Unchained - How dYdX Allows You to Take a Short Position in One Token - Ep.86

Episode Date: October 2, 2018

Antonio Juliano, founder of dYdX, explains how this protocol for derivatives will enable you to take a short position in a single token, why they are starting with protocols shorting and margin lending and how these protocols work vs. how shorting and margin lending work today. The former employee of Coinbase also discusses how the protocol determines the prices of the assets involved, how low liquidity affects the trading of the derivatives and who dYdX's users will be. He also talks about how the company, which has raised money from Andreessen Horowitz, Polychain Capital and others, plans to make money despite not currently having a token. Plus, we discuss dYdX's plans to create protocols for derivatives that are not fully collateralized and the risks that come with that. Thank you to our sponsor! Blockdaemon: http://blockdaemon.com/unchained/ Interested in sponsoring Unchained or Unconfirmed? Reach out to Raelene at [e-mail]. Episode links: dYdX: https://dydx.exchange Antonio Juliano: https://twitter.com/antoniomjuliano dYdX white paper: https://whitepaper.dydx.exchange Expo: https://www.expotrading.com https://medium.com/dydxderivatives/introducing-expo-ffe74a328f85 Investments in dYdX: https://techcrunch.com/2018/08/03/short-ethereum/ Unchained episode about decentralized exchange protocol 0x: http://unchainedpodcast.co/will-warren-of-0x-on-why-decentralized-exchanges-are-the-future Unchained episode about decentralized debt protocol Dharma: http://unchainedpodcast.co/nadav-hollander-on-how-dharma-could-create-new-forms-of-debt-ep80 Unchained episode about decentralized money market protocol Compound: http://unchainedpodcast.co/how-youll-earn-interest-on-your-crypto-with-compound-ep82 Unchained interview with Josh Stein of Harbor: http://unchainedpodcast.co/harbor-and-trusttoken-on-why-they-dont-mind-being-unsexy-ep77 Unchained interview with CryptoKitties: http://unchainedpodcast.co/what-makes-a-cryptokitty-worth-140000-ep75 Learn more about your ad choices. Visit megaphone.fm/adchoices

Hi everyone, Laura here. Quick request before we get into today's episode. I'm doing a TEDx talk soon and so need a short break to give myself enough prep time. But instead of playing a rerun, I'm going to do a listener questions episode. So send me your questions. You can email them in written form to Laura Shin Podcast at gmail.com. L-A-U-R-A-S-H-I-N podcast at gmail.com. If you do that, start your subject line with Listen. listener queue or, and frankly, this is more fun, you can record an audio file, which is super easy to do on your smartphone nowadays. You can also email that to Laura Shin Podcast at gmail.com. And if you choose to send in an audio file, please state your name in the recording. And again, make the subject line in your email begin with listener cue. The deadline to send your questions is by end of day Tuesday, October 9th. Again, send your written questions and your audio files to Laura Shin podcast, L-A-U-R-A-S-H-I-N podcast at gmail.com with a subject line that begins listener queue. Thanks and enjoy the show.

Hi, everyone. Welcome to Unchained, your no-hyped resource for all things crypto. I'm your host, Laura Shin. If you've been enjoying Unchained, pop into iTunes to give us a top reading or review. That helps other listeners find this show. up to the Bitcoin network but are confused by the multitude of choices and intimidated by the complexity of getting started, come to blockdaman.com slash unchained and launch a Bitcoin node in mere moments. We'll do all the heavy lifting for you. Looking to advertise your product on unchained and unconfirmed, reach out to Raylene at Laura Shen Podcast at Gmail.com to find out about sponsorship opportunities. Again, that's Laura Shin, L-A-U-R-A-S-H-I-N podcast,

at gmail.com to find out about sponsorship opportunities on unchained and unconfirmed. My guest today is Antonio Giuliano, founder of DYDX. Welcome, Antonio. Thanks for having me, Laura. Before we start, I just have a funny story to tell, which is that DYDX is definitely one of the more challenging projects I've had my head around. And preparing for this interview was giving me flashbox to when I was a senior in high school and I took calculus BC. And there's like two kinds of calculus you can take as a senior. And that's the more difficult one. And math was always like more challenging for me than other subjects. But I, I know, I just thought like, oh, I can do it. But it kind of had like too much fun that summer.

And it took me a little while to get into the school spirit when, you know, the fall semester role were around. So I literally got a D in the first quarter. And at the end of it, I went to the teacher and I was like, how, you know, can I change this? Like, is there something? I could do for extra credit. And he said, yeah, oh, well, if you do extra credit, I can give you a D plus. And I literally started like tearing up. And I was like, oh, my God, like, because I really wanted to go to Stanford. I'm never going to get in Stanford now. And what ended up happening is he agreed to give me a P for pass. And then I got an A minus the second quarter. And we averaged the grades with my final exam. And eventually I ended up with a B minus for the semester. So it was all okay.

Well, I'm glad. Hopefully, yeah, the name does. and give too many bad memories for too many people. Oh my God. Yeah, like going through all this stuff yesterday, I was just like, okay, it's not like I can't get it, but it's taking me so long. And I had done that pre-interview with you before. And, you know, I wanted to relisten to it to make sure I understood. And I had to listen to it again on 0.6 or 0.7 speed because you were speaking so quickly

and I could so barely understand what you were saying. So all of this preamble is just to say, go slowly, assume you're talking to fifth grader because, you know, I'm only barely grasping this. Yeah, absolutely well, do you. So, okay, so let's just start with the simplest thing. What is DYDX? So DYDX is a protocol for decentralized derivatives and margin trading. Basically, the first thing that we're doing is making a protocol for margin trading that lets users go short or get leverage on any, for now, Ethereum-based cryptocurrency. Our first product, that we're launching soon is called margin tokens. And with margin tokens, you can basically

represent a short or leveraged position as a regular fungible ERC20 token. This is cool because we can basically create the short Ethereum token, say. And now if you want to, say, go short on Ethereum, all you have to do is buy the short Ethereum token, which you can do on our product Expo or on any other exchange that lists the short or leverage tokens. What we think of DIDX not just as a margin trading protocol, but as a protocol for all types of financial derivatives, we just decided to start with the margin trading because we think that that's the most applicable thing to build in the market right now. And why did you decide to tackle derivatives? And just for listeners who aren't super familiar with the financial services system,

which in a way, I'm also not. I think also the vast majority of my listeners are, or at least the plurality come from tech. So what are derivatives and why did you decide to tackle this area of finance? So financial derivatives are financial products that are built on top of other underlying assets. So they vary a lot in complexity, things like options or swaps. And they're primarily used by bigger institutions or more sophisticated traders. to get better risk management or increase speculation on their profile, on their portfolios. So that's kind of what financial derivatives are.

