Odd Lots - Tom Schmidt Explains What You Need to Know about DeFi

Episode Date: June 28, 2021

By now you've no doubt heard about DeFi: the hot vision of crypto that aims to disrupt traditional lending and fundraising. But the space remains really difficult to grasp. There's all kinds of jargon — Automated Market Makers, Impermanent Loss, etc. — and the markets don't quite operate like traditional markets do. So how does it all really work? Where's it going? And what will it all be used for beyond speculation? On this episode, we speak with Tom Schmidt of Dragonfly Capital to break it all down.See omnystudio.com/listener for privacy information.

Oh, and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthal. And I'm Tracy Allaway. So Tracy, we've obviously done a few, or at least a couple, defy episodes this year, decentralized finance, sort of the hot thing in crypto. But if I'm being honest, like, there's just like still like a lot that I don't get. I don't think you're the only one to be fair. Like, I think there seems to be a lot of interesting things happening in the space, but it's hard to wrap your head around a lot of them because, frankly, they are so brand new. And in addition to that, as we've spoken about before, a lot of them seem to be kind of wrapped around each other.

It's like defy wrapped around, defy wrapped around defy, sort of defy all the way down. and it's hard to figure out exactly what the application is to people outside of the space. Right. And this is, of course, like, I think, like, you know, there's clearly a lot of, like, trading and speculation, and we'll talk about how those markets work because they work differently than, say, the stock market, but then there's also, like, the question of, like, what is it for? Because, like, it's very easy for me to, like, conceptualize sort of traditional equity or traditional lending because I have an idea of like what these financial instruments are for, whereas my impression of the defy space and large part is like it's incredibly sophisticated and

derivatives and all this kind of stuff, but like I still don't know what it's like for per se. Yeah, I think that's right. And I mean, to what I was saying earlier, who it's for, right? When I see a lot of the defy accomplishments, I think like, okay, that's great. You guys have built yourself a really interesting little defy ecosystem. And I know that sounds patronizing, but like, I don't know who's interested in it outside of that. I feel like that's the missing part of Defi. The space hasn't been very good at delivering the message about what this means for people who are actually outside of the defy space. Right. Where it actually sort of competes with traditional finance and so forth. Anyway, we always ask these questions, but I'm very excited

to say, I think our guest today is going to be really good. Multiple people have suggested that he's a great person to talk to, very active in investing in the defy space. So maybe we'll get a, maybe we'll get some answers today. I hope so. Let's do it. All right. I'm very excited. We're going to be speaking with Tom Schmidt. He's a general partner at Dragonfly Capital. It's a venture firm that focuses on the crypto space more broadly. Tom himself is a fairly long background. long as these things go in the defy space, very active in it. So we're going to get all our questions answered. Tom, thank you so much for coming on odd lots. Thanks for having me, Joe. Thanks for having me, Tracy. Tom, let's start with your background. I mean, like, I think the average

person maybe listening to this has been like fending the last like two months trying to understand defy. And the idea that like one could have a long lineage in the space is kind of weird. But you actually legitimately do. What do you give us like sort of like a little bit of like your background in crypto and defy, et cetera, how you got here? Yeah, it's funny that defy is now sort of a thing that people talk about, but it didn't sort of come from nowhere. I think in many respects, my sort of entrance into crypto parallels defy in some ways, not to get too poetic.

I really got into crypto during college. I was writing this sort of computer science ethics paper on interesting topic that anyone can choose. And I ended up doing this sort of Bitcoin regulation back in 2012. And I thought this was this brand new asset. No one really knew what to do with it. Sort of thinking through, hey, how might this thing be viewed in the eyes of the law?

And then sort of actually put it into Bitcoin mining from my dorm room along with a couple other friends. And that was sort of when I got interested in the cryptocurrency space overall. If you look at sort of those early days of Bitcoin, you know, sort of 2013, 2014, the things that people are doing are doing in DFI these days, people were talking about back then, back on, you know, Bitcoin talk where they're trying to do where, hey, there's this new asset, but it's sort of stuck. You know, it's not, it's just, it's this form of money, but you can only just sort of send this money back and forth. And people want to do other things with it, right? People want financial services. People want to be able to exchange.

But in order to do that with Bitcoin, you have to go through a centralized party, like a Coinbase or like a FTX. And they have to, you know, cost of your Bitcoin. They might go down. They might lose funds. They might exclude you. And so there's sort of this weird paradox where you have this great decentralized currency, but you don't have any financial services that are also, that also have those same properties. You know, one of those, those main functions that I mentioned was exchange. Decentrised exchanges have been around for a long time. People have always been trying to build them. I ended up getting, you know, back into the cryptocurrency space in 2017 when I joined ZeroX, which is one of the very first decentralized exchange protocols to run product for them.

And ZeroX is sort of a, this pure to pure exchange where you and I can, you and I can, you and I can, can agree to a trade, off-chain, you can sort of find each other. And then this smart contract basically acts as, you know, sort of the counterparties, the executor at the trade. So we don't have to trust each other. No one's actually taking custody. This piece of code sort of runs it for us. So I ended up working at Xerox for about two years and then joined Dragonfly about a year

and a half ago to do investing for us and specifically focused on defy. What was the transition like from Bitcoin to more of the Defi experience? Because we sort of take it for granted now that there's Bitcoin and now there's all this stuff being built on things like Ethereum in the defy space. But years ago, that split wasn't as apparent. So I'm just curious what the move was like or the transition a few years ago. There were a number of very early attempts to basically build defy the same sort of financial services on Bitcoin. One of them is still around and quite well known. It's called rootstock, basically a sort of side chain that sits alongside Bitcoin where people can write smart contracts that they can on Ethereum that do the same sort of things that, you know, early Defy protocols can do now. So another sort of blockchain called BitShares sort of that came out on the same time

that again had a lot of the same ideas that we see in Defi now, where you could mint debt, you could borrow, you could exchange. It's hard to say why a lot of these didn't take off. Certainly for some purposes, you know, the developer experience of building these things is pretty brutal compared to, you know, the developer experience of billing something on Ethereum. And so, you know, there's an argument that, hey, you just don't have that sort of nexus of developers who are going to make all these things that, you know, interlink.

