Unchained - Sam MacPherson on Why Spark Benefited So Much From the KelpDAO Hack

Starting point is 00:00:00 I would say so like right now we are probably in like a peak sort of danger zone, but I feel like we're going to move actually to a better place ultimately because AI, although it can be used on the offensive, it can also be used on the defensive. Hi, everyone. Welcome to Unchained, your no-hype resource for all things crypto. I'm your host, Laura Shin. Before we dive into today's interview,

Starting point is 00:00:21 we'll take a quick word from the sponsors who make the show possible. This episode is brought to you by 1-inch Aqua, the shared liquidity layer from, 1 inch. Back multiple liquidity positions with one wallet balance and keep your tokens in your wallet until a swap fills. See how it works at 1inch.com slash aqua. Today's guest is Sam McPherson, co-founder and CEO of Spark. Welcome, Sam. Yeah, thanks for having me. Heads up, everyone. I'm on vacation, so by the time you hear this interview, it will be a few weeks after this interview was actually recorded in mid-July.

Starting point is 00:00:58 Just in case something major blows up in D-Fi between now and then, and you're wondering why Sam and I don't discuss it. So Sam, Sky is the oldest stable coin. It's the true OG, and it started as MakerDAO, and your Defy Protocol, Spark, is built on top of it. Tell us what Spark does and explain its relationship to the Sky Protocol. Yeah, sure. So Sky formerly MakerDAO is originally launched in 2019 with the Dye StableCoin.

Starting point is 00:01:30 And there was sort of two restructurings that happened around the 2022 period. First was the rebrand from Maker to Sky. And then the stable coin became from Dye to USDS. And then the second piece was a restructuring of the governance. So that the first iteration of the DOWs were not really working that. well at scale managing large amounts of money. So it was decided to restructure into this sub-down model. So now the way things sit is that Sky functions more like a central bank and wholesale liquidity issuer. So the sub-dows, Spark being one of these, functions more as a commercial

Starting point is 00:02:12 bank that is able to draw on the liquidity reserves of Sky and then deploy it into commercial lending activities. And so primarily this is a mix between real world assets to get the base yield usually from treasury bills and then crypto over collateralized lending, primarily like Bitcoin and Heath back loans. Okay. And so what are the main products that Spark has? Yeah, so Spark started out with an internal lending market. So this is an on-chain money market, similar to like, you know, compound AVE, these types of things. And this is like the crypto-backed loans section of the balance sheet. It is focused on lending against Bitcoin, ETH, and these types of loans had been around.

Starting point is 00:03:05 It is similar to the CDP model that Maker originally had. Since then, Spark has expanded to cover a lot of the different verticals. So we have launched what it's called Spark Savings, which is, is a Volt product that will allocate, it sits on top of USDC and USDT, and this provides a yield on top of these stable coins. And so what Spark functions as is a allocator across the space. So you use a depositor into Spark savings,

Starting point is 00:03:35 Spark will allocate the capital on your behalf and allocate the opportunities between Defi, C-Fi, and TradFi with RWA's to optimize the risk-adjusted yield into that So currently we're offering 3.6% on USCC and the USDT rate is 3. or sorry, 2.75%. So other products like we've recently also expanded into institutional lending. We do custodial Bitcoin back lending through Anchorage.

Starting point is 00:04:06 So this is institutions who want to get financing against their Bitcoin on their balance sheet usually. And so they will, they will borrow from us. And this is facilitated by Anchorage, the qualified custodian. And another thing that we've recently got into is Spark Prime. This is CD5 Prime brokerage. We're still in the preliminary phase of scaling this up. But the idea here is that we do lending and hedge funds primarily are able to margin their

Starting point is 00:04:37 positions across DFI as well as CFI. And now actually there is support for TradFi venues, which is very interesting. especially with the uptick in more like traditional stocks becoming the big hype cycle right now. So this can provide hedge funds with coverage in Tradfai venues, connecting it to modern D5 venues like hyperliquid to provide liquidity. Okay. So you kind of were getting a lot of buzz in the wake of the Kelpdow hack. You know, basically when you look at the TBL of Spark, dot phi on defy llama it's very clear that you know something happened around mid-April and basically you know spark ended up

