How To Make DeFi Great Again | Adrian Cachinero Vasiljevic & Luca Prosperi

Transcript

Everybody loves stable coins because it's safer than a bank, faster than a bank, easier to transact, cheaper, and hopefully they're gonna get some yield or you get some meal from a back door. On this, we are so much better and there is so much so much stuff to do because now we are revolutionizing the banks. The banks hate us because now we're eating their lunch. There are things where crypto is so much so much better. >> Maybe we're not going to be better in so many other things where there are other primitives that are better than crypto. I think this idea of cryptomaxing the world and everything is going to go on decentralized rails probably is not true. Crypto is a great distribution channel because everything is permissionless and is global from day one. You have a great product and suddenly you put it in the market and

everybody can buy it. Uh but that doesn't mean necessarily that we need to have every product in the world on crypto rails. Nothing said on empire is a recommendation to buy or sell any investments or products. This podcast is forformational purposes only and the views expressed by anyone on the show are solely their opinions, not financial advice or necessarily the views of Block Works. Our hosts, guests, and the Blockworks team may hold positions in the company's funds or projects discussed. These gentlemen need no introduction. Uh but I'll do it anyways for uh folks that have been hiding behind a rock and not following the discussion on on Twitter.

Um, Luca from Mzero and Adrian from Steakhouse. Uh, guys, spend a minute just giving some context before we jump jump straight into it. >> Uh, I'll start. Uh, great great spending time together, guys. Um, I am one of the co-founders and CEO of a company called MZero. We are one of the I would say like most active at least cable infrastructure companies. Uh so we build onchain infrastructure for stable coins that want to be issued and used uh onchain with a big big onchain skew.

I've been researching and writing about D5 for a long time. Way be way before my time in M Zero on a on a subsack called dirt roads where I nerded out every now and then. And since my maker times and actually me and Adrian we go a long way in crypto years uh since at the time in maker when we were trying to connect the makers balance sheet with the real world of lending. So great great chatting. >> Yeah. And I'm Adrian. I'm a a co-founder at the steakhouse. Uh like Luca mentioned, we started as contributors to maker.

Uh as the strategic finance core unit, as the real world finance core unit, then the strategic finance core unit, then the real world assets unit or finance unit. There were a number of of initiatives that had to do with the real world and with finance in some regard. And since then we spun out an advisory business that has contributed to protocols like Lido and ENS and Arbiterum. And lately and at least since the launch of Morpho in Jan 2024, we've established ourselves as the leading Morpho so-called curator operating uh about two billion slightly under $2 billion in non-custodial deposits on different vaults mostly on Morpho but

including Camino and Solana >> and we also run one of the Sky ecosystem subbalance sheets uh otherwise known as Stars called drove uh with a mandate to sort of build out uh credit infrastructure for the purpose of let's say asset liability management on behalf of a stable coin and yeah I I know this both of you so you know nice to see you again >> great thanks guys look we want to have this conversation I think the backdrop for this discussion is look rates in DeFi are very low uh not all vaults are created equal vaults are all the rage um Morpho obviously plays a huge part of

that. You guys, Adrian been c to that. A big value prop of DeFi is look, let's bring more and more assets on chain. But when you're getting paid close to or below the risk-free rate, meaning treasuries, it really begs the question like what are we doing here? Because I think we can all agree that there is way more risk in DeFi. Um some that we may not even fully appreciate uh on the back of AI progressing quite a bit. I mean, I think we all saw the announcement of Anthropic and what you know, their ability to find bugs in code bases of well and far more capitalized companies. And so there's still a lot of risk in DeFi. Um, but nonetheless, I

mean, I think we're all here because we believe in the promise of of DeFi. There's some interesting properties that make it unique. And that's not to say that, but I think I want to unpack first, why are rates so low in DeFi? Let's just start there before we go into how do we fix it and what are some interesting strategies and but let's unpack like why are rays for two to three to 4% um on DeFi. >> Uh I can maybe kick off and I'm beginning to hear Luca's input on this. Uh I think I think DeFi has matured to a point where it's worth drilling down in exactly what we're referring to. I agree that generally kind of rates are low

