Unchained - DeFi Yield Farming: Why It's All the Rage But Risky - Ep.180

Episode Date: July 7, 2020

Dan Elitzer, investor at IDEO CoLab Ventures, and Will Price, data scientist at Flipside Crypto, discuss the yield farming craze. In this episode, we cover: the goals of protocols offering liquidity mining the goals of users yield farming right now whether users of Compound will have much awareness of COMP in the future how Compound is trying to dampen inorganic activity and properly align incentives  how incentives in one DeFi protocol can screw up another's such as changes in Compound's liquidity mining program causing Dai to lose its peg whether the activity created by liquidity mining is sustainable and how whether Compound is overvalued and how to determine valuations for DeFi tokens the security risks that come with trying yield farming how teams can keep their protocols safe given the composability of DeFi and the growing number of developments in the space whether the yield farming craze will cause the price of ETH to rise and why the prevalence of stablecoins might prevent that whether new DeFi tokens could push flagging layer 1s out of the top 10 what will happen if even more Bitcoin comes to DeFi how the next big thing in DeFi might be trying to stack yield across protocols and eventually prime brokerage protocols Thank you to our sponsor! Crypto.com: https://www.crypto.com   Episode links:  Dan Elitzer: https://twitter.com/delitzer IDEO CoLab Ventures: https://www.ideocolab.com/ventures/ Will Price: https://twitter.com/will__price Flipside Crypto: https://flipsidecrypto.com   Total value locked in Compound: https://defipulse.com/compound   What liquidity bootstrapping pools are: https://medium.com/balancer-protocol/building-liquidity-into-token-distribution-a49d4286e0d4    Dan on earning more from borrowing USDT than lending it on Compound: https://twitter.com/delitzer/status/1272642107128164354    Tony Sheng on how yield farming works and how much you can earn from it: https://twitter.com/tonysheng/status/1274393189231689728   And his followup on the risks of yield farming: https://twitter.com/tonysheng/status/1274780457729617920   The purpose of COMP for governance: https://medium.com/compound-finance/compound-community-ownership-ee0ed1252cc3  https://medium.com/compound-finance/expanding-compound-governance-ce13fcd4fe36   Risks of so much BAT being held in Compound: https://twitter.com/spencernoon/status/1276897377446776832?s=20 https://twitter.com/defiprime/status/1277026665952980992?s=20 https://twitter.com/devops199fan/status/1274732220192829441?s=20   Cyrus of MakerDAO concerned about the risks COMP poses to the Dai peg: https://forum.makerdao.com/t/upcoming-comp-farming-change-could-impact-the-dai-peg/2965   Dan Guido and Taylor Monahan on Unchained discussing DeFi security: https://unchainedpodcast.com/defi-security-with-so-many-hacks-will-it-ever-be-safe/   Twitter discussion on whether ETH price will rise due to yield farming: https://twitter.com/RyanSAdams/status/1274781676875452421   What will happen to other Layer 1s? https://twitter.com/Shaughnessy119/status/1274376237239189504?s=20  Aquaponic yield farming: https://bankless.substack.com/p/aquaponic-yield-farming Learn more about your ad choices. Visit megaphone.fm/adchoices

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The topic for today's show is yield farming. Here to discuss are Dan Elitzer, investor at IDO co-op ventures, and Will Price, data scientist at Flipside Crypto. Welcome, Dan and Will. Hi, Laura. In the last few weeks, we've seen a lot of people, particularly in Ethereum and DeFi, going crazy over this yield farming craze. It kind of started with the launch of the comp token on June 15th when people could begin earning comp for borrowing and lending tokens on the platform. And before launching this liquidity mining scheme, there was about $100 million locked in compound. And now there is about $650 million, or I think $600 million. as of the time of this recording.

So let's break down what this trend is. There's kind of a few different ways of looking at it. And I think there's one way of looking at it, like from the protocols perspective. So can you describe that like when a protocol maker sets up a liquidity mining scheme? Why are they doing that? What do they hope to get out of it? And why don't we, for audio listeners, Dan, why don't we start with you? So they recognize your voice.

Sure thing. Sounds good. So I think the important. thing to understand with liquidity mining is that there are multiple goals here. So one of the goals is just to decentralize governance over the protocol. And so one of the reasons why compound is doing this, compound labs, that created the initial version of the compound protocol, is they want to make it truly decentralized. So it remains permissionless and remains censorship resistance.

And so the best way for them to do that is to actually give ownership over it, or at least over a very significant piece of it to the people who are using the protocol. So that's one piece. The other thing is because they're giving ownership over the protocol and there is perceived value to that, that effectively subsidizes both the lending and borrowing rates on compound. And so this is going to encourage a lot more activity. As you noted, there's been hundreds of millions of dollars of additional capital that has flowed into compound and a lot more borrowing demand that has resulted. And one of the things that we

can go into is, you know, how much of that is real net new usage that's going to stick around as this kind of levels out over time. But the goal is to actually pour rocket fuel on what was already one of the most successful protocols in Defi. And Will, how would you describe it? I would echo a lot of dance points. And one thing. that I would add is that I don't think that anybody anticipated the comp token being as valuable as it is. In fact, I believe right now it's about 10x the value that the original liquidity pool was launched at. And as a result, we're seeing all sorts of contrived and inorganic behavior by users who are attempting to maximize their rewards for using the compound

protocol in the form of governance tokens. And so I think a lot of other projects are taking notice and are likely to use a similar distribution mechanism in the future for their governance rights. Yeah, I find it really fascinating that Dan actually started his answer with the governance piece because in a way, I actually feel like that's sort of, to call it like a front is too strong, but I actually feel like, you know, this idea around bootstrapping liquidity is kind of more of what the at least at least the initial impetus was or and has maybe I don't know about for compound but especially for some of these other ones also that are looking to do this like they just want to

have you know a lot of assets you know well in this case because it's a lending protocol they want to have a lot of assets for people to lend and borrow right um but then yeah what has ended up happening is like the users as will pointed out they have a really different goal out of it and you know as you started to talk about, like, they're trying to just maximize their earnings. So can you just describe for me a little bit more from the user's perspective, kind of what this means for them and what they're trying to get out of it? Well, I think in these early days, it really is about users getting a bonus for using the protocol. Right.

