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Beyond Bitcoin - Understanding the Block Chain Ecosystem

Modern Investor Journey has the privelage to sit down with one of the world's leading academic thinkers on block chain, distributed ledger technologies, smart contracts and DeFi (decentralized finance). Having recently won a North American contest to work with the Bank of Canada, Dr. Alfred Lehar shares his leading edge perspectives on tokenization, the recent explosion of DeFi commerce, central banks and regulating the crypto wild west.

Podcast highlights

02:30 The Interplanetary File System

05:20 Distributed ledgers explained

07:02 The block chain

10:07 Etherium

13:52 Smart contracts explosive growth and disruptive potential

17:55 Tokenizing stocks and real time settlement

20:08 Earning a return by providing liquidity to tokens

27:43 Debt collateral

29:01 The academic approach to DeFi

33:00 Central banks and digital currency

36:45 Fractional banking

40:38 The need for commercial banks

43:47 Regulating the wild west

48:07 Wrap up

About Alfred

Alfred Lehar (2).jpg

Alfred is associate professor in the finance area. He has been teaching at the Haskayne School of Business since 2005. He received an undergraduate degree and a PhD from the University of Vienna. Prior to Joining Haskayne, Alfred held positions at the University of Vienna and the University of British Columbia.

Alfred teaches a introductory finance for the MBAs and a class on Corporate Finance for PhD students. Alfred's areas of research interest include fintech, bank regulation, financial stability, and corporate finance.

Alfred is currently researching mining fees and price differentials in Bitcoin markets, decentralized exchanges, and under what conditions renegotiations can facilitate a private sector workout of a financial crisis. He also works on how information produced by financial markets can be optimally used in bank regulation. In his previous research Alfred developed several methods on how to measure the probability of a financial crisis, analyzed conflicts of interest for financial Analysts, and looked at the empirical fit of alternative option pricing models. Alfred’s work has been published in the Review of Financial Studies, Management Science, the Journal of Financial Intermediation, the Journal of Banking and Finance, and the Review of Finance.

In his spare time he enjoys skiing and hiking

Transcript

Rod: Hello and welcome to this edition of the Modern Investor Journey. My name's Rod Heard. I'm co-founder and CEO of SmartBe Wealth. And I'm here with my partner, Art Johnson, co-founder and portfolio manager. And today we're delighted to have with us, Dr. Alfred Lahar. He's Associate Professor of Finance at the Haskayne School of Business.

[00:00:29] He did his PhD at the University of Vienna. And prior to moving to the Haskayne School he was working at the University of Vienna and then had a short stint at UBC. We're really excited to talk to Alfred because he's an expert in Bitcoin, smart contracts, and the pricing in mining of these new markets that are emerging.

[00:00:48] I think you'll find that we'll have a very interesting conversation that will enlighten a lot of us on what is happening in this sort of cryptocurrency space, as well as the smart contract blockchain aspects. Alfred's widely published and published in a lot of the tier one financial journals. And, you know, is one of the University of Calgary's and Haskayne School's shining stars in that area. And most recently Alfred was awarded a competition. The Bank of Canada had a competition to 20 universities across the country and they were looking for people to help them understand how the fiat currency group in the Bank of Canada , with the Canadian currency, needs to transition into this digital age.

[00:01:29] And I'm sure we'll get into that a little bit. So Alfred, welcome to the show. We're really delighted to have you on.

[00:01:35] Alfred: Thank you so much for having me. It's really great to be on the show.

[00:01:39] Art: Yeah, it's I just wanna give a real plug to Alfred because as an economist a lot of the times you find people who are black or white in their thinking. Very linear.

[00:01:49] And I think Alfred is not that way. And I I'm absolutely certain that the way he gravitated to Bitcoin as just a fascination with the thinking and why people do things and all of that, and trying to figure out the puzzle of why this thing is doing what it's doing, but also having the technical background to understand it from the classical economics fashion.

[00:02:10] So it's fascinating to have you on because of what's going on with Bitcoin, but more importantly just I love you on cause I love the way you think. So that's fantastic.

[00:02:19] Alfred: Thank you so much for your kind words.

[00:02:21] Rod: I also Alfred love the fact that you're a father and I got to relate this story. Alfred has been at one of SmartBe's conferences in the past and gave a great dissertation on some of his earlier Bitcoin work. But he said that the best investment he's ever made was from his, I think at the time, five or six year old son who they were doing an investment club at home and his son picked Costco out of a group of all of the companies to invest in.

[00:02:45] And it turns out to be one of his greatest investments. And as you'll learn in the show today, he's now got his daughter into the cryptocurrency world tokenizing one of her pieces of art and trying to sell it in the ecosphere. So maybe why don't we start there, Alfred? Why don't we talk about your daughter?

[00:03:00] I think it's on Uniswap. It might be on another platform, but help us understand how that market works and what the space is all about.

[00:03:07] Alfred: Yeah. I was just totally fascinated how as this is an example of how blockchain and FinTech will change our everyday life. And this was not an area where I initially expected this to happen.