It's just probably not going to happen. You're not going to sort of hit that critical mass. You could also say maybe it was just too early, right? a lot of things that are happening in Defi right now. Again, we're being discussed, you know, five years ago. But if you don't have the users, if you don't have the liquidity, if you don't sort of have, you know, sort of this confluence of people and capital, you can't really get a true market farming.

And so some of the problems were obviously technological, where, you know, Bitcoin is obviously very slow to upgrade, which is a plus in many respects. But a downside when you're trying to, you know, build something brand new and trying to, you know, tweak the underlying platform to make it easier for developers to actually start building these things. So one of the, you know, within the defy realm, you know, one of the pitches, I guess,

or one of the reasons people get excited about it is like, is the yield opportunity. They're like, oh, you're like, enter into this trade or lock up your asset and you get 200% APY or a thousand percent APY in some cases. And we actually talked to someone several weeks ago who's like a yield farmer, kind of more from the trader perspective. But, you know, this kind of makes my head hurt because, like, no one gives away free money, right? So how would you describe, like, where these returns in Defi come from? Like, what is the activity who is paying you for the service of, say, locking up your ether or locking up your stable coin or whatever? Like, how do you sort of, like, describe some of the basic mechanics at play?

Yeah, this is, I feel like, what has sort of brought, in part, defy into the mainstream maybe over the past years, people see these eye-popping returns and, you know, wonder kind of what's going on because it sounds kind of insane. I think we sort of saw that with the whole Mark Cuban Iron finance thing maybe a week or two ago. I think yield in sort of the defy space comes from a couple places. The main source of yield that, you know, sort of drives, again, these huge numbers that we talk about actually comes from these protocol tokens that are given away. And a very concrete example of this, one of the first projects to do liquidity mining was compound finance. Compound finance, it's a decentralized money market on Ethereum, where people can deposit, lenders and borrowers

can deposit assets into the smart contract and then borrow against it, and if they wish. And so, I don't have to call up a lending desk, get a quote, hope that they're open, have them custody my assets. The smart contracts sort of take cares of all of that for us. And then they also set the rates programmatically. So compound, it's been around for about a year, and a half or so, but about a year ago, so this is March 2020 or May 2020, they announced this program, which has since been dubbed liquidity money, where in addition to the returns that you would get, the interest that you would get, just for lending out assets to somebody who wanted to borrow, so let's say, maybe 6% on your stable coin, your USDC or your Ether or whatever,

they'll also give you some comp tokens. So comp is the native governance token of compound, where people who hold comp can vote on how to upgrade the, compound smart contracts over time. So if you want to add a new feature, if you want to add new types of collateral, if you want to adjust rates, comp holders get to vote on chain as to how that actually gets upgraded. So there's no central party that actually controls this thing. So compound started giving away about 50% of the total supply of comp to people who are using compound. So people who are borrowing, people who were lending, anyone sort of proportionally to how much you actually doing either of those things. So how much capital you were actually borrowing or lending. In addition to this

6%, you started to get this supply of comp tokens. And basically that yield comes from sort of the market price of where people think comp should be trading at. So, you know, if I'm earning, you know, again, 6% on that USC, then I'm earning a few comp tokens and let's say comp is trading at a few hundred dollars, suddenly you sort of project out these sort of two combined assets I'm getting both the USDC, the stable point interest plus the comp. And suddenly my APR looks huge. And so people have basically been tweaking this over and over again, different ways of doing. is liquidity binding, where they're incentivizing growth of the protocol by giving away this native protocol token. And that's a large part of where you see a lot of these numbers come

from. You call them governance tokens, and you describe their value as being able to vote on upgrading the protocol, but obviously just voting rights typically aren't worth that much. Are we really talking about de facto equity in a different name? And as part of the upgrade that one can vote for is directing trading revenue to the token holders. Yes, this is maybe a little bit of a touchy subject in Defi because people do not want, you know, want to sort of skirt around this topic. But I think a lot of people, a lot of investors definitely see it that way where, you know, with compound, there's no company, right?

There's no entity that I want to get take equity in that is, you know, going to take some profit. But the protocol itself obviously generates tons of revenue. And so there's sort of an idea that, hey, these are sort of, of going into the company treasury. They're on this protocol balance sheet. And if I have control over that, you know, much in the same way that, you know, maybe I, you know, have governance rights in a company that has, you know, $100 million on the balance sheet, certainly those governance rights should be worth something, even if maybe I'm not, you know, entitled to dividend rights at the moment because I can vote in dividend rights down the road. I think one of the very earliest

