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Recent Publications (2016-2019)

A.Lipton, Towards a stable tokenized medium of exchange. To appear in Cryptoassets: Legal, Regulatory and Monetary Perspectives, C. Brummer, Ed., Oxford University Press - 2019.

Existing banking and payment systems, while still functioning, are rapidly becoming obsolete and misaligned with the new challenges of the modern economy. While open access Internet Protocols have unleashed a wave of creativity and growth in numerous fields, banking is not one of them. The reason stems mostly from the fact that internet protocols for money and identity, while sorely needed, are conspicuously absent at present. We argue that a regulatorily compliant fiat-backed token, which can be viewed as an electronic analogue of cash, can help to fill this gap. Experience suggests that all decentralized crypto coins are inherently unstable, which makes them less than useful for commercial applications. Contrary to often-made claims, it is not possible to build a truly decentralized stable token. We argue that any potentially successful stable token has to be at least partially centralized, with varying degrees of decentralization. We describe four approaches to building stable tokens including fully collateralized custodial tokens, partially collateralized custodial tokens, tokens overcollateralized with cryptos, and dynamically stabilized tokens, and conclude that only fully collateralized tokens can be stable, even under extreme circumstances. We also introduce narrow banks and describe their important role as anchors of a diverse digital banking ecosystem and potential emitters of central bank backed digital cash.

T. Hardjono, A.Lipton and A. Pentland, Towards a design philosophy for interoperable blockchain systems. IEEE Transactions on Engineering Management - 2019, to appear.

There is considerable interest today in the use of blockchain technology to provide better visibility into shared information among a number of participants and systems arranged in a P2P topology. However, more attention needs to be placed on challenges around the aspects of the manageability of blockchain systems, the survivability of blockchain networks, and the cybersecurity of systems and infrastructures that participate in blockchain communities. Crucial to answering these challenges is the need to understand aspects of the Internet architecture that has made it scalable, resilient and a commercial success as a global connectivity infrastructure. In this paper we discuss a design philosophy for interoperable blockchain systems, using the design philosophy of the Internet architecture as the basis to identify key design principles. We recast some of the challenges faced in the design of the Internet architecture to that of the design of an interoperable blockchain architecture. We emphasize interoperability as a crucial requirement for the survivability and manageability of blockchain systems. The goal is to define an interoperable blockchain architecture, in which common components of the blockchain architecture can begin to be standardized, leading to lowering of development costs, better reusability and higher degree of interoperability.

A.Lipton, Don’t fear the clearer. - 2019 (May).

M. Grasselli and A.Lipton, The broad consequences of narrow banking. International Journal of Theoretical and Applied Finance Vol. 22, No. 1 (2019).

We investigate the macroeconomic consequences of narrow banking in the context of stock-flow consistent models. We begin with an extension of the Goodwin–Keen model incorporating time deposits, government bills, cash, and central bank reserves to the base model with loans and demand deposits, and use it to describe a fractional reserve banking system. We then characterize narrow banking by a full reserve requirement on demand deposits and describe the resulting separation between the payment system and lending functions of the resulting banking sector. By way of numerical examples, we explore the properties of fractional and full reserve versions of the model and compare their asymptotic properties. We find that narrow banking does not lead to any loss in economic growth when both versions of the model converge to a finite equilibrium, while allowing for more direct monitoring and prevention of financial breakdowns in the case of explosive asymptotic behavior.

M. Grasselli and A.Lipton, On the normality of negative interest rates. Review of Keynesian Economics, Vol. 7 No. 2, Summer 2019, pp. 201–219.

We argue that a negative interest-rate policy (NIRP) can be an effective tool for macroeconomic stabilization. We first discuss how implementing negative rates on reserves held at a central bank does not pose any theoretical difficulty, with a reduction in rates operating in exactly the same way when rates are positive or negative, and show that this is compatible with an endogenous-money point of view. We then propose a simplified stock–flow consistent macroeconomic model where rates are allowed to become arbitrarily negative and present simulation evidence for their stabilizing effects. In practice, the existence of physical cash imposes a lower bound for interest rates, which in our view is the main reason for the lack of effectiveness of negative interest rates in the countries that adopted them as part of their monetary policy. We conclude by discussing alternative ways to overcome this lower bound, in particular the use of central-bank digital currencies.