I don't think that in the long-term future for compounds, that most people using compound, will even need to be aware of the existence of the comp token, right? If compound achieves what I think a lot of the builders and backers hope it achieves, then it's handling tens, hundreds of billions of dollars in assets, maybe more than that, right? Let's get crazy. But in that future, the vast majority of people interacting with it are not needing to think about comp as a token. So this is something that's on. the mind of the early adopters who see an opportunity to have a piece of something that they view

as being very valuable in the future. It subsidizes their rates right now. But I don't think it's really a core part of the long-term roadmap for compound to have everyday users needing to interact with the comp token. Totally. And I agree that that is the long-term goal. And the analogy from the physical world would be that a holder of an index fund wouldn't necessarily be voting their individual shares and a custodian like BlackRock would be doing voting on behalf of their users. And that's likely to be the case for a protocol like compound if it does wind up with tens of billions of dollars in assets under management. I would take it a step further and say it's in some ways it's more like I can buy Nike shoes

without owning Nike shares, right? It is ultimately where we're headed. But it's saying that this is a product where it is valuable to have this. be decentralized and have it spread out. And so part of that bootstrapping is distributing that ownership across a wider range of people. Absolutely. But to your point, Laura, there is a dynamic at play where increasing the assets being length and borrowed on compound or the assets under management on a protocol like balancer, which has a similar scheme, helps them reach the network effects required to achieve exit velocity, so to speak. Yeah, but yeah, I don't know.

I still, I guess I feel like in the way that you're describing it, it's almost like a little bit more noble than what's actually happening because I feel like the users are primarily just trying to maximize yield at this moment, right? And they're, you know, borrowing assets and then relending them just to earn more comp. And so, you know, it's just, I mean, that's pretty much the definition of yield farming. and they're doing this sometimes with up to like Forex leverage. So, I mean, wouldn't you say that up front close when we're just talking about kind of this moment in time that that's actually what's going on and it's not the like high minded governance stuff? Sure. I think it's hard to deny if you look at the numbers that the majority of compound usage today is organic.

I think it was prior to the launch of liquidity mining, but it's all, as Will said, a lot of this is inorganic usage purely to receive the comp token. But I think that this is a really interesting mechanism. If you even go back to Bitcoin with proof of work, right, essentially, I think the reason people use the term liquidity mining is it's kind of like mining Bitcoin. You're doing proof of liquidity rather than proof of work. And it's also, it can be analogized to proof of stake, right? In all cases, you want people to have some costs. In this case, the opportunity cost of their capital that they are giving up in order to earn the comp token. And so that ensures that the people who are receiving the token have really put some

economic value behind their acquisition of that token. Now, just like Bitcoin miners, whether they are long-term holders of that token or not, isn't necessarily important. It's a way of fairly, you know, it doesn't mean equitably, but fairly distributing this token out. I think this is a very interesting mechanism for doing so. And I think there's already been steps taken by the folks who are governing the compound protocol actively today, the folks who have received delegations or some of the early investors that are trying to tamp down some of the incentives so that it doesn't lead to, just so much inorganic usage.

And there are some things that I'd like to see happen to get it even to a more sustainable level. But, yeah, I'm not going to argue that today this is largely organic usage. Yeah, and I could add some color to that in a second. But one thing that I'll highlight is that these governance mechanisms are dynamic and that you never know exactly how an incentive scheme is going to work in the wild. When these users don't exist in a vacuum, right? their participants in the broader defy and crypto ecosystems.

And so what you see happen is you have unintended effects. Like, for example, right after the compound launch, massive amounts of tether were borrowed and converted to USDC recursively because that was the shelling point strategy whereby people were able to earn the most in governance rewards. That dynamic pivoted towards basic attention token, which, to put some data on it, has about $300 million in outstanding borrow at the moment, 85% of which has been resupplied to the protocol by those same users, which is a bit scary from a liquidity perspective. And compound has rightly so taken steps to mitigate that.

but it's illustrative that incentives can cause unintended consequences. Yeah, yeah. I mean, I feel like if there's any lesson we've learned in crypto, it's that when things happen, they happen quickly and like kind of flare up in these big ways. So, yeah, I know these kind of very wide pendulum swings, I feel like are part and parcel of a technology that moves so quickly and that can be programmed. It's, it is scary to watch. But I actually was so curious.

So, Dan, when you talk. about the different measures that they're taking to kind of tamp down the incentives so that it isn't this kind of crazy inorganic activity? What are some of the proposals there? Yeah. So one of the proposals that passed last week was to say, we're going to look at these tokens that are not Ethereum, not ether and not stable coins that are on the platform. So basic attention token, the zero X token and Auger's rep token. And they all have, of interest rate curves within the compound protocol that would make them ideal for this type of yield farming.

And they said, okay, well, if we try to nerf that and make it so that that's not the dominant strategy anymore, people are just going to rotate to these other two coins. And so just there was a blanket move to say, we're going to increase the protocol's reserve factor on the interest paid from. I believe it was like zero or maybe 10% up to 50%, which means that there is now a much more significant cost, not just an opportunity cost for doing this farming, but there's also the cost of 50% of the interest paid. You're not paying back effectively to yourself.

You're paying to a reserve pool held within the compound protocol. And so that's one thing to introduce real cost. the more recent governance change was saying, rather than calculating comp distribution on the basis of the amount of interest paid per asset, it's just going to be calculated on the basis of total outstanding U.S. dollar amount borrowed per asset. So we don't have to worry about the differences in the interest rate curves across different protocols as much. It's more just where it is the demand. I do think this is going to flip the game on its head, where rather than going for the highest interest rate assets to borrow and lend, people are going to be wanting to borrow the lowest interest rate asset and still lend at the highest supply rate.

So I think that's actually a much more healthy dynamic because it should be natural that people want to earn the most when they're lending assets and pay the least when they're supplying it. And so that helps to kind of restore that natural balance. Yeah, this reminds me about how, like, early on you had this tweet where you showed that people could earn more from borrowing USDT than they could lending on compound. And like, just intuitively, this doesn't make sense. So, like, obviously there's something messed up there. But yeah, actually also when what you described reminds me of like whack a mole, because it just sort of feels like people are just, like, the governance actors are going to constantly be trying to tweak based on what's happening.