D5 protocols, MakerDAO actually launched with this sort of baked in where MakerDAO, it's a decentralized credit facility where anybody can come up, they can put down collateral, and then they can borrow die, which is the natural stable coin, their native stable coin, against that. So you can put down, you know, $200 worth of ether. You can borrow $100 die against it. And now you have liquidity, which you can use to, you know, for operating expenses, to pay taxes, to send you your friend, whatever. You have this die, which is pegged to a dollar. You can use it for any purpose. Now, Maker obviously, it's a lending facility, so if they figure out how to set rates, rates get set by m-careholders. So it's not,

being done programmatically. And careholders basically to determine how much, how much interest to charge people who want to borrow against them, how people who want to make die. They also take on risk where, let's say that they onboard bad collateral. They want to add, you know, iron token as collateral onto maker. People mint a bunch of dye. Suddenly, die is, suddenly, you know, the price of iron, you know, drops by 99%. And now you have a bunch of unbacked die. So you really want die to trade out a dollar. Suddenly, there's not enough collateral to back that up. So where are you going to going to get enough collateral to sort of reback this dye. And the answer is that the Maker Dow protocol will mint and sell more MKR in order to recilateralize itself. So in one sense,

you're governing the protocol, but you're also taking on this risk because there's a chance you might be diluted if this system accrues debt. And so in response or in compensation for that risk, MCR holders also get reward in that they are entitled to all that interest that is being accrued by the system. That interest is then used to buy back. MKR off the market and, you know, effectively give that back to MKR holders. So MKR, you know, right now you can look online. There's a website makerburn.com, which will tell you, you know, how much cash flow is basically being given back to MKR holders, you know, every single year. And it's pretty insane. I think the last time I checked it was maybe $100 million or $200 million

that is bought off the market and basically given back to MKarholders. So they're a good example of one of the few protocols that actually has those sort of cash flows turned on. But certainly to your point, there's a lot of speculation right now around, hey, when are fees going to be turned on, if they're going to be turned on at all? I think there's a counter argument too, which is, hey, these are all very nascent protocols, right? You really don't want to be charging fees right now. You want to be incentivizing growth. It's sort of like, you know, if you're a early stage startup, you don't want to charge full fee. You don't want to, you know, sort of be maximizing revenue. You want to be maximizing growth and think about how to sort of turn on revenue down the road.

So the equity question kind of reminds me of one of the bigger issues hovering over the entire space, which is, I mean, Defy in my mind is kind of like fintech on steroids. And I used to cover fintech. I used to cover peer to peer lending. And a lot of the use case for that new industry was this idea of we're going to cut out the middleman and we're going to directly connect lenders with borrowers. And we have all this new cool technology that's going to allow us to do it. I'm not saying it's a one for one analogy, but a lot of the conversation around DFI reminds me of that.

So my question is how much of Defi is about the technology versus how much of it is about doing something outside the existing financial system and existing regulation? I guess a shorter way of putting it is like how much of this is regulatory arbitrage and giving people exposure to financial assets that would be more difficult or more expensive for them to get in the traditional financial system. Yeah, that's another great question. And I think it's frankly a large part of the appeal of Defi. I would say, you know, regulatory arbitrage, I think, at face value maybe sounds like a bad word. But when you look at something like Uber or you're looking at something like Airbnb, where, you know, regulations were, you know, probably overly arduous and probably, you know, hampering the growth of this market, I think what's interesting about Defi, there's a couple main components, right?

One being the sort of permissionless access. So anyone around the world can go and use these different protocols any time of day. any time of night, anywhere you are, you can go and trade, you can go and borrow. That's a pretty powerful, I think, concept that you don't have to be

living in a particular area. You don't have to be of a certain status or be able to post particular collateral in order to use any of these things. And so you have this truly sort of global market from day one. The other, as you maybe you were sort of alluding to, is sort of permissionless to build on top of.

And that's where I think this whole thing gets really exciting where I don't have to be incorporated. I don't have to live in a particular locale. I don't have to be certain requirements. As long as I can write software, I can go and experiment. And I think that sort of permissionless innovation is sort of what made the internet what it is, where I don't have to go and apply to the FCC for the license to, you know, broadcast and, you know, buy all this equipment to, you know, set up a television station.

I can just go and take my camera and start posting it to YouTube. And that's where you sort of get this consumer surplus where, you know, these entrepreneurs all around the world are constantly devising new, better financial services. and they have a very low bar in order to actually deploy them and make them accessible to anyone around the world. So you have not only sort of permissionless access, but you also have permissionless access for builders who can, again, just use this thing

as long as they can actually write software. And the third thing that makes it interesting is sort of transparency around it. You know, people sort of, again, site sort of 2008 where you had all this sort of crazy debt, all these crazy derivatives that were piling up. And, you know, sort of after the crash, we saw that many different parts of,

the U.S. financial system were levered like 3.5 to 1. And that wasn't really revealed to us until after the crash, because there was not really a lot of transparency. It was just technically wasn't really possible to see all the different instruments and all the different ways people were positioned. With Defi, you know, as I was sort of alluding to earlier with Maker, you can go to any of these websites right now. You can look at the Ethereum blockchain itself and pull the data and you can see exactly how much debt is issued. You can see exactly, you know, the credit balance of every account. You can see the revenues of Maker. You can see who's going to get paid, who's going to get liquidated, et cetera. And so this thing is 100% transparent

and 100% audible. And that just presents this huge sort of step function leap over what is possible the day where you can have people that maybe make an ATI that is up or available some of the time. And you sort of have to trust that the data is available. But sort of the core base layer is not auditable and is not transparent the same way it is with a lot of the products that are being built in Ethereum, or in the Ethereum DFI ecosystem. So those are sort of how I think about, you know, a lot of the value props of DFI. The fourth, obviously, being and sort of the, you know, direct analogy to fintech is programability.

