Bankless - 74 - The History of Electronic Markets | Tarun Chitra

Starting point is 00:00:01 Welcome to Bankless, we're we explore the frontier of internet money and internet finance. This is how to get started, how to get better, and how to front run the opportunity. I'm Ryan Sean Adams. I'm here with David Hoffman, and we're here to help you become more bankless. David, great episode today. Turun Chitra on the podcast. He is a polymath. He's got, he spans so many different ideas, such a big brain. But this episode, we really drew his attention to the history of the markets, in particular, the history of the electronic markets. What did we cover today? Yeah, really the concept or story being told here is that the Internet, as we all know, changed everything.

Starting point is 00:00:54 And it especially changed how markets are structured. And so as soon as the Internet started to invade the world of financial markets, an interesting story is told. And so Turun has delineated the growth in this story into three phases, phase one, two and three of the growth of electronic. markets where we stopped yelling at each other inside of the pits about what trades we wanted to make, and instead we just started typing our trades into computers. And that has gone from people order routing into various exchanges in the 80s and 90s to consolidation to brokerages like your Charles Schwab and your e-trades online in the 90s and early thousands to where we are today with defy markets and crypto exchanges. And each one of these phases has similar story or similar themes

Starting point is 00:01:36 throughout each one. There's themes of what happens when a financial crisis happens because we're talking about market infrastructure. The way that the market infrastructure is built impacts the nature of the financial crisis. We have the stories of how regulators came in to each phase and impacted the story of the development of each phase. And the way that the communication and computational abilities of the infrastructure or the hardware of the world impacted the accessibility and centralization or decentralization of the markets. These themes are reoccurring throughout history. This is definitely a podcast about, you know,

Starting point is 00:02:11 history doesn't repeat, but it definitely does rhyme. And there are lessons to be learned about electronic markets that we are trying to apply to defy so that when these events unfold in defy, which Turin thinks that they definitely will, we will be prepared for them. Yeah, absolutely. I think one of the three lines of this episode

Starting point is 00:02:27 is just in every phase of the electronic markets, you know, eras, there was increased access for individuals, right? And I guess this is the story of markets from the very beginning, the first, you know, joint stock companies and the first stock markets that was kind of reserved for sort of the elites and like the Uber wealthy and kind of like mercantile class and that sort of thing. Just that the markets are opening up more and more over time. And it's very interesting to see like Defi as the third phase of this where you've got all of that, but at warp speed. Like anybody, anywhere with an internet connection can open a marketplace, can create an asset,

Starting point is 00:03:09 can even if they have the skills, create a new financial product. And that's something like we've never seen before. I mean, I know there are correlaries to what this looked like, Drew and says in the 1980s with the first era, but I also feel like this is uncharted water and uncharted territory. Yet, it fits this trajectory of markets are becoming more and more open. and like everything is kind of becoming like I guess I don't know if I'd call it hypercapitalism because it has some negative connotations but hyper marketization.

Starting point is 00:03:40 I don't know if that's the word, but that's kind of what we're seeing here. And it's a good thing because it means more financial inclusion for the world and more capital coordination. Absolutely. We often talk about how crypto and defy is the Wild West. Well, you can imagine what the world is like before the internet when trades are being made by people yelling at each other on pit floors and doing. hand signals make their trades.

Starting point is 00:04:02 It reminds me of the movie from Ferris Bueller's Day Off. But all of a sudden the internet comes, and instead of, you know, yelling at each other and doing hand signals, we're inputting, you know, our trades into a computer. And the structure of the entire market absolutely changed. That was the absolute Wild West back then, too. This is not the first time financial markets have gone through their Wild West moments. Like the first Wild West moment happened in the 80s. Turin tells a story about this one guy that had like 10% of all trading violations.

Starting point is 00:04:29 going through his server in his garage. And it was just some random dude. And there's a lot of interesting correlates between what we see now in crypto where just one rogue developer builds this brand new financial product and all of a sudden like half of the world is using it or whatever. Half of defy is using it.

Starting point is 00:04:46 Similar stories, similar themes. You know, history definitely rhymes. And I love where this ends where we go through the lens and we sort of apply the lessons learned from previous eras to the current era to try to map out what the future looks like. because look, man, the future of crypto and DFI is so uncertain in terms of like,

Starting point is 00:05:03 we know long term this is going to be successful because this is unstoppable, but what might we see in the interim, in the short to medium run? And this gives us a framework for starting to project this. I especially liked Turin's description of risk that we might see in D5. Both the plus side of this, where we've an open financial system so we can maybe see these risks more easily before they emerge, but also how risk has been kind of, not the downfall, but an issue with every single electronic era previous. So exciting episode, make sure you guys tune in to the end of this episode. Before we begin, we want to thank the sponsors that made this possible. Arbitrum is an Ethereum scaling solution that is going to completely change how we

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Starting point is 00:08:13 trade your crypto assets. All right, Bankless Nation, we are super excited about our next guest. We have Tarun Chitra. He comes from one of the most rich and complex corners of Ethereum. He is a big brain. I don't know. Can't even keep track of all the things Tarun is doing. He's the co-founder of Gauntlet that provides economic simulation to DFI protocols to help them harden their economics, super important stuff. He's also a co-founder of robot ventures where he invests alongside Robert Leshner, who's been on the podcast several times in DFI. He's also a frequent guest of the Zero Knowledge Podcast, so you will appreciate his audio He's also a leading thinker on MEV.

Starting point is 00:08:56 That is maximum extractable value and so many other topics. Today, we're going to talk about his concept for electronic markets and the third era of electronic markets that we find ourselves in today. Turin, how's it going, man? How are you? Thanks for having me on. We're doing great. You know what, man? I love that background.

Starting point is 00:09:17 You got to tell us, is this like an NFT or like, what is this background? It's super colorful. your glasses seem to kind of match the ambiance of it. What's the story here? So I love kind of weird niche math things that have very pretty pictures. And so this thing behind me is something called Penrose Tiling. Oh, I know this one. Get David to explain it then.

Starting point is 00:09:44 If David knows it, David. If I'm right, then I could be wrong. But this is penrose Tiling is like the basis of a pass. If you color it, right, the coloring I think is very important, and it could be wrong. But like it's a pattern that never, ever repeats. And so it's an infinitely recursive pattern and you will never find the same tiling pattern ever again as the, and it's an infinitely recursive pattern. So it can go into infinity, but you will never find the same pattern twice. Is that right?

Starting point is 00:10:13 Yeah, basically. Yeah, it's sort of, yeah, infinite tiling with no repeated. There's a certain weird way in which the no repeated. units as defined, but people make very pretty pictures like this one of them. That is super cool. That's going to be great, this entire podcast. We enjoy looking at that. But let's get to the topic, because today we are here to explore the topic of electronic markets. I think, Turin, you have this idea that there have been three arrows, three stages of electronic markets, the first, a second, and now we are

Starting point is 00:10:48 entering the third. And when David and I heard about this concept you have and this mental model you had, we knew we absolutely had to unpack it here on bankless because I think it's an important mental model for us all to understand. So let's start with some definitions and scope here. When we're looking at electronic markets from a satellite view, what do you mean by the term electronic markets and what does that mean more generally? Yeah, for sure. I think, you know, if we kind of take a step back prior to electronic markets, what were markets? They were, you know, you think kind of from history class, like, hey, it's like in the center of a city. There is like a bazaar and there's like a bunch of people who have stalls and that's like the earliest form of market.

Starting point is 00:11:39 But every new form of technology that has been invented inevitably finds its first usage and adoption in financial markets. you know, when people sort of had the telegraph, the telegraph became sort of this B2B business to business device that was used for different businesses in different towns to kind of like send messages about the weather or whether like a shipment wouldn't make it or sort of commercial details. And that was sort of the original sort of starting point of the telegraph. but then as kind of time evolved and everyone got electricity, we had telephones and then the masses started using effectively the same communication technology. And that led to a lot of sort of new markets in the sense that people could buy things over the phone,

Starting point is 00:12:33 people could find new customers via telemarketing, which of course now is viewed as antiquated and annoying. But I think at the time, you know, sort of post-World War I was sort of like the heyday of like going into kind of the golden 20s. There was actually kind of viewed as probably the way we view like Instagram ads today as like much more in culture, kind of in vogue type of advertising versus those ads. And so but these were all very markets that were very peer to peer. And I mean peer-to-peer more in the bad way. Like, you have to do a lot of work to find a buyer or a seller when you're the opposite. You have to go manually kind of like figure out how to put the dots together. There's not like a central place or a central kind of source of funds and trading.

Starting point is 00:13:28 But what happened once we had the Internet was sort of in the very earliest parts of the Internet. So Internet created sort of by the Defense Agency. in the 70s. But in the early 80s, people in finance realized the internet was a really good way to price assets that sort of disintermediated, you know, large entities who kind of controlled most trading. So if you think about stocks in the 1970s and 80s, only institutions could really buy them? Like, you could buy a mutual fund who could buy shares and stocks, but you yourself

Starting point is 00:14:14 couldn't really realistically do that. And you would have to go through an intermediary, like a bank. So how would you even do that in the, in the 1970s, 80s? Like, most listeners are kind of detached from that. So you have to, like, schedule an appointment with a banker to go, like, buy your broker. Okay. Yeah. To go buy your mutual fund? Yeah, to go buy shares in a mutual fund. And the mutual fund would go invest in stocks for you. I don't know if you've ever, like, I feel like I've always seen this in sort of smaller towns in the U.S., but there are like these like physical broker branches.

Starting point is 00:14:45 Like there's a Charles Schwab that actually exists as a, you know. I've never walked into them. I don't know what they do there. It's certainly made for like, I don't know. Yeah, it's definitely made for a more geriatric audience, I think. Yeah. In a lot of ways. But that's the vestige of that time where like in order to buy stocks,

Starting point is 00:15:03 you would like go to a physical venue, you would pay someone like 5% to execute the trade, if you're lucky. And then it would go through a series of middlemen and then it would go to banks. And banks were the only ones who kind of dealt with the stock exchange for you. So there was this like huge chain of intermediaries. So this was a time where we had markets, but we didn't have the electronic part of it, right? It was just markets and full of intermediaries. Yes.

Starting point is 00:15:32 not very peer-to-peer from an electronic perspective. Yes, exactly, exactly. Like the phrase electronic markets, I think, really refers to the idea of replacing a lot of the middlemen with compute and communication via the internet and also via, like, being able to use a lot of compute power. And people in the 80s realize that you, you know, you could actually do that quite efficiently and get rid of a lot of middlemen in banking. And that sort of started this trend that obviously went to today where you have Robin Hood and you can go buy stocks on your own. You don't pay anything. You know, you can do your own research, stuff like that. You know, I think we, the earliest part of the electronic market revolution was getting rid of intermediaries and brick and mortar entities, automating a lot of the execution and settlement and storage of stocks.

Starting point is 00:16:29 So, you know, stocks for even though you might not know that you still could request this, there is actually a physical certificate sitting at Bank of New York Mellon that represents, like, the share that you bought. But, you know, when you're trading on Robin Hood or Interactive brokers or Charles Schwab, everyone is holding IOUs for those shares. And you're really only trading the IOUs. No one's actually physically usually moving the stock. the brokers kind of net settle every day of like, hey, I bought for all my customers 500 shares of Apple, and I sold 600 shares of GameStop.