Is that just how this is going to go? Or do you ever see this reaching some kind of equilibrium? I would say that it's likely to reach an equilibrium when the value distributed is a much smaller percent of the assets under management. So people who are participating in the protocol are receiving governance rewards in a much smaller proportion than they currently are. I don't don't think that we're likely to find a stable equilibrium in the short term while compound is giving away half a million dollars a day in governance rights. And for example, the change that Dan alluded to where high interest rates will no longer be rewarded is likely to have ripple effects elsewhere in the ecosystem, particularly with assets like die, the stable coin, which are inherently

supply constraint. So, yeah, actually, why don't we dive into that? Because There was this post that Cyrus UNessi at MakerDAO wrote where he talked about how he thought a way a change, you know, in the way compound is paid out could just make die lose its dollar peg. So can you explain how what his theory was and like whether or not you think that will happen or what will happen there? Yeah. So I think it's a definite possibility. And actually, but explain why he thought it would cause it to lose its peg. Sure. I guess we can start with the theory. It all boils down to the shape of the interest rate curves. And that essentially means what percent interest are borrowers paying lenders as a function of the total amount of assets being used from zero to 100 percent? And the shape of the die interest rate curve is very flat up until about 90 percent utilization. And so effectively what that means is that borrowers pay a relatively low rate of interest to borrow dye. which under this proposed new scheme, which is likely to go live tomorrow, Thursday, July 2nd,

will incentivize die more so than any of the other assets on the platform. So that will have happened by the time this comes out. So the audience may already know something that we don't know. But anyway, keep going. So I think Cyrus was right to point out that these exogenous factors could have an impact. on the monetary policy that Maker uses to manage their stable coin peg. And it's going to be interesting to watch what happens. Yeah.

And to add to Will, your point about, like, there's just a massive subsidy happening, right? Prior to the launch of this comp distribution, compound borrowers were paying, I think, was in the neighborhood of like $1,200 a day or so in interest. So, like, that's how much could be earned in total across the system by lending on compound. And now we're up to, like, hundreds of thousands of dollars per day in subsidies. So, yeah, things are massively out of whack. And it's very likely that that will impact other protocols in the system maker and die specifically seem ripe to have impact felt.

Yeah. So, you know, I actually want to continue this line of thinking a little bit. more. But I actually, before we do that, just want to ask a little bit more about the sustainability within comp itself, because I have a whole series of questions about composability and whatever. So let's just kind of finish talking about comp. I mean, we alluded to this before, but like, do you expect that these protocols that offer these liquidity mining incentives to maintain their level of activity? Because the way I see, it's sort of like how in Bitcoin, you know, people worry about whether or not the security of the network will be affected once they transition

from the block reward to transaction fees. And this is something that they're worrying about, and it literally won't even happen until we're all dead. So, come, obviously, that distribution ends in four years. And like, is there some kind of contingency plan? Or do they just think, like, oh, there will be enough liquidity, we'll be fine forever after that? Or, you know, what do you guys think? Well, I think actually the philosophy that I've heard from the TASA community occasionally, I think applies here. It's like if you've got good governance, you can have anything, any other feature that you want.

And I think for compound, that's the case, right? The governors of the protocol can change the parameters. So what was literally set out when they announced a four-year schedule was something like 42, 43% of this, you know, what was it, 10,000, 100 million comp cap was going to be distributed through the system. And that was laid out as a certain number of comp per block, I believe. And what we found was that blocks were going a little bit faster than was expected. And so that actually even pushed the subsidy up higher on a daily basis.

So there was an adjustment as part of one of these other. governance decisions to reduce the issuance rate. Now, there's nothing stopping the governors of this protocol from further reducing that and bringing it down to a sustainable level. Now, you still have the same number of comp tokens in this supply to be distributed through this program, and so that would necessarily extend the window past the four-year mark that was initially proposed. So, you know, all of this is subject to governance. And I think it is very, very unlikely that we will see a kind of flatline issuance over four years and then seeing it drop to zero. Because, as you said, like, that seems very problematic.

So I would expect that the people who have some ownership in this protocol will use that ownership to have at the very least a smooth landing. We might even see something resembling the Bitcoin having. Yeah. Yeah, whether it's a halving or, you know, a smoother decay or even just spread it out. There's essentially tail issuance. Like, who knows? It's all on the table. That's interesting. Well, so to pull in a little bit of history and all this, can you describe how this all got started? And I think maybe one of the initial kind of like, I don't know if back then it would have been called liquidity mining or. or maybe it would have been, but when synthetics began offering something similar with its synth, eth, and eth pool on uniswap? Like, was that the first instance of this? And if so, can you kind of describe what happened there?

But then also maybe describe, I think they wound it down. So like, and that was just like a year ago or whatever. So, you know, how did that go? And is that similar to what you're describing here? Yeah, yeah. So I would say that's the first on-chain incentive program to see. widespread success, but I believe the term liquidity mining was coined by a company named hummingbot in reference to paying for orders on an order book. But in the case of synthetics,

they had massive success incentivizing their one-to-one peg of their synthetic assets to real assets by subsidizing people who were willing to put both of those assets into a liquidity pool with their protocol's native token. And Robert, from compound has said as much that it was an inspiration to compound labs and the rest of the stakeholders in the ecosystem when designing their process. And, you know, Dan, this goes back to what you alluded to in your aquaponic yield farming article, but all of these protocols are interconnected. And now that many other liquidity pools are incentivizing liquidity, there's no need

for synthetics to subsidize that synthetic eth and eth pool anymore. other protocols are doing it for them like balancer oh okay so that's why they wound that down so it like didn't cause them any problems or anything correct they do have an incentivized pool on another platform called curve which is optimized for stable pairs but the original incentive has been wound down okay and then just to also now ask a little bit more about governance like do we have any sense of what percentage of these, I mean, okay, like amongst the people that have comp, there's probably two groups. There's like the speculators and then the people who are actually interested in governance. And I'm curious to know like what percentage, you know, each group makes

of the total pool and whether or not there's overlap, like whether or not you sense that this speculative mania is actually going to lead toward people getting interested in governance or Or is it just like, you know, you're going to give away a bunch of comp and then eventually through trading it will find its way to people interested in governance? I suspect that it's more the latter that like eventually through trading it finds its way into the hands of people who are interested in governance. One of the nice things about the protocol, though, and I know the compound team, but a lot of thought into this, is to the delegation function.