across the board regardless of the risk of the collateral type or the type of instrument. But I think if you anchor on something like over collateralized Bitcoin lending, let's say, or loans against overcolaterized loans against ETH, that's where you see that rates are kind of at or near or slightly under sofur, but basically trending around the tra traditional finance risk-free rate. And I think we would generally expect one expect this and two kind of see this as an example of DeFi's maturation. So we're not super stressed about it necessarily. Uh and the reason for this I think is worth so just to hog the mic for a second and give you the the vault stakehouse vision. Uh our view

of vaults is they work it's it's not necessarily just about like randomly bringing capital on chain. It's about recognizing what the unique value propositions of crypto and DeFi are and maxi and you know maximizing that surface of crypto. And so we make a distinction between what we call crypto guarantees and social guarantees. And cryptog guarantees would be examples of something that is simple, something like a rule or a very simple set of parameters. And the execution of these is enforced by immutable code or by smart contracts in a in a very minimalistic way. Uh you know liquidation thresholds, nav accounting, things like this. basically anything

that can't be overridden by anyone and is sort of the purpose under of crypto anyway and you need these guarantees because the blockchains although like Ethereum has like whatever half an hour or I don't know how long it is to get finality on Ethereum there is de facto instant finality like when a transaction executes it's basically gone you know and nobody's like trying to reverse the blockchain and oh quick we have to do it before finality like once it happens it's like out there and people assume that it's it's just going to finalize and the re that's the reason that you need these very strong crypto guarantees and so we view vaults as a way of expanding the remit of all of the things that can be cryptographically guaranteed and anyway to come back to your point

like why are rates are low in our view a vault that only lends to overcolateralized ETH uh loans comes very close to essentially maximizing the surface of crypto guarantees that are possible on that specific instrument and so you really would expect it to be very near uh sofur. But in everything else that we call social guarantees, you know, this is obviously far more complex and uh you know, it actually may be the more interesting area to like dig into because there you go into operational security, smart contract risks, different types of economic primitives and protocols, uh you know, trust in counterparties and then obviously the you know levers for risk multiply at Infinum. And there's a

very legitimate question of sort of what rate is it at what rate is it actually worth it to participate in these. But then to like my TLDDR answer for why a rates so low, I have a suspicion I have an uncorroborated suspicion that because all of DeFi lending has to work on uh supply and demand incentive equilibrium because the cap the cost of capital for the cost of capital to go on chain for DeFi has actually spiked in recent days. there's more risks, more hacks, more macro uncertainty and so forth. Ironically, this actually tilts the incentive down back towards borrowers and it effectively has the effect and it and it has the effect of making the rates lower just because people are using it less, lending less and

borrowing less because there's less risk. So, yeah, depending on the context and the protocol, this may have some, you know, perverse effects for sure. Yeah, I'll go next. Um I think let's start from the headline like why why rates are so low in DeFi. I think ultimately the reason is that this the defi capital markets is disconnected from from the traditional one. So you have you have money in defi you want to keep it in defi for whatever reason convenience because defi is optimized for trading or leverage trading or taxes or KYC or whatever. And I think that a lot has

been written about this like the convenience you like it's easier for you just plug in and out just to put it in a moro vault and it's instant atomic instead of just buying a treasury onchain or offchain. So I think there is a disconnection between the markets and that's what is making the yield so low. But I think that the questions here that I I wanted to embandled when I started writing about this and again for me I have no I have no horse in this race you know I I I'm a very good friend and actually indirectly an investor in the more full product I think the guys these guys have been amazing and including the steakhouse guys that are partnering with me in many other initiatives but I like to look at things and try to understand what's going on and have a framework so

in my opinion I would split this into two like the first One is what is actually what are actually lending markets doing because like Santi you were saying like vaults are all the rage and we see like oh my god the whole capital markets are coming on chain and vaults are going to intermediate credit for around the world etc etc. Is this true? Absolutely not. Do do vaults have all the require the required infrastructure actually to avoid rack pooling or adverse selection of credit on chain? Absolutely not. Is it going to happen in the future? Hopefully hopefully but this is not where we are right. uh uh DeFi is great at one thing which is overcolateralized lending on cryptog guarantees as Adrian was talking about or looping these are the two great things that defy is doing if you look at

the mor TVL this is not 100% of the TVL so I think the question here is first of all let's look at let's look at things for what they are and uh so that we can build better things and I mean the the the steakhouse guys are absolutely on this in the same camp I'm sure the second one is trying to understand then where it makes sense to actually participate at the current market, right? Uh given that this is the best we can and I think that it depends, right? I think the reason why I wanted to put the I wanted to put the the finger on this is that yes, if you're a whale, if you're like a DeFi large pro large protocol or or and you have money stuck in DeFi, this is the best alternative is is the safest alternative you have.