Starting point is 00:17:09 So, you know, the two counterparts execute that trade. But sorry, we're getting a little away from the definition of electronic markets. But I think the definition is any sort of form of marketplace interaction where you can aggregate, buyers and sellers, and they can transact autonomously without needing white-listed trusted parties. So just to ground the listener, Tarun is much more of an expert than us on the history and progression of electronic markets. And so we definitely want to pick his brain about how these things came to be. Like, how did we go from, you know, the telegraph and the telephone into where we are today, which is, you know, trading on Robin Hood? And, you know, while the listener of this podcast and the

Starting point is 00:17:54 Bankless Nation are beyond trading on Robin Hood. They are, you know, trading on Defi and using defy apps. Defi is really just the next logical continuation of the emergence of electronic markets. And so I think it's really important to understand the history of these things as a concept. And then we can talk about how defy is a continuation of electronic markets with new things, with the old things and a couple of, you know, weird kinks here and there as well. Terune, help ground the listener. What would you say are the common themes and through lines and just like reoccurring elements of each wave of each emerging electronic market? What are we going to continually revisit over and over and over again in this conversation? Yeah, for sure. I think the number one thing is there's always a boom and bust cycle hidden somewhere in each of these waves.

Starting point is 00:18:44 another thing that happens in each wave is that there is a new technology and or regulation introduced that causes sort of a seismic shift in terms of market microstructure and how people interact with these systems. And then the third thing is I think like there's a kind of gradual disintermediation of third parties at each step. And I guess the final thing is that each new wave of technology makes the market more competitive, which lowers prices usually for in aggregate for people. Okay, so we're going to see these themes, I guess, reflected in each of these eras. But you have kind of a framework of eras that we want to go through. And maybe high level, I'll kind of say what they are.

Starting point is 00:19:35 And we can maybe start with the first one. But the first is like electronic markets 1.0. and that was really the genesis of electronic markets. We had these analog markets, and now we're making them electronic. That started the 1980s, and I think lasted into the 90s. Then we had electronic markets tutado, which started in sort of the 2000s. I kind of think of this as like the e-trade era at the start of it, and that lasts into the present era now. maybe Robin Hood is kind of a transitory thing into partially one foot in era two and one foot in era three.

Starting point is 00:20:14 That's started in the 2000s and up to this point. And then we have electronic markets 3.0, which is kind of the crypto and Wall Street bets type era. Maybe that started in 2015, 2016 or so, and it overlaps with era too. So these are the three eras that we're going to talk about. So take us to the first turn. talk about this electronic markets era 1.0, the genesis of electronic markets. Take us all the way back to the early 1980s. What was the technology that really enabled this? And where did it start? And where did electronic markets start arriving on the scene and take us through the timeline?

Starting point is 00:20:54 Yeah. So I know many people have probably seen in movies like these pictures of these guys at the stock exchange or the commodities trading exchange, like raising their hands. hands and like doing all sort of types of hand signals to say like hey i want to buy like 500 cows or i want to sell you know 500 shares of disney that was what was happening in the 70s so there was you know the new york stock exchange the physical location was filled with people from banks and sort of brokerage and trading firms and they were the only ones who were officially allowed to trade stock um and what happened in the 80s is you know actually sort of in this 1970s, something that we don't really see right now.

Starting point is 00:21:40 Right now, when you think of stock exchanges as just an individual, you think of the New York stock exchange, you think of NASDAQ, you think of maybe the Chicago mercantile exchange, maybe the London sock exchange, maybe the Tokyo stock exchange, you know, like there's always like one or a few in each country, but you don't think of like many. But in 1970s, every city in the U.S. had their own. stock exchange. So there is much more regionalized stock trading. So you might be at the Philadelphia stock exchange and Comcast would be listed there instead of in New York. That seems so bizarre. Why is that? Is that just because like every, all the companies in that region would sort of

Starting point is 00:22:22 aggregate to their local city stock exchange? Yeah. So the idea is that like, you know, maybe people in Philadelphia, the companies that are IPOing there are a little smaller than the ones in New York. But the buyers and sellers had to meet physically to actually buy the stock. So the buyers in Philadelphia tended to have either less money and the sellers have less lower valuations to sell. So they just met geographically in the kind of like their local, they represented their community as finance. This was like pre-globalization, right? It's just like, hey, like, I'm going to invest in the company down the street from me. Exactly.

Starting point is 00:23:04 Rather than I'm going to, like, send my order to New York. Yes, exactly, exactly. And so what happened, there was a little bit of consolidation, but the consolidation wasn't in, due to technology. The consolidation was just like the New York stock exchange bought the Philadelphia Stock Exchange. And so they're the same brand, and they would net settle for you. So if I lived in Philadelphia, I wanted to buy a stock in New York, I'd go to the, Philadelphia Stock Exchange and then they would relay it and there would be fees on relaying. So the problem with that is that's extremely expensive because A, I'm paying locally for the

Starting point is 00:23:40 relayer and then B, I have to pay on the other end like when the trade actually gets executed. So what happened when the internet came out was people realized they could get rid of this relaying system and this kind of net settlement a few days later. So like if I was in Philadelphia and I was my stock in Chicago, I wouldn't even be guaranteed my execution would happen within a day. It might take like two to three days. They might not be able to actually fulfill it. They might not find sellers. It was very inefficient and like very, it was almost like going to the mall and like going to each store and like looking for like the one share that you're looking that you want. Right. There was no liquidity. So like you place your, you place your bid and then any time between one

Starting point is 00:24:22 and three days later, it might get filled. Is that kind of the issue? Exactly. Yeah. And there's no, There was no way to find the liquidity. It wasn't easy to figure out, like, who wanted to sell, who versus who wanted to buy. And that's why these... You kind of just needed to, like, cast your line, right? You would cast your line and just hope that somebody... Is that why they're all shouting at each other in all of these pictures? Is that why they're so loud and, like, arms waving shouting?

Starting point is 00:24:45 It's because they're casting their lines and making a scene so that someone hears their bid. Yes, exactly. That's... It's called open outcry. That's like the pit where people would do that. And it literally is self-descriptive. Like, people are in the open crying out. Wow.

Starting point is 00:25:02 Okay. So open outcry exchanges are kind of these old-school ones. And so what happened was when the internet, even just the idea of the internet came out, you know, DARPA, like late 60s or late 70s, people who were traders were like, hey, I could replace this whole relaying system and communicate information about bids and offers between the different stock exchanges without actually having. to do this physical relay thing, right? And now all of a sudden, people were able to compete on price across different stock exchanges. And that was sort of the first glimpse of, hey, this idea of like, hey, really fast communication networks and a lot of compute power can replace the system of, like, hundreds of people

Starting point is 00:25:50 and, like, very uncertain execution. Like, you don't know when you're going to get filled, stuff like that. So is this kind of like the emerging? of the, we use the phrase liquidity begets liquidity. And while that usually is pertaining to specific assets, as in like the US dollar is liquid and it tracks a bunch of liquidity, but right now we are seeing like perhaps, you know, running on the example of the Philadelphia stock exchange, perhaps there is like an internet connection, one of the first earliest internet connections between the Philadelphia stock exchange and the New York stock exchange. And now

Starting point is 00:26:20 those two liquidity pools, all of the people shouting in Philadelphia, can also technically also be heard in New York. And so these two liquidity pools are now collapsed into the same. They merge into the same liquidity pool of the stock exchange. And is that kind of what we're talking about? Yeah, in the same way that like now like VCs and like Silicon Valley people love talking about aggregation effects. This was the first aggregation effect due to the internet.

Starting point is 00:26:44 It's literally aggregating liquidity across different stock exchanges. So there was still people shouting in the pits, but now the people were connected to more cities, right? Yes. I mean, so people shouting in the pits, let's say I shouted in Philadelphia prior to the internet. Let's say I wanted to buy five shares of Disney. And I knew there were only like three brokers who had Disney. I would go like, hey you, broker one, I want five shows of Disney. Broker two, I want five shows of Disney. Broker three, I want five shows of Disney. How much can you sell it to me for? And what's your offer? Prior to the internet, they were literally like getting on the phone, calling someone in New York saying, hey, can you? Can you shout in New York and tell me who actually has Disney? That person in New York would go, you know what I mean? Like that part got turned into like query. And so like slowly but surely the internet started replaced,

Starting point is 00:27:39 but there were jobs, there were physical like people whose jobs are literally to just like sit and pick up the phone. And their jobs are kind of replaced by the by basically the computers. Those are the relays. Those are kind of like the bridges between blockchains, yeah. Relayers. Right. Like order routers? Like there's people look like the order router, right?

Starting point is 00:27:58 You know, like the phone phone ones? It's like basically like that. They were basically doing everything like that prior to the internet. Right. And so like in the crypto world, we have like decks aggregators, right? They're going and finding offers at all the different deckses. Are these like the original exchange? Like, I'll find you the best rates by calling up all the different brokerages and all the different exchanges and I'll sell you the best one. Yes. Same kind of deal. Except extremely slow. Extremely slow. And with huge fees, with huge fees. So this had to be, Turin, when this came about, electronic markets started showing up in the 1980s. This had to be hugely transformative for the financial industry. Give us a sense of how quickly this happened. Yeah, so you would think it happened really quickly, but kind of a little bit like Defi.

Starting point is 00:28:44 It took place, it kind of really started with the more esoteric and new assets first rather than the older assets. So options, so like the right to buy a stock in the future or the right to sell a stock in the future, we're sort of done kind of only by legal contract prior to maybe like the late 70s. There are two reasons for that. One is economists only sort of figured out the math for options to some extent in the 1970s for how you should think about how much an option is worth given how much the stock is worth. But the other thing is that, well, that math is quite computationally intensive. And so you needed a lot of compute power to actually compute what you should think, you know, compute a price to quote for an option.

Starting point is 00:29:38 And so options had this double-edged sword where they needed both a lot of compute and a lot of like communication about liquidity, where the bids and NASS are. And so they were a natural fit to be the first electronically traded asset because, A, you need a computer to even figure out what the price is. And B, you also need a – you have this problem of, like, open outcry just doesn't work for options very well. Right. Correct me if I'm wrong, but options, in order to really be a competitive product, they need more participants than the typical bid asks of spot markets. Is that correct? Yeah, to some extent. So one of the reasons is options trade at every price that theoretically they trade at every possible price.

Starting point is 00:30:25 Like I can buy an option to buy Apple stock at one cent. I mean, the option will be worth basically nothing. So you have to actually consider all possible future prices, not just the current. Like buying a spot instrument is like, I just bought it. I hold it. With the option, it's actually its value changes quite a bit as a function of how much volatility there is in the price of the asset. And so you could think of it, you know, in some ways an option is sort of a form of insurance. And so the more volatile an asset is, the more you're willing to pay for insurance.

Starting point is 00:31:00 But the problem is you have to compute, do a bunch of actuarial math to basically say like, how much insurance do I need to get a certain type of exposure or certain type of protection. And that's where a lot of the compute comes in. And so kind of in the way DeFi is, is like there are these crypto-native assets that are kind of computationally annoying if you were to like turn them into a stock in some weird, right? Like, you know, we talk a lot in Defi about synthetic stocks, but you could also imagine the opposite. What if someone traded synthetic maker at the New York stock issue?

Starting point is 00:31:35 There's no reason they can't in some way. They, they, there are synthetic stocks in the normal world. Like, for instance, Chinese companies, when they're in the U.S., the stock you're buying is not actually really. stock in the Chinese company. It's actually a synthetic sort of implicitly pegged to the real thing called an auditory deposit receipt. But the idea is that kind of esoteric assets that have weird computational needs or weird sort of behavior are always sort of the earliest assets to get adopted by new electronic markets. And so options kind of led the 80s.