So, you know, if you want to have your voice heard and you want to, you know, you feel pride in owning some comp or want to have some piece of it over the long term, you don't have to actively be involved in making every decision yourself. You can delegate the voting power from your comp tokens to somebody else. And so, for example, IDEOColav Ventures is a delegate for comp. We don't actually hold any comp as a fund at this time. But we have multiple portfolio companies, including Instadap and pool together, that use compound very heavily. And so we participate in the governance process through comp that's been delegated to us because we want to protect their interests and the interests of other startups and protocols

that may build on comp in the future. And we also think that it's just an incredibly important player in the ecosystem. And so we are learning a lot through participating in this governance process. and we're learning things that we're then able to share those lessons with other companies in our portfolio as they look to roll out their own governance platforms. Oh, and just to clarify some facts, because I'm not sure I fully understood that. So you guys don't personally own comp, but people can delegate to you and you guys vote? Yes. Okay, correct.

Super interesting. And Will, it looks like you were going to say something? The only thing that I have to add to that is that given how early we are in the, lifetime distribution of these assets, most of the circulating supply is owned by team members and key stakeholders like venture capitalists. And so the small amount of comp that is circulating beyond those communities is most likely in the hands of speculators at this point in time. But as more and more assets get issued, people who are interested in the long-term future

of governance, whether those be large users of the protocol or people, people who see it as systemically important to the ecosystem are likely to control a larger and larger fraction of the supply. Yeah. Yeah. So maybe this mechanism will work out the way that they hoped. We'll see. You know, it would be nice if that did happen. But now let's talk about something that we also, again, alluded to earlier. It's amazing how quickly the comp token reached like a pretty high market cap on coin market cap. When I did the research, it was 23 on coin market cap, but I actually wasn't able to check it right before we spoke. But currently the market cap is around $2 billion.

However, the total value locked in it is $600 million. So what do you guys think? Does that mean that compound is overvalued? Or like, how do we term an evaluation in defy? Well, you're the numbers guy. I want to give it a shot? Okay. Well, so the interesting thing about this is that we have a positive feedback.

loop here. The more the governance rights are valued, the more people are going to put their assets into compound in order to capture a piece of them. And the more assets that are in compound, the more valuable those governance rights are. So I think we're in early days in terms of reaching an equilibrium price. But the only rational way that I've seen to value governance rights is to assume that those governance rights are likely to eventually result in fee capture from the protocol, and then to do a discounted cash flow analysis. Wait, so just so I understand, like, meaning that people are rewarded for good governance? So anytime that people have full control over the protocol, you have to assume that there is a

non-zero probability that they will vote themselves their revenue share at some point in the future, and that those cash flows will have value. Okay. Okay. Okay. But so then based on that, when you look at the activity going on, like, you know, just do you feel like it's going to trend in that direction? Or? I would say Dan is probably the expert here. Fair play. Yeah. So I think I think Will's analysis is spot on, right? That's how you would likely construct some sort of valuation model reasonably around this. What the likelihood is, the probability is that you assign to their. ever being some kind of capture on the value going through the protocol is a big piece of this. But, you know, we'll explain the game that, you know, as more assets are in there,

you expect the future value to go out. So I guess we don't know where it's going to end up. As Will mentioned, there's not a lot of kind of float out there in terms of like new, newly received comp that, you know, presumably it's, you know, short-term speculators potentially who are trying to get their hands on this, and there's not a lot to be traded there. So this is going to take a little while to get to some kind of stable price discovery, whether that will ultimately net out significantly above or below where it's trading today. I don't know. If I did, I would be making a lot of moves right now and make a lot of money.

I think it's interesting to watch. I think there are certainly ways you can put together a model that say the current valuation is very reasonable. There's ways you can say it's very rich. It's all based on your assumption of how much money do you ultimately see flowing through the protocol, how much do you think can reasonably be captured by the governance token holders, and what probability do you assign to the governance token holders eventually choosing to capture some of that value? All right.

So the only last question I want to ask that's kind of like really focused just on what's happening here is I was just looking at how, you know, there are these other apps like you mentioned Instadap where it just makes it much easier for you to basically chase these yields through smart contracts. And I just wondered like as more people do things like that, that's just going to further what we were talking about, what that would cause these wild swings and the values of the assets. So like doesn't that make governance like so much harder? And do you predict that that will be a consequence of things like that? Because I just wonder like how can you control something like that where everything's just programmed to just always go after the highest yield and everybody's glomming on to, I don't know. It just, you know, because like I guess right now, in trading, the way you make money is like you're ahead of the curve or whatever and you kind of have your own little niche. But just if everybody's doing it with these smart contracts, I kind of, I don't know how that's going to. work? So the yield farmers are going to move their assets from protocol to protocol in search of

the highest short-term returns. But some liquidity is sticky. For example, tether was the favorite of the yield farmers, and there were $300 million worth of tether that were borrowed at one point just a couple of weeks ago. But there are still about $50 million of tether borrowed on compound, even though that is no longer the optimal strategy, which is far, far, far in excess of the less than one million that was borrowed before the start of this liquidity mining initiative. So some liquidity will be sticky. Okay, that's impressive. Yeah, I think, you know, we've talked a little bit about the finding natural equilibrium within a protocol like compound. I think there's also going to be a process of finding a natural equilibrium

across the broader ecosystem, because to the extent that these protocols are composable, and as people are looking to farm yield across multiple protocols, the subsidy being too high compared to natural demand on one protocol or too low on another is going to have ripple effects across these other protocols. And so I think it's going to take significant time to get there. I think having these big numbers, I don't think it was actually a mistake to launch this comp distribution in the way that it was. Because I think that the hype that's generated is good, right? It's not sustainable, but it got a lot of interest.

It showed people the power of these incentives. and now it actually gave both people involved in compound and people involved in other protocols a real clear incentive to figure out a better way to incentivize their users and get this to a more sustainable state. I think what's interesting, if you think about it, going back to the model well laid out, is you're valuing these things if you're trying to do a valuation on these things. then you should be valuing them looking at discounting back potential future cash flows.

