Written by James, NEST Community CoFi Researcher
What is the difference between centralized assets and our real-world assets? The difference is that the decentralized assets formed cannot be replicated by large categories of assets in the real world. It is impossible for you to copy the risk-return structure of decentralized assets with existing large-scale assets.
So from the perspective of finance, what is finance to do? In general, it is to deal with various uncertainties of human beings. A risk-benefit structure corresponding to each uncertainty. Whenever you discover a new risk-return structure and make the corresponding assets or products, it will definitely eliminate the risk of all human beings in asset allocation.
The most simple and easy to understand is in the volatility risk. For example, Markowitzs asset portfolio theory, if two unrelated assets are put together, their volatility can be reduced without changing the income structure, and the purpose of improving investment risk can be achieved. The goal of decentralized assets is to eliminate uncertainty for all human beings.
Credibility and Availability
There are two variables here, one is called credibility and the other is called usability. Usability is the removal of uncertainty from the common man. Credibility is the removal of human uncertainty. BTC does not spend money on usability, but spends 20 billion electricity bills every year to solve the credibility problem. So, who will solve usability? It may be solved by Bitcoin holders. They promote Bitcoin to ordinary people, so that those who do not understand Bitcoin can understand Bitcoin. The purpose of Satoshi Nakamoto creating Bitcoin is to propose a new risk-return structure to eliminate the uncertainty of the entire human race.
In the entire decentralized market, as long as a centralized institution is introduced, your risk-return structure is similar to that of equity to some extent. This is equivalent to copying a bitcoin + equity, and does not create something new. This is why I want to make the project so decentralized. Here we also want to mention DeFi, which has been particularly popular recently.
The current problems of DeFi: first, the risk of the project is unquantifiable and uncalculated; second, it is difficult for DeFi to deposit centralized assets on the chain. If centralized assets cannot be deposited on the chain, this DeFi project may eventually become a computing contract. The calculation contract means that no matter how you calculate, the amount of information will not increase. Computing is all about encoding messy information into something understandable. In the process, it does not eliminate the uncertainty of human beings, although it may eliminate the uncertainty of some specific groups of people.
asset pricing
asset pricing
Similar to many problems in our real world, asset pricing is also a difficult problem. For example: how to design traffic lights? Optimal transportation network problem? The optimal social network problem? Optimal business network problem? These issues related to the network are complex issues.
Asset pricing is a calculation problem of optimal price. This problem cannot be solved by P calculation. Ethereum cannot price assets with smart contracts. Therefore, without an oracle machine, Ethereum can only do these three things: transaction (Uniswap), stable currency (USDT), and ETH-wETH mutual conversion. This is determined by the limitations of the p function.
Considering that complex calculations such as asset pricing are difficult to complete on the chain, a new mechanism must be formed to approximate this result. So we built such a plan: how to approach this price if there is no external market; or how to pass this off-chain price up when there is an external market.
If there is a calculation result of the NP problem on the chain, it increases the amount of information and provides brand new information for the entire ecosystem. The important thing is that it constantly expands the boundaries of the blockchain. Only when the boundaries are expanded can it truly become a substantial progress. If the entire network only progresses horizontally, such as faster programming and larger blocks, this is not a substantial progress. In fact, many of our cognitions about the blockchain need to be adjusted.
In terms of eliminating human uncertainty, it is not necessary for everyone to verify the ledger. We just need to open it up so that everyone can have the power to verify the ledger. Analogy to Layer1 and Layer2, Layer 2 is to eliminate the uncertainty of ordinary people, while Layer1 is to create new value, developers can discuss how to increase the block size, improve packaging time, etc.
So, in this context, what does NEST do? The first one is that NEST will form more and newer decentralized risk-benefit structures. The second is that it needs to expand the functions of the blockchain, so that things that could not be done on the original blockchain can now be done. Of course, all of this must remain decentralized.
When referencing NESTs oracle machine, a series of by-products are produced. The first very important by-product is making risk calculable when quoting prices. After the credit risk is stripped, the whole calculation result is relatively more accurate. The credit risk here mainly refers to the subject risk after excluding the project risk. Subject risk is generally difficult to calculate. For example, how much cash flow this project can eventually generate and the probability of failure can be calculated and analyzed, but the question is what if the main body absconds? In fact, this reflects the incompleteness of the system.
