Economics and Technology of Financial Innovation

GENERAL INFORMATION

  • Stay updated on the business/finance news and check how the markets are doing during the course. (See for exampe Yahoo Finance)
  • Prepare the exam using the slides and the associated material – the slides alone are not enough for a deep understanding of the topics.

Teaching Assistant:
Davi Marim (davi.dealmeidamarim@telecom-paris.fr)

Grading
Problem sets 50%
Exam: 50%

PROBLEM SETS

  • Form groups of 4-3 people to solve the problem sets together.

  • Theory exercises can be handed either in Latex or as pictures of paper documents.
  • Programming and empirical exercises can be done in any language (preferably in Python whenever possible).
  • Business cases can be handed in Word.
  • Groups can manage a private Github to store the solutions to the problem sets.
  • All problem sets are due on Monday April 20th.

PS1
PS2
PS3

LECTURES

LECTURE 1. The Landscape of Digital Finance
Slides L1

Readings:

  • European Central Bank (2024). Study on the payment attitudes of consumers in the euro area (SPACE). ECB.
  • Bank for International Settlements (2022). Payments and digital money. BIS.
  • European Central Bank (2022). Neobanks: Business models and financial stability implications. ECB.
  • Ahnert, T., Hoffmann, P., & Monnet, C. (2022). The digital economy, privacy, and CBDC. ECB / CEPR seminar paper.
  • Nagel, R. (1995). Unraveling in guessing games: An experimental study. American Economic Review.
  • Frost, J. (2020). The economic forces driving fintech adoption across countries. BIS Working Papers No. 838. Bank for International Settlements.

Sample Balance Sheets

Markets:
https://coinmarketcap.com/
https://polymarket.com/
https://www.justetf.com/

LECTURE 2. Money
Slides L2

Readings:

  • Kiyotaki, N., & Wright, R. (1993). A search-theoretic approach to monetary economics. American Economic Review, 83(1), 63–77.
  • Williamson, S. D., & Wright, R. (2010). New monetarist economics: Methods. Federal Reserve Bank of St. Louis Review.
  • Lagos, R., Rocheteau, G., & Wright, R. (2017). Liquidity: A new monetarist perspective. Journal of Economic Literature.
  • Lagos, R., & Wright, R. (2005). A unified framework for monetary theory and policy analysis. Journal of Political Economy.
  • Kocherlakota, N. R. (1998). Money is memory. Journal of Economic Theory.
  • Fernández-Villaverde, J. (2018). Cryptocurrencies: A crash course. University of Pennsylvania, lecture notes / working paper.
  • McLeay, M., Radia, A., & Thomas, R. (2014). Money creation in the modern economy. Bank of England Quarterly Bulletin, Q1.

Handouts:
Poisson Process in Search Theory
Kiyotaki-Wright Model

Other resources:
Nash Bargaining

LECTURE 3. Blockchain: Cryptography and Nakamoto Consensus
Slides L3

Readings:

  • Nakamoto, S. (2008). Bitcoin: A Peer-to-Peer Electronic Cash System. Self-published whitepaper.
  • Back, A. (2002). Hashcash – A Denial of Service Preventive Measure. Mimeo
  • Biais, B., Bisiere, C., Bouvard, M., & Casamatta, C. (2019). The Blockchain Folk Theorem. The Review of Financial Studies.
  • Guo, D., & Ren, L. (2022). Bitcoin’s Latency–Security Analysis Made Simple. Proceedings of the 4th ACM Conference on Advances in Financial Technologies (AFT ’22).
  • Haber, S., & Stornetta, W. S. (1991). How to time-stamp a digital document. Journal of Cryptology, 3(2), 99–111.
  • Merkle, R. C. (1987). A Digital Signature Based on Conventional Encryption. Advances in Cryptology — CRYPTO ’87
  • Koblitz, N. (1987). Elliptic curve cryptosystems. Mathematics of Computation
  • Miller, V. S. (1985). Use of elliptic curves in cryptography. Advances in Cryptology — CRYPTO ’85, 417–426.

Books:

  • Shi, E. (2020). Foundations of Distributed Consensus and Blockchains – Chapter 14. (online)
  • Narayanan, A., Bonneau, J., Felten, E., Miller, A., & Goldfeder, S. (2016). Bitcoin and Cryptocurrency Technologies: A Comprehensive Introduction. Princeton University Press.

