASDAQ that was fully regulated was coming at the other side and asking the SEC to shut them down. They didn't want the competition from the disruptors. It took 3 years for the SEC to answer that question. I don't mean answer it like with a letter. They had to propose a rule and they had to do a final rule and it was 3 years to do that. In blockchain, I think we are through some of the big questions. We know how most jurisdictions tax it as property and not as currency and some of the tax issues. We know in most jurisdictions how it fits into broadly Bank Secrecy Act and illicit activity. There's very choppy implementation, very spotty implementation. I would say the investor protection side we're at the early stages and it's going to take in most jurisdictions another 3 years maybe to sort through some of how — and this is just crypto finance. I don't know, Matt, does that — this is I'm giving you some predictions. Some of it could be multiple decades. We're still today trying to figure out the public sector's figuring out how to regulate Facebook and Google. I'm going to take one last question and then because I got to do permission.
All right, can I kind of ask because I was kind of like — it kind of answers the side of like following the technology, but I think for me what I was kind of wondering about was this the way we're like as soon as you apply regulations to something that at least a good portion of the market seems to value being deregulated, it seems like a lot of the activity will change either in scope or scale.
So, Matt's raising — there's a trade-off about bringing something under regulation or into the public policy sphere. I'm probably just one voice of this, but I think it's probably true. There's very few economic activities that grow large that stay fully outside of the public policy framework of a society. It doesn't mean that public policy frameworks don't change, get adopted, get adapted. The internet comes along and at first it's a question of, you know, with Amazon, is it going to be taxed or not? Is there sales tax? And then later, you know, at first it's not, later it is. And in some jurisdictions there were questions in the internet was liability. And this is a very critical question of early internet was there liability for any of the information of the flow of information. I'm talking about libel laws and all the liability issues and so forth. And so in the US, there's a section of the law in 1996 was passed and now we're coming back and saying, 'Wait a minute, that gave too broad — it was basically exempted the internet from liability as carriers.' But now that was modified in 2018, 22 years later, to say, 'Well, if it has to do I think with basically child trafficking and slavery and everything, maybe that's we should tighten that up a little bit.' So I don't believe any broad economic activity is going to remain outside broad fully outside public policy frameworks. And I'm glad to be challenged on that, but I think blockchain and particularly crypto finance is at this grappling stage to get in. So, let me move forward because this is more about permission and permissionless. I just wanted to cover some of these. We will cover initial coin offerings and the public policy issues around initial coin offerings and the Howey test. We will cover crypto exchanges and we will cover central bank digital currencies a lot in the second half of this semester. So, back to the tradeoffs that we talked about already. The tradeoffs of centralization and decentralization and Coase's work from the 1930s about the firm. This is the cost, remember. This is the cost. As we get centralized, there's more cost of economic rents, single points of failure, and capture. Some fragility in a sense in the system. But, decentralization has its cost as well. You'll notice that these two lines are crossing somewhere. It was my failed attempt to say, you know, maybe there's a balance. Maybe overall, while some organizations will find all the way to decentralization and some to centralization, I think economic systems tend more towards the centralized side of things. But, you can change the slope of these two lines if you want. I'm just trying to give you a framework of thinking about — So, as we've talked about, the financial sector pretty much favors permission systems. The financial sector is saying, going back, no. Too many costs of coordination, governance, security, privacy, and scalability. We're over on the other side. And so that's where they are today. I'm not sure that's where they'll be in 5 or 10 years, but it is definitely where they are today. So let's go back down our list in a sense. Where do you think I'm going to — I'm going to have a bunch of check marks and X's on the right? Where do you think I'm going to have check marks and X's? This is the same three big buckets because I can't think of anything. Emily, do you have a point of view?
I mean, I think in terms of the permission technical features, one of them is obviously that it's not using that proof of work. It's not using the same proof of work.
Not using proof of work, so I had to give away the — you know, reveal the current — All the cryptography that's used in permissionless systems is used in the permission systems. It might be used a little differently. I'm not going to say the Merkle trees are exactly the same, but all that broccoli we were eating a few lectures ago are relevant on both sides. Sorry, Eileen. What's that? You —
You like broccoli, a computer scientist speaking. Everything they know about digital signatures and hash functions and so forth are relevant to both of these, but they're not necessarily relevant to every traditional database, which we'll talk about in 10 minutes or so. But as Emily said, there's really not — I said no, there's not decentralized network consensus. I'm stretching it a little bit because permission systems can be decentralized. There could be five or 10 or 20, you know, nodes, and so that is decentralized. So I shouldn't have really said no, I should have said maybe or hybrid. And instead of proof of work, the permission systems use a bunch of consensus mechanisms. And I just listed a couple notary nodes or PBFT for Byzantine fault tolerance again. But they don't have native currencies. So, that's the big — that is a very big difference. No native currency. If you have a solution for your final projects or you have a solution for some entrepreneurial business that you're going to do in the future that you want a native currency, you're probably more over into the permissionless world. If you want to have an incentive structure, something to motivate customers or users or create token economics, token economics is more in the permissionless. I say more because you can create a token even in the permissioned space. We'll talk about it in a moment. And then transaction scripts or UTXOs, they're not technically UTXOs in a bunch of permissioned systems, but you need some ledger. This last box, if I just called it ledgers, you'd still have ledgers in — So, it's really the consensus mechanism in the middle, as Emily said. A couple key design features. First, membership's limited to basically an authorized set of nodes. So, does anybody want to say if you were a bank, who you might — you know, what might you do if you were a bank and who might you authorize if you're doing a bank, I don't know. Let's say that it was loans. Or if it's Mark Snyderman's real estate, it's real estate loans. Could you ever see real estate loans going on a blockchain, Mark?
Loans maybe. Loans could.
Loans aren't traded as much.
So, if real estate loans were on a permission blockchain, who might be that membership? The limited — who would — I'm — it's not just a rhetorical question. Who would actually care about the database of the loans?
Broker dealers that are active in loans and institutional investors that are active in loans.
So, the broker dealers who are actually trading the loans and maybe the investors. The loans.
Yeah, just the rating agencies when you securitize those loans.
Loan services. So, maybe loan services, maybe the rating agencies. So, it's basically who has a need and needs that data. I'm not sure that this is the right community, but it's the discussion I'm thinking about. And again, as you're thinking about — I'm jumping again to a little bit final projects, but when you're thinking about, you know, who actually needs data and who has a reason to amend the data or write to the ledger. Because if you don't have a desire and a need to actually amend or change the data, move value in the system, you might not need an open database.