Still is not risk-free because there is a lot of unknown unknowns. We have seen liquidation cascading and not going well in the past. But the qu the problem becomes when you're connecting this to CFI retail front ends and de facto this is becoming uh a very cheap and easy to use and tech cryptonative uh deposit account then you're actually there is a risk of misleading the user and then actually you're actually attracting users uh or uh and exposing user users to risk that they don't really understand. So that's why I think I wanted to point the finger because it's good to have like smart conversations in understanding exactly what's going on.

>> Um in the there is reason why while yield yields are so low I think I'm on aance camp is a supply demand thing. There is a lot more demand than supply >> is that so I agree with that. I think that's my diagnosis too and I think it's been like that since rates go up in 2021. you just seen a just the the a lot of participants well actually I don't know what you would attribute that to my assessment is there's just a lot of the strategies just became less interesting when you can capture you know a pretty nice rate offchain so there's a whole set of participants that over the course of the last four years have decided to exit the market for a variety of reasons right you've had you know blowups like Terra Luna and that you know uh you've

had uh the offchain world just be more interesting um when you guys see the this like trying to decompose the supply and demand like where is the demand coming from? What is that? Is that like mostly retail or I'd just be curious uh maybe I'll go with you Adrian like where are you seeing most of the demand on chain come from today? >> U we had a until until we partnered with Coinbase to power their DeFi lend integration. We had a very small number of depositors and a very large TVL which was suggestive of the focus that we had on working with integration partners supplying let's say a custodian of stable coins or an exchange or so forth

access to like these prime vaults uh or sort of large users and funds that were parking capital for a period of time between strategies I think the retail there's and then there's like a long tale of like retail users with a whatever or the distribution of wealth is >> and and sorry if I interrupt and and protocols I think maker maker before the coinbased integration was probably 30 40% of morpho liquidity >> yeah that's true yeah maker had a that's true through the spark uh curator uh now like with grove and spark they kind of dip in and out depending on the rates uh yeah it's true as stable coin reserves stake USDC was a reserve asset for angle protocol I don't know if you remember

this amazing stable coin that went down unfortunately a few months ago. Um so yeah for sure there's also some DeFi native B2B uh at play and I think the morpho construct lends itself well like you were making a point earlier Luka about how the infrastructure is not there yet and like I think I generally agree and like vault is I generally agree but I do think there are like some bright spots and the moro vault uh the moro philosophy to the vault is I think the right direction which is to make it as because like vaults essentially and like you know forgive any vault enjoyers But bolts fundamentally have to track the nav, not get hacked, you know, like it's mostly around sort of downside

avoidance and sort of the less they do the better. And that's kind of been Morphos's philosophy uh since the outset of trying to find like the smallest primitive, maximizing the surface of things that you can secure in a cryptographic way and then and then kind of releasing the the the breaks. And then of course there's nuances around how you configure those but I I do think that's the right approach. Uh with Coinbase DeFi lend that's where we saw like the first influx of like tens of thousands of retail depositors but Coinbase I would flag as actually quite a good um a good actor example of how these integrations are made. I don't know if you've had the chance to use this application but they don't call it a deposit account. They don't call it a

savings account. They call it defi lend. And there's a very long FAQ. They explain bad depth, what can go wrong, etc. And this is for a prime vault, you know, like they they're mostly lending to CV BTC borrowers on Coinbase as well, for that matter. Um, but yes, there's obviously a spectrum about how you can market these. And, you know, we ourselves, we go out of our way of saying like this is the closest proxy to kind of the DeFi risk-free rate, but it's obviously not risk- free. Luka, how do you how do you see it? I mean, I think the I do hear you. A lot of a lot of the demand is coming from exchanges that unlike the last cycle that they purported that these ALGO stable coins were just sort of dollars