Starting point is 00:32:17 Right. And options, just to rehash what you said, options were specifically enabled by advancements in our humans' ability to compute things thanks to computers. But also importantly, humans' connectivity with other humans, markets connecting to other markets with the internet. And so this is one of the themes that you've been talking about, like growth in our ability to leverage the internet for communication allowed for more liquidity, more total market participants. And then also our growth in computers allowed for more complex and and rich financial products like options. So options perhaps never would have been a thing or really not the thing that we know of today without this new first wave of electronic markets. Is that correct? Yes. So actually, maybe that's another very good point that you've made,

Starting point is 00:33:03 which is that when you're asking about, like, what's caught a common thread to each new revolution? And each time, there's always some new set of financial assets that couldn't have existed without, like, the new type of electronic market. That's a really good point, and we're going to come back to that. So I can imagine, did we see, like, options volume? Because I can imagine that in the old days, you had to get a whole legal crew, like lawyers involved, to draft up options contracts, right?

Starting point is 00:33:29 It's super, like, time-intensive process, cost-intensive process. And so I would imagine options markets and products were very limited. But during the 80s, did we see an explosion in options market as a result of these electronic markets? Yeah, yeah. We definitely, actually, that's another, I guess, common thread is each new electronic market revolution removes a layer of lawyers. Automates them. Because, like, I don't even view Defi that much as, like, a financial revolution, as much

Starting point is 00:34:04 as, like, a legal revolution. It's really about just, like, removing the Matt Levine's. Like, I use this as kind of a joke. So Matt Levine is kind of this famous Bloomberg columnist who writes this Comcom money stuff, which a lot of people, both in finance and outside of finance, Reed. And he used to be a derivatives lawyer at Goldman. And, like, I view a lot of the products I see in Defi as basically replacing his job. Like, he would be like the derivatives lawyer is, like, looks through the contract, tries to structure how it should be priced.

Starting point is 00:34:35 And, like, now that's being done in, like, a smart contract. I mean, they're not called smart contracts for nothing, right? Like, contracts. That's a legal domain, not a financial domain. Yeah. So that's another thing to actually keep track of as we go through this, is that, like, think about all the lawyers that are getting removed or, like, how much you need a lawyer, how much that's reducing. Well, that makes me feel good, but, like, more abstractly, I guess, what is the role of a lawyer or contracts to begin with? It's like this more abstract notion of, like, establishing trust between parties, right?

Starting point is 00:35:09 And so I guess what we're doing is where enabling that trust to be like pushed into code, pushed outward. And that just unlocks a whole bunch of new use cases, I suppose. So every time we remove a lawyer, we're removing the trust in like the legal system and the contracts, and we're putting that trust somewhere else. Is that a way to think about it? Yeah, for sure. I mean, this concept of an exchange tradable asset needs some notion of standardization, right? Like, if I go to a stock exchange and I'm like, I want five shares of Disney.

Starting point is 00:35:51 And then tomorrow I'm like, I'm going to sell five shows at Disney. It needs to have fungibility. It needs to be able to be standardized and people aren't like, no, no, no, I don't want the Ryan Disney share. I want the David Disney share. Like it can't have that property, right? But the problem is these bespoke financial options, for instance, like employee stock options are a great example of something that's quite bespoke relative to a normal option on an equity instrument. And obviously, those have very low volume, right? It's like employee stock options, you can't trade them.

Starting point is 00:36:26 And part of the reason is there's an enforcement mechanism that has to take place. And so anytime you want to standardize an asset so that it can. be traded without people having to, on every trade, inspect the asset carefully, manually. That's kind of when, that's a sweet spot for these types of things. And over time, like, we, we can do more and more complicated enforcement of transfer logic in code instead of with lawyers. Because the lawyers in the legal system enforce property rights, which is the logic for transfer of anything. And so, the less you need the legal system to enforce that, the more you can increase volume and

Starting point is 00:37:11 liquidity. That's sort of the trade-off. So Turin, what else did we see with the advent of electronic markets in the 1980s? We've seen some new products. We've seen the removal of like some lawyers. We've seen standardization of assets. Were there any downsides as well to this? Or how did it end? How did this first era end? For sure, yeah. So there were, you know, I think kind of in the same way. We've financing DeFi doing one year what took all of the 1980s to do.

Starting point is 00:37:43 There was a lot of experimentation with new asset types, and most of them were just options on X, which doesn't sound like a lot, but remember, options were already like kind of this mind-blowing invention then, or mind-blowing that you could trade them

Starting point is 00:37:57 and anyone could use them type of invention. And so basically, people started experimenting, and then people started doing riskier and riskier kind of options. And what happened in 1987, which was sort of partially driven, the crash that happened, was partially driven by the options market, was basically that there are these types of banking institutions called, thrifts, I believe. So thrifts or savings and loan banks,

Starting point is 00:38:40 if you've ever heard of it. But yeah, so basically what happened with these thrifts is they were a sort of, they were promising much higher interest rates than your normal savings account, but they weren't really FDIC insured. So they're

Starting point is 00:39:00 not banks that promise they'll pay back if they go under, or like the government promises to pay you back if they go under. And these banks, savings and loan banks, work in the following way. Like people who are depositors earn yield directly from people who are borrowing to buy houses. So there's only like your money when you put money in to get yield is only used to lend to people who are buying 15 to 30 year mortgages. But the problem was.

Starting point is 00:39:33 there was a ton of inflation in 1980s. And the problem with mortgages is mortgages are fixed interest rate products, right? Like, you fix the rate at the beginning of the lifetime. That's it. When you're in a really high inflation environment, if you're promising the depositor is like 5% yield and you've issued all these like 6% mortgages, right? So there's just a little bit of spread. if there's a ton of inflation, that 6% is actually worth less and less over time.

Starting point is 00:40:05 And it basically means, like, you have to do riskier and riskier things. And these savings and loan banks started, like, trading options and indirectly through weird ways. And that exacerbated some of the problems that later happened. But what was learned, which was really good data from 1987, was we learned when the option math breaks down. So people didn't know exactly how. the math should work. And that big collapse kind of helped crystallize in people's minds the benefits and the downsides, the risks of these electronic markets if they weren't designed correctly and

Starting point is 00:40:44 people weren't like being very careful with them. Wait, what collapsed? Sorry, like the stock market had this huge, huge collapse. I think it was called Black Thursday, I believe. Sorry, Black Monday. Black Monday. This was a consequence of the speculation that was going on in order to combat interest rates. So do you remember that when GameStop was kind of peak GameStop, I guess, March or February or whatever?

Starting point is 00:41:10 Yeah, right when I bought, yeah. There were a lot of memes about something called a gamma squeeze. Right. So what that means is basically option sellers. So like, let's say I buy a call option. That means the person selling me sold me the call option, which means that when I exercise it, I have to have a share to deliver to them, right?

Starting point is 00:41:37 An option is the right to buy in the future. And so usually people, banks, who are selling options, you're paying them a premium up front for it, like insurance. They will cover it. So they will go buy the share so that their exposure is net zero. People in the 1980s didn't totally understand that you need to do this quite carefully. And electronic markets help you automate this, but they weren't as good as they became in the 90s to actually automatically hedge your risk when you're selling options.

Starting point is 00:42:12 What happened was all of these people who bought options started exercising them because the price crashed. And they're like, I want to buy, I want to put a floor on my loss or something. And then the underwriters had to go sell. In this case, there weren't call options. They're all puts. But they had to go sell shares. And then there's kind of this compounding effect. There's sell shares, push the price down, more people would exercise, people would sell more shares.

Starting point is 00:42:36 And you had this kind of like, the opposite of sort of like a, yeah, you had this bad feedback loop. And like that kind of, that was the first time we had a sort of like electronic market in the modern definition sense collapse due to this. feedback loop. And because it's an electronic market, it wasn't easy to stop. Right? In the, I'm in the pits raising my hand thing, the, the referee, I mean, like, whoever owns the stock exchange who, they actually literally had people who would, like, have whistles and stuff. So I prefer, I like to call them the referees. And then just, like, blow the whistle, like, no trading. Guys, can you please stop trading? Can you? Yeah, no, it was actually literally that. Like, there was, like, the whistle person to do that. So,

Starting point is 00:43:21 this was something that was new, right? This didn't exist prior to having electronic markets. We weren't used to this idea that these things could just run on their own and kind of have big collapses. But I think what happened after that was the crazy thing is that options volume crashed after 1987. And then people slowly started to get more and more comfortable with like buying options and then for banks and hedge funds and stuff hedging their risk in options. and options volume just grew exponentially since it has not decreased. And so, you know, the 90s, especially in the first tech bubble, boom, we actually saw kind of the markets, even when we had the dot-com crash, the market didn't collapse due to like bad risk management. The market collapsed because there's no demand, which is much safer than what happened in 1987.

Starting point is 00:44:20 And so that was kind of, you know, I kind of bucket those two boom and bus cycle as like the first era because, you know, what happened in the 80s was, you know, a few people realized how to do this. And there was kind of a small set of people who really understood like the technology. And then, of course, once the crash happened, and a lot of people like, hey, well, this is this thing people are doing? Like regulators started looking into it more. but then in the 90s what happened was basically everyone realized hey I could just start a stock exchange

Starting point is 00:44:57 or in the same way that you have hey I can just like fork this AMM and you know deploy it somewhere else and there's kind of this weird effect of like there was tons of new stock exchanges and then they eventually collapsed

Starting point is 00:45:12 and that's what leads us to 2.0 before we get to phase 2.0 I want to hammer on some details about the first wave. My intuition is that this new frontier at the time of electronic markets enabled by the internet and computation also probably, I'm guessing, opened up the, or lowered the barrier to entry for new participants, right? Like the theme that I think is also probably true is the same thing with defy, right? Like, I personally probably never would have gotten into the world of finance if it weren't for crypto. The invention of crypto opened up the doors

Starting point is 00:45:43 to more and more people to be more inclusive and include them into what was previously, a more permissioned, more siloed industry. Did that same theme happened in the first wave of electronic markets? And who were the people that were new to finance that, like, the emergence of electronic markets really enabled them to come into the fold? Yeah. So that's a great question. So two things.

Starting point is 00:46:07 So my first, you know, my first job was I worked somewhere for this billionaire who was a CS professor at Columbia in the 1980s, he left and went to go work at Morgan Stanley after. And then after a year of like kind of being pushed around by the jocks, jock old school trader people, he left to start his hedge fund, which is, you know, one of the most successful quantitative hedge funds that has been made. but a lot of the people in the 80s and 90s were really like CS and hardware and technology people who like never would have been exposed. And it's sort of similar in defy in a lot of ways. But there's another example. Like so yeah, in the beginning, the very first wave was actually a lot of academics in math and physics and like basically like people who had to do the quant math math modeling for things like options.

Starting point is 00:47:10 because like no one knew how to use them. Right. The finance people couldn't figure it out. So they needed to get like the quants and the math wizs is in there as well. Exactly. And then by the 90s, things had people had a better understanding. And you got made more of the computer scientists, technologists, style of people. So I think one of the coolest examples of this, there are two examples.