We're excited about building them because they oftentimes bring a lot of maturity to the underlying markets. The way that most people are trading cryptocurrencies right now is basically just to buy and hold them. But that's not at all the way that people trade traditional assets. They often use financial derivatives to kind of hedge their. bets or get different types of speculation or risk management that they couldn't otherwise get. So that's kind of what financial derivatives are. In response to your question about why I decided

to tackle the challenge of building financial derivatives on the blockchain. So I really wanted to build something that was actually useful in the market right now. And the way that most people are using cryptocurrencies is for speculation. But like I was saying, a lot of these more advanced trading tools that traders are accustomed to don't exist in the market yet. So we thought that this would be an interesting thing to build in something that would actually be useful in the market right now. Well, actually, so one thing that was interesting is in the white paper, you said that derivatives will open up new avenues for speculation. And yet, here you're kind of saying like, oh, we want to do something that's different. So how do you square those two statements? Yeah, so derivatives can be used

for a lot of different things. Kind of the two main use cases I mentioned are either hedging, something that's really good to do in kind of bare markets. So a lot of these crypto hedge funds could use financial derivatives to basically hedge their long bets and protect their downside, which is something that probably a lot of people should have done more of in the past six months or so. The other application that they're widely used for is increased speculation

or getting leverage. You can also kind of bet on more interesting things like volatility that you couldn't really bet on with basically just buying and holding the underlying assets. Oh, interesting. So if this protocol had been available as of January 1st or something, then we might see a lot of people making profits off of this bear market. Is that correct? Yeah, absolutely.

And actually our first product, short Ethereum, which is the short Ethereum, would basically be a really simple way for users to bet on kind of Ethereum going down. So a lot of people could have used that to basically actually profit in the bare market of the past six months. Interesting. I recently had like a maximalist on the show and it was toward to Maester. So maybe I'll let him know and see if he wants it, but his money where his mouth is. Well, actually, that brings me to this other question because I am curious. So right now, if I wanted to short ether, how could I do that?

So there are a couple different ways you could short ether right now, and they're pretty much all on centralized exchanges. So probably the easiest way to do it if you're a big traditional institution is to buy futures on some of these centralized exchanges that offer futures products, like I think CBOE and a few of the other ones do. So a lot of the bigger institutions are kind of using those mechanisms to get short exposure. There are also a number of centralized exchanges that do offer margin trading, such as Polonex or Bitmex or those types of things, where you could basically go to take a short position on any cryptocurrency that they offer. And kind of the final way that we've seen people doing it in a bigger way are through over-the-counter desks. So there are certain OTC desks that do provide lending liquidity that you can use to short assets, like Genesis trading, for example, I believe offers OTC lending. So those are kind of the three predominant ways we see institutions getting short exposure right now. But there aren't really any products that are super available

for more individual traders to kind of get short exposure on a number of these assets in a really simple way. And if they're doing it with DYDX, then they can maintain control of their private keys, it sounds like. Yeah, absolutely. That's a big selling point of kind of our proto and is similar to a lot of other protocols such as Dharma or ZeroX or similar. Yeah, I've had both of them on the show recently. In case people haven't noticed, I'm trying to do a little series on this sort of world of decentralized finance that I am watching being built, which is basically incredibly fascinating to me.

But so before we get into how DYDX works, I actually also want to bring up your background. How did you get into crypto? So I got into crypto in 2015 when I started working as a software engineer at Coinbase. I was much different than most other people that worked at Coinbase in that I didn't know anything about Bitcoin before that. Oh, no. Yeah. So I was at Princeton CS at the time and I was just graduating and Coinbase was one of the like 20 places I applied to as a senior. I kind of only applied because Fred Wilson actually came and gave a talk and mentioned

Coinbase in one of the classes I was taking at Princeton. But one of the unique things about Coinbase's hiring process is that they did a work trial. So basically during my senior year, they flew me out to San Francisco and I worked with them for a week. And at the time, I still didn't really know anything about Bitcoin, but everybody was just so excited about it. And all, there are so many amazing people at Coinbase at the time. So I could just see that I wanted to work with these amazing people. And they were all super excited about this Bitcoin thing. So I just decided to give it a try and jumped on board full time at Coinbase after graduating. And then once you're at Coinbase, it's pretty much impossible not to get excited about Bitcoin

because everybody just talks about it all the time. You get to sit down and have lunch with amazing people like Fred or Brian or Olaf, who just are far and away like the best thinkers in the space. So just kind of having that exposure to the really best people in the space really got me excited about it. And then after I worked at Coinbase for a while, I knew that I wanted to build things in the space in the future, which is kind of what led me to D-Y-D-X. Yeah. And so you're feeling that part of the story?

So I actually left Coinbase to work at Uber briefly. So I was at Uber for like six months after working at Coinbase. And I knew even when I went to Uber, I knew that I wanted to still work in the cryptocurrency space and that I wanted to start a startup. But my plan was to work at Uber for like a year, make some more money, kind of give me some time to work on my personal projects. But I only lasted for six months at Uber before leaving to start my own thing. And the first thing that I started was not DYDX.

It was a search engine for decentralized apps that I called Waypoint. So I built this whole thing out and basically it was trying to be like a Google for decentralized apps. and I was working on it full-time for like three or four months, and literally nobody was using it. And that kind of led me to my realization that I really wanted to build something that's actually applicable in the market right now. And the main problem with the search engine thing

was that just nobody is building any decentralized apps, or especially at the time, like, a little over a year ago. So there was just nothing to search for, and it was too early in the market. So I kind of spent a weekend sitting down in thinking about the types of problems that I could solve with a decentralized protocol that would actually be useful in the market. And that kind of led me to financial derivatives.