R. Dembo, A.Lipton and S. Burkov, Account Platform for a Distributed Network of Nodes. US Patent Application Publication, US 2018 / 0293553 A1 - 2018.

In this paper, we study the non-linear diffusion equation associated with a particle system where the common drift depends on the rate of absorption of particles at a boundary. We provide an interpretation as a structural credit risk model with default contagion in a large interconnected banking system. Using the method of heat potentials, we derive a coupled system of Volterra integral equations for the transition density and for the loss through absorption. An approximation by expansion is given for a small interaction parameter. We also present a numerical solution algorithm and conduct computational tests.

A.Lipton, V. Kaushansky and C. Reisinger, Semi-analytical solution of a McKean-Vlasov equation with feedback through hitting a boundary. Submitted for publication - 2018.

In this paper, we study the non-linear diffusion equation associated with a particle system where the common drift depends on the rate of absorption of particles at a boundary. We provide an interpretation as a structural credit risk model with default contagion in a large interconnected banking system. Using the method of heat potentials, we derive a coupled system of Volterra integral equations for the transition density and for the loss through absorption. An approximation by expansion is given for a small interaction parameter. We also present a numerical solution algorithm and conduct computational tests.

A.Lipton and V. Kaushansky, On the First Hitting Time Density of an Ornstein-Uhlenbeck Process. Working Paper - 2018.

In this paper,we study the classical problem of the first passage hitting density of an Ornstein–Uhlenbeck process. We give two complementary (forward and backward) formulations of this problem and provide semi analytical solutions for both. The corresponding problems are comparable in complexity. By using the method of heat potentials, we show how to reduce these problems to linear Volterra integral equations of the second kind. For small values of t, we solve these equations analytically by using Abel equation approximation; for larger t we solve them numerically. We also provide a comparison with other known methods for finding the hitting density of interest, and argue that our method has considerable advantages and provides additional valuable insights.

A.Lipton, Systemic Risks in Central Counterparty Clearing House Networks. Margin in Derivatives Trading, L. Andersen and M. Pykhtin, Eds. - 2018.

The global financial crisis of 2007–10 had enormous implications for the financial ecosystem as a whole.Among many other changes to its way of working, both the range of products and the number of trades cleared by central counterparty clearing houses (CCPs) increased enormously (see, for example, US Office of Financial Research 2017). As a result, whether they like it or not, all large banks are engaged in trading on CCPs.Accordingly, there is a clear need for banks to assess any potential losses due to defaults of general clearing members (GCMs) and CCPs through the CCP network they participate in. The interconnectedness of the CCPs themselves, arising due to the fact that they are linked through common clearing members, means that it is important to model most of the network. In this chapter, we take the perspective of a hypothetical banking group, “XYZ Bank”, and explain how it may assess its risks based on the partial information available to it. Typically, a banking group has multiple subsidiaries, each of which are distinct clearing members. Understanding the risk of XYZ Bank is a challenging task, which requires analysing the contingent cash flows between a large number of agents (hundreds of GCMs operating on multiple CCPs) that have a complex interrelationship. To describe this relationship adequately requires capturing the dynamics of variation margin (VM), initial margin (IM), default fund (DF), reassignment of trades in the event of a member default and allocation of these default losses.

A.Lipton, T. Hardjono and A. Pentland, Digital Trade Coin (DTC): Towards a more stable digital currency. Royal Society Open Science  - 2018.

We study the evolution of ideas related to creation of asset backed currencies over the last 200 years and argue that recent developments related to distributed ledger technologies and blockchains give asset-backed currencies a new lease of life. We propose a practical mechanism combining novel technological breakthroughs with well-established hedging techniques for building an asset-backed transactional oriented cryptocurrency, which we call the digital trade coin (DTC). We show that in its mature state, the DTC can serve as a much-needed counterpoint to fiat reserve currencies of today.

A.Lipton, A. Pentland and T. Hardjono, Narrow banks and fiat-backed digital coins. The CAPCO Institute Journal of Financial Transformation. #47  - 2018.