Starting point is 00:05:29 kind of being a big beneficiary of that hack the tvl in eith is up about 50% from that time today and even in early july it was up about 80% from that point and you know this is a a moment where spark kind of I would say differentiated itself from the rest of DFI because obviously the rest of DFI took a big hit. So why do you think Spark was an exception? Yeah. So first I'll say these types of events are unfortunate for the space as a whole. And so like we're not like wanting these events to happen even though it is relatively speaking good for Spark. But yeah. So what we tend to do is we take a much more conservative position compared to the wider market. So we did not engage with looping in the same sort of way that some of the other markets were doing.

Starting point is 00:06:23 Additionally, we've had rate limits on all of our markets since shortly after we launched in 2023. Sparkland has – so one of the big deterrence for these types of hacks is that basically when – I believe the actor is assumed to be North Korea, they're looking for ways to exit into decentralized assets, usually ether, Bitcoin. And so they will take a route that is easiest to get through. So you kind of need the asset issuer to make a mistake with, you know, the way the layer zero configuration was with Kelp Dow. And then you needed a venue to get to ETH. And so Avey was the main venue for this.

Starting point is 00:07:07 So Sparkland has a fairly tight rate. limits. So this, like, even if there was some sort of incident with one of the assets that are on the, that are available as collateral, there's just not that much capital that can be extracted through Sparkland. Because as a regular user, the most are okay with just waiting a bit and like, you know, take some time to take out a loan if it's legitimate activity. The ones who need to go through right away, usually there's something wrong there. So we, we designed the market from the ground up to have these sort of safety controls. Other features that we have, we run a triple redundant Oracle.

Starting point is 00:07:44 So even if one of the major providers, so we run it between Chainlink Redstone and Chronicle. And so if one of the Oracle providers prints a bad price, we actually have lied in us even through this type of event. So yeah, these are just a number of features that we've been like, we're just very risk averse in this space. And so we've been taking this line. And sometimes it's been a little bit,

Starting point is 00:08:07 you know, to the deficit of like business growth and revenue opportunities. But this is a new space. And I think we're entering, it's a little bit more of a dangerous time with all the AI stuff going on. But we know how to do best practices. And so we just will continue to follow best practices. And I'm quite confident we will get through this. But the other good note is that I see a lot of change in the space as a whole, like a sort

Starting point is 00:08:37 of a maturing of taking security seriously. These things are all preventable with just even basic security best practices. So I'm optimistic. This is a tough, tough period. And I'm actually glad they were able to recapitalize the market there as well. So I think it's a lesson. And I feel like the space is going to just get better.

Starting point is 00:09:00 And why have you made this conservative approach part of Spark's DNA? Yeah. We just have taken this tack throughout, like since, like, Maker launched back in 2019. We have never really been chasing the newest thing. You know, there was stuff in 2021 that was going through the hype cycle. We largely avoided it. And so this practice, during bowl markets, there's, you know, the new flavor of the year. And things, you know, are perceived to be overtaking.

Starting point is 00:09:36 us, but we found that just compounding these can, like, just take the conservative view and compound the growth slowly over time, has been the winning strategy. So this is why sky as the whole is over 10 billion in stable coin deposits and is the market leader by far in terms of stable coin deposits in the space. And what were you doing before you launched Spark and got involved in Maker? Yeah, so I was, I'm a software engineer by trade. So I had previous companies, worked in a completely different space. I was working in video games before this. But then I worked in Maker. Oh, okay. Okay. I didn't know if you were going to say, like, you worked in Tradfai and, you know.

Starting point is 00:10:20 No, just been picking it up. Okay. Okay. I don't know if you saw Hassev, Koreshio Dragonfly tweeted that it's a red flag if, like, a founder doesn't get good at video games or something. Yeah, yeah. I guess I pass. Well, so, you know, the reason that you were able to kind of make it through the Kelpdau incident unscathed was because before that exploit Spark exited RSEath, which was the asset on Kelpdao that got manipulated. And the way that happened was that Phoenix Labs, your company, which is kind of like the main centralized entity that, you know, manages. Spark, a SparkFi, made a proposal to exit RSEath, but that then had to be passed through on-chain governance.