I didn't really know anything about derivatives at the time, but I spent a lot of time talking to a lot of good friends who had gone on from Princeton to work in the finance world and quickly came up to speed on kind of what derivatives are. Kind of the hard part about derivatives is not understanding how they work, but more understanding how people trade them. Like how an option works is kind of fundamentally fairly simple, but how people trade options is very, very complicated.

So I definitely did not understand all of that at the time, and that's still something I'm working on. But I did kind of come up with basically a protocol that supports fully collateralized options, which is the first thing that I came up with. And then soon after that came up with the beginnings of the margin trading protocol, which is what we decided to start with, and are launching now.

So that's kind of what led me to building DYDX in the derivatives protocol. I want to, yeah, I want to get into that a little bit more later about how what's more complicated is the way people trade them because I would imagine maybe part of the complication comes from the complexity of the existing financial services system itself. But so before we get there, why don't we just go into how DYDX works, you started by talking about the margin tokens, but I actually want you to walk me through how a short sell works in DydX on the back end, you know, not through the token, but just like step by step. And for listeners who don't have, you know, the background on how a short sell works,

traditionally it would be you borrow the asset that you want to short. You immediately sell it. So you kind of know how much, you know, your sale price is. And then after the price of that asset falls, at that point, you buy the shares at obviously this lower price and return them back to the lender. So in DIYDX, it's like a little bit different. So why don't you walk me through how that goes? Yeah, that's a good walkthrough of how normal short sales work. And it's actually quite similar in DYDX.

So at the beginning of the show, I did mention are short and leverage tokens, which are the simplest way to get short or leveraged expos. on D-YD-X, but actually backing every short or leverage token is a short or leveraged position. So for taking a short position on D-Y-D-X, it basically works the same way as a normal short-sell in that you have to borrow the asset that you want to short and then sell it to a trader on the spot market and then lock up some collateral in the position. And then that kind of collateral basically just sits there for the duration of the trade, and then you use whenever you want to close your position, you use some of that collateral to buy back the tokens that you borrowed from the lender, and then you get kind of whatever's left.

So let's just kind of walk through an example of how shorting Ethereum on DYDX works. So if you want to short Ethereum, you need to borrow Ethereum from somebody. DYDX has its own kind of lending protocol built in, and basically it kind of works in. a couple ways. Lenders can basically offer to make loans for Ethereum by signing an off-chain message. And this message contains details such as how much they want to lend, the interest fee, like the maximum duration, et cetera. And then these loans are held on a relayer, which is very similar to the concept of a relayer used by many other protocols, again, such as 0x or Dharma. And then, so now if you want to short Ethereum, you can go to the relayer and find an offer to lend you Ethereum.

Similarly, you need somebody to buy Ethereum from you on the other side. You also need something to short Ethereum against. So say we're shorting Ethereum against the Dai Stablecoin, which is Maker Dallas Stablecoin. Then you basically need an offer to buy Ethereum and sell Dye stablecoin. which you can use that buy order to basically sell the Ethereum that you just borrowed from the lender. DYDX plugs into a number of different decentralized exchanges, the primary one being zero X. So normally people will use a zero X order to, that's basically offering to buy Ethereum and sell die in this case. So you, the trader, just want to short Ethereum.

So you go to the relayer, and the relayer finds you this loan offering offering to lend you Ethereum. And similarly, this buy order offering to buy Ethereum and sell die. Then you take those two things and send them in a transaction to our smart contract. And our smart contract does a few things. It verifies the signature on the loan offering to make sure it's legitimate. And if it is legitimate, then it basically pulls Ethereum from the lender. So now our smart contract has some Ethereum. Then it sells it to the external buyer and gets some die from that trade.

An interesting thing about 0x and other decentralized exchanges is normally they're used for just peer-to-peer trading. Like, I'm a human and I trade with some other human. But a really interesting property of them is that smart contracts can also trade with them. And that's kind of what we utilize to enable us, to enable our smart contract to basically trade with an external 0x maker. So at this point, our smart contract only has die. It basically sold all the Ethereum that it got from the borrower.

And then it takes some margin deposit from the short seller proportional to, and the amount of margin deposit is basically specified on the loan offering that was offered by the lender. So now it has a die equal to whatever it got from the sell plus your margin deposit. Let's just say kind of putting concrete numbers to this, you borrowed like one Ethereum and then you sold that Ethereum for 100 dye and then you put up 50 die as margin deposit. So after all of this stuff has happened, then the smart contract ends up with 150 die locked in the position. It's also important to note that all of this stuff that I just talked about happens atomically

in one transaction on Ethereum. A really interesting property of Ethereum that we heavily make use of is that smart contracts can call other smart contracts within one transaction. So basically we use that to kind of do the borrowing and the selling and the locking up of collateral all in one Ethereum transaction. So it makes the process really simple. Just to clarify, so this part that you, where you described, it all happens atomically, is that with the margin token?

So this doesn't have anything to do with the margin token quite yet, but basically has to do with just how Ethereum transactions work. And it's really nice property because, say, for example, we do the borrow and then for some reason the selling fails, it'll kind of roll back the whole thing. That's basically what Adamicity means. So kind of all of it will happen or none of it will happen. You can't get into like a weird state where you kind of have borrowed some of the funds but haven't actually sold them or things like that. Okay. So keep going. Okay. So now the state of the world is that you, there's a position and you are the shortseller and you've shorted Ethereum. On the other side, there's a lender that you owe Ethereum back to. And there is 150 dye locked up in the position. So we use continuously compounding interest to basically determine the amount of interest that's owed to the lender at any given time. So you, the short seller, can decide to come back and close your position whenever you want to. So say you wait like a week and now the price of Ethereum has dropped to 50 die and you owe a little bit of interest.