The difference, you know, being with defy is I don't have to rely on a particular company to grant me API access to, you know, be available when I'm available to have particular uptime to, you know, do whatever is I need it to do. The API is sort of embedded into the contract into the product itself. So as long as, you know, the Ethereum blockchain is running, which it almost, always is, you can go and call into any of these contracts as a programmer and actually go and build new applications. And so, you know, those are sort of a few of the core value props when we think about defy. And certainly there's a lot of overlap with with fintech, but there's a lot of things that

are new and sort of expand the market beyond what, you know, something like a strike could do, for example. So pretty soon I want to get to the question of like, what are these tools being used for besides, say, speculation? Because, you know, you mentioned Maker and I can post-collar, and get die. But my impression is probably most people would do that, just use that money to buy more coins as opposed to anything resembling business. But before we get to that, I, like, here's another question I have. So we'll get there. But here's another question I have. Can you explain impermanent loss? Because I've like had this, like, people have done threads and explained like, you know, the uniswap liquidity providers. And it's like, oh,

just can you explain what that's all about? Yeah, yeah. So permanent loss refers to this future or this byproduct of what are called automated market makers. And so automated market makers are smart contracts that perform the function of a normal market maker on a normal order book based exchange. So normally, let's say you want to go and, I don't know, trade Apple stock, right, on the exchange of your choice. Maybe you want to buy at a certain price. You want to sell at a certain price. You have a market maker who's holding a inventory that is quoting you on both sides, right? They're posting orders to buy, they're posting orders to sell, to provide liquidity to this market so that if anyone wants to show up, they can buy or sell Apple stock at a reasonable price. Now, these same sort of market makers exist in crypto, where you go on Coinbase and you have market makers holding Bitcoin inventory, US dollar inventory, and they're sort of posting these orders to make sure that there's sufficient liquidity in the markets. An AMM basically replaces that function with a formula. Sort of the most popular style of AMN is what we

call a constant product AMM, meaning instead of asking a market maker, hey, what kind of quote can you give me if I want to buy or sell 100 shares of Apple? The answer is whatever the formula sort of spits out. And so that's the quote that you're going to get. And the way this works, again, in a constant product sense, is let's go with another simple, really simple example. Let's say I want to be a market maker for the ETH-USDC market. I can go. I can take some ETH. I can take some USC in equal proportions and deposit it into a smart contract like Uniswap. And now anybody can buy or sell against me, right? This smart contract is taking my assets.

And now they're basically acting as the marketing. They're acting as the quote provider. And anybody can buy or sell any amount of asset through this smart contract anytime they want. And smart contract will give them a quote. So in this really simple example, again, the constant product formula is X times Y equals K. So in this example, let's say I put in 10E, and 10 USDC, assuming ETH is $1. So 10 times 10 is 100. So no matter what sort of amount that you want to buy, at the end, the amount of ether left in the smart contract times the amount

of USDC left in the smart contract has to equal 100. So now the question is, you know, again, let's say I want to buy five ether. I'm a new person. I want to buy five ether from the smart contract. Well, so at the end of this transaction, there's going to be five ETH left, but five times something has to equal 100. So there's going to be a new person. I'm a new person. I'm a new person. I'm 25 USDC left. So there's 20 USDC. So let's say there's 10 USDC, 5Eath. So my quote is basically two USDC per ETH. So this thing is basically able to offer you a quote for any amount of asset you want to buy yourself through the smart contract. Now, the problem is, again, let's say you're that LP. You're the person who put in 10th and 10 USDC. Well, now you've

suddenly sold a bunch of ETH as ETH has presumably gone up in in market. And so you're worse off than if you had just held ETH and USDC. You have five ETH. You have five ETH. You. You you have 20 USDC, that's only $30. You would have had $40 if you had just stayed. In permanent loss refers to this concept that in a concept product market maker, as the market moves, you will have, you know, less busy, less assets, less money than if you had just held on those assets and not put them into this smart contract. It sounds permanent to me.

Yes. So here is the caveat, right? This would normally be an absolutely terrible value proposition, right? You lose money as soon as you start to put assets into this smart contract. The way AMS make up for this is by charging fees. So Uniswap, for example, charges 30 bits on every trade. And the idea is that with enough volume, those fees will begin to make up for any of any of that permanent loss.

And additionally, you sort of want what we call mean reverting assets. So you actually want a lot of volatility because that's going to encourage people to trade. That's going to allow you to accrue fees. But ultimately, at the end of the day, you want those assets to sort of return to the ratio that they were when you put them in initially. And that's how you sort of avoid impermanent loss. But to your point, if those assets never return to that initial ratio, so let's say you become a liquidity provider for ether, when eth is $10,

and ETH goes up to $1,000, eth is probably not going to go back to $100. You probably would have been better off just holding onto that ether instead of putting into the smart contract. But with enough volume, you can, in theory, make enough on fees in order to compensate for that loss. So at a very high level, that's sort of how the whole A&M, and permanent loss sort of the thing works is you're sort of banking that there's going to be

enough volume, so you're going to be able to accrue enough fees in order to offset sort of this drift in asset prices. Okay. I have a question. And it sort of feeds into where we want to go next, which is the real world applications and what people are actually doing in this space. But it feels like there is a huge obstacle to defy going mainstream just in the fact that it seems very, very complicated. So what you were just discussing about impermanent loss, it feels like I am going to have to go back and re-listen to that conversation a couple of times in order to wrap my head around it. How difficult is it going to be for these types of concepts and this type of space to actually go mainstream and attract a lot of people if you're asking them to participate with a level of

understanding that, like, I would say borders sort of on obsessive. Like, just listening to people who've come on to Oblots before, like the yield farming episode, these are people who are intensely into the space. How are you going to attract people who are slightly outside of it? Yeah, I think right now there's definitely a huge sort of prosumer power user annual element to defy where there are people who sort of live and breathe this stuff. and, you know, they sort of biased towards being active with it, right? Like, I like attending my yield farms and I like sort of playing around with new stuff. And for the majority