Starting point is 00:11:14 So I have two questions about this. First of all, I'd love to hear kind of like what metrics or protocols or processes Phoenix Labs uses to identify these types of risks in DFI. Yeah. So RSEth, you're correct. It was off-boarded in January of this year as part of a general risk reduction strategy. There tends to be during bull markets, some assets will be onboarded. Some prove to be successful revenue generators.

Starting point is 00:11:45 But there's always a trade-off between your risk surface and the opportunity that onboarding an asset can bring. So even with the RS-Eath onboarding, even if we didn't afford it at the time, we never onboarded it into what is called efficiency mode in the market, which is this high leverage with the eth looping. it was only onboarded to borrow stable coins. So the LTDs are much more in like the 60, 70% range. So even if we didn't offboard it from the market, it's quite likely that there would be either no or sort of minimal losses that were easily recoverable from in the Sparkland market. But yeah, sort of what is the decision process for offboarding?

Starting point is 00:12:30 We look at all the assets in the market continually and watching liquidity, how much people are using them. And there's just sort of an ongoing calculus, you know, if something's not being used that much, we don't want this, this kale risk present in the market. So we will offboard it. And to be fair, the other lending markets do this as well, sort of just a sort of a waxing and waning of the bull bear cycle is pretty natural. But I think the key point is that even when these assets are on board of these sort of newer, more untested assets, we keep them in very conservative risk policies until we see sort of like some actual organic adoption, demand growth and sort of transitions to be this staple.

Starting point is 00:13:17 So Sparkland is intentionally keeping a very minimalistic set of collateral since there was a bit more before, but now we are down to just about, I believe, like five assets. There's CBBT, WBTC, Lido Stateke, and then E. etherfi. These are the collateral that are accepted in Sparkline. And this covers most of the organic usage in the market. So we're okay with that. Okay. So in a moment, we'll talk a little bit more about the

Starting point is 00:13:49 Kelthau incident, but first we'll take a quick word from the sponsors who make this show possible. $540 million. That's how much concentrated liquidity sat idle in a given week in the first half of this year. About 30% of the Defi TVL, if you're wondering. That's according to Dune Research commissioned by One Inch, but there's a solution. One Inch Aqua is the new shared liquidity platform. It lets LPs back multiple positions with the same token balance and keep their tokens in their wallet till the swap comes.

Starting point is 00:14:20 Why does that help? Because the LPs don't have to split their tokens across positions. They can cover more market conditions and pairs with their full balance. That means more activity across deeper liquidity. See how it works at 1inch.com slash aqua. Remember that providing liquidity carries risk and fees aren't guaranteed. Back to my conversation with Sam. So my second question about a spark exiting RSEath, just in time to avoid being hit by the Kelptow attack, is about that decision-making a process because essentially Phoenix Labs identified this risk.

Starting point is 00:14:57 But in order to act on it, you had to propose it to the Dow, you had to get it approved. that's pretty kind of like slow and cumbersome. So I was curious like how well that works. Yeah. So maybe you're referring to sort of like if there's some sort of emergency, is this process able to like react in time? Is that where you're doing? Yeah, yeah.

Starting point is 00:15:19 Like I was wondering when there's something more time sensitive or is some kind of imminent threat, you know, how does governance work in that situation? For sure. So there are definitely emergency processes. We did not perceive any emergency with the regularly scheduled off-boarding process. So the governance process takes on the order of about a month. It has to go through several stages, including a risk council, which sort of checks that Phoenix Labs as the proposer is doing things that makes sense.

Starting point is 00:15:50 So we have three teams sitting there that are doing reviews on sort of what's being proposed, and then we'll make sure it's all okay. then it will go out to SPK voters who vote on it on a snapshot poll. And then it will be sent to Sky. And Sky is basically there to put a final check on it, that there's not something odd going on. It's like as long as Spark is sort of following the rules that Sky sets out for doing lending, it will pass it provided it adheres to the risk framework.