Other resources:

Julien Prat’s course on blockchain: https://sites.google.com/site/julienpratecon/teaching/blockchain?authuser=0

Example of ECC:
– elliptic curve over the reals
– elliptic curve over prime field
– attempt to guess the private key from public key and generator

LECTURE 4. BFT-Blockchains, DAG-Blockchains, and Scaling Solutions
Slides L4

Other resources:
Presentation on Ethereum

LECTURE 5. Trading, Hedging, and Market-Making
Slides L5 PART 1

DIARY:


Day 1

The digitalization of finance:
– shifts in payment methods, market volumes, business models
– new actors in the financial economy (bigtech, fintech, wealthtech)
– financial innovation and financial inclusion
– business model and balance sheet  
– attention markets: meme stocks, meme coins
– information markets: polymarket

Asset values and coordination games:
– the Keynesian Beauty Contest game (experiment guess 2/3 of average)
– Nash Equilibrium of the Keynesian Beauty Contest

Basic economic notions:
– equity, debt, stock, bond, asset, liability
– long position, short position, strike price, spot price
– inflation, nominal value, real value
– discount factor, discount rate

Money:
– historical examples of monies
– money as unit of account, medium of exchange, and store of value

Money as a Network Good:
– first encounter with the Kiyotaki Wright model
– conditions for sustaining money exchanges
– coordination failure and multiplicity of equilibria

Day 2

– Recap on definition of money

– Kiyotaki Wright (KW) model basics (2 periods)

– WK with single coincidence meetings in discrete time:
— model definition: agents, payoffs, states, distributions, value functions
— From discrete time to continuous time
— Equilibria of the KW model (non-monetary, monetary, and mix)
— Welfare calculation in the KW model

– Poisson process in continuous-time search and matching models
— Poisson distribution
— Exponential random variable
— Minima of exponential RVs
— Probability of state arrivals
— Derivation of the Bellman equation (Value function in recursive form)

– KW with double coincidence meetings and barater
— model definition,
— equilibrium,
— welfare

– KW with idle producer state (V0, Vg, Vm)
— value function
— steady state balance equation
— equilibrium system


Day 3

Money creation (modern system)
— narrow vs broad money (cash/reserves vs deposits)
— “loans create deposits” (bank balance sheet expansion)
— constraints on lending: reserves/settlement, funding cost, regulation, default risk

Policy rates and the role of the central bank
— central bank sets the price of money (policy rate), not a money quantity
— ECB rate vs Euribor (interbank)
— nominal vs real: r≈i−πr \approx i-\pi
— quantity-theory rule of thumb: MV=PYMV = PY

QE and “whatever it takes”
— zero lower bound
— quantitative easing: central bank buys assets to inject liquidity
— Draghi “whatever it takes” as commitment moment

Private money / crypto motivation
— distrust in discretionary money + account control (freeze/censorship)
— “digital gold” idea (scarcity narrative)
— policy debate on crypto

From toy coins to blockchain
— GoofyCoin: signatures work, but double spending is possible
— ScroogeCoin: central ledger fixes double spending, but centralizes power
— distributed consensus problem

Bitcoin / Nakamoto consensus (3 rules)
— proof-of-work: find nonce s.t. H(⋅)<DH(\cdot) < D
— longest-chain rule (resolve forks)
— confirmations: wait k blocks for finality

Crypto tools used
— hash functions (tamper-evident chaining)
— Merkle trees (logn verification)
— public-key signatures (ECC)

Incentives + security preview
— miner income: block reward + fees (later: MEV)
— security intuition: honest vs attacker “Poisson race”; deeper blocks harder to rewrite

Day 4

– Recap on blockchain as decentralized money and record-keeping
-– Blockchain infrastructure
–— public-key infrastructure: public key, private key, signing, verification
–— double spending problem
–— hash chaining of transactions
–— SHA-256 and immutability

– Economics of blockchain
— why miners / validators participate
— block rewards and transaction fees
— Bitcoin as deflationary “digital gold”
— Ethereum and alternative tokenomics

– Recap of Nakamoto consensus
— proof of work
— longest-chain rule
— confirmation rule

– Blockchain security
— Poisson race model (honest chain vs adversarial chain)
— notion of probabilistic security
— 50% threshold intuition
— Probability tools
–— Moment generating function
–— Markov inequality
–— Chernoff bounds
–— exponential tail bounds
–— Random walk
-– Formal security properties
–— liveness
–—– chain growth
–—– chain quality
–— consistency / safety

– Financial markets recap
— asset classes: stocks, bonds, currencies, commodities
— indices and ETFs
— yield curve