uh and the yield was really interesting. I think now we're doing a better job of disclosures. Luka, I I read your article that I think everyone should go check out and I think you just did a great analysis around look, the yields are just not there. They're like so so maybe kind of like give a little bit of context and then would love your take on maybe explaining like what is the difference between like morpho and prior instantiations of like yield farming like like year like what is m what what has made morpho more interesting and how do you when you kind of I think the the tlddrv article is look we're getting paid 2550 bips above the risk-f free you should be getting paid 200 400 that's not the case why is that and how do you see the risk risk of interacting with

someone like Morpho or other protocols. >> Yeah, I mean first of all I want to start like a couple of comments and the first one is that we are in a so much better position compared to four years ago. Right to Adrian's points I think that the work that the guys at Morpho has done is phenomenal because they they have isolated simple primitives and they're building only one primitive on top of the other. The only thing I'm saying is that there is a long way before we start incorporating more sophisticated assets and still the thing that works uh in crypto is overcolateralized lending on crypto crypto stuff or uh e like eel looping right which is a different could be a different strategy but the direction is absolutely there and uh we are in so much better position I don't think we

are misleading the retail at all in a way that that is any in any way similar to the terra days uh or the C5 days in general Um I think that what I and then also Santi like a short comment to what you said like I think that the the the lack of interesting higher yielding opportunities in DeFi in the last four years is true. I think there is one bright spot that was Athena. I think Athena came out with a very good idea of just tokenizing the basis trade in a way that was higher yielding enough to attract a lot of customers. It was shortlived trade uh but I think it was a very good I mean and the guys executed very well. Uh but uh I think that so what I I wrote this article on my dirt roads nerd nerd uh nerd Luna Park um

uh like last week because what I wanted to do is like I wanted to try to decompose risk and try to understand exactly what we were underwriting. Now this is not my day job. I do this like over weekends and nights. So a lot of people came out with I uh criticizing the the parameterization, criticizing the the model and I I loved it because actually that was exactly what I wanted like you know started like a smart conversation about stuff instead of just like doing crypto Twitter wars between a morpho and stuff like that. Uh so it's great that we are here but what I what I wanted to say is like I say like what is actually what actually are we underwriting? What is the risk that borrowers have? I focus on market risk.

There is a lot more uh that I'm going to touch in a second, but like just to to simplify things to like brute brute simplicity for these vaults like the the prime vaults that Adrian was talking about, you're putting money in a vault uh in the form of like a stable coin and then somebody else on the other side is uh depositing collateral like Bitcoin or ETH and they're taking a loan out that is significantly overcolateralized. So there is way more Bitcoin than the loan you take out. Now if the if the price of the bitcoin and eath goes down above a certain threshold which is there is a very healthy buffer a liquidation cascade happens the collateral is liquidated and you get repaid. Uh the the point here like the reason why the

yields are so low today is that first of all these systems are extremely battle tested and the liquidity the liquidity uh algorithms have been tested uh at least the new the latest vintage hasn't been catastrophically affected the past vintages yes the maker we remember um so like the the the algos work and also there is much more demand much more supply than demand. Everybody's very everybody's depositing. Not many people are taking money out because there is not a lot of demand for leverage on Bitcoin and ETH these days, right? So, I think that this is one of the reasons.

But the reason why the yields are so low is that the system works very well. uh the the way Morpho does it differently from from even from a is that and I think that that was like absolutely a winner uh for the team and actually in my opinion they inherited spiritually from another team called RARI back in the day uh where they've been isolating those markets so instead of having one big pot uh where there are all the collaterals are there and there is like a DA or somebody that is doing risk management they are isolating these markets so these markets are very simple uh you you understand them you can understand them very well and then they're simplifying and they're creating another layer called the vaults uh where there are asset managers like the guys