[00:03:19] So what we did was my daughter loves to draw on her tablet and create these digital art pieces. And so her art up on the interplanetary file system. It's a really thing. It sounds like Star Trek.

[00:03:36] But it really exists. And you upload that, then you can meet a token that represents the ownership that piece of art. So it's a digital token, similar to a lot of the other cryptocurrencies that we have. But in this case, there's only one token available. And that represents that ownership. And then you can put up the token for a sale at the digital platform. The platform we are using is OpenSea.

[00:04:05] And so there was a lot of art there. And to my surprise, I read that this is a multimillion dollar market. So I think in December 2020 I read somewhere that 20 million US dollars worth of art was sold digitally. And so-

[00:04:21] Rod: Is that since inception or is that over the year?

[00:04:23] Alfred: In one month! And it's a tremendously growing area so that didn't exist half a year ago or a year ago. So there's just a tremendous amount of growth. Now, the exciting part is that this same technology can be used for a lot of other things. Like you can digitize invoices, you can digitize containers this way that are shipped across the world's oceans.

[00:04:49] And this just shows you how this technology has the potential to really change so many things we're doing every day in our life from art to container shipping. The underlying technology is there. It works. It's being tested right now. And that one day it will just come and boom, change everything we do.

[00:05:08] Art: It sounds like I've got to dust off some of my old Spider-Man drawings. From when I was 10 to make some, a side hustle here!

[00:05:15] Alfred: Make some money there. Yeah, that's right.

[00:05:20] Art: Can we step back a bit and just like, you know, we're going to use a lot of words that probably people aren't going to fully understand. A token. Even Bitcoin.

[00:05:29] Can we even go back to the concept, you can help us here. Like, this is a libertarian concept to have a fractional reserve banking system. And that's really what we're talking about. And the idea... we had it at one time with the gold standard. And the idea is that it requires no government involvement other than the simple enforcement of contracts.

[00:05:48] So can you walk us through contracts and just give us a base understanding of what is a token? What, like, what is the disruptive technology as you see it?

[00:05:56] Alfred: So I think the big achievement that Bitcoin really showed can exist is that we can create a ledger of who owns what without trust. So usually we have a lot of ledgers in our current economy, like land registry, or if you go to the bank it's clear that you have a lot more in your account than I do.

[00:06:18] And we all trust the bank that the bank keeps track of that. But this is a trusted party. In the land ledger we trust the government to keep that ledger correct. But with Bitcoin, this is the first system that really achieved to keep a consistent ledger that everybody trusts in without any trusted party.

[00:06:36] So everybody's kind of broken on the internet almost. That's kind of the premise that Bitcoin is built on, but we can still generate this system that allows us to have ownership in a consistent way and to have proper record keeping. And as it turns out, that's a really important for the success of Bitcoin.

[00:06:58] So there's no real economic value, of course, to Bitcoin.

[00:07:02] Rod: Can you describe the main components, Alfred, from the smart contract to the miners, to the encoding. Can you simplify what this world means to, you know, maybe a grade six or eight level for us?

[00:07:15] Alfred: A block just consists of a bunch of these ledger entries. So who owns what? Well you can write in these blocks that Art gave Alfred one Bitcoin. And so that's the kind of information that's in there for the most part. And we can add these blocks. We can add a bunch of these ledger entries to a block. And then we connect these blocks with each other to form a blockchain.

[00:07:40] Now, what is important is there's some cryptography that makes these blockchains, these block entries, tamper-proof. So if somebody would try to falsify a record entry in the past, then this would be detected through this cryptography mechanisms. And what we often hear in Bitcoin is this process of mining.

[00:08:01] So what mining really means is that miners select these ledger entries and compile a block, compile them to a block. Now the unique thing about how security works in Bitcoin is that creating this block has to be hard. Hard meaning it's computationally expensive. You need a lot of computing power to compile one of these blocks.

[00:08:23] The reason for this is that this makes it hard for somebody to go back in the past and falsify the ledger because if I want to go back and change the ledger entry that was like 50 blocks ago, I have to go back and recompute that block that it's valid. And then I have to recompute all the blocks that came after it. So I have to recompute 50 blocks. And at the moment, this is so computationally expensive that nobody will do that. And so this is why the system is safe. This is why nobody goes back and tries to change the past. This is why the system works. Now, the downside of this is it's kind of bad for the environment, because we use a lot of electricity to keep this going. So the Bitcoin system uses about as much electricity as Ireland or Norway or Belgium.

[00:09:14] Rod: Wow. So computationally expensive. What would the expense of decrypt defying one block be? Is at a million dollars, $10,000, $1000, $1?

[00:09:25] Alfred: So I think that's if you want to recompute those 50 blocks, you would have to spend millions of dollars to do that.

[00:09:32] So, and for the most part, that's not worth it. And so people don't do it and it would just even be at the scale where it's hard to get the resources to do that. That's why there's this mining is just a big industry where a lot of computing power is spent. We have these mining farms where there's racks of computer after computer, and they have specialized computers that are just focused on mining Bitcoin.

[00:09:59] They cannot do anything else. They're just purposely built to mine Bitcoin blocks. So, this is why this is such a big business.