Starting point is 00:47:34 The first example is there's this company, I forget the name of the founder, but there's a company called Automated Trading Desk, which was a guy in West Virginia, who was just a developer, just made a exchange in his backyard. He just made, you know, back then there's no data center, so he just bought a bunch of computers in his garage. And at some point, had like 20% of, at U.S. equities volume,

Starting point is 00:48:01 running through this, like, basement in West Virginia because he was just undercutting everyone on feet. He was just charging, like, one-tenth of what like nasaic and nicy we were doing. And then Citigroup got, you know, kind of like FOMO, and then they bought Automated Trading Us for like $800 million. And so it's like there was this kind of like, oh, if you have a good idea, you can get rich type of thing,

Starting point is 00:48:28 which kind of, I think also resembles Dify. I've heard this one before. Hey, guys, I hope you're enjoying the conversation thus far. in the second half of the show, we get into electronic markets 3.0 or Defi and talk about some of these companies that are transcending the barriers or transcending the gap between 2.0 and 3.0. Robin Hood, Coinbase, centralized exchanges, these come to mind. But also we talk about the different ways that electronic markets 3.0, Ethereum and DeFi, are fundamentally constructed differently and where electronic markets 3.0 really rhyme better with 1.0 rather than 2.0. I thought that

Starting point is 00:49:06 was a fantastic conversation. And then we also get into the new risks of Defi. Now that defy has come and solved a lot of the problems that we find in the legacy world, what new risks have we introduced and what is Tarun doing at Gauntlet to help deal with some of these risks? Hope you're enjoying the conversation. There's so much more to get into. Before we go any further, however, we have to talk a moment about these fantastic sponsors that make this show possible. Living a bankless life requires taking control of your own private keys, not your keys, not your crypto. That's why so many in the Bankless Nation already have their ledger hardware wallets, which makes proper private key management a breeze. But the ledger ecosystem is more than just

Starting point is 00:49:46 a secure hardware wallet. Ledger is the combination of the ledger hardware wallet and the Ledger live app. And if you're used to seeing all of your crypto services and favorite the apps all in one place, ledger is where you want to be. Not only does Ledger let you buy crypto assets straight from the app, but it also hooks into decentralized exchange aggregators like Paraswap, which make sure that you are getting the best prices on your trades without your assets ever leaving your control. Defi never stops growing, and the Ledger Live app grows alongside with it. So click the link in the show notes to see all the Defy apps that Ledger Live has, and stay tuned as more and more apps come online. And if you don't have a Ledger hardware wallet,

Starting point is 00:50:24 what are you even waiting for? Go to Ledger.com, grab your ledger, download Ledger Live, and get all of your D-Apps all in one place. Bankless is proud to be supported by Uniswap. Uniswap is a new paradigm in asset exchange infrastructure. Instead of a cumbersome order book system where trades are matched with other humans, Uniswap is an autonomous piece of software on Ethereum, which is what Ryan and I call a money robot. No human counterparties or centralized intermediaries,

Starting point is 00:50:54 just autonomous code on Ethereum. Input the token you want to sell and receive the token you want to buy. Something brand new in the Uniswap EcoSwop, system is the uniswap grants program is now accepting applications for grants. We have been saying this for a while and we'll say it again. Dow's have money and they are in need of labor. If you think that you have something to contribute to the Uniswap Dow, apply for a grant to Uniswap. Just look at the size of the Uniswap treasury. It's almost $3 billion. This mountain of capital is looking for labor. Do you have something of value to contribute to the Uniswap Dow? No matter how big or small your idea is, you can apply for a

Starting point is 00:51:32 Unigrant at Unigrantz.org and help steer Uniswap in the direction that you think it should go. That's exactly what we did to get Uniswap to be a sponsor for Bankless, and you can do the same for your project. Thank you, Uniswap, for sponsoring bankless. I want to talk about one last one, maybe before we leave the 1.0 era of electronic markets. And we had this kind of maybe nasty crisis that was partially as a result of electronic markets in 1987. the Black Monday that you're talking about. Did regulators step in after that?

Starting point is 00:52:08 And what happened to the incumbents? Was there some consolidation? So how did regulators react? And how did the market shake out from a consolidation or centralization perspective? Yeah, that's actually a great question. So regulators really focused on the thrifts. So they focus on these people who were buying the options and less on the stock exchanges. So what happened was there's a ton of bank consolidation.

Starting point is 00:52:34 So a lot of the megabanks you see now, the seeds of consolidation happened then. Like city group at that time in 1987, forget about group. It was just Citibank. They were only like in New York and like Boston or something. And there's this guy named Sandy Weil who became the CEO. And he went on this like M&A spree and just. just bought up, like, hundreds of banks. And one of the reasons he was successful was partially because, like, of the savings and

Starting point is 00:53:07 loan crisis, because, like, government regulators, like, started regulating these savings and loan banks became too unprofitable to be, like, podunk town community bank. That's a savings and loan bank, thrift. And so they were all, like, kind of for fire sale for cheap. And so he had the strategy of just, like, buying up every bank. And then that's kind of how we got to the current state was regulators, regulate the banks and not the exchanges and brokers. But that theme will be recurring in 2.0.

Starting point is 00:53:41 I think the time when regulators started to realize they had to maybe do something in regulating the exchanges was in 1997, which is toward the end of this first era. there was what was called the Asian financial crisis. And the Asian financial crisis, you know, I think is well detailed in this book called When Genius Failed about these like Nobel Prize economists who started this hedge fund that actually caused some of the collapse. Okay, so like wrapping up the first era, we've gone from this analog era where we had orders in the pits and manual human order. operators to this first inkling of electronic markets. And what that did was there was a massive liquidity boom, right? Made these markets more efficient. It enabled new assets. It removed a layer

Starting point is 00:54:36 of lawyers, as you said. There were some asset standardization. We had lower barriers to entry, so all sorts of new entrants. It kind of ended or got bumpy in a crisis. Regulators stepped in. There was some consolidation. These are some of the lessons we learned from the first era. Now, True, take us to the second era. Pick us up. And I think it's maybe starts in the late 1990s or early 2000s. Where are we in our timeline? Yeah, I think the Asian financial crisis might be the end, like 1997.

Starting point is 00:55:04 Let's say 80s to 90s. Let's do that. So now we're in era too. What happened in electronic markets era too? Same way that people get fomoed by crypto and the price to go up. People got fomowed by all these tech IPOs, like pets.com and whatever, all these like things that, you know, if you're old enough. you might remember like your parents being like,

Starting point is 00:55:23 I got a buy, get e-trade and Charles Schwab and go like, buy this company. Have you ever heard of it? Like, and so that era, part of the reason that like the e-trades and stuff of the world could work was that electronic markets made it cheap enough for new businesses, new entrants to actually build these kind of front-end businesses that faced the retail users,

Starting point is 00:55:49 face consumers and hid the complexity from them, but also didn't require extreme, like, ownership of, like, a brokerage firm. Like, like, extreme, you don't have to do as much work as a bank, right? The idea is, like, you,

Starting point is 00:56:05 the electronic markets made it easy to be kind of like a light bank. You could view e-trader, Charles Schwab as, like, bank light. Is this, like, early fintech, would you say, or not quite fintech? Yeah. Yeah, yeah, yeah, exactly. Early fintech.

Starting point is 00:56:19 at each phase, I think there were sort of like bridge companies that connected the two sides. These hybrids. So like in this side, yeah, in this side it was like E-Trade, Charles Schwab when they became electronic, interactive brokers, which was a public company. And then on the between phase two and phase three, it's Robin Hood. And the real question to me is like, if I map this to tech companies, Robin Hood is sort of like my space in some weird way. Like that if we if we view defy as like kind of the the the future. And we're saying that Robin Hood is transcending phase two and phase three just because it has crypto assets on his platform, right? Yeah.

Starting point is 00:56:59 And they also like provide, this like zero fees thing is kind of like I think like this idea, that idea is like very not phase two in a lot of ways in other ways. It's not really phase three either. Right. But it's sort of. So it really sounds like the delineation between these. phases is not clear, as in there is no event that delineates between phase one and phase two, and there is no event that delineates between two and three, is just kind of an overarching theme. I think the Asian financial crisis plus the development of E-Trade that era, 1997, and people getting

Starting point is 00:57:35 home computers was, I can't give you like a date. The precision I will give you is one year. Sure. But 1997 is like a very good point to say. because that was the time when kind of retail users were fomoed into buying stocks and they're like, why should I pay a broker? And like people who were young and had their first computer and dial up internet were like, I can just buy this online.

Starting point is 00:58:02 It's cheaper. Why would I go to this brokerage pay them 5% when I can pay like $8 fixed? Because that was a big innovation and fees at that time, that you had to pay a fixed price for arbitrary size trade. Before that, you had to pay percentage points. Right. And so would you say that phase two is really a story of financial markets and brokerages making their way into the homes of the everyday persons because of computers, because of the personal computer? And the internet. And the internet. And yeah, and home internet. And also the dot-com boom was made it a little bit like or a boros, like it ate itself,

Starting point is 00:58:37 because like people were investing in all these companies giving internet to people at home. Like, you know what I mean? Of course, you know, people had a bit of exuberance, just like, but, you know, like we see in crypto all the time. And maybe went a little crazy. And then, you know, we had this kind of pullback. But after the dot-com bubble crashed, it was a very gentle crash in the sense that none of the financial infrastructure broke. Like in Black Monday, 1987, 1997 Asian financial crisis, the financial infrastructure actually just broke. like markets behaved in ways they were not supposed to.

Starting point is 00:59:17 There weren't correct like risk settings done. There wasn't like risk monitoring. There weren't people really paying attention because the risks weren't really, you know, when something's new, it's oftentimes really people sort of at the, on the edge who are playing with these things, but they're not like trying to actually analyze them. They're just like, I want to like play with cool new gambling toys. And so those standards get learned. over time and there are people who kind of do that.

Starting point is 00:59:45 Trying to stay on the same path, but also going down those quick little side quests. What does it mean for a market to break? As in like, do things just not clear? Is that how you define a market breaking or just kind of go into that a little bit more? What does it mean for a market to break? Yeah, for sure. In 1987, definitely not clearing was certainly one of the problems and not settling. Like, there just weren't enough shares.

Starting point is 01:00:07 Like, brokers promised X amount of shares delivered and those shares didn't. materialize and like that caused people to have even further lack of confidence because they're like oh i thought i bought the share and now i can't like sell everything else maybe markets breaking is like well i brought these shares and some company i have this legal contract where they owe me shares and they don't have them to deliver therefore we're going to court we go back to the lawyers it was the twitter fail whale yes going to court it was the twitter fail whale and if you guys remember that when twitter started they were just like all ways down like this this is like that that's kind of what I mean. Like, you're trying to use the service to buy or sell things and like it just doesn't

Starting point is 01:00:47 definitely down. Turin, would you say 2008 was another example of markets breaking? A little bit different than like the dot com bust in that, you know, that was a bubble in the plus. But 2008 was a bit more like, oh, we don't really understand these financial, new financial products that are on our balance sheet. Yes. 2008 was things breaking for sure. Again, because it was like, in the same way in 1987, people didn't understand. understand properties of options and like when certain risks need to be hedged and when you know like when they aren't hedge like what the worst case scenarios people just were like oh well that's a low probability event turns out it's not when everyone is trying to sell the same time same thing

Starting point is 01:01:28 2008 it's just that it was done with way more complicated derivatives that have no transparency and so there's kind of this theme that whenever there's a big blow up oftentimes you find under the covers that there's this kind of these assets that people don't realize hold risk, but actually are holding a ton of risks. I can definitely see the lens that we've been using, which is like the new entrance are these retail people with their computers. We've got increased liquidity, I suppose, coming from retail. Do we have any new assets in this era?

Starting point is 01:02:02 I guess we have some innovations in like trading fees, that sort of thing. But are there, like we saw the birth of options, really, in the first era. Do we get a new set of assets in 2.0? Yeah, yeah. Actually, I would maybe delineate this era, to be more precise, as like 1997 to 2012. And it has both a boom and a bust. The last cycle had a boom and a bust, and it actually sort of had two busts. But here we have sort of like the buildup to the financial crisis and the financial crisis, and then kind of the recovery post-financial crisis.

Starting point is 01:02:45 And the reason I'm stopping in 2012 is I put the Robin Hood era plus crypto. I'm sort of mixing those two in kind of a new era with Defi sort of being kind of the where we're living in that era now. But what happened then were a couple things. So in this era, there were a lot of new financial products, mortgage. back securities of different forms. Like mortgage back security has always existed, but they didn't become tradable until this era.

Starting point is 01:03:19 And one of the reasons they didn't become tradable was people didn't have a math model that they thought worked. Of course, we learned that was not a very good model, but we also learned that with options in 1987. So there is quite a bit of similarity. And once people had a model, they could, like, write algorithms. to quote prices. And then things became exchange tradable.