We outline a framework for issuing fi at-backed coins to a wide set of end-users. We show that a narrow bank is an important part of this framework, needed to increase circulation and acceptance of such coins. We argue that fi at-backed coins issued by a purpose-built narrow bank have considerable advantages compared to central bank digital cash, and can be used to achieve improved financial stability and solve some of the more vexing problems affecting financial infrastructure.

A.Lipton and A. Pentland, Breaking the bank. Scientific American - 2018.

A.Lipton, Financial Engineering. Selected Works of Alexander Lipton. World Scientific  - 2018.

Edited by Alexander Lipton (Quant of the Year, 2000), this volume is a collection of Lipton’s important and original papers on financial engineering written over his 20-year career as a preeminent quant working for leading financial institutions in New York, Chicago, and London. The papers cover topics ranging from the volatility smile problem, credit risk, macroeconomics and monetary circuit, and exotic options, summarizing Lipton’s fundamental contributions to these areas. In addition to papers published in leading academic and practitioner-oriented journals, this volume contains a detailed introduction and two previously unpublished chapters. Some of the seminal papers in this book cover local stochastic volatility models, passport options, credit value adjustments for credit default swaps, and asymptotics for exponential Lévy processes and their volatility smile. Alexander Lipton is one of the most respected quants of his generation and the first recipient of the prestigious Quant of the Year award by Risk Magazine. Readership: Undergraduate and graduate students of quantitative finance and banking, as well as industry professionals.

A.Lipton, Blockchains and distributed ledgers in retrospective and perspective.  The Journal of Risk Finance, Vol. 19 Issue: 1, pp.4-25, 2018.

Purpose – The purpose of this paper is to introduce blockchains and distributed ledgers and describe their potential applications to money and banking. Design/Methodology/Approach – The analysis compares public and private ledgers and outlines the suitability of various types of ledgers for different purposes. Furthermore, a few historical prototypes of blockchains and distributed ledgers are presented, and results of their hard forking are illustrated. Next, some potential applications of distributed ledgers to trading, clearing and settlement, payments, trade finance, etc. are outlined. Findings – Monetary circuits are argued to be natural applications for blockchains. Finally, the role of digital currencies in modern society is articulated and various forms of digital cash, such as central bank issued electronic cash, bank money, Bitcoin and P2P money, are compared and contrasted.

V. Kaushansky, A.Lipton and C. Reisinger, Numerical analysis of an extended structural default model with mutual liabilities and jump risk. Journal of Computational Science 24 (2018) 218–231.

We consider a structural default model in an interconnected banking network as in [1], with mutual obligations between each pair of banks. We analyse the model numerically for two banks with jumps in their asset value processes. Specifically, we develop a finite difference method for the resulting two-dimensional partial integro-differential equation, and study its stability and consistency. We then compute joint and marginal survival probabilities, as well as prices of credit default swaps (CDS), first-to-default swaps (FTD), Credit and Debt Value Adjustments (CVA and DVA). Finally, we calibrate the model to market data and assess the impact of jump risk.

V. Kaushansky, A.Lipton and C. Reisinger, Transition probability of Brownian motion in the octant and its application to default modelling. APPLIED MATHEMATICAL FINANCE (2018).

We derive a semi-analytical formula for the transition probability of three-dimensional Brownian motion in the positive octant with absorption at the boundaries. Separation of variables in spherical coordinates leads to an eigenvalue problem for the resulting boundary value problem in the two angular components. The main theoretical result is a solution to the original problem expressed as an expansion into special functions and an eigenvalue which has to be chosen to allow a matching of the boundary condition. We discuss and test several computational methods to solve a finite-dimensional approximation to this nonlinear eigenvalue problem. Finally, we apply our results to the computation of default probabilities and credit valuation adjustments in a structural credit model with mutual liabilities.

Filling the gaps smoothly, A. Itkin and A.Lipton. Journal of Computational Science 24 (2018) 195–208.

The calibration of a local volatility models to a given set of option prices is a classical problem of mathematical finance. It was considered in multiple papers where various solutions were proposed. In this paper an extension of the approach proposed in Lipton, Sepp 2011 is developed by (i) replacing a piece-wise constant local variance construction with a piecewise linear one, and (ii) allowing non-zero interest rates and dividend yields. Our approach remains analytically tractable; it combines the Laplace transform in time with an analytical solution of the resulting spatial equations in terms of Kummer’s degenerate hypergeometric functions.