[00:10:07] Rod: Now Bitcoin seems to have grabbed the heart and attention of the public because it's a currency and it's going through the roof. And, you know, we hear all of the news about it, but my understanding is there's a number of chains out there.

[00:10:18] A number of blockchains out there that are beyond Bitcoin. Can you tell us what the landscape looks like?

[00:10:23]Alfred: So there's a lot of start ups. So the second biggest and I think the most interesting blockchain at the moment is Ethereum. So Ethereum differs from Bitcoin in the sense that it's main purpose is not to support the cryptocurrency.

[00:10:38] Its main purpose is to run a decentralized world computer. So on this blockchain what you can deploy is, instead of just record keeping, what you put in these blocks are little computer programs. And so you can run computer programs there. And these computer programs can do a bunch of things. First of all, they can generate these tokens that we talked about before.

[00:11:03] So a token is just some digital piece that I can transfer to somebody else. And there is a record-keeping of who owns which token. And so we can use these tokens for many different things. So one example was the ownership to the digital art that we mentioned before. Other examples are there's finally this Filecoin coming

[00:11:26]live. So if you have some extra hard disk space on your computer, you can rent it out. You get paid for that using with these Filecoin tokens. And if you want to store something on the internet, you can store it on somebody else's computer also, and you pay with these Filecoin tokens. So we can think about this like a Dropbox.

[00:11:48] But it's not a central server or a company that's behind it. It's decentralized. So it gets spread out all over the internet. It's encrypted. So you cannot read what other people are storing on your computer and they can not read what you're storing. And so it's a safe way to implement something like a decentralized Dropbox.

[00:12:11] Art: And that's fascinating to me Alfred, because I think as someone in finance, where I struggle with Bitcoin is that individuals are comfortable speculating in it. And trying to aggressively grow and expand their wealth by investing in it. But not storing wealth in it. What you're talking about is eventually where Bitcoin becomes, or a cryptocurrency becomes, kind of like the defacto

[00:12:34] currency in a way through these types of systems. Is that what I'm clearly understanding or am I getting that okay?

[00:12:40] Alfred: Yeah, I think it's kind of a currency. A lot of these tokens are special purpose currencies to buy specific services. Like in this Filecoin, you can only use it to pay for storage, but there is active markets where you can try and translate this Filecoins to other cryptocurrencies or even fiat currency. So I think that is true that these markets will be more like currency based markets. There's a huge market for stable coins at the moment. So we have a lot of tokens that represent the value of the US dollar.

[00:13:20] And so this is a huge market out there that is growing very fast.

[00:13:25] Art: I think that's really important because the vast majority of people that are buying Bitcoins are not doing so because Bitcoin's removed the hardships associated with conventional money. What these are actually becoming, that's the real disruptive part that I find, you know, it's hard for me to say this in simple terms, but to connect the dots on these things, it's like it's allowing people actually to do different things based on the Bitcoin. And that's what's fascinating.

[00:13:52]Alfred: So there's new Ethereum based, mostly Ethereum based, tokens offer huge possibilities that otherwise you cannot offer. And this comes with these smart contracts where you can link those currencies or these tokens directly into smart contracts.

[00:14:12] So a smart contract is just a computer program that does certain things for us, and we see a tremendous growth in these smart contract based finance. So this is called DeFi, or decentralized finance, and we see a tremendous growth in this market. Many of the protocols there've been other rounds a year ago, and now they have billions of dollars invested in them.

[00:14:38] Rod: You mentioned that there was a lending platform. I think it's on Uniswap that's the lending market right now is in the 4 billion USD range. And that there's a crypto token market on the software side, that's a billion dollars. And I was fascinated by the fact that this is really, really new.

[00:14:55] Like this is not two years old, even. It's not even 18 months old. Where are these pockets of real commerce happening in the blockchain smart contract world?

[00:15:05] Alfred: Two leading landing platforms are Make and Ava. Between them, they have just looking up the stats today, they have over 12 billion US dollars invested in them.

[00:15:16] Rod: Wow.

[00:15:18] Alfred: And Ava was not around probably a year ago. So this is tremendous growth. And what is really important here is that these are just kind of, they're testing the waters. They're trying these platforms out and we will see once this goes mainstream if you have more stable coins, if you have tokens that are linked to a Canadian dollar, then anybody can also just go to these platforms and take out a loan.

[00:15:45] The system works. That's being proven today. We see this is already big, but once we see more mainstream assets entering this token world, once we can tokenize more assets, then we will see each as this technology being applied to these new tokens and it will grow tremendously.

[00:16:05] Art: And that's the critical point.

[00:16:07] Bitcoin in itself is just a means to an end. It's like investing in gold, but when you get to borrowing and investing against a crypto. That's where it gets really fascinating.

[00:16:16] Alfred: Yes.

[00:16:17] Rod: I think the way I've rationalized in my own mind is there seems to be two universes. There's the crypto currency universe, which is a Bitcoin related, trying to replace a fiat currency type of thing.

[00:16:29] But then there's this other platform, which is the plumbing and infrastructure and code that allows for a smart contracts to proliferate with tokens and coins, which has nothing to do with the currency side of things, but rather is intended to remove a lot of friction from traditionally very laborious transactions and has the potential to be massively disruptive.