take house or gauntlet that are doing the risk management across those markets and also like so they the composibility is there I haven't wrote about the vaults I have another piece coming on vaults like in next as soon as I have some time in the next few weeks but I think that um the way the the the morpho system works today is that to Ryan's to Adrian's point is super super simple markets, simple to understand markets compared to the past. So you don't need to uh you it's difficult to get lost in the DeFi labyrinth of things that are interconnected. That's also why I think it's fair to say that the risk is relatively low. Now in my opinion, it shouldn't be so low and I think it's pushed artificially low because there is way too much demand uh than the way too

much supply. there is some uh inherent risk that is actually embedded in this like you know if the market moves abruptly ultimately you're writing you're underwriting some volatility of the crypto assets which is not risk- free uh there are other risks included like you know that we are not parameterizing like you know hack risk smart contract risks like catastrophic risk that can happen that is definitely not not risk- free so this stuff is not risk- free now interestingly the reason why we do not have a risk true risk-free rate on chain is that the the regulator is avoiding it. So we cannot stream yield from stable coins. If USDC or whatever stable coin partner M0 could stream yield continuously for retailers, this was this is p pure risk-free but

you cannot do it. So al interestingly enough what is happening is like circle is making money. Coinbase is making money. The retail they're underwriting the risk. So uh that is like this is like this is what is happening. The retail and the borrowers are underwriting the risk. So we could do much better. Uh but in no way in no way in no way we are in a position compared to what we had uh before. Now this is the then I'm done. I'm I'm I finish with my spiel but this is exactly f this only focused on overcolateralized prime super safe faults. When you're starting doing something more exotic is different like when you have loops like and morpho spiked in the TVL when Athena and maker were looping uh USD uh yield. This is

different right like then you're putting leverage on leverage even even RWA looping is different this is putting leverage on leverage stuff that not there is no free lunch so when eels is 20% 30% it's a different story but to your point something I've I've seen I've seen your comment to one of my to my research is yes I know that these are all the dynamics but if you're a sophisticated investor are you getting paid for the risk you're underwriting this is a question I wouldn't put my money personally because I don't think it's enough I would just park it and probably do a barber with Bitcoin, but this is my own personal money. So, I think everybody should ask whether based on the market conditions, the money and the the the the emerging yields, is it enough for the risk you're underwriting?

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As always, investments in blockchain technology involve risk terms and conditions apply. >> So, just to summarize before we go any further, so sounds like a lot of the demand is retail. Uh, you can attribute most of the compression and low yields to a lack of demand. I almost, as I was hearing you say that, I think about like short sellers. Like if you own a stock um and there's like not not a lot of like short interest, you're not going to get paid much for lending out your stock. And I think that's sort of the rut where like crypto is, which is you have a lot of these long-term hodlers that have Bitcoin and Ethereum and are

saying, "Okay, I'm going to deposit into a long-term holder, so I might as well clip some yield and I don't necessarily care. It's just extra." where I think Luca you and I agree with or maybe Adrian I don't know if you would is there's still some risk tail risk of that protocol that you're interacting as much as it is battle tested and has really good you know liquidations like you know we're not in a I still remember the black Friday event where maker didn't have a good keeper system and we're we're very much more battle tested than back then but there's still I think we can all agree there is a not insignificant probability of impairment and total princip multiple

laws, smart contract hacks, OBSC issues, uh you you have a go to a v4, there's just more surface area. So when you factor that into whatever sophisticated math or simple math you want to do, it's it's a it's a very tricky situation. You might as it reminds me a lot of like the staking yield, right? Because I think Adrian, you mentioned that, right? That that could be the risk-free like you should be staking your assets. I've heard so many institutions say we actually don't want to stake because there is a nonzero probability of our assets being locked or what have you. So I'm not holding this asset for the incremental two to three to four to 6%. I'm holding this asset because it has venture-like

um return outcome and so anyways a lot there but what is the what is the solution to this problem? I think the solution. So I I agree like in DeFi, but this is kind of what I love about DeFi. Like we can tell ourselves, okay, def facto, the treasury rate is essentially risk-free, right? And within the box of the US monetary system, it may as well be because of the ability to create new dollars. And within that fixed frame of reference, you know, every every fiat currency is risk-f free. And the dollar and the dollar more than other currencies to be sure. But what I personally like about

