Lecture 10: Designs of Financial Infrastructure Utilizing Encryption

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ROBERT TOWNSEND: So today, I'm going to give this application lecture using encryption. So Sam and I have been working on market making, combining economics and computer science, and Sam's going to present that on Thursday.

Looking forward to it. All right. So today, designs of financial infrastructure utilizing encryption, and I'm going to go through three examples today varying in detail.

One is an auction, which is a familiar setup, but we'll be encrypting it. Then I have this what I call hybrid credit and insurance, having to do with insurance against balance sheet shocks in various contexts.

And then finally, a market implementation using encryption. So first, we'll do the auctions. So auctions are used frequently, but they're typically organized by a third party.

And the example here is Mortgage Capital Trading's use of a trade auction manager. Worrying that perhaps this slide was a bit out of date, I checked this morning on the web, it's alive and well.

So Mortgage Capital Trading is still being used, as are many of the others. But trusted third parties like Mortgage-- the trade auction manager there are not always needed, and in fact, they're not always beneficial.

So what are called these "bid-wanted-in-competition" dealers are asked to bid on a list of securities.

Not necessarily securitized mortgages in the first example, but much more generally. And there's a typical, as you could imagine, abuse, or at least potential abuse, where the auction manager is on the phone, he's the seller of the asset, so he has an interest in making the price high, so he calls buyer A,

he says, I prefer you, my friend, but buyer B just offered a slightly higher price. So if you can just make some effort, the good-- is the security is yours.

But at the same time, he's saying exactly the same thing to buyer B for this example, just say there are two buyers, which has the intent of propping up the price.

And of course, neither A nor B can check on what this manager is saying to other clients, and neither can they check on the bids that are coming in in order to verify the claim of the auction manager that, in this case, buyer B was a little bit off.