After the blockchain strips off the credit risk (in a decentralized way), only liquidity risk and volatility risk remain. Since liquidity is a natural advantage of the blockchain, it will not be discussed here. Volatility risk is calculable, and it has a strong theoretical basis. In fact, in the 1970s, Samuelson, Black, Merton, Fama and others put forward relevant financial ideas: historical models have studied this risk so thoroughly, and these risks can be priced. Cant these risks be managed automatically?
Then these ideas were learned by hedge funds, and many new investment models and risk management models were formed. The most typical is the long-term capital management company at that time. Although they built a very sophisticated model, they ultimately lost on the incalculable subject risk: Russia defaulted.
Now we are all talking about Alpha Go defeating Go and other artificial intelligence topics. In fact, this dream existed in the Turing era. Despite the fits and starts of AI development, the dream lives on. While computable models are subject to subject risk, there is no such risk to worry about in the decentralized blockchain space (at least logically). In the absence of credit subject risk and market inefficiency, it is possible to make risk management algorithmic, which is obviously much better than the era faced by long-term capital management companies.
Can risk management be calculated on the chain?
In fact, DeFi simply means transactions, interest rates, and positive securities/negative securities. These three structures are a very rough division of finance.
There are two most important things in a subject: one is the basic concept. Discussion of each basic concept may take hundreds of years. And the formation of each concept has to go through a lot of tempering. The second is that this concept must promote the formation of the theoretical commanding heights in this field. If the theory equals common sense, the discipline would be meaningless.
When Satoshi Nakamoto designed the blockchain architecture, functions such as computing/storage/communication and related technologies were available. At that time, the digital currency had to solve the double-spend problem, that is, money used once, cannot be used a second time. In fact, zero-knowledge proof/homomorphic encryption schemes have been discussed, but they cannot solve the double-spend problem. Decentralization is not only distributed, it does not mean that I assign the work to you, but let you upload something consciously and combine it automatically.
Looking at it now, the structure of Bitcoin is a bit inefficient: it is very redundant in terms of computing, information storage, and communication. Redundancy refers to multiple computers performing the same computation repeatedly and storing the same data repeatedly. Redundant architecture will make it difficult to complete matching transactions (that is, asset pricing is very difficult), because it is difficult to solve by functions or voting.
From the perspective of the market, matching transactions is the acme of information interaction in the modern economy. Transactions are not suitable for matching on the chain. In other words, once matching transactions are available on the chain, the advantages of off-chain exchanges will be even greater. Its a matter of comparative advantage.
What types of traders are there in the micro-market structure of matchmaking transactions? The first level is called insider traders, the second is information traders, the third is market makers, the fourth is value traders, and the fifth is noise traders. Here we will focus on information traders. An information trader means that the information obtained by the owner has an advantage, and he must discount the price of the asset based on the information he has at all times. For example, every time he receives new information, he will tell you how much the price has changed. These information owners have the most extreme desire for transactions and requirements for computing, storage and communication, and are also the main providers of exchange volume and liquidity.
For example, high-frequency traders on American exchanges are accurate to the nanosecond level, and they must continue trading outside when the exchange is closed. Because they feel that the information is constantly changing, and they have an information advantage, they must price assets every moment. For such people, exchanges with computing, storage, and communication advantages are more suitable for them. For example, any asset that has value on uniswap will also be moved to the centralized exchange, because information traders want to profit from this, they have greater advantages here, and are more willing to provide more Trading and Liquidity.
Suppose there is a price sequence off the chain, how to form it on the chain?
Since there is no advantage in pricing on the blockchain, we feel that price calculation should be formed off-chain. The blockchain system is not to make you more efficient, but to make you more credible. Assuming that there is a price sequence off the chain, how to generate this price sequence on the chain and keep it true?
The first is that the verification and generation of data must be decentralized.
The second is to ensure that these two prices do not deviate.
The third is that the generation mechanism cannot be influenced by others.
The fourth is that there will be a delay in the generation of all price sequences, unless you have a price in each block. The delay here refers to the latest effective price and the block interval between calling the price and completing the transaction.
When you call off-chain data to on-chain, the first thing that will happen is the price deviation. And this deviation is the possibility of arbitrage by off-chain copyable transactions. At the same time, the delay will indirectly affect the price deviation, because the prices corresponding to different times must be different. At present, none of DeFis oracle machines has risk management on these two points. In fact, when you operate on uniswap, the market maker bears the risk of price fluctuations and the risk of being arbitraged by others. The question is how big is this risk and can the fees charged by market makers cover this risk? At present, the model of this type of oracle is still in a relatively rough stage.