DeFi intellectually is that it kind of brings all of these issues to the surface. They get complicated when you conflate them and when it gets difficult to sort out one thing from the other. So to your example for instance of if I put in my bitcoin in a to earn two bips just because what are the risks that I'm implicitly underwriting there I agree that it's more complicated to parse that because is a more complicated protocol it's bigger and has lindy and umbrella and a bunch of other features but those are all kind of remediations to the central fact that it's just a design that's a bit more aggregated and a bit more difficult to parse out what's what.

uh you know not to be the eternal mor for sure but I think the advantage of doing things in simple in simpler primitives is that it makes it easier to isolate what the risks are and so I think that the I actually so you know when I when I read Lucas post my perspective was this may well be true for you know high yield repo lending but for Bitcoin and ETH over collateralized lending I think it it overstates it because I do think that we're nearing a point of uh close to efficiency on Bitcoin and ETH over collateralized lending and for sure there is still risk like the the main risk. Okay, like a neat example is wrapped ETH USDC uh over collateralized loans because the

collateral is about as cipher punk as it can get. like the rapper ETH contract was like deployed by was it Nikolai Mushvian and is like you know signature Nikolai like un unchangeable immutable completely bulletproof the only real risk there is I suppose if USDC faced to some kind of an impairment for whatever reason so it's not immaterial but it's not specific to lending or if the oracle uh of ETH price to USD price suffered a loss which suffered either there a gap because ETH but ETH would have to gap 60% in a block in a single block like we're talking about very very volatile

price gaps which are not impossible but very very unlikely in our view um or the Oracle uh network would have to like fail and chain link would have to shut down or have some kind of malicious and again not risk-free right so what our solution is is this unbundling to rebundle I think is very helpful. I think in the high yield repo lending you have more of the effects of what you're describing. So like I also don't necessarily agree with the characterization of like a short sell or a put or things like that in particular for the prime vaults because there is so much credit enhancement that's built into just the structure of the market and the protocol. It does start to take on more of those

characteristics with higher risk collateral. uh and what we see here in the vault space is in particular if you're restricted just to underwriting repo markets against different types of collateral is the adverse incentive of I want to print as a curator I want to print the highest APY so I'm going to add more and more stuff randomly the lender is not going to get commensurally uh rewarded for that risk and the risk starts to take on more turkey like characteristics um and that's like kind of a bad outcome uh in our view I think there's a point like we take the view that lending should be a different like the the degrees of risk on lending should be a

degree of liquidity and market size and if an investor in stable and and if a stable coin investor wants to take on more risk they should just they should just take on more risk in other words they should allocate into vaults that expose them to leverage looping for example uh because that's kind of the fair price for the risk that they're taking. And in this in this framing like the borrower like it is kind of yeah it may sound like steakhouse has kind of an adversarial relationship with the borrower and it is to a degree because our main priority are the l the lenders in the vault. The borrower is actively taking risk. So if they get liquidated it's kind of their it's kind of their

fault. like that's the risk that they knew they were taking and they were pursuing a reward greater than what they could have achieved by lending into the same vault. Um so that's like in in brief is like more on bundling and more unpacking what the different levels of risk are and relying more on crypto guarantees than on social guarantees to secure those. But once you get to certain levels of risk, like we release um the bulk of our volume is on lending, but we have a small program to try and launch these kind of leverage looping vaults or term vaults and things like this.

Um, I mean they're risky and we're not hiding. And that's kind of the what we're trying to do is say like for different tiers of risk exposure, what is the fair rate that investors will demand to get in? Um, and I think that's a better like if you work on that market mechanism and is and if the industry trends towards that market mechanism over time, I think we'll get to a point where those risks are adequ adequately compensated. >> Yeah. I I wanted to um I wanted to actually uh touch on a few a few of those points and one is actually uh against the argument I made at the beginning. Uh but

the first one is like you know selling put or not is this like a a repo or is an option? I don't think it's really relevant. I think the the reason why for example I took out this and I don't want to nerd out promise the the Merton model is like everything is volatility everything is return. So the way is like the way you should the only way to to model a credit that is a very uh is not a continuous payout uh instrument is like okay let's model it as a risk-f free plus an option right it's just a way to model it's just a mathematical framework it's not that is a very deep in the money option so it doesn't look like an option doesn't smell like an option because the option is there is more volatility in it but I think that

one one thing that actually is and then again is it enough uh are you paid enough or you're not paid enough. It's always in the eyes of the of the lender, right? Ultimately, you you do your own underwriting. You decide what is the you do the your own modeling of probability of um and and then you do and then and then you act upon it. Um we don't have enough primitives. We don't have insurance primitives in crypto for tail risk. Unfortunately, it's difficult to price, but we're getting there, right? I think we're at least perfecting the basis. We've been at this for like five years, less than 10 years, like it's nothing. Uh but the truth is we have perfected the base case. We are far away from perfecting the most sophisticated