[00:16:53] Is that the right mental model Alfred?

[00:16:55] Alfred: I think that's exactly right. So Bitcoin itself is like investing in gold and in a way it's stupid. You cannot really do anything with it, right? So it doesn't have any smart features, any utility. And in that sense, it's similar to gold. Gold does not have a lot of practical use cases. To these other tokens this world is really where the action is going to be. This is where the disruption is going to happen. So there is this token exchange, Uniswap, which is really huge. You can trade tokens against each other. They trade about a billion dollars worth of tokens every day, seven days a week.

[00:17:34] Rod: Wow.

[00:17:35] Alfred: And again, this was not around a year ago.

[00:17:39] So Uniswap was around a little bit longer than that, but it is not around like it's probably two years old. And I'm just looking a year ago it was trading about $11 million. And now it's up to a billion dollars.

[00:17:55]Rod: Huge growth.

[00:17:55] Alfred: This is tremendous growth in this area. And at the moment you can take trade descriptor tokens against each other, but once somebody like a JP Morgan or a large bank goes and says, well we'll take these stocks and build issue tokens against these stocks

[00:18:11] then you can start trading this stock tokens on Uniswap. And this offers tremendous opportunities there. So if you recently followed this story on why GameStop and how a bunch of kids on Reddit hyped up this stock on Robin Hood, then they're buying the stock. And eventually the frictions of the system became apparent.

[00:18:34] Robin Hood had to stop trading in the stock because it takes two days to settle an order in the current system. So if you buy a stock today, you put in a buy order until that order is settled, or finalized, it's two business days and Robin Hood and other brokers have to put up collateral for these two days.

[00:18:56] And there's such demand for buying the stocks and there's so much volatility that they didn't have the collateral to put up, to be able to allow users to trade the stock. So in the smart contract world settlement is instant and you don't have to wait for two business days for your transaction to settle.

[00:19:16] It just happens right now. And so this really improves the priming of our financial system. And this Robin Hood episode really showed where some of the frictions of the priming are that we have today. In the financial crisis we saw the frictions of the plumbing that we have. And so these new platforms really offer an opportunity to improve that and make it much more efficient.

[00:19:40] Art: Yeah. The Robin Hood is very interesting because really what they ran into was what they do is they lend their stocks out for cash. And at one point GameStop was 60% of the company. And so the people that were lending the money to them, the bankers, said I'm not going to take that risk. Where as in a smart contract that, you know, that would be a very different world. It just goes to how, like at a certain point, the regulated risk market comes in there and they make decisions which could impede a business. And that was fascinating to me as well.

[00:20:18] Rod: Alfred, who are the players right now that are transacting this billion dollars a day? Are they sort of, should we be thinking of dark

[00:20:25] net hackers in the back room with a hoodie? You mentioned Morgan Stanley mainstream. It's obviously not the mainstream people. It's distributed. The plumbing is not owned by anybody. It's open source. So who are the innovators? Who are the pioneers of these crypto markets?

[00:20:41] Alfred: The Uniswap was started by some guys at a hackathon, some conference, just put it up on GitHub and it's open source and everybody can use it. And now there is a lot of money invested into this and a lot of these things are small new innovative companies that start up. Often they think of themselves as not trying. Their main goal is not to monetize this, but to provide a system that is being widely used. And at the top that the investors in this space are all over. It's little small investors who buy into this. And there's also a lot of institutional money flowing into this. If you provide liquidity, or if you provide tokens for these markets, you can earn yields that are above the yields that you get if you invest in a lot of other assets. So this is just an attractive investment opportunities and the smart pools of money around the world have realized that you can earn 5%, 6%, 10% yield on providing this liquidity on Uniswap and providing this money that gets lent out on Maker or Ava.

[00:22:01] So there is returns here and people chase after these returns. And this is not just little small investors.

[00:22:08] Art: That's the most fascinating part, Alfred, to me is that you couldn't do that in the cryptocurrencies themselves. When you get into borrowing and storing wealth, that's when the wealth can multiply. And that's the most fascinating part because that is a new change.

[00:22:23] That is a fascinating new change.

[00:22:25]Alfred: And it offers really new investment opportunities. Right? So on Uniswap, for example, this is this token trading platform. This inventory, if somebody comes in and wants to buy some tokens, that has to come from these... tokens have to come from somewhere. So there's an inventory of tokens.

[00:22:42] So if you want to approach this market and want to buy some Bitcoin in this market, then these rep Bitcoin have to come from somewhere. So there's a liquidity pool that that has this inventory. Now, all the people that provide this inventory get a return for the service of providing this liquidity.

[00:23:03] Rod: You had indicated you're a liquidity provider.

[00:23:05] So how did that process work?

[00:23:07] Alfred: I have a whole $500 invested in this. Well, if I teach about this to my students, so then I have to do that myself. So far it's just been a very good investment. But we'll see how that goes.

[00:23:22] Rod: The janitors aren't talking about it yet.