of people, when they think about, you know, financial services, that's not what they want, right? They want to, you know, buy, buy S&P and put it in their 401K and not really, really think about it. And so, you know, I think the answer comes from, you know, a couple different, you know, vantage points. One is just from a sort of offerings perspective, I think there going to be more and more abstractions built on many of these protocols such that the end user doesn't really end up thinking about this kind of thing. In the impermanent loss example, you can sell off some of that yield to pay for any impermanent loss that you might experience or you might buy puts and calls so that, you know, you can sort of hedge out some of that

volatility that you're exposed to. Ultimately, that can be, you know, bundled inside of a, structured product and sort of a given to an end user. And so I'm not thinking about, you know, sort of what's in this basket of goods that I'm that I'm buying. I just know, hey, I want to earn some yield on asset XYZ and maybe this is a good way to do it. I think actually the stable coin market is a great example where, you know, cryptocurrency users are willing to pay, you know, a large amount of interest in order to get leverage on some of these assets, right? Like, you know, the futures markets often hit, you know, 300% annualized or even lending markets hit, you know, 20% EPR in order to borrow stable coins to get leverage on some of these assets.

But, you know, if you're not a crypto person, if you're, if you're, just want to, you know, sort of earn some interest on some cash that you have laying around, you can go to, you know, services like Coinbase or BlockFi, and, you know, they will take your USDC and they will lend it out for you and you don't have to think about, you know, anything that's sort of going on under the hood. I think actually a great example of this is in China. There's a company called MatrixPort, which actually went a portfolio companies. And they've sort of, you know, pioneered this sort of we call CD-Fi. So it's half-centralized, half-decentralized, where it's a custodial service, you know, they own your,

Bitcoin, they own your USDC, they sort of take care of it for you, you can't lose it. But under the hood, they'll go out and they'll yield farm for you. So they'll go put your USDC into compound. They'll take that comp, they'll sell it for more USC, and then they'll go give it back to you at the end of the day. So from an end user perspective, you don't sort of see what's actually, you know, happening. You just sort of think about, you know, the yield that that's, that you're getting. And so for a lot of users, I suspect that's going to be the way they're going use defy much in the same way, you know, most people, they don't think about trading bonds or, or, you know, selling, you know, complicated derivatives. They just think about putting money in their

bank account and, you know, the bank sort of handles how to get actually interest on it. So I would say there's still a good amount of abstraction that's remaining to make this stuff really palable to end users, not even talking about a lot of the transaction costs and all of the scalability issues. But I suspect that's going to be a large part of the way people actually, you know, get exposure to this thing. just on that note, we sort of touched on this before with the fintech angle, but if it's going to be similar to putting your money in a bank and just sort of trusting the process, isn't that where you kind of need regulation or at least you need to have some sort of faith in the middleman or the process that's doing this for you? So I guess I'm just curious, like, how you swear like people

not necessarily understanding all the details of the process, but also having faith in, in a decentralized process or method of doing this? I think it's about having exposure and having the ability to sort of go down to the metal and get access to it or audit it or do whatever you want. But there's always going to be people who are not going to want to be their own bank. I always hated that slogan that I think a lot of crypto people push because it's just not something that is appealing or feasible for a lot of people. I think of it a little bit sort of like email where most people don't run their own email server.

Most people don't have their own email client. They use a hosted service like Gmail. And Gmail sort of runs the email server for them. But email itself is still an open protocol. Anyone can go and run their own email server and I can go send you an email. You can go send me an email. That open protocol is always available to us if we want to use it. But of course, for convenience sake, a lot of people are going to end up using a lot of these sort of hosted services at the end of the day.

So the beauty is you have this sort of global permissionless, you know, 24-7 auditable. settlement layer that anybody can tap into. And again, that allows sort of permissionless innovation, but you can still have these really nice financial services that sit on top of it that, you know, give people a really simple yield that that's when they get access to or, you know, really let them really easily, you know, borrow money if that's what they want. The two don't necessarily have to stay in conflict. So you brought up something and actually it's come up a couple of times that I've been very curious about. So it's like, if I look on Coin Gecko, the top volume pairs traded on Uniswop right now. It looks like 50%, over 50% is the USDC-Eth pair,

another 5% is the ETH-Tether pair, another 4% is actually the USDC tether pair. A lot of this so-called defy is built on centralized stable coins. So this is literally like a token that in theory we were told is represented by a dollar's worth of dollar, denominated assets held at a bank somewhere. And then there is a decentralized stablecoin called die, which is backed by crypto assets, except from my understanding even that is significantly as one of the backing assets, USDC. So how much is this whole thing still like sort of like built on a highly centralized regulated asset that also could be significantly regulated further? Yeah, the stable coin risk is a real one.

You know, maybe for listeners who aren't aware, a stable coin such as USDC, which I realize I've been referencing quite frequently, it's a token that lives on Ethereum as well as a few other blockchains that is backed one to one by dollars that are in a, you know, audited US bank account. So one dollar comes in, one USDC is minted. And simultaneously, you can then go and redeem that USDC. So you can, you know, give center to its, you know, the name of the company, give them the USDC, and they'll redeem it, and why are you, you know,

US dollars to the bank account that you want? So really, really simple, you know, one-to-one back. Now, the problem is, this is sort of, you know, a little bit of a golden age of, of, this is sort of pure, you know, regulatory arbitrage, right? Where if I want to go and, you know, send a million dollars to you, Joe, you know, through a wire or do PayPal or whatever. Totally fine with that. Yeah, yeah, let's, we'll hook that up. You know, I have to go through, KYC AML, we have to be using, you know, everyone who is in the sort of, this middle party is being an MSB. There's a lot of regulation in between to make sure maybe bad actors can't use this. With USC, once it's minted, I can go and send it to you, you know, on chain, it's pseudonymous.