SC stuff, especially when it's the social proofs are important. Like that's there is so much so much talking about lending and private credit in crypto. We have been here before many times. We know that how this is going to play out, right? And uh there are large asset managers that love it. of course they have like a great great uh pipe to connect their products to unsophisticated investors. They shouldn't do that. >> Um but the last point that I want to make actually is against which I think is important is against what I was saying before. I was uh looking at reading somebody writing on this on Twitter uh today is actually this pro this uh protocols are so good for the for the borrower for the lender. They're

super safe for the lender, but they're brutal for the borrower because if you're sleeping, if you actually have if you actually have a position, you're borrowing money which is collateralized on Ethan BTC. You're going to sleep, you your bots stop working, whatever happens, you get liquidated, you take 5% liquidation cost. You get uh you uh uh crystallize your losses because the protocols are protecting themselves and they're protecting the borrowers. So the reason why the the costs are the the yield is so low to lend is because the only way you can actually attract borrowers is that the the price these guys need to pay is very low because if you're trying to get a Bitcoin uh a BTC backed lumber loan from like an OTC desk

it's way safer. You're not going to get liquidated overnight. These guys going to call you. They're going to restructure. But I will ask for you for much more money. So the maybe the other question is should we build new protocols that are actually more balanced between borrower and lender so we can have a better better market and I know that morpho is trying to do this with the intentbased morpho v2 where is they are matching but then let's see if there is enough uh lindy effect to actually attract liquidity but the reason one of the reasons why the the the rates are so low is that the this pro these instruments this mechanisms are brutal for the borrower so the only way to attract borrower is they don't need to pay That's a really 100% and but I would argue yeah so maybe the missing piece

there is the borrower the DeFi borrowers that are using it need to be like I we we think about borrowers a lot but obviously the priorities on the lenders from the curator perspective. So everything is kind of adversarial against the borrower. Uh but again like if you flip the framing it's like look the borrower is taking risk. So it's kind of like you get you get what you pay for. Uh but it's a really good point actually that the low borrow cost may be the difference between the difference that compensates for the experience on borrowing of borrowing on variable rate protocols because you can do it with like a bank or an OTC desk or something and you get a phone call you know and they invite you to like events and stuff. Uh but on more you just got

destroyed. Uh which is >> it's not only they invite you to events, they they call you and they say let's restructure this position instead of just wiping out your position overnight. >> Yeah. Yeah. Exactly. And that's a huge that's a huge advantage for for somebody who has a long-term position. But it's like it's also kind of the only way that you can make variable rate repo work on on chain uh in 12 second increments, you know, uh because the prior I I do think the priority should be on the lender in this instance. But I agree like the fixed rate model that Morph is experimenting with is going to be an interesting marketplace to figure out whether we can build a term structure in DeFi to compensate for this risk. We're indicatively getting some feelers from very cheeky people who want to capture

the variable rate at a fixed term with all of the protections. I do think it'll, you know, it'll require a little bit more than the variable rate. So I expect the fixed rate term structure at equilibrium to settle above the variable rate in that instance if the market is efficient and if nobody is doing you know underwriting you know illi liquidity like the way that this would collapse is if a curator underwroes too much ill liquidity for too little yield but then they would see an outflow from their vaults so the market will self-correct.