So say you owe like 55 die back to the lender. Now what you can do is basically you need to find somebody that's willing to sell this time Ethereum for some die. and you'll go to a relayer to find somebody to do this. And normally this will be through a zero X order, but I do want to emphasize that our protocol will work with a bunch of different decentralized exchanges, not just X. So you go to a relayer and find, say, a zero X order that's offering to sell back the Ethereum that you owe to the lender for, say, 55 die.

So you send that to the smart contract. And the smart contract trades some of its own die that it has locked up in collateral for that Ethereum. So it trades like 55 out of the 150 dye that it has locked up in collateral and buys back the Ethereum that it owes to the lender, gives the Ethereum back to the lender. So the lender is happy. They basically earned interest on their ether and were paid back. And then you, the short seller, get whatever is left.

And in this example, you actually made money because the price of Ethereum goes down. And you made basically the amount of collateral, which is 150 minus what it cost you to buy back the tokens that are owed to the lender, which is 55. So in this example, you made 95, or sorry, you get 95 die. And you initially put up a margin deposit of 50 die. So in this example, you make a profit of 45 die on the trade. Interesting. So a couple of things. So first of all, I spoke with, shoot, I'm pretty sure it was.

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That's why CBC News is putting more journalists in more places across Canada, reporting on the ground from where you live, telling the stories that matter to all of us, because local news is big news. Choose news, not noise. CBC News. I think it was Robert Leshner of Compound, and they used something called collateral ratio to determine how much collateral you put up. Is that just determined on an individual 101 basis in DYDX? Yes, it is determined on an individual one-on-one basis. So kind of a lot of, the parameters for loans are determined by lenders in DYDX. DYDX is a very kind of open and general protocol. So we let lenders specify pretty much any detail about the trade from kind of the

maximum duration of the trade to even the interest rate that they're offering and other things like that. So it's more just specified by the lender in our protocol. Whereas for some other protocols like the compound, for example, is what you're mentioning. A lot of the parameters are kind of specified globally on their smart contracts. And the, other thing I was wondering is in your example, you used Ether and Die. And Die, obviously, is a stable coin that's currently pegged to the price of $1. But what if, let's say, I want a short rep with Ether, and both of those prices are fluctuating in relationship to the dollar, then how does the collateral work in all the other aspects? Yeah, absolutely. So you can

use any pair basically for kind of what you borrow and what you put up as collateral. So you could absolutely use D-YD-X to basically short Rep for Ethereum. And we kind of anticipate that that will be a really big use case. Basically, that's basically just taking a bet that you think that, say, rep or whatever other token, it doesn't have to be rep, is overvalued as compared to Ether. And basically using D-Y-D-X to short that as compared to Ether would be a really good way to kind of take that bet without actually even exposing yourself to the overall risk of cryptocurrency. So even if, say, Ethereum went down by a ton, but RepB went down even more. So you're

actually right on your bet in that Ethereum kind of went up as compared to Rep. You'd still make money on that trade. So there are a lot of use cases for margin trading where it does make sense to actually use as collateral, something that's not just backed to the dollar or some other fiat currency like that. And it would make a lot of sense to kind of use underlying cryptocurrencies such as Ethereum or really whatever you want as collateral as well. That's interesting. I actually would think it would be the opposite because, you know, Ether is down so much this year.

So, you know, you would have to be, well, I guess, I mean, there are a lot of not so good tokens that have plummeted even more. So maybe actually it does make sense. But I just think it would be trickier. It's like you have to sort of make more than one calculation in a way. Yeah, absolutely. And you really do, like financial derivatives are in margin trading are definitely financial products that do require a higher level of sophistication to trade. So you really have to understand exactly kind of what you're buying or what trade you're making before you make it.

But these types of trades are commonly employed by more sophisticated traders. And that's more of the target use case that we're going after. All right. So let's then describe the short token how it works. Yeah, absolutely. So in my example, basically it described basically just an individual taking out a short position on ether. The way that the short token works is very interesting and it's actually fairly simple. All you have to do is basically there's this concept where positions and loans can not just be owned by individuals like humans. They can also be owned by smart contracts. And this is really important, because it allows you to unlock a lot of other functionality on top of the protocol. So the way the short token works is it works exactly the same as in my first example, except now the owner of the position is not a human, but a smart contract.

And this smart contract basically is an ERC20 token. And the ERC20 tokens basically just represent fractional ownership of the backing position. So say I take out a position in exactly the way I described in the first example, and I take out like I'm now short, say, 100 Ethereum. So the protocol will basically mint me 100 short Ethereum tokens. Now if, say you want to short 50 Ethereum, you don't actually have to do all the complicated stuff that I described in my initial example. All you have to do is buy 50 short.

tokens from me. And then you'll basically own half of the short position because there are 100 short tokens and you own 50 and I own 50. And basically just the fact that the position is owned by an ERC20 token allows you to do really interesting things like splitting up ownership of it. And also due to the economics of it, the price to buy a short token will always be equal to the price to mint a new short token. In minting a new short token, in minting a short token is just done by kind of the process of opening a position that I described before. So it's really interesting because now only a really small number of actors need to actually do the complexity of opening and closing positions. And the vast majority of users can just

live in this simple world where if they want to get short exposure, they can just buy the short token or if they want to say close their position or like exit then they can just sell the short token to somebody else and somebody else can kind of deal with the complexities of opening the or closing the position for them and so with the short token then there's not like a duration baked in right it's just like when i want to sell that that's when i sell it and it's at that moment that it determines whether or not i profit or loss it's not like i'm betting oh i think the price will fall, you know, to this price by this time. And if it does, then I, then it cashes out for me or, you know, and if it doesn't, then it goes out to the full duration and I lose money. How does that part work?