[00:23:23] Alfred: Yeah. Well, they're starting to. So the way this works is that you have to buy these tokens that you want to provide for this inventory, and then you can give those tokens to Uniswap and you get a custody token in return. So this is like you go to a coat check at the theater and you hand in your coats and you get little kind of plain plastic piece in return that at the end of the day you can give the plastic piece back and get the coats back after the performance.

[00:23:57] So on Uniswap it works similarly. You hand over your tokens to the Uniswap smart contract and these entities trading inventory. And then at the end of the day, and whenever you want, you can just go and ask to have these tokens returned. And so then you can hand in your claim slip and you get whatever part of the inventory back that is there at the time.

[00:24:23] Art: So do you earn an interest rate? Is it a predetermined interest rate or do you get like, how does that work?

[00:24:28] Alfred: So on Uniswap everybody who trades on that platform has to pay a 0.3% fee. And so these fees go to the liquidity providers. So if there's more trading, then users can collect more fees on that. Now, of course, if you are providing liquidity, there's a risk always that the market moves against you if you're a market maker. So that fee is in part a compensational for that risk that you are the market maker and then you sell these tokens to somebody and then the market moves against you.

[00:25:04] Rod: If I'm a new entrant, I'm just trying to get this right in my own brain, you've indicated that there's roughly a billion dollars a day of liquidity on the Uniswap platform. And let's say I have a grand idea that I want to have $5 billion a day of liquidity. Do I need to come to the marketplace prepared to offer that liquidity with my service or will the fact that I put the service out organically see people come in and increase that liquidity? Is it a sort of, a prescribed necessity to bring liquidity with your business idea or does the market ebb and flow organically?

[00:25:44] Alfred: The market ebbs and flows organically. And we can see that people will come up with a cave idea are able to attract investors. So you have to decide the economics of the protocol, right? So that people who provide liquidity get a fair compensation and the people who trade on this get to pay a reasonable fee for that. There's trading. So the whole economics of designing these platforms can be a little bit tricky, but then you just put the technology out there and people will come and use it. And the great thing about this is that this is that it works like Lego. So this Uniswap where you can swap these tokens is one example. There's the lending platform, these lending platforms, they're also Lego pieces. So you can create your own smart contract that utilizes the services of these other platforms.

[00:26:37] You don't have to reinvent the wheel of how do we swap tokens against each other. You can just use Uniswap in your own program or in your own platform. You can build on these other existing platforms to build something on top of it. One thing, for example, we could try to do is to look, or what is happening now is to look at credit risk, so at the moment all the loans that are out there are collateralized. So what could happen is that we separate the credit risk and I could say, well if the borrower defaults then somebody guarantees for that loan. This way we can give out loans to people who don't have the collateral, say businesses, and somebody else can guarantee for that loan.

[00:27:26] So that might be that you know this person in the real world and then say, well, I know that this person is trustworthy. So I secured a loan in this cyber world.

[00:27:37] Rod: And you'd get paid in interest based on what your knowledge of the risk of the loan and you get paid the feed. Exactly. Cool.

[00:27:43] Art: So would the collateralized debt be better through a smart contract than a rating agency? Is that the real advantage here?

[00:27:51] Alfred: I think this smart contract offer a lot of... well credit rating agencies are usually biased. We know that they have huge conflicts of interest. They want their businesses to issue credit ratings, and they want to issue a lot of credit ratings.

[00:28:08] And of course they get more businesses if the issue of favourable ratings. So there's in the whole business model, there's an inherent conflict of interest. And we've seen that materialize in the financial crisis. So this smart contracts offer, in a way, a more efficient settlement. They offer a lot of opportunities that otherwise don't exist.

[00:28:30] And using these kinds of Lego blocks, I think we can create new platforms, new plumbing, that that in many ways is better, faster, more global than the existing plumbing that we have.

[00:28:44] Rod: So is this motivation for you to quit your teaching job and start a smart contract around credit rating?

[00:28:50] Alfred: I don't think so. No. I'm still interested mostly in the analysis of this whole market at the moment. And I love my job, so I don't think I'm going to go there.

[00:29:00] Rod: People will for sure. Yeah.

[00:29:01] Art: Can we dive into a bit of that? Like why? I mean, it's new technology, but how does an academic approach an issue like this?

[00:29:09] What do you look for? What are you trying to understand? You know cause I think that's something that people don't get in finance a lot that there's a tremendous amount of academic research on finance. Actually trying to answer the basic questions that investors are trying to ask. Why does this work?

[00:29:31] How does it work? So how do you approach an issue like this? If you can give us some insight that'd be tremendous.

[00:29:36]Alfred: A lot of the stuff that you read and this kind of crypto world is, Hey, that's great. We can now take over the world. And the old system is bad. And I don't necessarily think that the old system is totally bad.

[00:29:50] It has its issues but the crypto system has its issues too. So, there's always frictions in every system that humans build. So the question is how do the frictions compare and where is one system better than the other system? What kind of old problems do we solve? And two, we create a new, new problems along the way in this crypto world?

[00:30:14] And so when I look at this is to say, how does this improve the existing system? What can we do better with this technology? What other problems are being created with this technology? And I often think, what if everybody would use this, what problems would we see? And there's many problems that we see.