Starting point is 00:16:26 So in the emergency situations, obviously this is, way too slow. So what we do have emergency multi-sigs that can pause the protocol and just to see what's going on if there is some sort of emergency situation. And yeah, there will be like, if there needs to be some sort of like emergency changed under the protocol, everything is behind time locks. So there is like certain minimum constraints. And this is for safety. Having assets under custody with no time lock is actually quite dangerous and makes you a target for North Korea, as we can see with like the drift hack, for example. So having a time lock on the assets in the Sky Protocol as a whole is incredibly important. But if we really need to move quickly, there is

Starting point is 00:17:13 expedited emergency processes that can be done on the order of a day or two to do these sort of administrative changes. But first and foremost, the multi-sigs provide this protection. They're not custom in the assets, but they're like a pause and let's take a beat and see what's going on sort of protection. And this is pretty standard across DFI. Okay. Yeah, I'll ask you a little bit more about that governance, but in a while. But I do also now want to ask about another question that came up quite a bit during that whole period because it wasn't just the Calpto attack, but obviously there was drift. And then there was this whole slew of other ones that seem to pop up because of AI becoming just so much more capable.

Starting point is 00:18:01 You know, we saw that a lot of people began debating what the fair yield was to offer people in defy for the risk of putting their assets on chain. And I wonder how you think about that question. Yeah, I think it's a fair question. I'm more in the camp, I would say that, you know, whatever the market rate is is what it is and people are willing to accept this risk. I do think it's important that we make the risk clear to the depositors. And this is something we've been striving for at Spark is having defy ratings. Because I think this has been a big missing piece is that people, they'll often look at like, you know,

Starting point is 00:18:41 what is the highest APY and not really understand deeply what sort of the risks that are involved with these structures. So first and foremost, we want the user to be aware of like what what they're getting into when they deposit. Now, I mean, why is the yield sort of around SOFA, and I guess it's being argued that it should be much, much higher because this is a new space. There's lots of risk. You know, that might be true. But, like, also, there is just an excess of stable coin liquidity searching for yield in the

Starting point is 00:19:16 space. So this just naturally leads to more compressed rates. And so for us, Sky has around $10 billion on its balance sheet and about 40% is deployed or so into various forms of lending. A lot of it sits as idle liquidity. And so the rate will naturally converge to around sulfur. But yeah, I think as more and more like stablecoin use cases come on chain, I think having this highly liquid base yield is a good thing. People want sort of the treasury yield at all times on their cash. And so this product, we're aiming for Spark to be sort of like the conservative version of

Starting point is 00:20:03 this where you can just park your cash and not have to worry about it. We are in very conservative strategies. As I said, most of it is cash, T-bills, and crypto-backed lending, which has been quite solid over the years. There's been no major loss of end against like, Ether Bitcoin collateral. And so, yeah, we think it's a fairly safe product. And we want everybody to be aware of the risk because it's ultimately the individual's

Starting point is 00:20:34 judgment call. Yeah. I mean, it's very difficult to make that judgment call when things are shifting so much. So speaking about how things really have changed dramatically for Defi recently, this whole wave of new hacks that are happening because of the AI thread. is obviously causing, first of all, a lot of people to pull their assets out of defy, but it's also resulting in calls in the industry for defy DAOs, for founders to think more critically about how to protect their systems. How do you think about that and how do you think

Starting point is 00:21:10 the industry should be approaching that threat? Yeah. I would say so like right now we are probably in like a peak sort of danger zone, but I feel like we're going to move actually to a better place ultimately, because AI, although it can be used on the offensive, it can also be used on the defensive. And form of verification is really where we're going with all of this. Smart contracts in particular actually are quite safe just because of the simplicity of the code. If you look at the major hacks, these are all OPSEC hacks. And OPSEC, like, again, we know how to do this correctly.