So there is a maximum duration, both to positions and the short and leverage tokens, but you can also close your position before that maximum duration. So say the maximum duration is like a month and you buy a short token. There are two ways you could profit on it. First, is say 15 days through the month, you decide you've either made or lost enough money and you sell your short token and you basically just make whatever profit that the short token made during that first 15 days. Or you could basically wait the entire duration of the short token. And we have automated mechanisms in our protocol that will basically close the short token at the correct price without you having to take any action. So you could simply like,

The simplest way to get short exposure on the DYDX protocol will be to just buy a short token and then wait, say, the maximum duration of the short token and then let the automated mechanisms close the token for you. And then you can just come back and withdraw kind of the payout that you would have gotten. And the payout that you would have gotten is basically just the profit that the short token made during the entire duration. Okay. We're going to keep discussing your other products. But first, I'd like to take a quick break for our fabulous sponsors. Interested in becoming a blockchain citizen but unsure of how to get started, come be a part

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opportunities on unchained and unconfirmed. that's Laura Shin Podcast at gmail.com, L-A-U-R-A-S-H-I-N podcast at g-mell.com. I'm speaking with Antonio Giuliano of D-Y-D-X. So your other product right now, I think, is a leveraged long token. What is that and how does it work? So it works very similarly to how the short tokens work. The only difference is that you kind of flip the token that you borrow and the token that you put up as collateral.

So actually, the protocol doesn't really even know what is a short versus what is a leverage long. All it knows are kind of what the tokens that you borrowed are, and then what the token that you put up as collateral is. So let's kind of go through an example of how getting leverage on DYDX would work. So in our first example, we kind of borrowed Ethereum from the lender, and then we put up Dye as collateral. If you want to use DYDX to instead get.

leverage on Ethereum, you'd, in this case, borrow dye from the lender, and you'd put up Ethereum as collateral. So you could basically, so if you borrow die from the lender, you're basically increasing your buying power. So say you put up, you have like a hundred die with which you want to buy Ethereum. You could just buy $100, say, worth of Ethereum with your 100 die. Or you could borrow, say, another $100 from a lender and then use your 100 die plus the 100 die that you borrowed from the lender to buy 200 die worth of Ethereum with your 100 die. And the way that this works is, say you, in our example, you put up 100 die and then you borrow another 100 die. So now the protocol has 200 die locked up in the position. Then it sells that 200 die for,

Ethereum. Let's say in this case, the price of one ether is 100 die. So it sells that 200 die for two Ethereum and then locks that two ether up in the position. Now that two ether basically just sits there for the duration of the position, but you still owe the lender back an amount denominated in dye, not in ether. So in this example, let's say the price of Ethereum goes up to 200 Dye, whereas it started out at 100 die. So now the two ether that are locked in the position are actually worth 400 die, and you still owe, say, ignoring interest, 100 die to the lender. So you could close your position by basically buying back 100 die and giving that to the lender.

And then basically, there's 300 die left, and you could basically take that as your profit. So in this example, you'd end up with 300 die, whereas you only put up a margin deposit of 100 die. So in this example, you'd make a profit of 200 die because basically you were leveraged 2x on Ethereum. Whereas if you had only, say, bought 100 die worth of Ethereum with your 100 die, you would say would have initially bought one ether with that. And then ether went up by 100 dye. so you would have made 100 die on the trade, whereas being leveraged 2x with D-YD-X, you would have made a 200 die on the trade. So kind of in our example works very similarly to how shorting on D-Y-D-X works, except you basically just flip the token that you're borrowing with the token that's held as collateral. Super interesting.

One other thing I was wondering about is how do you guys determine the price of the assets? because obviously all these exchanges have different prices. So the way that prices are determined on DYDX is that each trader can kind of select their own spot order that they want to use to open or close a position. So say going back to our initial example of shorting Ether, I mentioned that the price for Ether in that example was 100 die for one Ether. So, and basically, the reason that that price is what it is, is because that's the best price that is offered by a zero-x order to basically trade Ethereum for dye on zero-x. So basically, the trader has an economic incentive to pick the best order for themselves because there would also be orders on the book for, say, like trading ether at, like, 90 die,

but you want to open your short position at the highest price possible. So traders will always pick the order with the highest price for themselves. So it's very similar to how just kind of limit orders work on exchanges. And traders always have economic incentives to basically pick the best order for themselves. Or similarly, say like 0X was offering a price of like 100 die, was the best price you could find on X. But like Khyber or AIS or something else, like some other decentralized exchange like that were offering a better price.

then you could kind of open your position with Oasis instead and basically get a better price for your trade. That's interesting. So as far as I understand for margin tokens, when you close your position, those tokens get burned. Why is that? So the margin tokens basically represent your ownership in the position. And when you use basically the reason that margin tokens have value is because they allow you to close a fraction of the backing position. and receive the appropriate payout. But when you basically use your margin tokens to close part of the position and get the appropriate payout, you no longer own a fraction of that position.

So we basically just have to burn the tokens because the tokens always represent ownership in the backing position. And if you close your ownership in that backing position, then you should no longer have the margin tokens to represent that. Okay. Something that I was curious about is you know, you were talking about how these orders will be filled on these different decentralized exchanges and how you can, you know, set the parameters with your lender and stuff like that. But how well do you think margin tokens will work with low liquidity tokens? Yeah, that's a great point. And we do think that they will work a lot better with tokens that have more liquidity. And that's one of the main reasons why we're starting with short and leveraged Ethereum.

because the Ethereum die market is by far the most liquid on decentralized exchanges. So that's actually one of the main criteria we're considering when deciding when to offer different assets for short and leverage tokens is how much liquidity there is in the underlying spot market. So it's kind of that combined with how much lending liquidity that we think there is for each asset. So if you want to short something like we've been saying, you need to borrow it. So we actually need to go out and find lenders that are willing to lend all these different assets that people want to short. So kind of the two things that you need are the underlying spot liquidity and the underlying lending liquidity in order to trade a margin token on DYDX. Yeah, I imagine that's the case now.

But I could sort of picture this going into some kind of long tail thing where really, really far in the future, you'll be able to do all kinds of different combinations, including of somewhat. obscure tokens, if this all, you know, works. But yeah. So one other thing I was curious about is, so is the person creating each Morgan token, the trader, him or herself? Or do you imagine there are going to be companies that crop up to kind of like feature different kinds of smart contract based derivatives that you can buy? Or how will that part work? Yeah. So DYDX is a very general and unopinionated protocol. So anybody can use it to take out any position or margin token that they want to. So you can use DYDX just to trade peer to peer if you want to.