[00:30:34] I mean there's no perfect system, but I think that it will change a lot of stuff that we do today, a lot of the plumbing, a lot of the back office work. So this will create a lot of change.

[00:30:50] Rod: How much does the availability of high quality data impact what you are able to study?

[00:30:57] Alfred: This is a big challenge.

[00:30:59]So, and a big opportunity here. So the data and computing power that you need for this is tremendous. So I was talking to our Dean and he thought that I added an extra zero to the number when I said this is kind of the compute that I would like to buy because the kind of computing power that you need to analyze this data is really tremendous.

[00:31:29] So I'm in my research on Bitcoin, we produce about 300 gigabytes a week on data, and that is just running in the background on some cloud instance that that we get through a university research network, but that is approaching the limit.

[00:31:46]Rod: They're coming after you. The data cops are coming after Alfred!

[00:31:50]Art: Amazon's knocking on the Dean's door.

[00:31:52] Alfred: And this Ethereum data is also huge. These are billions of transactions. And if you want to do some research on this or analysis on this, you have to go and select very few transactions. A million transactions or 10 million transactions out of 10 billion or something like that kind of order of magnitude. And so this has to be really fast. You need really fast and powerful computers to take a look at this data. And so this is certainly a challenge and the data is growing a lot every week. And so this just gets bigger and bigger. So you really need to, through some serious computing power, add this to analyze the data.

[00:32:35] Art: And I think that's the main difference that people don't understand. If you're listening to some blog poster there's a whole different deal when an academic is doing research. They're pouring through massive amounts of data.

[00:32:48] Rod: It's rigor.

[00:32:49] Art: That an average person would never get access to. They may arrive at the same answer, but exactly like you said, Rod, the rigor of the analysis is fantastically better.

[00:33:01] Rod: And the peer review process after that everybody's throwing buns at your work to make sure that the data was accurate, that the math you used was correct. That the sample size wasn't biased. All of that stuff is , it elevates the trust or the standard of, and you know, the fact that Alfred gets published in these top finance magazines that gives the world faith that other super smart people with bigger computers because they come from wealthier schools or whatever it is, have looked at your rigor. I'd like to change gears just a little bit, Alfred, help us understand this competition and your work with the Bank of Canada. Because I think the Bank of Canada stuff is really important to us as a nation. And to everybody who's wondering about fiat currency, and if you haven't heard of the term fiat currency, all it means is a country's currency. Like the USD, like the Canadian dollar, where a central bank controls the amount of money that you have, they can produce money, they can reduce money.

[00:33:54] That's the traditional fiat currency model. Where these crypto platforms now are, with Bitcoin as the primary example, forcing central banks and the other banks of the world to try and think, how do we evolve into this space? So if you could just tell us a story about the competition, how you got to the table and give us some insights around what's happening at the Bank of Canada.

[00:34:16] Alfred: The Bank of Canada is reaching out to us and over 20 other universities across North America to participate in this challenge. And they, like all the other central banks around the world, are looking at the possibility of introducing a government issued cryptocurrency. And so there was a competition with several rounds of selection, and we were one of the three universities to be selected for this. So I've worked together with Kyoung Jin Choi from the business school and three colleagues from the computer science department. And this was a really great collaboration, interdisciplinary work, to come up with a proposal of what we think a Canadian cryptocurrency should look like. I think the Bank of Canada is doing really great job here at talking to the universities to get different perspectives. I think it's important to have different thoughts here and different ideas. And academics like to think a little bit outside of the box to come up here with a really good system in the end.

[00:35:19] So it was really interesting to be part of this competition and our report came out a few days ago. And so it's now officially out there on the web and this has huge potential. Every central bank, every country around the world, is looking into this. The Chinese are pretty far ahead. They have started massive trials of central bank digital currency with the population and they're probably the ones that move first on this. But every country, at some point in time, they'll come up with this. And this is great for many reasons. So at the moment we have two stable coins that are issued by private companies, but we very often don't really know how trustworthy they are. So they say, well, for every token that we issued that represents the US dollar, we also have one real US dollar in a bank account somewhere. Okay.

[00:36:15] Rod: I trust you.

[00:36:16] Alfred: I trust you. Right. Is this really true? Right. So I mean, if a bank says that we know that banks are audited by auditors, they are audited by the government. We can trust banks and still sometimes even banks fail. But for the most part, those are pretty trustworthy.

[00:36:34] There's a bunch of regulation and security and safety net around that. But these companies we just have to take the word for it. And so it's very often not clear whether this is true or not.

[00:36:45] Art: This is what's fascinating to me. I mean, central banking was invented because free banking doesn't work. So you're literally going in talking to central bankers who say these type of systems are highly unstable, prone to bank runs, severe liquidity crises. How are they handling that?

[00:37:01]Rod: Sorry, which type of systems Art? The new crypto systems?

[00:37:03] Art: The new cypto systems. Like a fractional economy or fractional banking. I mean, central bank stepped in because they literally said those things don't work.

[00:37:11] Alfred: And in most countries if you go way back in time bank notes were issued by banks. Private banks issued notes or slips of papers.