And in that sense, what you're doing is you're just kind of shifting those future cash flows to the present as a way of subsidizing user acquisition and kind of assets liquidity acquisition within the protocol. And so that's not dissimilar from PayPal in the early days and many other consumer apps, paying your referral bonus if you bring a friend on board or paying new users to sign up. The difference is they've got this asset that has use in terms of being able to make this a decentralized protocol and people are projecting value on it according to this model. And they're just using that and saying, hey, rather than us need to go out to VCs and raise $10 million, $100 million,

to pay to subsidize growth, you know, we're just going to go direct to the users. They can see where this is potentially going, and they'll value owning a piece of it. So I think it's actually really cool to then go directly to the users of the protocol who believe in it, and they're provided the subsidy directly rather than having to play a game of raising capital through VCs to pay people in U.S. dollars. I couldn't agree more. But Laura, I think we missed addressing your point about Instadap's tools, making it easier for people to pursue these inorganic strategies. And I think that what Instadap does is provide a better user experience.

And what people choose to leverage that user experience for is something that was already possible within the protocol. And if it demonstrates an issue, it's going to come to the surface sooner. and the team can iterate quicker in the case of compound. So I don't see it as an issue at all. And in fact, I see this in that positive. Okay. Yeah, let's talk a little bit more about actually a number of these issues, including just counter cash flow.

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Get up to 10% back on Uber Eats, McDonald's, Domino's, Domino's. pizza, Walmart, and many more when you pay with your MCO visa card. No card on the crypto.com app, buy gift cards and get up to 20% back from merchants like Whole Foods, Safeway, Burger King, Papa Johns, and Dominoes. Download the crypto.com app today and enjoy these offers till the end of September. Back to my conversation with Dan Elyzer and Will Price. All right, gosh, I feel like we could do this forever because there's just so much to discuss, but I actually wanted to go back to the discounted cash flow thing that you guys described. So can you just walk through what that looks like for something like comp? Yeah. So discounted cash flows generally, you need to start with something

that's called a hurdle rate or an internal rate of return. And that's basically what is the opportunity cost of your capital? So a dollar today is worth more than a dollar 10 years in the future. and then you take that discounted rate and you apply it to the cash flows that you expect to receive over time. And then you take what's called the net present value of that. And that's the rational current valuation for the protocol governance. But like, so what you're doing is you're kind of projecting what comp should be worth at some point in the future and comparing it to what it's worth now. Is that what you're doing? It's less about what comp is worth at some point in the future and more about what cash flows will comp generate for you at all points in the future.

And then trying to collapse that down to what is that series of cash flows worth to me today. Oh, okay. And that would be generated by what, like when you engage in governance and are rewarded in some fashion? Yeah. I mean, any way that the protocol can capture value, could be valued in this way. And it's really up in the air. And these are not trivial assumptions to make. Oh, no wonder. Yeah.

Yeah. Because, yeah, just I could totally imagine different people coming up with wildly different valuations and some making it seem good and some making it seem bad because the assumptions are just way too unknown at this point. Absolutely. Okay. All right. Well, let's talk about security.

because I think that's a huge concern at this point. We've seen with everything even just as far back as the Dow, but then also these recent defy hacks with like synthetic and BZX and Lentfmee. And when you combine all that with like the interoperability of these protocols, I'm just curious for you guys, when you think about security, like what gives you most cause for concern? Most cause for concern. I would say it's,

the fact that we are moving so fast in developing new things, and there is so much money at stake. And so when people see these big numbers, you know, it's natural to get a little greedy and be like, I want to try to get a piece of that. And I don't think that most people are able to understand the level of risk that is inherent in some of these protocols. I think one of the reasons why I'm more comfortable with compounds being the place where we're running this first experiment in how these types of systems work is the level of diligence that the compound team has applied in building their protocol, the number of audits they've done, their internal processes. They've just really put security front and center. And I think that the same cannot be said for a lot of other teams in the space, not saying that any of them have any, you know, bad intentions, right? But, you know, from what I've seen of the compound team and what they've written publicly and Roberts talked about publicly in terms of processes, they just take this with a very different level of seriousness than a lot of the teams in the ecosystem.

them. And they had advantages of Robert being a very experienced founder and being able to raise capital and having the resources to dedicate towards this. And it's understandable that if you, you know, you're an early stage team and, you know, you've raised nothing or maybe it's a few hundred thousand dollars. It's really hard to go through all the same steps because it does mean that you're, you're moving slower and you're having more expense. But when you start layering all of these different systems together and they haven't all applied that same level of diligence, yeah, you're going to find edge cases in places where things break and real money can be lost. Compound has taken the approach of white listing assets that have been thoroughly vetted,

which reduces my level of concern, which is still reasonable given the amount of money at stake. there are protocols like Nexus Mutual and Open, which provide insurance in the form of a mutual backing or in the form of options, which can give users some peace of mind. So I'm excited for those protocols to grow. So let's talk about one of the recent attacks, which was on balancer, which is, I guess, like an automated market maker. but can you explain what happened there just so people can understand like how, you know, one way in which people can lose money. And actually also, it wasn't even clear to me, well, just to explain what happened with

Balancer and then I'll ask you my next question. Will, do you want to? Are you referring to the deflationary token? Yeah, where, yeah, $500,000 got lost in Valencer. Yeah. So what happened was there were two assets in particular. that had deflationary mechanisms. And that essentially means that the supply of the token could be reduced.

And that's not a standard ERC20 token feature. Yeah, it was almost like a recursive call type thing in the way where they just did a transaction over and over again, and it was draining small amounts because one side accounted for the fee and then the other side didn't. And so then at the end, after you had done it a number of times, one side of it, was drained, but then the other side of the contract didn't know that asset was drained. Yeah, yeah. Essentially, they used a flash loan to recursively cycle through, like you mentioned. I think there were something like 600 event logs in that transaction, which is insane.

But they were able to drain the assets from the pool. And, you know, Balancer was aware that this sort of mechanism wouldn't play nice with their pool, but I don't think they were aware the extent to which it could be exploited via things like flash loans. Okay. Yeah. Go ahead. And they had been alerted to the existence of this type of vulnerability by somebody external from, I think it was a hex capital.