The first use case that we're really focusing on is the margin tokens. And the kind of standard margin tokens, which are the ones that we're offering on Expo, are kind of the ones that are created by DYDX. But anybody else could come along and create their own margin token on DYDX. And all that creating the margin tokens means is that you kind of specify the parameters for the position. So you specify the things like what are the tokens being traded, what's the interest fee being paid to the lenders, what's the maximum duration, other things like that. But DYDX is a very general protocol. So we do anticipate that other people will use DYDX to build all kinds of different applications on top of our margin trading protocol and other protocols that we offer in the future.

but we did think that it's important to offer the first and easiest way to trade DYDX margin tokens, which is what we're launching with Expo. And actually, just before we continue on, you mentioned Expo before, but I don't know what Expo is. Yeah, so Expo is our end-user-facing application that we're building on top of the DYDX protocol. and Expo will be the simplest way to buy and sell D-Y-D-X margin tokens. This is actually like an interesting point in something that we're kind of doing differently than a lot of the other protocols that I've seen is that we are building a lot of these end-user-facing applications

and supporting services on top of our protocol. So what we're doing is a lot more than just building smart contracts on Ethereum. But Expo is basically just a regular website similar to any other DAP that you might use. And basically it allows you to go and see what's the different short or leverage tokens that are available to trade are and gives you a really easy interface to buy and sell them. And kind of how it works is it plugs into other decentralized exchanges on the back end to get to the buy-sell liquidity that you need to create to buy or sell the short tokens.

Wow, this is really, really interesting. I know I keep saying that. I'll try to stop. So earlier you mentioned that as you've been going along, you've realized that what's easier in a way to comprehend is the actual derivatives themselves, but what's more complicated is to understand how traders are trading them. So what are the differences and what are you having to learn in that regard? Yeah. So just the way that margin trades or options work aren't really that complicated from a technical perspective. Like for margin trading, it's basically what we just went through. Like you borrow something and then you sell it to somebody else and then you lock up collateral.

And for options, which we haven't really talked about, but they're fairly simple. Basically, you kind of lock up collateral and give somebody else an option to basically buy that collateral at a certain price. So it's not too difficult to make them from a technical perspective. really the complicated thing is to understand how traders actually use them in trading and kind of what trading strategies they use with options or with margin trading. This is something we've been doing a lot of is kind of reaching out to customers to understand how they want to use to start with margin trading and then in the future options or other types of derivatives on cryptocurrencies and kind of what strategies they want to employ with them.

like interesting things. Like margin trades are probably the simplest type of more advanced financial product in my mind. But once you get to more sophisticated types of derivatives like options or swaps or similar, then you can kind of do a lot of really interesting but more sophisticated things. Like for example, with an option, you can kind of lock in your price for Ethereum or really limit your downside. So say like Ethereum was at like $1,300. before and you were like, well, this is great. I still think Ethereum will go up, but I want to protect myself if the price of Ethereum

goes down. You could basically use a put option, which is basically an option to sell Ethereum at a certain price to kind of lock in your price. So you could buy a put option with basically a strike price of, say, like $1,000 when Ethereum is at $1,300. And then if Ethereum goes up, you don't have to be. have to exercise that option because the price of Ethereum would have been higher. But if the price of Ethereum, say, as it did, went down to like $200 or whatever it is now, then you could have used

that put option to instead sell your Ethereum at $1,000. So that's kind of one example of a really simple use case where kind of these more advanced financial products can be used to really protect downside and hedge against like extreme volatility. So we think that they're a really important part of the overall trading market and something that we haven't really seen used very widely in cryptocurrency. But traditionally, we see the derivatives markets being on the order of 10x having more, like 10x more volume than the underlying spot markets. And in cryptocurrency, that isn't the case at all yet. So we really think that derivatives are going to be really widely used in the future, especially given the underlying volatility of cryptocurrencies.

So that's kind of why DYDX is something we're excited to build in the short term. Before we move on, do you want it? Just walk me through your version of an option briefly? Yeah, absolutely. So our current options protocol, and to be clear, this isn't something that we're launching right now, but something that we're planning to launch in the future. But our current options protocol is for what's called a covered option. and covered basically just means a fully collateralized option.

So there are two different types of options, and I mentioned one of them before. There's a call option, which is an option to buy an asset at a certain price. So you could buy a call option on Ethereum, and it would have some strike price, or a put option, which is an option to sell an asset at a certain price. So the way our options protocol works is that there are these. people called writers, which basically are the people that create and offer to sell options. So if you want to, say, buy a call option, which is an option to buy Ethereum on Ethereum, then you'd go to a writer. And when you buy an option, basically, you have to pay the writer

a premium, which is kind of money that you pay the writer up front in order to basically own the option. So let's kind of go through a concrete example. So say the price of Ethereum is, is at $200 right now, you could basically buy a call option on Ethereum at, say, a strike price of $300. So if the price of Ethereum goes down or kind of stays the same, then that option will expire worthless because why would you ever buy Ethereum for $300 when you could just buy it on the market price of $200? But say the price of Ethereum goes up by a lot, say it goes up to like $1,000 or something like that. And now you still have this call option to buy Ethereum at $300.

Then you would have made $700 on that trade. So that's an example of kind of how options can be used to increase speculation. Going into the specifics of how our options protocol works, it's actually a good bit simpler than the margin trading protocol, especially for the covered options. And the way it works is that a writer will basically lock up Ethereum in a smart contract and will immediately get paid a premium. And what the owner of the option gets is a brand new ERC 20 token,

very similar to kind of how the margin token works, that basically represents the option. And what this ERC 20 token gives you is the right to exercise the option at a specified date or strike price in the future. So if you say own a call option token on Ethereum and the strike price is $300, whoever owns this new option ERC20 token will get the right to buy the Ethereum, which remember was locked up as collateral in the smart contract by the writer at, say, 300

die in the future. So that's pretty much all there is to it. So it's basically just the writer's lock up collateral in a smart contract. The smart contract mints a new ERC20 token, which represents the option. and whoever owns that option token can buy the collateral that's locked up in the smart contract for a specified price. That's really so fascinating because I imagine that in existing financial services, everything that you just described takes a lot more kind of like paper and a lot more intermediary.