[00:37:20] Oh, trust us. This is worth the dollar. And sometimes this works, but as you've mentioned, this created all these huge crises and problems. And so I think this will fail again, and this is a huge concern, so I can understand the central banks want to come in here. And these tokens being issued by an entity that we all trust in. Where we can make sure that yes, this is backed by the Canadian Government and by the Bank of Canada. And this is a trustworthy token where we know that this has some value to it. The same way we trust the Canadian dollar instead of a private company issuing it open where there might or might not be enough backing there.

[00:38:05] So I think this offers great possibilities. We do see that cash is in decline in general. Many businesses... I was in Denmark before the pandemic, giving a talk at the university. And when I walked around a lot of coffee shops or shops would not accept cash anymore. They would just take electronic payments.

[00:38:25] Rod: Well, and COVID boosting our tap limits has been, you know, one of the unintended consequences that was a bonus from my perspective, right?

[00:38:32] Alfred: I think that cash is at some point in time going away and you have to be ready for that. But in our proposal, I think what we try to emphasize is that you could do so much more with this technology. You can really build the same way with use the smart contracts on the Ethereum platform today, you can use the same kind of smart contracts on a central bank digital currency platform.

[00:38:57] So we can settle trades and stocks with smart contracts. And we don't have to go through a cumbersome process as we have today. So when you buy a house, for example, today you have to deposit your money with a lawyer or else there's an escrow, it's a certified check. It's complicated. It doesn't happen very often, but occasionally the lawyer runs away with the money.

[00:39:20]Art: Yeah. It goes into their personal trust.

[00:39:23] Alfred: And so you can automate this with central bank digital currency, and you can run this on a platform where you can give your cryptocurrency to a smart contract. The smart contract talks to the land registry. Once the title gets transferred, the money gets paid, at the same time you can take out the new mortgage, repay the old mortgage with that. So it could all be automated. And this could create a lot of benefit for everyday Canadians, but also for the whole economy. It would simplify a lot of processes that we do today that are cumbersome and require a lot of back office work. This could be structured in a much more efficient way on a smart contract platform.

[00:40:05] And what you need for this is a kind of medium of payment. So you can build all these smart contracts. In the end what you want is you want to pay real people in real money. And so that's a little bit the part that's missing today in this whole ecosystem that we don't have any form and efficient way or a good way to pay people with real dollars. So this is where the central bank digital currency could come in and fill that gap. And this could really boost the whole system and cause a lot of disruption and an improvement in efficiency.

[00:40:38] Rod: In our warmup call Alfred you had mentioned though that the approach that you guys took it at the UFC at Haskayne and the collaboration was different than the other players in that you didn't want to see the central bank have all of the power and that the necessity for the other, you know, the big six banks that are in Canada from a distribution perspective. Can you help us understand your thinking around that component? Cause I thought it was quite fascinating.

[00:41:02] Alfred: A lot of the central bank digital currency proposals that exist today see this as more or less electronic version of cash. Now if everybody in Canada would hold all their savings in cash dollars, this would be very bad for the economy because we need to deposit the money with the banks the banks give out loans to companies. Those companies create jobs, they keep the economy going. So it's really important that we don't freeze out the bank from this system. And our proposal's very important point is to include the commercial banks in this CBDC proposal, that there's a seamless transition that you can always deposit your central bank digital currency in a commercial bank. The same way we go to the bank branch today and deposit a hundred dollar bill into our checking account.

[00:41:57] We think this is a really important step to preserve in this new digital world, because the banks need the deposits to give out loans to sustain the economy. If everybody would just hold their money directly with the central bank, that would be very safe, but it would cripple our economy. And that is not a very good thing to do.

[00:42:19]Rod: I always find myself going to the bank to take out money, not to put the $100 back in.

[00:42:24] Alfred: Somebody has to put in the money that you take out.

[00:42:28] Art: But that's the critical point isn't it is, is that it isn't a debit card. That's the way the governments would want to look at it. But it really is that the smart contract becomes a borrowing and investing vehicle and a store of wealth.

[00:42:41] And if someone could back that, then it really transforms things. That's what the most fascinating part is here because currently the trustworthiness of that store of wealth is up in the air. But for the economy to work off this type of platform, it has to become a boring investing vehicle. And that's what these new exchanges are just fascinating to me about.

[00:43:03] Alfred: Yeah. We definitely need some kind of government involvement here to, first of all, coordinate a little bit, these kind of smart contract so that, you know, proposedly, we emphasize that ideally this would run on every bank that you could deploy the same smart contract to do a certain thing for you on whether your money sits with Bank A or Bank B.

[00:43:27] This is how you can generate this efficiencies. And you also need the trust in the bank of Canada. So that people can really be confident in using that and that we have this means of settling these financial claims in a trusted, inefficient way.

[00:43:42] Art: Yeah. It takes out so much of the frictional costs when you think of it.

[00:43:46] Alfred: Yes.

[00:43:47] Rod: With the providers right now that are saying that they've got a dollar in reserve, there's an amount of trust there, so I think we have high trust in the technology and the crypto and the smart contract. But what I'm hearing you saying is that we need to have a government step into make this become mainstream part of the economy.