And they noted that it was an issue, but they hadn't realized, as Will said, that like flash loans could be utilized in this way to, like, really amp up the danger. And, you know, they acknowledged their responsibility. I think, you know, they didn't handle the initial bug report well in terms of like they'd kind of dismissed it. But when when this, you know, exploit happens, they fully owned up to their mistake and said they should have been more diligent around this. And they're kind of covering losses for people in those particular pools based on, you know, they felt like this kind of, you know, they took some responsibility for it. But as well said, this is a permissionless protocol and people can put. any assets they want into it.

And the reason why those assets were there and why there were so much of that was people were trying to do liquidity mining or yield farming on balancers' battle token. And so in some ways, I think it's, you know, play stupid games, win stupid prizes. Don't, if you're going to try to take advantage of the kind of edge cases in the system or take advantage of some rules that aren't really in the spirit with which these programs have been laid out, then it's really buyer beware. And so don't use a promotionalist protocol with some non-standard token and expect that somebody else is watching out for you. All right. Well, yeah, so this was actually my question because I just wanted to make sure I

understood it. So like when I was reading the articles on this, was saying things like Balancer lost $500,000, but it was basically all the different providers of liquidity in the various tokens that were drained. Those were the people that lost money. And I'm assuming that they lost money in proportion to their holdings within the pool. Is that? Yes, that's exactly correct. Okay. Yeah. But just that pool, right? So it wasn't people who had funds and other balancer pools, it was limited just to those who chose to provide liquidity into that pool with these weird deflationary assets. And then you were saying that balancer was making them whole somehow, or what was there?

Yeah, so balancer, because that they were aware that this was an issue, and because even though their protocol is permissionless, they didn't flag or somehow disable these pools in their UI, Balancer Labs made the choice to make these liquidity providers whole. Wow. Okay. It reminds you of like how Coinbase did that with the ETH flash crash. But anyway, okay. So I feel like for a number of these, like one of the main vectors of attack really is taking

advantage of the composability, right? It's like in this case with these deflationary tokens that shouldn't have been used on balancer or like with the BZX attacks, you know, that was using multiple different protocols in different ways. The LendFME one was about the ERC 777 token being used where it shouldn't have. And I mean, I think one thing that's really fascinating is that all these attacks usually indicate that the hacker has like extremely sophisticated knowledge of multiple DFI protocols. I shouldn't like, like it's.

one of those weird things, like when you see it happened, like, you're almost like impressed, you know, and obviously they're doing it for bad purposes. So, um, however, so what I wanted to say was just like, if defy grows beyond this small, small ecosystem now in which most everyone kind of knows each other and like can basically kind of keep up on developments, I mean, even at this point where like, for instance, with LendFME, that attack was known about like the year before. And the teams still didn't do things to prevent that. So, and that's, like I said, when the, and that was even when the defy space was even smaller than now. So like, how do you think teams will be able to keep their protocols secure in the future?

Like, you know, I was brainstorming. And I was like, should there be some like standards body? But then I was like, that will move so slow compared to defy like that. That will never work. So I don't know. What are people talking about this? Yeah, it's certainly a topic of discussion. And I think, as we'll pointed out, there's a difference between a protocol like compound that requires assets be whitelisted for inclusion and they go through a pretty strict betting process.

Maker does a similar thing. And protocols like balancer or uniswap where anybody can use any asset in there. And so it has a very different risk profile as a result. I think you're asking a great question, though, because as you pointed out with like the LendafMe issue with the 770s, sevens. A lot of these attacks are known issues, right? They were previously reported in that case, even there was like an example, like code snippet that could be used. This is pretty low-hanging fruit right now. And so, yes, we should be scared about what happens when we get past the low-hanging fruit and we have an even more interconnected system. And then there are really

sophisticated attacks that haven't been reported yet that are, you know, zero-day attacks, essentially. Like, what happens then? It's very, it's very concerning. We're building what we hope is new global financial infrastructure here. And I think we need to, as an industry, just step up the level of diligence and care that we're applying to the creation and use of these protocols. But when you say that, what does that mean that, like, the security teams for each of

these protocols has to get bigger? Or, like, what does that look like? I don't think that in the long term, we can rely on the end user to be a good judge of the technical aptitude and security rigor engaged in by each team. And so I mentioned insurance earlier. I really think that a wider adoption of insurance is likely to be the solution here, not in terms of eliminating the risk, but in terms of offloading it to people better equipped to assess it. Yeah, that's one thing. I think another, I know my friend Richard Burton has been talking about going to kind of like these NASA, like, formal verification workshops and stuff and like getting some like,

little rocket scientists into the field and people who can really formally verify some of this code. I know formal verification has made that a few teams have pursued to some degree, but I think it just needs to be a much more common practice. I think, you know, there are some fantastic teams that conduct audits on smart contracts. But, you know, as good as they are, you can never say, like, oh, it's been audited, so it's safe. there's only so much you can do within the scope of an audit. But there is some elements of these auditors are paid by the teams that are doing the development. And they write, you know, I think very honest reports, but there's some elements of they can't come out and say, this is a flaming pile of garbage.

When somebody's like paid them to give the report. So they need to, we can be a very, very plain. very dry technical language. And I think that there is a need as investors like, like, you know, myself and others, are utilizing these protocols more to have them start to step up and pay for additional security reviews where it's saying, like, don't sugarcoat it, right? If I'm going to put, you know, millions of dollars in funds that have been entrusted to me into some of these protocols, I want to make sure that I'm getting it straight from the experts as to, you know, would they trust their own money?

Do they think it's safe? Yeah. I don't know if you listened to the episode I did with Dan from Trail of Bits. I'm just flicking on his last name and at Taylor. Guido. Yeah. And Taylor Monaghan of my crypto. But yeah, we talked about the Hedgick attack.