Starting point is 01:03:46 You need fewer lawyers. You have way more compute power. We're in this like Moore's Law era at that time where compute power is doubling every 18 months on average. Your home computer was getting doubly as fast every one and a half years. And mobile phones were kind of starting to take off around then. Although, yeah, I think apps really sort of the end of this era. But the new instruments were like kind of volatility futures, so like the VIX,

Starting point is 01:04:20 ETFs. So this was the era when people started really, for lack of a better phrase, aping into passive investments. And this completely changed the market structure of the financial markets. So an ETF, right, is a share of something you buy, that exchange tradable fund. which thanks to electronic markets improving in their efficiency, let you get an exposure to some type of sector. Let's say I want to buy the metals, metal miners sector.

Starting point is 01:04:56 But I don't want to go buy each individual stock. I just want to own metal miners that's equal percentage. When I own the sector, yeah. But it needs to rebalance. Maybe I just want 10% miners, 10%, I don't know, 50% miners, 50% miners, 50%, 50% like distributors in that industry. And I want a 50-50 weighted portfolio, just like a uniswap-la-Khodi-Share. I want 50-50 pool.

Starting point is 01:05:24 But that means I have to go trade to try to keep it rebalanced. And that sucks. And so what people were doing before then is you pay these active mutual fund managers and you pay a really big fee to them to keep it rebalanced. And so ETFs were once people were able to write algorithms that were. we're much better at holding option risk programmatically. ETFs became possible because you could basically say, hey, we're going to, here's what the portfolio is going to look like.

Starting point is 01:05:58 Here's how we're going to rebalance it. And it's going to be done electronically. There's not going to be human in the loop actively saying what to buy and sell. And there's going to be this arbitrage game that's created to keep the portfolio roughly balance. So where does the role of communication? and computation come in with these ETFs. How does improvements in these two things really enable that product? Yeah, so the improvement in communication is that, you know, somewhere in the middle of this era.

Starting point is 01:06:28 So 2003 to 2006, the U.S. government decided that they really wanted to make sort of arguably at that time, you know, what they said the intention was, was not what the outcome was. But what the stated goal was was to make markets more sort of equitable. Every stock exchange had to offer the national best bid and offer. And what that means is let's say, let's go back to my example of like the New York Stock Exchange and the Chicago Stock Exchange. Let's say they're owned by two different companies. One is NASAC.

Starting point is 01:07:14 One is NIZE. And let's say that there are two, there's a company that's listed on both. So there's GM shares at NYSE and there's GM shares at NASAC. Well, before, the prices were allowed to be different. So the NISI could tell you GM's share price is $30. NASDAQ could tell you it's 25, but that was just because like the people trading on NASDAQ think it's 25 and the people trading at Nizzi think it's 30. The U.S. made this regulation called Regulet Neutral Market Service, Reg NMS.

Starting point is 01:07:48 And it basically said every market had to actually go look at every other exchange and quote you the best price. So basically this meant that Nizzi actually had to go to NASDAQ and say like, hey, NASDAQ, what price you're offering? And, hey, we have to offer it at the same price. because there's this idea that this would be like more fairer and transparent. This caused insane consolidation. This is the reason we have like so few exchanges in general. This also just seems completely antithetical to the concept of markets in the first place. The SEC is the agency that put in the regulation NMS in place.

Starting point is 01:08:28 And they're just dictating that the market must price certain assets at a specific price as dictated by the lowest or the best most optimal. optimized market participant that's giving the best price. And they're saying like everyone else must offer that same price. That seems a little bit crazy. Right. And I think it was like that I still like so I wasn't working in the industry at that time. So I don't have at that I don't understand what the intention was because like you read the law.

Starting point is 01:08:56 It doesn't really make any sense in modern terms because basically it led to this consolidation we have where you have an oligopoly of like Citadel jump, a few other people who are the main market makers. So it turned everything into this computer science, distributed systems problem of how do I synchronize many nodes? Think of each exchange as a node. How do I synchronize prices across all nodes in the minimum amount of time? Because, like, there's an arbitrage profit. So the government basically created this, like, weird arbitrage profit. And the exchanges, exchanges don't want to take risk.

Starting point is 01:09:31 They don't want to be traders. They just want to, like, collect fees on every, on volume. So what they did is they invented market maker, maker-taker rebates, which you may be familiar from just on centralized exchanges, or even yield farming in some ways as sort of a maker-taker rebate. But they basically offered you incentives for making sure they met the reg and MS rules. So like if you did a bunch of volume and you also did a bunch of trades that made sure that like the NASDAQ price and the NISI price were synchronized, then you got a cheaper. you basically got a discount on your fees. And that kind of led to this heavy consolidation, both in exchanges and also in trading firms that were market makers.

Starting point is 01:10:18 So you remember how, as in era one, there was this kind of wild west of like, hey, this guy in West Virginia just like made an exchange that had 20% of the daily volume. There were tons of exchanges like that in the 90s. Dotcom crashed killed a bunch of them. And then this regulation really killed all. all of them. And now we're back to kind of this like oligopoly. We have like CME, Chicago Mercantile Exchange, NASA, Knessy. That's a pretty much. And just rehash why the emergence of ETFs were so important in helping accelerate this story. Ah, yeah, yeah. So sorry. So ETFs are kind of guaranteed trading

Starting point is 01:10:54 volume. So one thing that that all of the kind of like smart, I put in air quotes money at that time, was saying it was like, oh, ETFs are dumb. There's tons of adverse selection. Everyone's picking them off. It's exactly the same as SBF saying Uniswap will fail because like everyone, there's a ton of adverse selection. There's a ton of adverse selection, but all these people don't care. They're fine paying 30. What's adverse selection? Yeah. So adverse selection basically means like, you know, you're, when I'm an ETF, and I'm, the ETF is like, hey, I have to buy 500 shares every day to keep my 50% 50-50 ratio of my two assets. You're telling you. You're telling the market, you're going to be a big buyer. And so everyone will front run you and just buy in front

Starting point is 01:11:37 front of you and then they'll sell to you at a higher price. Right. So let's say the current price is $10. Everyone knows the ETF has to buy new shares at 359 p.m. Everyone goes at 358 p.m. buys up all the shares, pushes the price to $2. And the ETF has to buy at $2 and they all sell into that. So like all the MEV stuff you see is the same as this. So it's, but the idea is that like, hey, the ETF's telling you what's doing, so you're going to get front run, so then anyone who holds the ETF is going to lose money. That's sort of true, but it's also there are a lot of people who like, they'd rather just own any exposure, even if it's losing money in the, like, it's not the optimal

Starting point is 01:12:21 exposure. It's still better than sitting on cash for them, right? And they don't have to think. They literally just buy the thing and they, it's sitting in the Robin Hood account. and they don't have to sit and lazy LPing. Yeah, it's lazy L peeing, right? And passive investing always wins. Like, if there's anything that this era has taught us is that passive investing used to be

Starting point is 01:12:43 10% of the market in the early 2000s. It's like 80% of volume in the stock market right now. Just because of ETFs? Because of ETS. And then there's all these other types of like, like all the active managers and mutual funds now rebranded themselves as like, hey, we're like active. active light. We don't do much trading. But that's all boomer finance. That's like targeted to boomers.

Starting point is 01:13:08 Like mutual funds are truly like I don't, I don't think anyone under, I don't think as single Gen Z person knows what mutual funds. Like if we're going to be real. Wait, so just sort of finalize this train of thought, the ETFs and the consolidation in the industry, we actually haven't finished that topic. How did the emergence of ETFs lead to the consolidation that we know today? Ah, right, right. So ETFs had a bunch of guaranteed volume, right? They're telling you when they're buying and selling. And people in the same way that Robin Hood sells or order flows, Citadel, the ETF underwriters, the banks who just want to collect some small fee, they collect a very small fee on creating

Starting point is 01:13:46 and redeeming. So creating is, let's say there's an ETF called the Carr ETF, the Detroit ETF. And it's made up of a portfolio of one-third Ford, one-third GM. and one-third Chrysler. So to create an ETF share, like an LP share, right? When I create a Uniswop LP share, I have to give them ETH, and I have to give USTC. Here, I would take maybe two shares of GM, one share of Chrysler, and half a share of Ford, and I would give it to the ETF Underwriter, and then give me one unit of ETS share. Same thing as like making a Unoswap LP share.

Starting point is 01:14:33 And then there's a redemption process, which is I can redeem one share for the fair value. And so that's this arbitrage game, just like with LP shares, that ETFs created to kind of like keep themselves synchronized to the market prices. So if someone observed a deviation in the price, they could buy the basket for cheap, create the share, and then sell the share for more. And then that way the prices would track. exactly like Uniswana. And basically that arbitrage game became extremely profitable if you bought Order Flow from the ETF. So you were going, the ETF underwriters, the people who are minting and creating the shares like BlackRock. You basically like, hey, BlackRock, sell me your order flow and I'll execute it and make sure it stay synchronized.

Starting point is 01:15:27 And so there's a lot of that that the passive order flow aggregated a ton of volume, but then all the volume got sold to a small number of people executing it in the exact same way Robin Hood is. Now, it provided better execution. It also lowered fees for people, but it did consolidate the industry into a very small number of players. So a very small number of players were responsible and had control over the order flow. And that starts to, in my mind, lead us into like kind of how the whole Robin Hood game stop debacle, how the foundations for that were set. Would you say that that's correct? Like what you are talking about right now is the tremors before the actual event of the whole game stop debacle.

Starting point is 01:16:11 Would that, would you say that's correct? Yeah. Yeah. This was the same thing happening at the like institutional level, like with order flow. Like basically banks used to be market makers. They used to be quoting prices on markets. electronic markets made it possible for small firms who were not banks and didn't have a banking license to quote much faster if they had better technology. And so all these technologists,

Starting point is 01:16:35 like my old boss in the 80s and 90s, they basically front-run banks into being market makers. But then once we had this kind of flip of the passive investing world, banks were like, hey, we're not even going to try to market it. We're just going to sell our order flow. And it's easier income for us. And then that led to further consolidation. That's why new trading firms are actually very hard to start right now, I would say.

Starting point is 01:17:01 In TradFi. And in crypto, of course, it's green pastures. Totally. So let's, in order to keep on like defining this wave to phase two of electronic markets, can you kind of compare and contrast the start of phase two and the end of phase two? And like, you know,

Starting point is 01:17:18 what were the state of things while phase two was getting started? And then once, you know, phase two was kind of coming towards maturity and kind of finishing up, where did it end up as? Yeah, so it started with the dot-com crash and kind of like a lot more, like, people kind of, a little bit like the crypto bear market. Like people basically, there wasn't much retail. There was only kind of like institutions and institutions were trying to figure out

Starting point is 01:17:51 new products like ETFs. By the end, we had these products really growing massively and increasing retail uptake. But we also had very few players who were able to be the market participants who are market makers. And so in a lot of ways, like, market making became just like a very small set of people who could actually do it. which, you know, unlike in DFI, we're like, anyone can be a liquidity provider if you want to be. I think that that sort of is, you know, we started, there were more, maybe like a lot of market participants, not many retail products.

Starting point is 01:18:40 By the end, new retail products, not many market participants. Right. So in phase two, and I think also perhaps phase one as well, we are increasing the accessibility of markets to, more and more participants, yet the service providers, the people actually routing trades and making sure things execute, has consolidated to a fewer and fewer set of people. You say that's correct? Yep. And what's the role of the stock exchanges in Phase 2? Where's the NASDAQ?