[00:44:04] I'm interested though, it beckons, what is the regulatory environment with these private systems right now? Are they regulated? Is it kind of the wild west? How does that whole financial market system that's in the crypto or in the blockchain smart contract world work from a regulatory perspective?

[00:44:21]Alfred: This is the total wild west out there for the most part.

[00:44:24] So it's just really, there's no rules whatsoever. If you're not careful you get robbed. If you read about, it's interesting to follow these discussions on Reddit. So if somebody exploits a weakness in a smart contract and kind of takes $10 million out of that, some people say, well, that's bad. This was a hacker.

[00:44:48] That it's a bad thing. And the other people you hear saying, well, it was stupid for them to write such a piece of code that doesn't work. So they did the right thing. It's in a way, a really wild system out there. We see that some entities that operate in this space seeking regulation, they want more regulation.

[00:45:08] They want to check themselves to regulation because this increases trust in the system. They've understood that, but there's a lot of players that also in that space don't like regulation, that don't care about it. And so this is of course a concern. I think this whole privately issued money is a bit of a problem because the closest

[00:45:34]example in the existing financial world today is our money market funds. They also take your money, give you the certificate for it and invest your money in short-term assets. And they are regulated. They are run by professional companies, but we still saw that some of these money market funds broke in the financial crisis and the US government stepped in and bailed them out.

[00:45:57] And so even if companies tried to do this properly, I think there is an inherent weakness in this idea of privately issued money. And that's why eventually this went away before this recent episode, we didn't really have a lot of countries where private money was issued. And so I think that eventually the government has to come in and issue a government cryptocurrency that we can use.

[00:46:25]Art: But the attraction, to your point Alfred, of this whole system is what the one party is saying there, if you're stupid, you pay. Whereas the current system, unfortunately, because of regulation and political interests, the collateralized debt was stupid. And it got bailed out by the tax payers. And this is the whole issue. Has Bernanke opened the Pandora's box, where if you're stupid and have an asset that doesn't pay, it used to be taken behind the woodshed and you got shot.

[00:47:02] Now, if an asset fails, the government keeps bailing out what would be stupidity. So the market never clears. So there is, there is an argument to both of these sides of the equation.

[00:47:16] Alfred: Definitely. That's true. I mean I totally agree with you that this creative distraction that is so important to capitalism has been absent in many ways because the government bails out certain segments of the economy based on political pressure.

[00:47:34] Art: That's not capitalism anymore.

[00:47:36] Alfred: That's not capitalism anymore. So capitalism needs this creative distraction to some degree, if you're stupid, you have to, you have to go bankrupt. And that's good because it eliminates a lot of, we learned, that certain things don't work. It creates discipline in the market. And that's what capitalism is about. And too much intervention here, bailing out failing technologies, bailing out failing business models. It's distorting the market and that's not always good.

[00:48:07] Rod: Fascinating. Well, Alfred, unfortunately our time's up. I'm sure we could spend the next couple of hours in deep discussion.

[00:48:13] It's just such a treat for us to have someone of your caliber with such a depth of knowledge in this area that's new and up and coming. A couple of takeaways for me that were really important from your message is oh, my gosh, like hanging on to the guard rails. This is happening fast. A year ago, 18 months ago, there wasn't markets out there and crypto markets are here.

[00:48:36] They're trading in the billions of dollars. And DeFi is going to change how things work no matter what goes on in the world. The second takeaway for me was just really nice insight. Like at SmartBe we talk about academic rigor and we talk about transparency and the ecosystem seeking truth.

[00:48:57] You really brought that to ground zero for me today in, you know, the conversation about having to go to the Dean for a computer that's way more expensive than anybody could have ever dreamed. And just the amount of data that's out there for you to do the type of analysis that provides that rigor that your peers can look at and get published in the big journals.

[00:49:17] So thank you for that takeaway. And the last piece for me was the wild west, trust, regulatory. This has to move into the, like, I mean, the trajectory to me says that this has to move into the mainstream. And it may not be in six months. It may not be in a year or two, but the fact that there is so much friction in some of our existing institutions and infrastructure to me really means that there is going to be disruption in a whole brave new way of doing things.

[00:49:44] So thank you so much Alfred. This is Modern Investor Journey. My name's Rod Heard, I've been with my co-founder and partner Art Johnson. We've been talking with Dr. Alfred Lahar who's associate professor in finance at the Haskayne School. Thanks so much Alfred, we really enjoyed our day.

[00:49:58]Alfred: Thank you so much. This is really great. And you're really doing great work at SmartBe. So it's really a great pleasure to be on this podcast. Thank you.

[00:50:05] Art: Thank you, Alfred. It's lovely to have this intersection between the academics and the real investors that we're trying to build and get the work of people like you out into the mainstream. And really help investors to bridge that kind of knowledge that there is this deep body of research, as Rod said, that is actually looking to answer the same questions that average people are asking.

[00:50:27] And not just the narratives they would hear from financial intermediary that there's some real value in that. So this is wonderful having you on.

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