 The theme for the market make ETH Global Hackathon is the future of finance and when I was studying to become an actuarial fellow in financial applications there was this problem that really annoyed me, the diversification illusion. So we assembled the team and created a decentralised application called EtherTree that securitises laps risk and addresses the diversification illusion. Now a large part of finance is about managing risk and return and generally in order to get more return one must take on more risk. So if we have a blue asset with low risk and a low return and an orange asset with a high risk and a high return and we look to capital asset pricing models we see that a combination of assets isn't given by this linear relationship. No, a combination of assets can give the same return for a lower risk. Now this reduction in risk depends on the correlation strength. High correlation gives a small benefit whereas low correlation gives a big benefit. Now when the market is stable we see that different asset classes have low correlations with each other and this gives us the belief that we have reduced our total risk but correlation isn't constant. We can use Archimedean copulas to model its fluctuations and we see that when the markets crash the correlation between these assets increases, thus total risk increases and our portfolio is undefended when it is most vulnerable. Think of it like this, the diversification illusion is like having a bunch of bodyguards that then run away as soon as danger occurs. Now if you want to know more about capital asset pricing models and Archimedean copulas I do have a few other videos on my YouTube channel that goes into the mathematics of it but essentially this is our problem, the diversification illusion. Now let's talk about the solution. The blockchain allows for new asset classes to be created as it facilitates securitization and we have the technology in the form of Ethereum. Now all we need is a risk that is negatively correlated with traditional assets so we want something that will go up when the market goes down and we found it, lapse risk. Lapse is when someone breaks their promise to make a series of payments or when they surrender their financial obligation. So we have the technology and we have the negatively correlated risk. All we have to do now is combine the two to create a new asset class. Now we know that capital asset pricing models, correlation, copulas are not the easiest of things to understand and so we decided to gamify our new asset class so that it has a better user experience. And our game is called Ether Tree. Now there are two types of players, planters and waterers. The planters, they determine the parameters and the risk characteristics of the lapse security. In terms of the game, they're planting the seed for the Ether Tree. The waterers on the other hand, they browse the various securities and pick one that they believe is fair so in terms of the game, they're choosing which seeds to water. Now the game has got four parts. Part one is planting the seed and this is where the planter gets to determine the parameters. The parameters are duration, payment frequency, payment amount, number of waters, start date, planters fee, bounty and lapse limit. We'll explain what planters fee, bounty and lapse limit mean in just a minute but essentially what will happen in part two when it comes to germinating the seed, the waterers will choose a seed to water and we're going to see that they're going to prefer a high bounty, a low planter fee and a high lapse limit and the rest of the parameters will depend on their own personal preferences. In part three, this is when it comes to watering the tree. Now the waterers need to make a series of payments to the Ether Tree contract. If a waterer misses just one payment though, then it's game over for that waterer. However the rest do get to continue and they get to reach part four which is harvesting the fruit. Now the planter gets either the total fund and this is if all the waterers lapse during the duration or they get their bounty back plus their fee and this is if the lapse limit is breached or they just get their fee if the lapse limit isn't breached. The waterers, they get either nothing if they lapsed, a share of the bounty plus a share of the total funds after fees if the lapse limit isn't breached or they get a share of the total funds after fees if the lapse limit is breached. So let's maybe talk a little bit more about this lapse limit bounty and planter's fees. So let's start off with the bounty. The planter deposits a significant sum of Ether at the start of the contract and this is kind of to lure the waterers in. If the lapse limit is breached, the bounty returns to the planters. If the lapse limit isn't breached, the bounty is shared amongst the waterers. So the higher the bounty, the more desirable it is for the waterers but the more that the planter could potentially lose. When it comes to the lapse limit, I guess the best way to explain this is through an example. So let's say the planter sets the lapse limit to be 10% then if more than 10% of waterers lapse then the limit is breached and the bounty returns to the planter. If less than 10% of the waterers lapse then the limit isn't breached and the bounty is shared amongst the waterers who didn't lapse. When planters fee, this is the percentage of the total fund that the planter receives at the end of the contract, although they have to give it up front and because it's the blockchain, we have transparency. An idea here is that if the planter sets it too high, you will scare the waterers away. This maybe go through an example to aid our understanding. So in part one, planting the seed, this is where