Starting point is 01:19:07 Where is the New York Stock Exchange? How did those grow and develop during Phase 2? Yeah. So those grew kind of the way in the, you know, after the savings and loan crisis, I said the government's like regulated these drifts. and then like you got these conglomerate megabanks. You had the same thing happen where basically like after Reg NMS came up, basically it was impossible to be a small upstart exchange and everyone just sold to

Starting point is 01:19:37 CME or NASAC or NICEC or NICEC or NICE. So like the big exchange conglomerates you see now are they just basically bought up everyone. So when I say fewer market participants, I also mean fewer venues. Right, right. And also, correct me if I'm wrong, but we're also kind of seeing like the very early days of what the crypto knows as MEV also crop up during phase two, where like there's, you know, everyone wants their orders prioritize first. And then the people routing the orders have the advantage. Can you talk about the early days of MEV, but in electronic markets phase two, which we wouldn't even have called it MEV? Did you even have a name?

Starting point is 01:20:15 Just high frequency trading. Just high frequency trading. Talk about the emergence of that. Yeah, high frequency trading really refers to like, when exchanges started selling co-location. So exchanges were like, hey, you know what? We should actually sell, I wouldn't say it's like selling priority, but they kind of were like, hey, we'll like sell priority in some weird way, where if you pay to rent a server at our data center,

Starting point is 01:20:42 you get slightly faster execution speed. And then it became this kind of like hardware war of like who could build the best hardware. And high frequency trading boil down to like who could build the best hardware so that your order got the moment you got a new signal, you could process the signal as fast as possible in like output and order as possible. And so people started making custom hardware for that. And that kind of was like, I'd say like the peak peak HFT was actually post-financial crisis. pre-financial crisis, the technology wasn't that good.

Starting point is 01:21:21 Post-financial crisis, I think the financial crisis in general kind of caused the exchanges to be like, hey, we need a diverse fire business model. And then there was also this new wave of HFT people who are way more hardware and CS and way less quant. And they were sort of the wave of people who are doing that. So some, I guess, I worked in HFT before I came to crypto. So, but like, it, it's definitely like a industry that's, like, focused on, like, speed and execution and less on, like, did I have the right math model. Is there still a huge arms race in HFT, Turin? Yeah. I mean, it's kind of, the arms race in HFT has also led to, like, super consolidation.

Starting point is 01:22:08 Because, like, just, yeah, the cost of, like, hardware, microwave towers, everything is gone up exponentially. and the profits have decayed. So, like, yeah, basically it's... The profits don't totally decayed. They're kind of flatlined. But if the cost of hardware is going up every year, then it's like only the biggest ones are going to survive. Would you say the whole high-frequency trading phenomenon?

Starting point is 01:22:32 Is that more of an afterthought of the phase two of electronic markets? Or is that, like, a core component of it? It's definitely enabled by... That's a core component at the end. At the end. Yeah. Why at the end? So I think the financial crisis caused people to be very cost-conscious, which will lead into phase three.

Starting point is 01:22:50 And so when people are cost-conscious, they want really fast execution. Because there's a sense in which the faster your execution, the lower the information difference between market participants. Because markets are synchronized faster, and that means the prices are the closest to the true price in some sense. the MEV part of this was just like, hey, if there's a ton of people competing to be first, then they're all competing and keeping the prices synchronized, right? Like there's sort of a sense in which competition does drive prices down. The MEV case is a little weird, though, because the order flow is public, right? So it took Citadel a while and Virtue and others to realize they should be buying order flow by writing contracts.

Starting point is 01:23:39 So you do high frequency trading, but you sign multi-year deals with Robin Hood or whatever to buy all their order flow. In MEV land, it's actually quite different. The order flow is just public, right? Like, it's sent to the mempool. Of course, like with some nuance, I mean, some miners let you send order flow directly and stuff like that. So before we finish out the second era and go to the third era that we are in right now, I got to ask a question.

Starting point is 01:24:08 Did we remove any lawyers in this 2.0 era? Yeah, I think we, like, added a bunch of lawyers in the beginning because, like, people wanted to make these crazy volatility products and mortgage back securities and weird derivatives. Like the Matt Levine's of the world, that's when their careers took off. Financial Crisis killed all those lawyers, I would say. You know, I think there's a reason he's a journalist now. I'm not doing that.

Starting point is 01:24:35 I mean, there's probably many reasons, but I wouldn't, I would say that's probably one of them. What about the second phase really killed the lawyers? I think basically the advent of high-frequency trading and the advent of passive investing vehicles meant you didn't have to do all sorts of weird structuring. Because the passive investing vehicles made this arbitrage game a little bit like Uniswap that kind of replaced the lawyers having to do the pricing. the market was able to do the pricing without them. When it comes to the financial crisis, how did the state of the market structure as a result of the changes that we saw in Phase 2, the way that the markets were set up and architected, did that change or impact the financial crisis at all?

Starting point is 01:25:23 I think it did for these kind of like ethoteric securities, like mortgage-backed securities. partially because those were all traded on weird venues or over the counter between banks. So there's no transparency into how the contracts, what the terms of the contract are and how they get executed and what triggers payments. And I think, you know, when we go to phase three, we'll talk about how like that defy is kind of like made, makes, lets you do that without lawyers. and also while making it transparent as to what the payoffs are. So I think it's time that we actually move on to phase three. But first I'd like to summarize phase two. How would you characterize, like, if you could do it in just like a sentence or two,

Starting point is 01:26:08 how would you characterize the legacy of phase two? What did it leave behind as we go into phase three? Passive investing is the main way the market wants to invest if you want to increase the number of market participants. To HFT, completely annihilated. the banks from market making. And then the order flow business is created, but for institutions, not for retail, but phase three will move to that.

Starting point is 01:26:39 And what's the incoming themes for phase three? And also was there some sort of, you know, event or year that really marked the leaving of phase two and the entrance into phase three? Yeah. So I think, you know, if I go by industry profits, the peak profit in year for high trading was 2012. So that sort of like signals to me one of the ends. Like that was like the pinnacle of that era.

Starting point is 01:27:08 And what happened from 2012 on was this new, new entrants of retail via apps like Robin Hood and also via crypto, retail into markets in general. And I think like centralized crypto, and Robin Hood are sort of the stepping stone. And Defi is sort of like the expression of like that taken to kind of its logical extreme of how can we sort of remove middlemen. So the thing about HFT is it's often reviled like, oh, people front running us. But the weird thing is the prices for everyone, the reason Robin Hood can exist and offer you free trading is because like HFT is so competitive that the price is just like,

Starting point is 01:27:57 fell through the floor. And basically, you know, these like traditional brokers can't take like percentage points at all anymore. Right. So there are two sides. You say high frequency traders brought prices to the floor.

Starting point is 01:28:11 Do you mean like the arbitrage opportunity as in like margins for arbitrage got tighter and tighter and tighter? Exactly. And so like a lot of these like old school brokers who like that's, that's where they made their money, couldn't do it without a ton of technology and a ton of resources. And so, like, obviously the technologist kind of killed the fat cats in that case. So would you say phase three is not, phase three isn't defy.

Starting point is 01:28:37 It's more about access to markets. And so I think perhaps the reason why you're including Robin Hood in phase three, even though it has nothing really to do with crypto other than the fact that it allows crypto assets on its platform, is that it's really. Robin Hood is the weed of defy. It's the gateway drop. It's like, it's like coin base two perhaps. Like these are these.

Starting point is 01:28:57 that are like phase 2.5 maybe? Really? They're, they're, they're kind of these transition things. Yeah, yeah, exactly. Okay, so how would you characterize phase three then? What's the theme of phase three? Why does phase three exist? I think the theme of phase three is internet culture and memes will beat suits in some sense. And, you know, I think a lot of people who are doing quant trading probably have had better decades than they did since kind of this era. And what is the underlying technology of phase three that really unlocked phase three? Yeah, so there are two aspects to it. One is new backends, some new backend technologies that replace intermediaries.

Starting point is 01:29:45 So that's crypto. And the other is the mobile phone. So, you know, yes, the iPhone came out in 2007. but if you remember for like two or three years Apple not only didn't have an app store but you could jailbreak your phone and like install these kind of like renegade third party app stores and we kind of had a little bit of like

Starting point is 01:30:11 the like hacker culture in mobile phones that completely got eviscerated by the app store and so like by 2011-ish I think I feel like that was that was sort of the you know, the era of like centralization in mobile phone land. And why is that as such a thematic component of phase three? Why does that matter so much? Because it changed the user experience for finance.

Starting point is 01:30:38 Like basically people got super comfortable. Once they got comfortable with mobile phones and apps, they also got comfortable with mobile finance, like doing finance on your phone. and the idea that you can do this without going to a branch, remember we started in the 80s where you had to go to the weird brokerage firm in your town and go stand in line, whatever, and now it's just like, I can just use this whenever, or feels like 24-7.

Starting point is 01:31:09 That was like a huge tectonic shift, and that was something I think that brought new users and new people, new entrance into the marketplace. And I think the other thing that's interesting that kind of really took place is that crypto over time became kind of the prediction market for what would happen in stocks.

Starting point is 01:31:34 So I feel like the boom of retail investing started in crypto and then kind of got copied by, we saw the same trend of like memetic investing over sort of like fundamentals-based investing kind of seeped through. we also saw sort of like disintermediation or like calls for disintermediation

Starting point is 01:31:59 from crypto kind of starting to be seen in the equities market especially after the GameStop stuff and you know people actually realizing that hey the back end of the financial system is actually still whatever stuff was made in the 90s like it hasn't you know and

Starting point is 01:32:20 then, you know, we sort of see this idea that like retail users want to buy exotic products. Like the, you know, I think DFI portended this thing where like options volume on Robin Hood has never been, you know, it's like there was more retail volume in options than institutional volume for the first time ever this year. And this idea that financial access to even complicated products. is made easier by A, sort of mobile phones, B, everyone has computer with a ton of power around them all the time, like, and they can be

Starting point is 01:33:06 crunching numbers and doing kind of like basically doing all of the financial modeling themselves without any infrastructure costs. And then C, this idea that you can use financial products and apps almost as easily as it is to use Facebook or to use social media or Twitter. And I think that is really what portends to Defi, where once you have composability, it's just like,

Starting point is 01:33:41 you know, using apps on your phone, like using integrating apps on your phone and being able to like play with a much larger universe of products. So I think the last phase has really been, is really brought up by the de-institutionalization, first of all. That's clear that that is the number one trend. But the second thing is that compute has become so cheap and easy, and communication is so cheap and easy for everyone, not just for companies, not just for exchanges, not just for market makers, that these markets can kind of, scale to all humans and also at the same time be awake 24-7 and people can create and destroy products as they need them, which I think in normal finance is extremely slow to make a new financial product. And it takes a lot of time to get liquidity and get people to understand

Starting point is 01:34:42 what it is. And defy and crypto really have made it so that the inventors of the products can be their own marketplace. They can be their own media. Go, like, you know, go market down Twitter and TikTok. And then they can also just, uh, kind of like do this without any, with like relatively low capital costs. Turin, I'm interested when we talk about like the first era and the second era, right? And, um, we talked about these kind of companies and products that are sort of these bridge-type products. And maybe Robin Hood is one such bridge product, right? But what strikes me is the way era three is different than era one and era two is the previous electronic market eras existed within the existing financial system, right? Whereas era three is creating this brand new,

Starting point is 01:35:40 almost from the bottom-up financial system, where all of the themes that we saw in the first and second era of like increasing liquidity, enabling new assets, removing a layer of lawyers, standardization of assets, your C20s, right? Lower barriers to entry. All of these things seem to be like almost on steroids in this third era, in this new parallel financial system that we've invented. So it feels like Robin Hood is just this like bridge thing to get us to this weird, bizarre, world in this new financial system that we've built from the ground up where it's like era one and era two except amplified to you know to the 10th degree um what's your take on that yeah i mean i think that's a that's a good way of thinking about it it has this like exploratory