Starting point is 00:21:47 You just have to follow best practices. And you can, you can, like, you don't have to. to worry about the AI is not a like a magical thing that can just do anything. It does follow the rules of physics. And so we do know how to deal with it. Yeah, where I'm optimistic that we're going though, so already smart contracts are quite robust. We are using internally at Phoenix Lab AI for we still have human auditors. But like we are complimenting that with the addition of AI. It is starting to become good enough that is actually catching up to some of the best human auditors that are available. And yeah, again, including formal verification, this is where you have

Starting point is 00:22:28 like the highest confidence that the code is indestructible. So this is just going to make the industry a lot more robust. So I think what people are seeing is, you know, there's hacks and all this like software that's been around for like the longest time. But these code bases are like millions of lines. So it's more just about the surface area. Of course, there's going to be someone that made a mistake in these large code bases. And this is where we're seeing a lot of the hacks. It's not so much in the smart contracts where most modern smart contracts are intentionally kept as minimal as possible.

Starting point is 00:23:02 Human reviewers can have high confidence after auditing themselves, like that this thing is safe. And now we're going to get this extra piece that just, I think, cements smart contracts is one of the safest ways to custody assets. Hmm. Okay. Well, I want to circle back to what I asked earlier about when you had to propose that, you know, RS, E, be exited and then had to wait for the full governance process. You are probably very well aware that we're at this moment in time where DAOs are either disbanding or they're being paused or they're, you know, basically just becoming more centralized in various ways. Or there's wars over a, to, you know, centralized at least certain aspects of their functions. So I wondered how you think about that because you operate a centralized entity that is, you know, managing these decentralized protocols. You have to deal with this decentralized governance. Are there any thoughts about changing it in either direction? Or do you have thoughts on just the trends that we're

Starting point is 00:24:14 seeing where some DAOs are just becoming more centralized? Yeah, so there's a few things. On the token versus equity, I believe there needs to be one instrument that value accrues to. So for us, that is the SPK token. And then the broader Sky ecosystem has a fairly good track record of keeping everything under Sky as much as possible. There are realities of interfacing between legal and smart contracts that just aren't there yet. so you have to make due. But to the best of our ability,

Starting point is 00:24:50 we do put all of the value into the token side. So Phoenix Labs exist as just an operating company, that we are not raising money under Phoenix Labs or anything like that. And so for that, I think I'm very clear on that. I guess the next part of your question, sort of where the Dow structure, I guess. So we kind of went through this like Dow issue. like back in 21, 22 with Maker was actually like one of the first Dow's that was like

Starting point is 00:25:24 operating a large scale protocol and really tried to do the Dow thing for real, like the Maker token voting and then you had there was teams that were operating within it. But just this, we do quickly realize this like flat structure just doesn't work. So what happens and it's not much different than any sort of like governance with humans. is you get political factions forming and sort of informal alliances, structures. And so you really kind of need a more natural way, place for that to sit. And so this is why the sub-dow model was conceived, is that the core Dow no longer has to make decisions about what to do. It will just set the rules and the risk policy that the sub-dows have to

Starting point is 00:26:11 follow. And then the sub-dows can splinter off into these, into political factions even. that then compete in the free market to deliver the most value to the core Dow. So we're still in the process of scaling this up. Will it work? It's not proven yet. But having worked in both structures before, the sub-down model is just a much more natural fit for sort of getting the advantages of like more things that look like a little bit more centralized and can move quicker with the emergent,

Starting point is 00:26:47 decentralization of the structure as a whole. Super interesting. Okay, let's also now talk about stable coins because we're just in this moment where clearly stable coins are probably going to be the next big onboarding tool in crypto. Less sexy than ICOs or DeFi Summer or NFTs or even dads, but they're still going to be probably, I would imagine, the biggest onboarding tool. ultimately for crypto. Now, along with all this new stable coin activity, we're seeing like the flourishing of

Starting point is 00:27:25 neobanks and there's just so many players that are competing to offer yield on stable coins. Rahmanhood chain is now offering 7% in its earned product with USDG. How do you think about competing in that environment? Yeah, so Spark was selected as one of the three asset issuers to back that 7%. percent fault. So our product we have there, which is Spark Savings, USDG, provides a yield that can, it's cross-chain yield that can be used on a new chain like Robin Hood. So what we're seeing in the market right now is this playbook that Coinbase started where it's, you have the exchange,