our planter determines the parameters and this is probably the most important part of the game for them. So let's say they set the duration to be one week and the payment frequency to be daily and the payment amount to be one each and the number of waters required to be 100. Let's say the start date is the 15th of December and the planter's fee is 5% and the bounty that they're putting up front is 10 each and the lapse limit is 10%. So let's say they set this up, then let's see what is the best, worst and normal case scenario for the planter. So the best case scenario for the planter would be if all waterers make all payments except for the last one. Why? Because this means the total funds go to the planter. This means they get their bounty of 10 back plus all 100 of them making 6 payments of one ether each means you're going to get 610 ether plus any return from a liquidity pool but we'll talk about that in another video. So essentially you're putting in 10 and you got out 610 over a duration of just one week which is pretty good but that's the best case scenario. A normal case scenario would be something where 10 waterers lapse let's say right at the start and 90 waters don't lapse thus the lapse limit isn't breached. This means that the fee times the total fund is going to be the 90 payments times 7 because all the payments are made times the fee of 5% and we're going to get 31.5 ether plus any return from a liquidity pool. Here you're putting in 10 and you're getting 31.5 out still not bad but what about the worst case scenario? Okay worst case scenario is let's say 99 waters lapse right at the start but you have that one waterer that doesn't lapse this means you're just going to get 5% of 7 ether plus your bounty back so you put in 10 and you got 10.35 out and with gas prices that's probably not a very good investment but like I said this is based on the parameters that we are using in this example and this is what makes the game really fun and I guess complicated is that different sets of parameters are going to give completely different return distributions but let's look at the waterer with the same example worst case scenario is that you make every single payment except for the last one and that means you put in 6 but you get nothing out the best case scenario is when you make all the payments and everyone makes all the payments but the last one because this means the total fund is now 601 ether and when the planter takes their 5% fee what we see is that you put in 7 ether and you got out 570 now that is the best case scenario probably not going to happen so let's look at a more normal case scenario and this could be something where 90 waters make all the payments and 10 waters lapse off the payment number 4 so now our total fund will be 90 times 7 plus 10 times 4 plus the 10 bounty and we get 680 now once again the planter takes their fee and we divide it by the remaining waters which is 90 and we see that we put in 7 and we got 7.18 out now what we can see is that probably the parameters here were way too much in the planter's favor although having said that this is still a 2.6% return after a week and if you had to annualize this it gets you like 275% for the year but again these things depend very much on the parameters and what actually happens and what makes this game difficult to determine what your returns are actually going to be is because how many lapses and when they occur are unknown at the start now for the water is this is a simple game you pick a tree to water you don't forget to water it and you get a share of the fruits low risk low return but you're still getting exposure to laps risk and it's kind of interesting because the more people that lapse the bigger your share of the total fruit although the total fruit will be a bit smaller so it's not going to be a linear relationship between the amount of people that are lapsing and the amount that you're getting back now for the planters it's a little bit more of a complicated game because you need to optimize the parameters for the tree if you're too greedy no one is going to play if you're too generous you might make quite a big loss so it is high risk high return but once again you do have exposure to lapse lip lapse risk and generally the more lapses the more return however you still need some payments to be made so there's no point in making a bunch of fake water accounts that immediately lapse because then there's going to be nothing in the total fund so overall what we can see is that the expected return on lapse risk is unknown but and this is important lapse risk has a negative correlation to traditional assets think about it when markets crash there's a liquidity squeeze people tend to need cash so they tend to lapse on their financial products thus introducing exposure to lapse risk gives your portfolio a real diversification benefit making it more robust and lowering your total risk okay think of it like this with regards to the capital asset pricing model introducing lapse risk makes gives you the purple curve instead of the brown curve so we are lowering total risk in a portfolio of assets now look in this video we're just giving an introduction to ether tree another video will go through some of the code as well as some of the non-fungible tokens that you can also earn by playing the game now there's still a lot more for the defy community to do in order to revolutionize finance but we believe that ether tree by using the blockchain to securitize negatively correlated risks to achieve real diversification in portfolio construction is a step in the right direction thanks so much for watching and job make sure to to find out more about the project going to the following social handles