A. Itkin and A.Lipton, Structural default model with mutual obligations. Rev Deriv Res (2017) 20:15–46.

In this paper we consider mutual obligations in an interconnected bank system and analyze their impact on the joint and marginal survival probabilities for individual banks. We also calculate prices of the corresponding credit default swaps and first-to-default swaps. To make the role of mutual obligations more transparent, we develop a simple structural default model with banks’ assets driven by correlated multidimensional Brownian motion with drift. We calculate closed form expressions for many quantities of interest and use them for the efficient model calibration. We demonstrate that mutual obligations have noticeable impact on the system behavior.

R. Barker, A. Dickinson, A.Lipton and R. Virmani, Systemic risks in CCP networks. Risk.Net - 2017 (January).

We propose a model for the credit and liquidity risks faced by clearing members of Central Counterparty Clearing houses (CCPs). By considering the entire network of CCPs and clearing members, we investigate the distribution of losses to default fund contributions and contingent liquidity requirements for each clearing member.

D. Filipovic and A.Lipton, Pas de cryptomonnaies sans technologie blockchain. Le Temps  - 2017.

D. Filipovic and A.Lipton, Keine Kryptowahrungen ohne Blockchain-TechnologieFINANZ und WIRTSCHAFT  - 2017.

A.Lipton, Money Changes Everything: How Finance Made Civilization Possible, by William N. Goetzmann. Quantitative Finance - 2017.

A.Lipton and I. Tulchinsky, Bitcoin blockchain and beyond. WorldQuant - 2017.

Bitcoin may not be the disruptive force that some have predicted, but the distributed ledger technology underpinning the cryptocurrency has the potential to transform the financial ecosystem

A.Lipton, Can quants defuse the pension time bomb? Risk.Net - 2016 (December).

Alex Lipton argues new quantitative methods are needed to solve the looming pension crisis. There is an urgent need to develop a new, 
robust and intuitive asset management framework. The key to accomplishing this task is to be able to maximize the probability of achieving one's investment goal in the real-world measure...

A.Lipton, The decline of the cash empire. Risk.Net - 2016 (November).

The last line of defence between us and punitive negative rates is paper currency. It is possible incumbent banks have outlived
their usefulness, and need to morph into something more compatible with technical progress achieved in other industries...

A.Lipton, Blockchain: a solution looking for a problem. Risk.Net - 2016 (October).

The last line of defence between us and punitive negative rates is paper currency. It is possible incumbent banks have outlived
their usefulness, and need to morph into something more compatible with technical progress achieved in other industries...

A.Lipton, Macroeconomic theories: not even wrong. Risk.Net - 2016 (September).

Flawed and inconsistent mainstream macroeconomic theories such as efficient market hypothesis are dangerous to society, says Alexander Lipton. These theories are not only pointless; they are dangerous. They adversely affect both academic discourse and the practical actions of regulators and politicians.

A.Lipton, Banks must embrace their digital destiny. Risk.Net - 2016 (August).

Alexander Lipton believes the time is right for advanced digital banks to take the industry forward, and quants can lead the charge. This situation opens a unique opportunity for building a digital bank from scratch by utilising the most advanced technologies

A.Lipton, On derivatives and quants. Risk.Net - 2016 (July).

Alex Lipton on how the role of quants is adapting to the new financial environment

A.Lipton, D. Shrier and A. Pentland, Digital Banking Manifesto: The End of Banks? Visionary Future - 2016.

A.Lipton, Modern monetary circuit theory, stability of interconnected banking network, and balance sheet optimization for individual banks. International Journal of Theoretical and Applied Finance Vol. 19, 2016.

A modern version of monetary circuit theory with a particular emphasis on stochastic underpinning mechanisms is developed. It is explained how money is created by the banking system as a whole and by individual banks. The role of central banks as system stabilizers and liquidity providers is elucidated. It is shown how in the process of money creation banks become naturally interconnected. A novel extended structural default model describing the stability of the Interconnected banking network is proposed. The purpose of bank capital and liquidity is explained. Multi-period constrained optimization problem for bank balance sheet is formulated and solved in a simple case. Both theoretical and practical aspects are covered.