Starting point is 01:36:33 playful nature though that sort of feels like a little bit reminiscent of the early part of the 80s prior to the crash you know like people were just like making all sorts of crazy stuff doing all sorts of wild experimentation. And, you know, I think that's sort of inevitable that we're going to run into some issues, right? We've already seen some issues with defied stuff. But I think the cool thing is the democratization of these assets basically means people will try to use them in weird ways that are not expected. and you know that that's going to be kind of both good and also bad but we're going to get new data points from it and I think the idea is like really about kind of like over time building risk you know I think one of the big things institutions have that retail users don't still don't really have and then they do now for stocks and options that say, but not for Defi, is really tools about, like, understanding risk and stuff. And that's because

Starting point is 01:37:51 it feels like the 1980s and options, where people didn't really know. And, you know, it's like getting the math right is the hard part. Right. And we've kind of, over time, we started with getting the math right, then Ang technology, then getting the math right, then Ang technology. And there's kind of this, like, back and forth. And usually the crashes punctuate the times when we transition between new technology, causes new behavior versus like new math causes new behavior, new product. When I say new math, I'm also mixing new product because there's a sense in which if you're making a financial product,

Starting point is 01:38:26 you do have to sort of define the math of like how the asset gets traded. So Turin, we've got this era of experimentation, this new playground, as you said. Do you think that this might also precipitate, like as in the 1980s, all this experimentation, precipitate some sort of crisis? And could that crisis even cause, you know, regulators to step in and do some things? I'm wondering about the themes that we can learn from era one and era two

Starting point is 01:38:56 so that we can project forward and see what we might anticipate in this crypto-defi era. Yeah, I think, you know, we're certainly going to see some forms of crashes again, you know, we already had, Cryptos had had a few. But the cool thing is they happen faster in crypto. But I think the second thing is that as we get into a world where there's a lot of Defyp protocols, there's a lot of DAOs, and, you know, these protocols kind of like learn best standards

Starting point is 01:39:34 and things, people kind of figure out how to model this stuff, we will eventually have tools that people can use to measure this risk themselves in a manner that's understandable and interpretable when they're building new products. It's sort of like if you could understand how to get composable risk models in the way of composable money logos, then you could make it just as easy as using Robin Hood. True. I want to run this by you because I'm not sure if it's completely true or not.

Starting point is 01:40:08 but the story of this podcast is that, you know, history doesn't repeat, but it rhymes. Yeah. Phase one and phase two are similar, but not completely the same. Phase two and phase three are similar, but not completely the same. But I think I can make the case that phase three is meaningfully different from phase one and phase two in the sense that you talked about how backends are different now. And you talked about how that's crypto. You know, Ethereum and Bitcoin are these new settlement networks that are replacing the bottom of a financial system.

Starting point is 01:40:36 Whereas phase two was an evolution on phase one, right? It was an evolution of financial markets as they currently existed into something new. Whereas phase three is something completely brand new. Now, we're not reinventing finance. We're just in reinventing the substrate that it exists upon. And so while these are the same themes throughout history, phase three is radically different from previous phases in the sense that the guts of the system are completely brand new. Would you agree with that?

Starting point is 01:41:06 I think phase one also is like that. Yeah, I think phase one was also like the guy. Yeah, phase one coming from phase zero, right? Like whatever came before. Yeah, coming from like pit traders like replacing that was that was also similar tectonic shift. Okay. But another overarching through line is that phase three and defy is just way more accessible than what came before it. And you talked about how like, you know, we can easily spin up new financial instruments and, you know, market that on Twitter. And like, I think we have seen... Also, not legal advice. Sorry, sorry, sorry, I should have. Very much not legal advice, never, ever. I think we can take a lesson from Andre Cronier's book when he, you know, releases yearn and it has this, like, this accidental success that he didn't even intend to market it. Right. Like, and he actually got frustrated at the level of success that it saw because of just the nature of the industry.

Starting point is 01:41:59 And so we are now seeing a complete democratization of what it means to make a financial product just because of the nature of this new. substrate. Yeah, for sure. It's completely different. It's completely wild. But there are still lessons to be learned, for sure. And I think a lot of the lessons boil down to like, how do you think about risk? At each new stage, there was a new mental model and new mental framework that needed to be invented, new tools to kind of think about risk. Because like a lot of the point of different financial products, like new ones, is to do risk transference at some level, transferring risk from some part of the market

Starting point is 01:42:42 to another part of the market. And in defy land, it's even wilder because the risks are sort of, when you have a composable network of apps, you know, the figuring exactly kind of like how to hedge that under any different possible user behavior is is quite different than, oh, I'm just hedging the exposure to the stock price and it's like a static object in some sense. There are a couple of themes that I want to revisit here. One of the themes is the removal

Starting point is 01:43:19 of lawyers out of the system. Can you talk about how, you know, phase three has removed lawyers? Yeah. So I mean, DFI definitely is removed lawyers. So I view Uniswap liquidity shares and and all of the generalizations of them as basically ETFs where you don't need Barclays to be the manager. Like the smart contract is the underwriter and a lot for liquidity

Starting point is 01:43:42 from the perspective of a liquidity provider, right? Because the liquidity provider is like, hey, I want a 50-50 portfolio and sure, you could use it to facilitate trades. From there, in sort of an abstract sense. And I think there's like that,

Starting point is 01:44:01 There's sort of disintermediation, both at the consumer level, like the retail user can go do it themselves, and at the issuer level. Like, why do I need to go to BlackRock to issue the ETF? And I think that's kind of the crazy, wild improvement that we've seen. Again, not without pitfalls. Like, if history rhymes, we're going to kind of learn that there are hidden risks. but you can only, you know, there's a combination of both modeling and thinking about things and also just like breaking things. And so you kind of need both lenses.

Starting point is 01:44:43 And the cool thing is this industry definitely feels like it's in this phase right now. I think for normal finance and stocks and stuff, I think people just are, yeah, it's like too regulated, like to do anything creative in. Yeah. Speaking of the regulation, I think one of the big ways that this third wave has really broken away from the previous two is that not only have we reduced the need for lawyers, but like to some degree, if you keep your construction of whatever you're building inside of defy inside of smart contracts, instead of needing lawyers, the EVM is the lawyer, right? The EVM is the law. And so not only have we broken away from lawyers, but we've also broken away from regulations, right? Because like I said, the EVM is the regulations. And so I kind of think that like regulators is going to take them a lot longer for them to come to terms with phase three than it was for phase one and phase two just because Ethereum doesn't use the U.S. legal system to settle. And so like if markets quote unquote break down, it's up to the EVM, not to the U.S. court system to make the markets clear. And so

Starting point is 01:45:51 what's your opinion on the fact that, you know, we now have this new court system, which is the EVM rather than the U.S. legal system and how regulators are going to approach this world of crypto using lessons from phase one and two. Yeah. I mean, I think the initial regulator strategy was, of course, block the on-ramps. So I will say regulators took a long time for electronic market, like the early, for phase one. They, like, didn't know what was happening. It's like closer to this right now.

Starting point is 01:46:22 I think that they didn't have the tools. They weren't really sure. Like, because they're so easy as start a stock exchange and you didn't have any regulation on this national best bid and offer thing, you shut down one like someone else will come up. Like it wasn't as structured as it is in crypto where it's like built around that being the modality. But that was what was happening in the like late 80s, early 90s for sure. But I would say, yeah, it's going to be hard for them. to grapple with. But I think that's the beauty of

Starting point is 01:47:02 kind of being in this space right now is that, you know, for now, I think it will be kind of, you can actually try out all of these new things without, you know, with some level of impunity. I think in the long run, governance will somehow end up being,

Starting point is 01:47:28 part of like regulators will somehow try to like you know like the block the fiat on ramps will be block the governance on ramp type of thing like that I think that's the route they would go yeah with the themes that we've been following so far in the show how would you account for just the fact that there's a massive number of centralized exchanges that have cropped up right in 10 20 years we haven't really seen exchanges outside of the new york stock exchange or the nasdaq but as soon as crypto shows up, we got Coinbase, Crackin, Gemini, Binance, you know, OKX, you know, BitThum. And that's not even to talk about the decentralized exchanges that exist on Ethereum. Why was that enabled?

Starting point is 01:48:09 Like, what part of this story enabled so many exchanges to just crop up? Yeah, I mean, it's a little bit like the early 90s when in stock exchanges, anyone could just go start a stock exchange randomly, right? And the difference is, if you remember, in phase two, we had this regulation that completely killed a lot of the stock exchanges and forced consolidation. In crypto, it's much harder because a, your Fiat, the centralized exchanges are the Fiat on ramps for most people, and they need to have local banks. And I think it's just way harder because it's like a global phenomenon to like imagine a world where there's like one centralized exchange.

Starting point is 01:48:54 I think the other thing is just there's so many assets and so many like different like standards at different exchanges for which assets they have, how much the could do they have. And it's actually really hard to do a lot of the arbitrage. Like people are like, oh, there's so much easy arbitrage between like the Thailand to Bitcoin exchange and the U.S. one. Well, the problem is you need a ton of Thai bot and a Thai bank account to get money into that exchange. Right. So there's all sorts of weird, like, pseudo-regulatory reasons for, like, the kind of, like, explosion in centralized exchanges, I think. But, yeah, I think the Fiat on-ramp thing is certainly the main thing governments know how to do. And that's, like, the only thing they'll probably continue to do.

Starting point is 01:49:41 So, Turin, you've mentioned a few times as we've been talking about, you know, phase three, that each of these other phases have presented new risks. and, you know, defy in this crypto phase presents new risks as well. I'm curious from your vantage point, and, like, you've got, I mean, you're working on this with gauntlet, your investor in the space, all sorts of things. You know MEV in and out. What are the big risks that you see on the horizon for defy and crypto at this point? Yeah, I mean, I think we, the composability is a two-sided sword as well. You know, there's the boons.

Starting point is 01:50:18 it's much more capital efficient in some sense. But obviously the risks are that you could compound your risk as you move through different protocols. But I think one of the bigger risks over time is going to be more from like users not understanding what they're buying. and I think that's like in general kind of fine. I think it's much harder when people are taking a ton of leverage and they don't understand when their leverage might, like, when they get liquidated or when something like an adverse event happens. And I think a lot of reducing that is figuring out how to convey

Starting point is 01:51:09 in simple terms, sort of likelihoods and probabilities of risk to users in a way that they can understand and in a way that they can say when I do action X this is how much it will change my risk. Now, a little bit like options in 80s, like, you know,

Starting point is 01:51:30 the math isn't there yet. The way of reasoning about things isn't totally there. But, I mean, that's sort of what we work on at Gondland. But it's like there's still this sense in which there's a lot of like fly-by-night kind of behavior. And I think if we don't have good risk,

Starting point is 01:51:49 we're not going to risk models, risk assessments, risk kind of understanding, we're not going to actually be able to get to this kind of dream of like closer to under collateralized loans and closer to being more capital efficient than centralized exchanges. Because capital efficiency comes to the cost of security, like how much capital you put comes at cost of like,

Starting point is 01:52:15 oh, how easy is it to take advantage of the system? And being able to walk that tightrope carefully is going to be the key to success of Defi kind of taking order from my point of view. Yeah, I will say just from like a practical perspective, it is really hard to understand the risks. So you take something like, you know, A-di versus C-dye, right? So like dye wrapped in compound versus die wrapped in Ave.

Starting point is 01:52:40 I have no way to tell the, you know, like the risk difference between those two assets and if one is riskier than the other. It's very difficult. Is this the sort of transparency you're talking about? And what do you do at Gauntlet to help with this? Because it seems like a lot of these things are hidden and like the risk is really difficult to quantify. So how do you start to quantify the risk of these types of things? Yeah, I think, yeah, so something the difference between A-di and C-di, that is not static. It's not like I can tell you forever at all times that the A-Di is safer than C-Di or C-Di is safer than A-Di.