You're just one address. I'm one address. And really, the only the KYC AML part, you know, takes place off chain. So if you want to go take that million dollars and you then want to go or redeem it, then you have to do KYC. But in the interim, you know, it's all sort of being transferred on chain. There's always this risk that, and we see this occasionally where, you know, USDC and Tether both have the ability to blacklist and freeze addresses. So if they determine that, you know, these funds were seized as part of a hack, or maybe they're being used for money laundering or funding terrorism, granted, this is very, very, very small percentage of all the sort of activity that's happening. They can say, hey, actually, these tokens are frozen. They're not redeemable anymore.

We're going to, you know, it would be like, you know, you, your bank account is frozen. It's just of functioning the same thing. And so there's always this risk that, hey, that might happen to maker or compound or Unisop or any of these services where they're sort of reliant on a stable coin right now. Over time, I think sensible regulation will come around, hey, how are these things actually going to interact with the traditional financial system? I certainly don't think it's going to be, you know, everyone needing, you know, constant on-chain financial surveillance all the time. But in the interim, it is sort of this weird place where there's always a little bit of risk that something like that might happen. I think to your point, that sort of

speaks to the need for something like die, which right now is, has a percentage of its backing in USDC for the purpose of stabilizing it. So certainly they could get rid of USDC tomorrow, but basically die would trade above a peg because people like to take that USDC and quickly arbitrage die by minting it when it's above the peg and selling it and sort of capturing that spread. So it's sort of a little bit of this tradeoff where you can have that stability. You can have that, or you can have that decentralized stable coin, but if you want to be perfectly stable, if you want to be really not volatile,

there's a little bit of a crutch right now where it's sort of dependent on USDC. I think most of these teams have plans to gradually wean off of these centralized stable coins because they see these same sort of risks. But you're right that right now, it is a risk in the ecosystem. So this reminds me of something else.

I've been wondering, but to what extent is Bitcoin collateralizing a lot of these DeFi operations or trades or industries through the stable coin channel. And like, if that's actually happening, does that mean that crypto, because DeFi seems to be such a dynamic space, does that mean that DeFi like is eventually going to have to outgrow Bitcoin? Or I guess another way of saying it is like by definition, you can't have a finite pool of collateral in the form of Bitcoin that's being used. in a system that's growing exponentially. Does that make sense?

That does make sense. I mean, I think the way I sort of think about purposes or sort of Joe and I've been discussing with what for it, sort of three main buckets, one of them just being financial services for crypto assets. So by and large, a lot of the services that you see in defy today are for ether. So people hold eth, they need liquidity against it. They want to trade it. They want to, you know, borrow it, whatever. All these sorts of different services allow you to do that. And there's even more sophisticated derivatives now where I can, you know, buy and sell decentralized options against my ether. And I can really do anything I would do on a normal exchange, but do it in defy. And increasingly, this is happening with Bitcoin as well, as maybe

you alluded to, where there are tokens such as wrapped Bitcoin, which is sort of like USDC for Bitcoin, where a custodian holds onto your Bitcoin and midst WBT on Ethereum. And now, you know, sort of going back to that initial Bitcoin defy dream, I can put my Bitcoin as collateral and I can borrow against it, or I can trade my Bitcoin for Ether or trade my Bitcoin for USDC or vice versa. I would say that's actually a small percentage of what's happening in Defi today. Most of it is sort of around Ether and other sort of defy native assets. But certainly for people who want Bitcoin exposure, it's a great way to sort of get access to these, again, sort of permissionless financial services that in many ways are superior,

just not accessible to, you know, many of the people who are using them. I think, you know, a great example of sort of this permissionless innovation. there's this service that we recently back called Ribbon. Ribbon, you know, one popular way people get yield is they sell covered calls, right? So I have some Bitcoin, I have some Ether. I want to stack more Bitcoin. I want to stack more Ether. I sort of care about accumulating.

When you sell these out of the money covered calls, in theory, they're not going to expire in the money. And so you get to collect the premium and just sort of keep collecting more Ether, collecting more Bitcoin. Ribbon, you know, this is a service that isn't really accessible to many people in the U.S. If you do want to do it, you need to sort of post, you know, $10,000 in collateral. You need to go through all these different types of, you know, hoops, or not actually get access to this thing. Ribbon, you can go, it's all on chain, it's all trustless, it's all decentralized.

Anyone can go and get access to this sort of, you know, a sophisticated structured product without having to go through a middleman and without having to, you know, sort of subject themselves to financial surveillance, which I think is actually a huge plus. I think going back to your initial question, these are all sort of just different types of financial services for crypto assets. The big sort of question is, how do you sort of break out of this realm, right? Like, how do you get out of just lending to ether or just lending to Bitcoin? And I would say there's a couple different ways. I personally sort of think about it. One is sort of through this realm of synthetic assets where, you know, there's, I would say,

die is a great example. Die is a synthetic version of US dollar. But there's many protocols that use that same mechanism of posting collateral and then minting debt and you sort of using what we call an Oracle in order to keep it in peg with some target price feed. But for other types of assets. So you can go on defy today and you can go and buy synthetic Tesla, you know, synthetic Apple, synthetic, you know, game stock, anything really. And it doesn't even have to be a real world asset. It can be the synthetic price of the median, you know, housing sale in the San Francisco