And that was definitely the subtext of that. conversation. You know, I was asking Dan about some of the ways in which the Hedgick team didn't seem fully professional and why they even took them on his clients. And he said, oh, you know, we've worked with all these anonymous people before with weird usernames and weird quirks. But, but yeah, he definitely implied that it was truly not, you know, not work that was ready to go and that people mistook the idea that they'd been audited as like a rubber stamp of approval. But anyway, okay, so we're kind of running out of time. And I want to ask a few other things. So in this period that we've seen the yield farming craze take off, why do you think we haven't

really seen the price of Ethereum rise? That is the question on everybody's mind. I think right now, people are very interested about the potential of these governments' tokens. and other defy assets and that people who might otherwise be investing in EF are migrating more of their capital into these areas and viewing ETH potentially more as a way to pay for transaction fees and nothing else. I actually think that in the long run, this yield farming meme is going to be very good for Ethereum, given that a central tenant of ETH2.0 is staking, whereby you lock up your

capital in return for yield in an analogous manner to what's happening right now on compounded balancer. Yeah, that makes sense. But it is kind of curious that, I don't know, Dan, what are your thoughts? Yeah, I also think that, you know, it's a very positive sign for the Ethereum ecosystem. And, you know, for ether as an asset, that said, you know, if we, I believe we're at the beginning of a very, you know, large kind of run-up and activity and, like, the evaluations and such in the D-Fi space.

And I'm super excited about many of the new protocols that I'm seeing that are getting ready to come into market or just starting to grow. If we do see this, like, bull run in D-Fi and Ether and Bitcoin also likely don't go along for the ride, that's going to force a lot of people to check some of their prior assumptions. My expectation is that at some point, we will see these base assets along for the ride for various reasons. But if we don't, I don't think that's necessarily a problem. I think if there is real activity happening in Defi, if there's real value being created, that starts to be more organic, then I'm still going to be hugely excited about the potential in

a space. But, you know, yes, as someone who holds some of those assets, it would be great to see them go along for the ride. Well, I'm so curious earlier when you said, like, what if we see a bull run in defy, but Bitcoin and Ether don't go along for the ride, do you literally mean just like, you know, all these different governance tokens in defy, the ones that are offered as incentives for liquidity mining that we would see those take off, but that like maybe Ether wouldn't and then maybe Bitcoin, because it's sort of like a different ecosystem, just would lag. Because wouldn't you, wouldn't you see people buying Bitcoin in Ether to get into the ecosystem?

Well, I think it's very different from, you know, in 2017 with the ICO boom, right? Ether was money. That was like the way that you could like kind of pay into these ICOs and participate. And so it created a lot of demand for Ether to just use the killer. case of these ICOs. If today the killer use case is yield farming or use of these defy protocols, we now have widely adopted stable coins. And so people already think of stable coins as money. They have the ability to expand and contract the supply based on people just literally depositing dollars and minting more of them. So it doesn't necessarily

put the same pressure of demand on ether-specific. specifically that the ICO boom did. I do think there is a lot of value in having a kind of neutral platform native, permissionless asset, right, that is not centrally controlled in any way. I think that is very valuable. I do think that is a real strength for ether and also a real strength for Bitcoin. But it's not as much of a direct need to force millions or billions of dollars in value into that one asset to watch the ecosystem grow in the way that there was in 2017. I will say, though, that if we do see a D5 bull run, we will stress test and therefore

trust many of these nascent financial primitives even more and ask more of them plug into each other. And we have a complex ecosystem forming that raises the moats for Ethereum and creates an almost insurpassable network effect. Oh, interesting. Well, okay, so I was going to ask you because, like, gas fees have about kind of roughly maybe quadrupled or quintuple since the beginning of the year. And I see people complaining about the gas fees when they're trying to do their yield farming traits. So, you know, obviously I feel like this is related to scaling issues. So I just wondered, like, you know, do people have concern that Ethereum will not scale quickly enough to meet this demand for yield farming or whatever might, whatever else might happen? on defy? And do you feel like there's a risk that this activity could move to some other blockchain? I think there is concern. I don't necessarily think that there is a risk. In fact, a couple of weeks ago, miners increased the block gas limit by about 20%, which basically means there's 20% more

capacity on Ethereum. But we didn't really see gas fees drop. So to me that says right now there's infinite demand for defy. And Defy wants to be on Ethereum because that's what the liquidity is. Yeah, I don't think it's a problem to have fees at the current level right now for where the ecosystem is. I think for non-Defi use cases, it may be pretty problematic because these defy use cases, you can directly say, yes, I'm willing to spend $5 in gas because I'm going to make $50 on the trade. You know, for, you know, crypto-kitties type use cases and stuff, it might be harder right now. That said, we've backed a team called Optimism, which is working on an optimistic role of solution for scaling. There's a number of other very strong teams working on their own Layer 2 scaling solutions. Hopefully, we see ETH2 at some point in the not too distant future.

But there's all these different things. I think a lot of these Layer 2 solutions are all starting to come to market around the same time. And so I think there's going to be a really interesting. to watch out there. I think that anybody who spent significant time looking at these blockchain networks and understanding some elements of the kind of limitations on their growth in various ways, almost inevitably comes to the conclusion that we're going to see in the end a lot more activity happening through layer two systems than directly on layer one. And it'll all be anchored back to layer one, but you can't do everything.

on chain on layer one. And so I think it's going to be great timing to see some of these really viable layer two solutions coming to market just as we're hitting this inflection point with demand where people want to be having a lot more transaction volume and a lot more complex transaction volume. Wait, and just so I understand, like you even think that will be the case that a lot of activity will shift to layer two, even on ETH2 where it's a sharded choice. Absolutely. Absolutely.