The formation of the external equilibrium price is an NP problem (non-polynomial time problem). What Uniswap does is a P calculation (this type refers to a polynomial time problem: give me an X, and I will output a Y to you). So in this case, when the market price fluctuates, it will definitely be arbitraged by others. If you ensure that the gains can cover the losses, you can form an equilibrium; then you also need to ensure that the equilibrium is stable, and you cannot start to deviate because of disturbances, and you cannot cover the losses, otherwise the market maker will withdraw.
When off-chain information is uploaded to the chain, there will definitely be price deviations, so how to optimize this price deviation? Because it is very difficult to minimize the price deviation, we thought that the price deviation must be less than or equal to the arbitrage cost. Therefore, the mechanism of the NEST oracle machine includes two-way options/price chains/Beta coefficients. The Beta coefficient is to fight against self-transaction attacks. The price chain means that the information flow can exist forever. The two-way option is a quotation mechanism. There is a verification cycle, which is mainly used to fight against blocking attacks. Otherwise, it can be as short as possible in theory. , and converge to the equilibrium price.
There are two costs that the oracle machine must include, one is the gas fee, and the other is the hedging cost. Chainlink is used before verification, and Nest is verified before use. How many problems are there in first use and then verification? The first problem is that it will definitely have a non-peer node at that time. It will definitely encounter the problem of centralization. If you mortgage assets here, there must be a centralized object as the punishment executor. The second is the mismatch in the scale of downstream risk mortgage assets. It is impossible for 1 million US dollars to support a 1 trillion US dollar project. Even if there is no motive for doing evil, downstream users will worry about the risk of doing evil.
Our society requires completeness. For example, the law supports the first use and then verification (punishment) mechanism. But the blockchain cannot be processed in our traditional way. We have to verify it before using it, and control the risk of errors before you use it. What is the verification mechanism cost in NEST? That is, after the verifier is arbitraged, he has to provide a double quotation, that is, the verification cost is Beta coefficient * two-way option (here beta = 2). The cost of arbitrage is equal to gas fee + hedging cost + Beta coefficient * two-way option.
So, what is the cost of arbitrage? After we made statistics on the price deviation of NEST, we found that the cost of arbitrage is about 4 per thousand. This statistical arbitrage is not an absolute arbitrage, but a calculated probability for a fixed price under market price fluctuations. According to the current volatility of Ethereum, the probability of being arbitraged is about 7%. That is to say, out of 100 quotations, about 7 were arbitraged, and the actual detection is about 2-3.
Jamming attacks are the first variable. (The so-called blocking attack is to use transactions to occupy blocks, so that other transactions cannot be packaged.) The oracle machine needs to verify 25 blocks to prevent blocking attacks. The entire Ethereum miner community has gradually begun to consciously start. Whenever a dust attack or a blocking attack is launched, the miners know that you are malicious and will choose not to pack it for you. The choice of miners to pack or not is a correction to the imperfection of the system, because it is undefined by the protocol.
Second, the verification cycle and volatility determine the cost of a two-way option. The verification cycle and volatility that cannot be bypassed by any verification mechanism. When this volatility rises, the price deviation of NEST will become very large. For example, on March 2, the volatility reached three thousandths. A volatility of three thousandths is equivalent to forty or fifty times that of A shares. Under this volatility, normal investors do not know how to predict and control it, and are often helpless. At this time, the design of financial products should be based on the information flow on the chain, rather than staring at the off-chain.
In fact, the mechanism of two-way option + price chain + Beta coefficient can be used in traditional finance. It puts the smartest information traders and arbitrageurs together for pricing. If you put the brightest minds together, you dont need as many people involved in pricing.
The second variable is latency. The delay is reduced by the incentive mechanism in the NEST system. If the price of NEST remains unchanged, and every quotation of one block becomes a quotation of two blocks, it means that your income has doubled. No matter how it is blocked, as long as the price of NEST does not fall much, there will always be people reporting it, because the yield is too high.
There will be a layer of risk protection when market makers quote NEST prices for transactions. This risk protection can ensure that the market maker will not lose the final expected profit during the transaction process. Because this price will fluctuate, no matter how it fluctuates, market makers may be arbitraged by others. If the oracle machine puts this price compensation in, and then does not lose money when the two parties conduct long-term transactions, then the two parties are suitable. If the market maker does not use this risk function for protection, the transaction price will deviate greatly, and it will keep losing money until it exits.
That concludes our discussion of Computable Finance and DeFi Oracles.