Bay Area or it can be, you know, a synthetic number of barrels of oil that are going to be, you know, shipped across the Pacific this week or whatever it is. You can go and create these really novel financial products. again, without having to apply it, without having to jump through a lot of the arduous hoops that are normally required, that I think is a really burgeoning area of innovation within DFI, where I can go and sort of get access to these products wherever I am around the world. And we already see companies that are, you know, trying to do this. And we see a lot of limitations with, you know, traditional, you know, brokerages, for example, around, you know, geographical restrictions or,

you know, trading restrictions as we sort of saw with the whole, again, you know, Robin Hood, GME thing, these services can't be stopped. As soon as this sort of synthetic GME gets minted, anyone around the world can go buy and sell it 24-7 wherever they are. So there's actually room, I think, to sort of grow a lot of the financial services that are becoming very popular in the U.S. and Europe, but have this sort of truly global 24-7 version of them that is, you know, in many ways superior. I think synthetic assets, obviously, you know, you're still sort of looking at ways to sort of expand the existing financial system, right? These are just sort of extensions of the equities markets.

I think the really cool thing is sort of what we call real world assets. So how do I go and get a mortgage from my house from Maker? How do I go and trade early equity for my company on Uniswop? How do I go and actually like bridge these things to the real world? And I would say that is probably the most nascent area within Defi. Just last month, Maker, I think sort of broke new ground where they are taking shipping invoices and using those as collateral in Maker. And so Maker basically becomes this invoice factoring facility

where if I'm trying to get liquidity for, you know, outstanding debt from this invoice, I can go, I can work with a partner. I can create a token for this asset, again, in a very regulated, legally compliant way. I can put that token inside of Maker and now I can mint dye. And I can convert that dye against pegged one to one with dollars.

I can go convert that die to USD, send it to my bank account. And suddenly Maker is undercurrent. cutting, you know, all these other existing invoice factoring services by, let's say, three or four X. And so because there's no middleman, because there's no employees, because there's not a lot of this operational overhead, it's just a smart contract, you don't need sort of these huge bodies and employees that, you know, someone like a neobank might employ. I just need to go and tokenize this asset, put into defy and then start borrowing against it. So this is starting to happen, but I expect we'll accelerate in the next, you know, year or two. Someone in that example,

whether and I'm aware of like a few different entities that are trying this, but someone in this example sort of like needs to be like, I don't know, I guess I occupy the meat space. Like if the ship or the, you know, the shipping invoice, there's like someone has to like, okay, you're like, you have to deliver the goods or something. Like someone sort of has to be the real world proxy to like take the shipper to court if they don't show up with the goods or something like that, right? Like there's sort of like, there's a lot of like the connective tissue between the chain or between just the protocol and the sort of real world assets. Like there's no real way to like avoid the fact that like some sort of like human,

at least in now, some sort of like human has to be there to like sue a delinquent, you know, someone who doesn't show up with the goods or whatever it is. Yeah, that is true. There, that whole sort of, you know, tokenization process that I mentioned, you know, is somewhat human intensive. But I think over time that will come down and become more automated. You know, another interesting thing that we see happen. running a defy is sort of like capital formation.

Defi, it's really low barrier to entry where if I want to go and raise funds to, you know, donate money to a cause or purchase an asset or start a company or whatever, I can go and, you know, potentially pool funds with other people inside of defy, give them sort of a pro rite of sharing it, and then we can go and I'll take our money and go to, you know, whatever it is that we actually want to do. And so, you know, we sort of saw this sliverative an idea, I think, in the initial sort of ICO wave in 2017. And obviously, I think that was very, you know, sort of poorly executed. But the idea that you don't have to go through traditional fundraising means, especially if you don't have access

to those, in order to get access to capital, and then be able to have sort of this, you know, pseudo-cap table, I think it is really powerful and is starting to come back through the rise of a lot of these DAOs. So if you were going to describe Defi to someone who had absolutely no knowledge of the space, but your ambition was to get them very, very excited about, about it and about how, you know, how much this could improve or change the world, what would be the project or the function that you would point to? I mean, I think I tend to fall back on these sort of old-reliables. I think Maker is really just incredible system, not only because it's sort of demonstrates the power of decentralized lending,

where, again, anybody can show up with collateral, borrow, you know, any time of day, they can repay any time they want, et cetera, and the whole thing is sort of self-sustaining. There's no company, but also because it produces. is this very useful asset at the end of the day, which is die. People, I think, you know, inherently sort of get the value of a dollar, the ability to, you know, send these dollars back and forth on, on a blockchain. We often use stable coins for funding where, you know, a team maybe isn't incorporated yet, or maybe they don't have a bank account yet. We can just send them stable coins directly to their Ethereum wallet, and then they can go and pay their employees who are, you know, sort of distributed across the world.