So I just find it really mind-blowing, frankly, when I learn about how this can be done with technology. So one thing I wanted to ask about was that in a previous interview with me, you said, quote, that you're working on things where you can take margin positions for other types of derivatives with not full collateralization. And then you said that you'll be putting all of that in a pool of collateral that will back, you know, many different positions. So I just was curious to know how would that work if there's a market crash? Yeah, absolutely. So kind of just taking a step back, and I can describe a little bit what I was talking about there. So our options and margin trading protocols are fully collateralized.

But this isn't the way that most people trade derivatives in more advanced financial products in the future. They usually trade them with fractional backing. And you can kind of see this by like the sum of like the total notional values of all the derivatives in the world, somewhere in the range of like a quadrillion dollars, which is clearly way more than all the money that exists in the world. And the reason for that is because all these people are trading derivatives and advanced financial products with fractional backing. So that's kind of what we're trying to solve with kind of this future protocol that will enable us to kind of back options or margin trades with not full collateralization. I want to caveat all of this with kind of saying that this is very, very much in the research phase.

and we strongly believe that kind of launching the fully collateralized margin trades and options are the most impactful thing we could do in the short term. But we are thinking about ways that we can kind of solve this problem of not full collateralization in the future. And kind of what you were alluding to is one of the ways that we're thinking about solving that is kind of with a pool of capital. And basically the pool of capital will kind of back a number of different derivatives and financial products together, and we'll kind of diversify the risk across a number of positions.

So kind of thinking about like some easy things that you could do with this, like on DYDX with like options, say you have like a put option and a call option for Ethereum, so that's kind of one's betting that the price will go up and one's betting that the price will go down. With the version one options protocol, you'd have to put up full collateralization on both sides, but you don't really need it because it's kind of either the price will go up

or the price will go down. So in that example, you can kind of back the position with half the amount of collateral. And that's kind of the general trend of how you can back like a number of different positions with less capital by kind of diversifying the risk across a number of positions. So that's kind of the general theme of the protocol that we're in the process of designing for the future. And something that we're really excited about. And we think solved. a really massive need for these not fully collateralized derivatives. But before you have not fully collateralized derivatives or kind of a pool of collateral backing them, you need to literally make like a margin trade or an option. So that's what we're focused on in the short term is basically

just making the easiest possible experience to do a margin trade or an option without trusting your tokens to anybody else. Yeah, I imagine also for that to work that you would need to mix in other asset classes besides crypto, like security tokens, because at least for the moment, crypto markets, the crypto market tends to move and sink, you know, like those days when you open coin market cap and everything is red or everything is green. So that actually leads me to my next question. Like, I know that Harbor, which does security tokens, that there are token standard, is ERC20 compatible? So does that mean that you could use a security token built with Harbor on DYDX?

Yeah, absolutely. So you can use any E.RC20 token on DYDX. So that opens up a lot of really interesting possibilities because once you start tokenizing real world assets with harbor or similar, you kind of can immediately tap into this whole ecosystem of decentralized financial applications, such as like you could trade it with zero X,

you could take loans out on it with Dharma, you could kind of take margin trades or options out on it with DYDX. So it's really interesting once you kind of get all these open standards working together. And that's something that we're just starting to see the power of that, I think. And I think DYDX is a really good example of different protocols working together because we are kind of built on top of different decentralized exchanges such as 0X. It's a pretty interesting example of how you can combine lending with 0X to basically make margin trading. So I think we'll see a lot of really interesting use cases pop up really quickly

once a lot of these protocols are actually live and start working together like that. And just out of curiosity, obviously this is a different token standard, but do you think eventually ERC 721 tokens, which are crypto goods like CryptoKitties, will work on DYDX? It's possible. It makes a little bit less sense with kind of the way that we're doing margin trading or options to start with because you kind of need an underlying spot price for the asset. But some things that people are thinking of doing are basically kind of fractionalizing ownership of like an ERC 721.

Like if it's like a really expensive crypto kitty or something like that, then you could kind of have an ERC 20 token, which represents ownership of that backing ERC 721 token. And then you could kind of use that to kind of like, say, short a Crypto kitty or something like that. But kind of the concept of just like shorting the one crypto kitty, like doesn't make as much sense because there's not a spot price for it. But those are the types of things that I think will be exploring more in the future. You have two million dollars in seed investment from Andrewsson Horowitz, Pollychain Capital, Brian Armstrong and others, but you don't have a token. So how does DYDX plan to make money? So there are a couple different ways we could capture value.

and kind of the biggest ways I think about it are the biggest question for us as a company is how we capture value. And we could either do it at the protocol level or more at the application level. And what I mean by that, so at the protocol level, we could actually do like an actually useful token. And I do think that there are a number of tokens that actually do have value. So that's something that we might consider in the future. We don't think there's a strong need for a token in the margin trading or the options

protocol. And my thesis on tokens is that they're not something that you need to rush into, and it's worth thinking pretty deeply about, first of all, whether we even need a token. And then if you do, what the best way is to implement that token in your protocol. So that's something where we really just wanted to come out with a protocol that works without injecting a useless token into it, first of all, and then kind of thinking about how we can add a token later. And kind of the way we're thinking about tokens right now is we may introduce one with kind of some of the future protocols that we're building. And we kind of briefly touched on the like collateral pool protocol, which kind of supports not full collateralization.