Starting point is 00:28:06 or even more generally, you have the distribution channel, you connect it to a chain on the back end is being copied. So we see this with Robin Hood now. But we also see it with stripe and tempo. So we're seeing a repeated pattern where you have distribution, you have the chain, and you have your own stable coin. And each of them is pushing their own stable coin. You see with the announcement of like OUSD even for Coinbase, for example. So everybody wants to own the net interest margin that comes from having users using their stable coin within the defy ecosystem. So where's FAR comes in? This is one of our, biggest growth areas is that we, because of our position as a fundamentally on-chain

Starting point is 00:28:52 protocol that has 10 billion in deposits, we're holding between us and hyper-liquid. Sky is one of the largest holders of USDC on chain. So we are able to pair with these newer stable coins such as USDG. We can provide a yield, but we can also provide market making to the issuer to basically kick them right up to scale very quickly so that people who are in USDG and they need to go to USDC for whatever reason. They don't have to like it. And this is for large scale.

Starting point is 00:29:24 They don't have to go through the banking system, which is slow. They don't have to pay redemption fees. They can go on chain. And this is a new product that we launched recently with Uniswap called the Stablecoinfx layer. And this is a, I think this is just a very cool use case for defy where you really really have all the Legos kind of coming together and providing a fundamentally superior product than what is traditionally done with market makers and liquidity. Because Sky is a whole is holding all these stable coins as idle inventory anyways, it doesn't have, there is not a cost

Starting point is 00:30:01 of capital, basically, to be doing this sort of market making with all these upstart stable coins. And it really helps improve sort of what you call like the singleness of money, where in the traditional banking system, the Fed backs all the U.S. dollar deposits into banks. And so bank deposits are largely interchangeable. This doesn't exist in defy. And really kind of you see Sky with USDS.DS is emerging as this sort of connecting this into the singleness of money of U.S. stable coins and Spark providing all the infrastructure and technology to do the automated allocation market.

Starting point is 00:30:41 within the sky ecosystem. All right. So let's now turn to the SPK token, which is Spark's token, which is used for both governance and staking. Despite the fact that Spark is doing quite well now, you know, after these last few months and especially having, you know, made it through that really existential moment for nearly all of Defi with flying colors, it's at or near. it's all-time low. And I was wondering how you think about how to bring more value to the SPK

Starting point is 00:31:17 token. Yeah, I can give you my view more broadly on how I view the way tokens are going in this space. So I see largely consolidation. I think there are a few like sort of store of value exceptions and, you know, the individual can decide where this is cut off, Bitcoin, E, Seoul, etc. But the rest of the tokens, I think, are just going to converge on like a DCF valuation. And so at least like the ones that are structured more like equity. But so what we can, what we have with Spark is that the protocol is revenue. It is profitable. We post all of our numbers on data.spark.5.

Starting point is 00:31:59 And we have quarterly financial reports that go out. So people are free to look at this. sort of, you know, underwrite the token as best as they want. But yeah, and I guess the last piece is the value accrual. So excess profits will go to buybacks in the token as this was voted through governance. So all of these things connected together basically mean that because there's a fundamentally strong business here, I'm not too worried about pricing in the short term. Okay. All right. Well, is there anything? else coming up for Spark that you would want to talk about? Yeah, I mean, just there's been a lot of

Starting point is 00:32:46 growth in the protocol. So the institutional lending, we've seen a lot of traction. We launched this at the end of last year. We're up to $250 million in loans issued there. And we're on track. We have a robust pipeline that is on track to grow to, I think, a billion and beyond by the end of the year. So, yeah, this is the new revenue stream. Our Spark Savings, U.S. This is a new product that we've introduced again at the end of last year. Already one of the most liquid USDT products on the market. And I expect this to become market leader in the near future. So yeah, I think like nothing in particular, just we're getting a lot of growth overall on all the products.

Starting point is 00:33:32 Yeah. Okay, perfect. Well, thank you so much for coming on Unchained. Yeah, thanks for having me. And thanks to everyone for joining this livestream. We'll catch you next week. Bye now. Nothing you hear on Unchained is investment advice.

Starting point is 00:33:46 This show is for informational and entertainment purposes only, and my guest and I may hold assets discussed on the show. For more disclosures, visit Unchained Crypto.com.

Unchained - Sam MacPherson on Why Spark Benefited So Much From the KelpDAO Hack

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