Starting point is 01:53:17 It's always changing based on the user behavior in these systems. So it's dependent on the types of loans that there are outstanding. It's dependent on the types of liquidity providers, how often they're adding and removing liquidity. It's dependent on the liquidators. Can liquidators? Are there enough liquidators? Do they have enough dye? And so this complex mesh here is different than normal finance in another cool way, which is you have multiple agents and participants who each have to sort of, if they're rational and the market conditions make sense, each of them working as expected somehow keeps the system safe.

Starting point is 01:53:59 But if any one of them is sort of removed, the system can collapse. And that's just the nature of decentralized version of this versus sort of like a bank. If a bank collapses, well, government bails out or, you know, like the legal system somehow resolves that, right? That's not going to happen here, right? So the key here is to make sure there's sufficient incentives for all of the participants and that all of the participants can earn a profit given their sort of utility, their measure of happiness in these systems. And so, you know, what gauntlet, you know, how we started and kind of how we got to where we are now, is when I was working in high-frequency trading, a lot of the ways that we were, we would optimize and measure risk in our trading strategies that we'd put in production is we would take our strategy

Starting point is 01:54:50 and we would take what we thought other people's strategies are in the market, and we would run a simulation where they sort of played a game against each other. and we run millions of different universes of the same simulation and say, like, hey, what percentage of the time does our strategy win? And which strategies does it win against? Crypto markets are kind of similar. There's, in the case of a lender, there is a borrower, there's a lender, and there's the liquidators. The liquidators are keepers. And they each have different incentives. The liquidators have very low time preference, and they just want to optimize profit instantly. the borrowers just want to pay the lowest rate, and the lenders just want to earn the most yield. And they all, even though those three are sometimes opposing, you can find these equilibria where they're very stable,

Starting point is 01:55:42 but you need to be able to say, hey, what do I think this user does, what do I think this other user does, and whether I think this other user does, based on the data that you've seen historically, and also things that you haven't seen, but could be kind of irrational, crazy behavior from them.

Starting point is 01:55:59 And crypto systems are also analyzed this way. When we analyze consensus protocols or we analyze zero knowledge proofs, we try to model a world where we assume that these adversaries or users can be Byzantine and maybe not rational and maybe sort of doing something erratic. And so what we do is we model all the users in the system and then run simulations of them kind of competing using historical data. and then say what percentage of the time does this particular type of adverse event, like a liquidation, happen.

Starting point is 01:56:35 And so it's slightly different than the way people quantify things in, you know, the way people think about risk models in sort of like an insurance company or sort of like more like an asset manager. But it's much closer to how people in high frequency trading and sort of AI in a lot of ways think about modeling risk. because here, the transparency actually means you can model it in a way closer to HFT or AI. And so, you know, from doing that, you can start to say things like, hey, if the parameter, the interest rate curve in the system was slightly different than this event happens 50% less.

Starting point is 01:57:16 And so that's sort of the outputs of kind of this type of modeling, if that makes sense. True. And I want to put on my like blind bull hat and then I want you to see if I'm being naive or smart or not. And a lot of the with these phases, phase one, phase two, there was some sort of like market event, market crisis that perhaps ended the phase and then moved on to the new one. Also regulators came in and started acting because of the crisis and started to, you know, shake things up a little bit. And I want to know if that's going to come true for defying crypto, right? So far this industry has been being relatively blessed to be protected from some a heavy-handed regulation. And there's definitely been conversations and some light regulation coming

Starting point is 01:57:55 But overall, as an industry, we haven't really been too regulated. We also really haven't had too much of a financial crisis because this, A, this industry isn't big enough to really have a financial crisis. But B, like, we go through booms and busts, and we have our market events that are negative, but they just don't really impact the greater globe. Crypto has gone through, like, multiple major drawdowns of 90% in asset prices, and it survived that. The market survived that. DeFi was born in 2017, 2018, and then we, we saw ether lose 95% of its value. Defi kept on going.

Starting point is 01:58:29 Worked just fine. Then we had Black Thursday with COVID or Black Tuesday or whatever it was, where asset prices got cut by 60% in under a day. So we've had both like long-term drawdowns with asset prices that caused liquidations and things were fine. And then we had extremely fast volatility drawdowns and very short amount of time. Things kind of got broke up a little bit, but ultimately markets cleared. The Ethereum blockchain kept ongoing.

Starting point is 01:58:53 Nothing really bad happened. and what you are talking about with this financial modeling that's going on that you guys do at Gauntlet to talk about, you know, risk parameterization for AVE and compound. We are able to do that by the very nature of what DeFi is. We have the data to do that and we can make more informed simulations to make more informed economic platforms. And so my bull case for DeFi and Ethereum and this industry at large is that we have so much data permissionlessly available to everyone. And we have this new financial substrate,

Starting point is 01:59:28 which is Ethereum and the EVM, that will continue to clear markets no matter what, as they have done, that perhaps we never actually have our big financial crisis moment that previous phases have had, that have brought in the regulators. And so perhaps the EVM and the Ethereum blockchain just keep on chugging.

Starting point is 01:59:48 People like you and companies like Gotlink, keep on doing great financial, modeling because of the richness of data that we have. And we are actually protected from any sort of massive financial crisis by the very nature of the industry. Am I being naive here? Well, you could argue that BSC was a financial crisis in some ways, just in the sense of like, in the sense of like all of the kind of like rug pulling.

Starting point is 02:00:15 And like, I think that the key thing to a financial crisis is there's a lot of naive or uneducated participants who lose a lot of money. And right now, the thing is, if we're being real, everyone in this space is like a little bit like, you know, paying, their risk tolerance is certainly not low, right? It's not like, you know, like, the SEC only really goes after people when, like, grandma loses her pension money, right? And like, that's the, that's kind of the type of thing, I think that would be more, like, institutions losing money.

Starting point is 02:00:51 Like some, let's say like some college endowment, like puts money into iron finance. Because Mark Cuban told them to. I don't know. I'm just like, that's the type of stuff I think that like people would call a crisis in some ways.

Starting point is 02:01:08 It's like when moms and pops lose money who are not kind of like risk seeking to some extent. And I'm not trying to say, I'm not trying to call everyone on this call super risks, but I'm just saying, you compared to like the people who like, yeah, like pension funds kind of, that's kind of when people start getting a little antsy, I feel like. Okay, well, my question still stands though. So like, is there a fundamental difference in these phase three of electronic markets that protects

Starting point is 02:01:40 us from systemic risk that we've seen happen in previous markets? Yeah, transparency. So one, one really cool thing, I think, that exists in crypto is that we've already, we have like tons of CDOs of mortgage-backed securities in Dufi. They're just under different names. Like you could view Maker as MKR as sort of like security for a CDO. You could view staking derivatives like Lido, which basically as sort of something like a little bit like a mortgage-backed security

Starting point is 02:02:17 backed by your stake that's locked up. And the cool thing about them, and this is the difference between 2008 and Defi, is not necessarily just that, you know, hey, it's electronic. The data is super transparent. It's also that the information is propagated through all the entities using things because of composability. So in the mortgage crisis, well, here's kind of how things would happen. you would go get a mortgage. Your mortgage issuer would then go securitize it. The securitizer would make shares, like they'd make a company that bought your mortgage.

Starting point is 02:03:00 That company would have shares. Those shares would get sold. Now, let's say you default on your house. So the company owns a bunch of mortgages that owns the securities. The default process takes like three to six months. I mean, a very locality to locality sensitive, right? like, oh, like, you know, maybe certain places, like, you can't foreclose on a house in one month, other places you can foreclose instantly.

Starting point is 02:03:26 And there's a whole legal procedure. And there's also all these middlemen. There's the person who made the company that's securitizing. There's the mortgage issuer. There's like this whole, like, cruft of that industry, which is mainly due to regulatory capture, to be honest. And so the security has a price. last traded price, but the information of like which houses are foreclosed, what's the true value of like the mortgages inside this black box, that's the company, it could take six months to reach

Starting point is 02:04:01 the security, like the securities holders will only learn about it six months later. And they'll be, they'll only learn about it via some weird disclosure form that's regulatoryly required, not because like the issuer wants to tell them. In Defi, you're issuing these crazy securities, but the information is priced basically instantly, like within a couple blocks, right? Like something happens, smart contract executes all of the price change. There's a decision tree of like, hey, how should we mark all the different components and like, here's the new price of the security. That fact that the information in a complicated financial product can be propagated through it and executed atomically and sort of instantly, basically instantly, is a hallmark of how this is

Starting point is 02:04:47 much more different than kind of what we saw in 2008 and why all the lawyers were necessary there because the lawyers were the ones who were like propagating the information between the different entities, right? Right. And ensuring that these transactions were order. They were order. They were order. They were order routing.

Starting point is 02:05:05 And lawyers, in case anyone listening doesn't know, take much higher fees than Robynode. So, yeah, you could basically think about that. And so I view the lawyers in that whole industry as like the open pit, you know, to get back to phase one, like the open outcry of people. They're the ones who are like doing the hand signals and shit. And they got replaced. And this feels a lot like, like, Defi really feels like it's these complicated financial products that were gate kept are now kind of being unleashed. So, Turin, this has been an incredible, I guess, walk through the three phases of, electronic markets here. And I'm wondering if you could just like leave us with a few final thoughts

Starting point is 02:05:53 for this phase three era. It feels like we're maybe still in the front half of phase three, but I'm not sure. So how do you see this playing out and how can we prepare ourselves for the rest of phase three? Yeah, I think the sort of main things to think about are you know, one, what primitives will be invented that might be even further out on the risk scale that get lots of capital in? Because I think those are the places where you're most likely to have kind of these kind of potential crashes, like super highly leveraged things that like, you know, get stuck in certain ways. Like there's no liquidation mechanism. There's no way for things to exit correctly.

Starting point is 02:06:49 But on the more positive side, being able to actually see like C-Fi entities become front-ends for defy because they just don't think their businesses are regulatory not viable. And so it's just easier to be a defy front-end than to actually be a centralized exchange. I think that that is the sign of like the transition into the new phase. we have a word for this. Yes, we have a phrase. We call this the D-Fi Mullet, Turin, which is like, fintech in the front, defy in the back. Yeah, exactly. It's really cool to see that with exchanges in crypto banks moving forward. Man, it's been great to have you. You are a wealth of knowledge, sir. Thanks so much for joining us on bankless. Thank you for having me. Action items, guys, we have some

Starting point is 02:07:39 books to read. Turin was kind enough to leave a book reading list with some of the themes from the episode. We will include that in the show notes when it's called Inside Job, Looting America's Savings. More Money Than God. When Genius failed, a few of the books there. So make sure you check those out. David, we could also use some more five-star reviews, I think, because you know how I know that? It's because we could always use more five-star reviews. If you're on YouTube, by the way, like and subscribe. But if you are listening to this on the Apple podcast, what should people do, David? They should absolutely go and give us those five-star reviews to get the banklist podcast up to the front of the markets and investing podcast business markets investing the wave three

Starting point is 02:08:18 is upon us and more people need to hear about it and they are hearing about it on the bankless podcast so go ahead and give us those five-star reviews absolutely guys of course risks and disclaimers none of what we said was financial advice not even a bit eth is risky bitcoin is risky crypto is risky so is defy we talked about some of the risks near the end the key thing is you could lose what you put in but we are headed west this is the frontier it's not for everyone but we're glad you're with us on the Bankland's Journey. Thanks a lot.

Bankless - 74 - The History of Electronic Markets | Tarun Chitra

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