So that's kind of something that might have a strong need for a token based on kind of how we design the protocol. The other way that people are thinking about capturing value at the protocol level is through just kind of straight up charging a fee through their smart contracts. I'm not as much a fan of this, but I could see like a world in which this kind of emerges as the standard for how protocols capture value. I think it kind of works in applications like CryptoKitties, for example, charges like a three point something percent fee whenever you trade a CryptoKitty. So I think it kind of works for games and things like that, but I don't really think

it works as well for serious financial applications like derivatives or lending because people really care about like kind of fees and like middlemen sitting in the middle. But that could potentially be an option. if that emerges as kind of the de facto way that protocols are capturing value. So those are the ways we could potentially capture value at the protocol level. On the application level, we could capture value

through actually just making money. And as I was mentioning, this is something that we're doing differently than a lot of other protocols in that we're kind of building end user-facing applications on top of our own protocol. And a good example of that is Expo. So Expo won't be charging fees to start, because what we're looking to do

is just getting to get as many users of our protocol as possible. But if it does like come out that most people are kind of using Expo to interact with the D-Y-D-X protocol, that could be a really good opportunity for us to kind of charge fees like you would see on a centralized exchange at that level. So those are kind of the three different ways we're thinking about capturing value. We have a lot of really excellent backers who are really, really long-term aligned in the space and also raising equity has given us a lot of flexibility to basically just build out something that's actually useful in the short term and think about capturing value later.

But we are thinking about it a lot when we're very much like a for-profit business, not just kind of like just an open protocol or anything like that that doesn't make money. So that's kind of how we're thinking about it for the long term. And who do you imagine your target users will be like, do you see Wall Street using this technology? Eventually, definitely not to start. So to start with, we're thinking our target customers are smaller crypto hedge funds. There are a ton of these crypto hedge funds these days or more sophisticated individual traders. So that's kind of who we're targeting with the launch of the margin trading protocol and expo.

Once we start getting into more sophisticated types of derivatives like options or anything else that we might add, that's kind of when you need more institutional type traders or really, sophisticated individuals to be able to trade those. So I think we'll kind of move up the spectrum from, like, I think about like customers as a spectrum from like full retail customers to like full institutions. I think we're starting somewhere in the middle, but we'll kind of shade more towards the institutional customers over time. A really interesting thing that having these tokenized positions offers you is that the positions like the short tokens, for example, are just regular cryptocurrencies. so they can be traded anywhere, even on centralized exchanges, very much in the same way that Bitcoin

is decentralized, but you can trade Bitcoin on a centralized exchange if you want to. So I imagine that this will be one of the main ways that users interact with our protocol, basically just buying the D-YDX short or leveraged or in the future maybe options tokens on an exchange without ever even having to interact with a decentralized application at all. So that kind of allows us to cater to a much more kind of traditional audience. There are like a number of centralized exchanges, as I mentioned at the start, that are offering margin trading and certain derivatives products, which those are kind of the like CBOE or example, for example, will be kind of where likely most of the traditional financial people who are

trading Bitcoin will trade derivatives for the short term. But I think in the long term, there are like a ton of advantages to using an open protocol like D-Y-D-X to do margin trading or derivatives. And kind of a number of those are that they're fully global. Like you can trade with anybody anywhere in the world, which is kind of like something you see come up a lot for why you would use a decentralized application. It's more secure.

There are kind of less middlemen sitting in the way. You can kind of share liquidity across a number of exchanges, which is actually a really important point. Because for all these exchanges that offer margin trading, you can only borrow from people that are on the same platform. Like, for example, if you're margin trading on Polonex, you can only borrow from people who are on Polonex. But with D-Y-D-X, like the protocol doesn't care where you get the lending liquidity from. So you can kind of share lending liquidity and spot liquidity across a number

of different exchanges. And I think that we'll really see that pay off in the long-term. But that's kind of how we see the evolution of our customers, starting with people who are already trading and using decentralized apps right now and eventually getting to the more mainstream over time. When you mentioned that you can trade with anyone anywhere in the world, it just made me think. So obviously, you know, there is an advantage of that in terms of liquidity, but it just sounds like a regulatory nightmare. And I just wonder, what are the regulatory issues? And is it simply incumbent on the trader themselves to make sure that they're complying with the laws of their jurisdiction? Or does that burden lie with DYDX? Or how does that work out? Yeah, so a lot of the time it will fall onto the centralized exchanges or relays on which traders are trading.

I think we see this a lot with different protocols. If they have any centralized components, those are oftentimes the most highly regulated. So I think if there's any regulatory burden, it will fall with those players. We have been thinking about this a lot. We're working with one of the very best cryptocurrency law firms, Perkins-Cooey. We're actively engaging with the CFTC, which is the regulatory. body that regulates derivatives and also other regulatory bodies to try to understand and educate them on how do IDX works and kind of what the regulations surrounding it are. You're absolutely right

that there's a lot of regulatory uncertainty and this has been said over and over, but especially once you get into some of these more heavily regulated spaces, such as financial derivatives, like a lot of the laws were literally written for like physical commodities, like, I don't know, like you could sell like an option on corn or something like that. And now the CFTC has classified like Bitcoin or Ethereum also as commodities and are trying to kind of apply the same regulations to it. So we're definitely taking a very compliant approach to this. This is something I think I really get from Coinbase and we really saw work well there in terms of we're being built like in the U.S. Like we're not like incorporated overseas or anything like that.

We're actively engaging with regulators. We're really trying to provide support as much as we can to other relays and exchanges building on top of the. protocol. But it's definitely something that I think the regulation will have to evolve with the technology over time. And that's kind of how we think about it. This has been an incredibly fascinating discussion. And I don't think I nearly failed as I was having flashbacks to last night. So thank you so much. Where can people learn more about you and DYDX? Yeah. So you can go to our website, D-YDX dot exchange, or if you'd like to try our application, head over to expo-trading.com. We are hiring for a number of engineering, design, and recruiter positions.

So if you'd like to work with us, check out our job postings on our website. Great. Well, thanks for coming on Unchained. Thanks so much for having me. Thanks so much for joining us today. To learn more about Antonio and D-YD-X, check out the show notes inside your podcast episode. new episodes of Unchained come out every Tuesday. If you haven't already, rate, review, and subscribe on Apple Podcasts. If you liked this episode, share it with your friends on Facebook, Twitter, or LinkedIn.

And if you're not yet subscribed to my other podcast, Unconfirmed, I highly recommend you, check it out and subscribe now. Unchained is produced by me, Laura Shin, with help from Rayling Gallipali, Fractional Recording, Jenny Josephson, Rahul Singh, Reddy, and Daniel Nuss. Thanks for listening.