I mean, as well said, right, we just bumped capacity 20% and didn't notice difference in gas prices. I think, and the ecosystem is so, it's tiny today, right? Like, you know, a successful, like, DFI protocol has thousands of users, like probably not even tens of thousands of users today. If we really want to scale this to billions of people, which I hope we all do, then, yeah, there's no way you can do this all on L1. Right. Yeah, well, so speaking of layer ones, I did. see that Tom, Shaughnessy of Delphi Digital tweeted that he thought DeFi tokens would end up pushing out what he called ghost layer ones out of the top 10 like XRP, like coin, Bitcoin Cash, Eos,

Bitcoin, Satoshi's Vision, Tron, Stellar, which disclosure is a sponsor of my shows. And so he was saying that he felt like that, you know, these were just going to be overtaken by defy tokens. Do you think that's what's going to happen or just from what you were describing it? almost sound like you were saying that Ethereum will become more like the defy chain and some of the other applications will shift to other layer ones. So I think it comes back to network effects, but one thing that makes me bullish on Ethereum in particular is that these layer twos can be optimized for different purposes. Right now we have a layer two payment solution in loopering live on chain today. We have teams like optimism working on fully fledged EVM execution.

environment where you can preserve defy composability. So I do think that there's going to be a compelling reason for projects, regardless of their domain, to remain on a fully interoperable system. Okay. Well, let's also now just talk about another really important layer one, which is Bitcoin. So now there's 11,000 Bitcoin on Ethereum, and it's about $100 million worth. Yeah. It's in things like wrapped Bitcoin, Ren, BTC, I am BTC.

And I mean, it's like a pretty significant increase from the end of March when there was maybe like about 1,500 BTC. So what do you like think is the significance of that? Like why do you think we're seeing this? Like could it pose any potential dangers to Bitcoin, which is to my mind, you know, really different because it's all about like security and conservatism. You know, what do you make of this? Well, as somebody who has been focused on Bitcoin for a long time and still is very bullish on Bitcoin, I think it's great seeing Bitcoin come over. I'm excited about Bitcoin and I'm excited about Defi.

So if I can use my Bitcoin in Defi, like great. I get the best of both worlds. That said, I do think that there is an extreme scenario, right? Let's say that DeFi and Ethereum are hugely successful. and people want to use their Bitcoin in defy applications, if you get the majority of economic activity from Bitcoin happening on top of Ethereum, that does raise some concerns for Bitcoin security model, because there will not be transaction fees or as many transaction fees required to support that.

I don't think that we're likely to approach a level of concern for that, like in the next few years. Who knows? It is an interesting dynamic to keep an eye on. I'm very, excited about Bitcoin's future regardless. But yeah, it's certainly a dynamic that I don't think a lot of people who've been focused on Bitcoin have necessarily, like, considered how extreme states might play out. Yeah. But on the flip side, I would say bringing Bitcoin to Defi is like probably going to be really good for Defi because there's so much more money in Bitcoin. Economic bandwidth, right? Yeah.

Economic bandwidth. And Will, what were you going to say? Well, I agree that there are a lot of Bitcoin holders watching all of the yield farming happening in Defi with a lot of interest. But one thing that's particularly interesting is the various flavors of Bitcoin that we have on Ethereum. So we have custodial solutions like rat Bitcoin. We have synthetics like SBTC.

And we have non-decentralized versions like RenBTC. And users who might want to on-ramp without KYC could use REN Bitcoin, but they might not be comfortable with the risks of holding RAN Bitcoin, so they could then swap for one of these other forms. So I think the plethora of different types is beneficial for the ecosystem as well. And do you have any particular ones that you think are more likely to take off than others? That's a good question. I think in the short term, Rapt Bitcoin has many. more integrations with D5 projects.

And so probably has the most short-term potential. But in the long run, I think it's anybody's guess. And can you just remind me that's the one, I think BITCO custodies that? And it's somehow through Khyber. What are the details on that again? I'm a bit fuzzy on the details, but I know BITGO is the custodian. Because the custodian. Yeah, there's a number of different kind of merchants who are part of the consortium there,

who have the ability to interact with BICO to kind of issue new. wrap Bitcoin. Okay. All right. Well, we're over time, but because this is just so fascinating, I was also just curious to know, like, where do you guys think that this yield farming trend will go next? Well, I think that right now, I just wrote a piece recently that I called Aquaponic yield farming. The idea being that aquaponic systems involve the combination of growing plants out of water with having fish in that water. your farming fish, the waste from the fish is going to fertilize the plants and plants clean the water for the fish. So it's a great system.

And we're seeing similar things that start to emerge. Will mentioned the different flavors of Bitcoin. There is now this different flavor of Bitcoin pool on curve, which is an AMM optimized for stable value assets. And so people are yield farming. from the upcoming curve token, their yield farming for, I believe, balancer, and then synthetics and Wren have also added, like, their own rewards on top of this, too. So people are kind of like mixing these things together, and I think it's very interesting. People are going to try to stack their yield across multiple protocols.

But I think ultimately, where it might get interesting is rather than stacking protocols, right now we're in a very, you know, blue ocean space, but as it gets more, you know, Red Ocean where there's not as much, you know, just fresh opportunity to go for, these protocols may start to encroach on each other's territory, and we may end up with the development of what I've called prime brokerage protocols where you're trying to,

under the roof of a single protocol, allow for exchange and, you know, borrowing and lending and creation of options and futures and other things, all under one roof. So, you know, we'll see. I think that would be something that will take, many years to lead to that point.

But stuff moves fast, who knows? Very fast. It would certainly be very interesting to example, have, you know, AMM pool shares be more widely accepted as collateral to allow OTC deals with your collateral on a system like compound. So the prime brokerage idea is definitely an interesting one.

In terms of yield stacking, I will say that we are building a complex ecosystem, complexity is emergent, and it is very, very hard to predict where things will go. Are you saying there may be some risk? I'm saying that we don't know the future yet. There may be some risk. Well, yeah, I think there is a lot of risk. Yes.

As unfortunately, some people on balance are found out this week or last week or whenever that was. All right. So where can people learn more about each of you and your work? You can find me on Twitter at D.E.Litzer. And IDOCOLAB.com slash adventures is for our team IDEOColab Ventures. I'm on Twitter as well. You can find me at Will double underscore price. And to learn more about Flipside, you can visit Flipsidecrypto.com.

Perfect. All right. Well, this has been so fun. Thank you both for coming on Unchained. Thanks for having us. Thanks, Laura. Thanks so much for. joining us today. To learn more about Dan and Will, check out the show notes inside your podcast player.

And also on YouTube, because we're not on YouTube. And don't forget, that's also where you can watch video recordings of the podcast on the Unchained YouTube channel. Go to YouTube.com slash C slash Unchained podcast and subscribe today. Unchained is produced by me, Laura Shin, with help from Anthony Youne, Daniel Ness, Josh Durham, and the team at CLK transcription. Thanks for listening. Thank you.