You guys do a little test transaction first, like when you do that. We do. You never grow out of that, unfortunately. You always get a little skittish. But yes, just 100% superior to trying to send an international wire, you know, waiting five business days, you know, praying that you typed in the correspondent bank your number correctly. A staple coin such as die is able to do that just instantly. And I think that's really powerful. I think really the answer, you know, and sort of the most succinct, you know, maybe a little glib answer is that it's going to do for finance with the internet did for information where instead of being siloed, instead of being opaque instead of being limited access. It's permissionless, transparent access to anyone

around the world wants it. And I think what we've seen is entrepreneurs will take that and they will develop novel products that we couldn't even imagine right now and probably can't imagine right now that will create this massive sort of consumer surplus. So my last question is, I mean, I go to like Uniswap. It looks like an unregistered stock market. I could see like mirrored Apple and mirror Tesla. Those look like synthetic derivatives. I mean, they're basically described as such. Anyone can buy them without any sort of like obvious like registration. There's no account or anything like that. Capital formation. The ICOs sort of like were basically just IPOs, but without all of like the regulation. Why is this not just all, you know, even if in

theory it's more transparent, stable, like sort of a flagrant violation of existing securities laws? and do you think about like that risk, frankly, as, as you're investing? It's definitely something that we think about. I think one interesting thing about dragonfly is that our team sort of split between Asia and the U.S. And so I think we talk about things, you know, very frequently this very much U.S. focused view. But, you know, increasingly a large part of, you know, exchange volumes, up until very recently, a large part of mining volumes. And increasingly a large number of defy users are coming from Asia.

They're coming from Japan or they're coming from China. they're coming from Japan, coming from Asia more broadly. And so what we see is sort of a lot of global talent around the world that might not live in the U.S. might not be American and might not sort of be, I think, reliant on a lot of the same issues that you see in U.S. jurisdictions. I think to your earlier point, what we see with Defi a lot and why we sort of emphasize this decentralized element is most of what we've seen today is it's really covered under free speech where users, you know, for example, the developers of Uniswop, they've written

this software, they've deployed it. but they're not taking fees. They don't have, you know, custody rights. They're not executing trades. Certainly they run this front end, but it's just a website, right? It's not actually doing anything.

You can go on the Ethereum blockchain and make these same sort of trades or, you know, become a liquidity provider or whatever. Because this software is permissionless, because it sort of runs without, you know, a middleman requiring to run it. It's sort of like BitTorrent, where BitTorrent can be used for legitimate purposes,

but obviously people can use it for malicious purposes as well. But that doesn't make the creators of BitTorrent liable for those malicious purposes. So Defi, I think, has, you know, created a lot of, again, sort of consumer surplus. It's made a lot of facets of my life easier, just, you know, going over the wiring stable coin thing that I mentioned just a few minutes ago. But that doesn't mean that, and certainly everything that within it is not super palatable, but that doesn't mean, you know, you just have to sort of throw the baby out with the bathwater. I think the other element, sort of that you mentioned around securities laws is certainly something that we consider,

but I think that really relates more to sort of token issuance. And not every protocol, not everything that comes out is going to issue a token. You can just create software and have people use it. And that, you know, is perfectly fine. It's sort of covered under the existing understanding of the law. Tom, so great to have you on odd lots. I feel like that lived up to the hype that you are going to be able to explain these things in a very clear way. And I feel a lot smarter. Well, I really appreciate it. Thanks for having me. Thanks, Tom. That was great. Thanks, Tom.

I have an idea for a DFI project that we should do. Okay. I like the idea of tending my own yield farm, but I have a feeling it's probably very different to the bucolic vision that I have of that. But go on. So you know how, like, Tom said you could, like, create any sort of, like, synthetic, sort of, like, asset that's tied to something in the real world or sort of, like, you know, tied to some price? we should create tokenized onion futures because that's like the one thing that, you know,

there's a law, like there can't be onion futures. But in defy, I don't see anything stopping us from, like, creating a decentralized onion futures market that just like goes based on like, you know, supermarket onion prices. I'm sorry. Why onions specifically? There's a law that says there's no onion futures in America. You didn't know that? No, I didn't.

I'm over here in Asia. Yeah. onions are a pretty big part of the economy. I think they've been fairly financialized, but maybe I'm wrong. There was some law like 100 years ago that said onions, there could never be an onion futures market in the United States. Okay, let's do it. The Great Onion Futures capers. I'm surprised you didn't know that. I thought that would be like a little, I thought that would be like a Tracy trivia that you would know about. I had no idea, but I have a feeling I'm about to go down like a massive research hole and learn about it. Let's do it. Yeah, let's do it. But seriously, I did think Tom was great. And I do think that he, he lived up to the hype in terms of like the clarity of explaining how all these things work.

I agree. I was also, you know, on the regulatory arbitrage issue, there is a tendency to think that regulatory arbitrage is a bad thing, particularly in finance where rules tend to exist so that, you know, there isn't money laundering or people aren't losing all their money. His vision or his summation of regulatory arbitrage as a way of generating more change in the financial system, similar to what happened with the internet and the idea that everyone can broadcast things like that. It's very alluring. I think there are still questions around it, but I can see what he's getting at and I can see why a lot of defy people are very excited about using this process regulatory arbitrage

to affect change in the traditional financial system. Yeah, though, you know what I was thinking like, and I get that, and I think it's interesting, and he made the comparison to Uber and Airbnb, which sort of like changed regulations. Yeah. Like Uber was going up against taxi companies. And frankly, I don't think the taxi drivers have ever had, you know, in most places, all that much political power. Sort of like going up against, like, highly regulated entities that in some sense, like make regulation and lobbying like a huge part of their core business model. I don't think is going to be as easy as sort of like Uber basically rolling the taxi industry in all these cities. No, and it's a much more sensitive industry given that you're dealing with money. I think it's going to be really hard.

Yeah, well, yeah. Definitely one to watch though. Absolutely. Shall we leave it there? I'm keen to go start reading about Onion Futures. Yeah, go read about that. Okay. This has been another episode of the Odd Lots podcast.

I'm Tracy Alloway. you can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. Follow our guest on Twitter, Tom Schmidt. He's at Tom H. Schmidt. Follow our producer, Laura Carlson. She's at Laura M. Carlson.

Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today. And check out all of our podcasts at Bloomberg under the handle at podcasts. Thanks for listening.