So, I want to unpack that a little bit. First of all, like I the point you're making that there's a asymmetry like the the borrower is taking way more risk because it's like 24/7 finance. Someone's calling you to to for a margin call, but give me the bear for the lender because I think Luca, you're saying, look, there's you're making it seem like the lender is taking very little risk. There's still some risk, right? The smart contract risk. There's there's um especially when they're upgradable contracts. So maybe paint the I don't want to make this like a doom and gloom podcast, but I do think it is just important to set what what is the tail risk because I think a lot of this conversation gets interesting when you go to the tales and say okay what is actually the worst scenario for a

borrower and the worst scenario for the lender. I think we've talked about the borrower but not so much lender. Yeah, I I can I can start and I think that so um the as I mentioned, you know, going back to the primitive, these positions are overcolateralized positions deeply in the money backed by super liquid cryptocolateral. This is what we're talking about on prime, right? Again, if we talk about higher risk, completely different business, but let's put it aside. most of this stuff is prime on on morpho and um or anywhere currently in crypto. So um significantly overcolateralized

positions on a super safe uh and super liquid cryptonative uh collater. Now what is the risk right the risk is the BTC and ETH price moves right? So like if it moves against you uh so it's actually reducing in value at some point you're going to hit hit a liquidation. So this stuff is uh actively managed. So the risk of hitting a liquidation is lower because there are people like the steakhouse guys that are continuously rebalancing that and just like putting more collateral or taking more to taking uh some money out. So I think there is an active rebalancing and u but still like money is not infinite. If the prices start going down

down down down people that took the position uh they uh if it goes very quickly they do not really have in like perfect perfect infinite money and perfect timing to rebalance. So uh if you look at the super super safe scenario that I modeled personally on market risk forgetting all the all the other all the other risks that I'm going to touch on in a second. My models were like roughly 45 40 45 basis points above risk-f free. What we're seeing in morpho is a bit less than that. It's like zero 20 25 30 basis point. So what is h what is what is real is like morpho is pricing perfect scenario. So are we in a perfect scenario or not? I don't believe in perfection. So probably there is some some friction that hasn't been priced in. No we need to the debate here

between me and Adrian is going to be is gonna it's 20 basis points this imperfection or it's 200 on 500. But there is is there is definitely something there. And where this could come from like you know uh imperfect imperfect uh bots or like operations not working not infinite capital liquidation systems not working very well because the prices move super fast and like the gas prices spike and everything gets congested. So you cannot really move. So there is there is some there can be some f friction in the liquidation process where the buffer you have is not enough and if that is not enough then you're going to have some sort of loss given a default case right my model was say okay the LGD is 5%.

That was my model so if there is a default if there is a liquidation you're going to get hit by a 5% loss. Adrian's point was this is too too harsh is probably close closer to zero is a few basis points 20 30 basis points as usual probably the truth is in the middle uh it's just you need to do the calculations yourself the good thing of doing uh what we think is good quality analysis is that I put a model out other took my model change the parameter you can do it yourself right you can put your GD that you think is one that makes makes sense and it's going to spit out the yield that you should have whether it's 400 spread, 300 spread, 20 spread, zero spread. Now this is only market

risk. There are other risks like like Santi was mentioning hacks uh like opsac somebody's hacking somebody like the multi-igs are not working this stuff is not fully fully permissionless not fully fully immutable the base the base level is immutable. So there is some like how then you need to price it. How you price it? Very very difficult because this stuff is not statistical. You probably need to do some sort of like probability scenario. What do you think is the risk of hacking? Like you know five years ago was 30%, now it's probably 1%, 0.5%, but you need to do your math. Uh the the the point here is that what I think my analysis was interesting for is that put like at least like a quantifiable

uh uh floor which I quantified at 40 45 basis points above risk-free and that is everything is perfect. So if everything is perfect you should get paid so far plus 40 basis points. Now that was my assumption. Maybe I'm wrong by a few bips but let's say that that is right and then you can do your modeling right. you can change the parameters and understand exactly what you think should be. Uh in my opinion, the spread should actually be between a I think it's fair to say it's probably a couple of hundred basis points if you think everything if you consider everything together market risk, hack risk and cut risk etc. But again, you do your own math, right? What what I think we should we should do is good give good frameworks to the market so they can do their own calculations.

So like I have Lucas position, Adrian has his own perspective. I'm sure these guys are using it. Now the point that Adrian is making is the more you go higher in the risk profile then the more interesting these models are because then you need to really understand what you're underwriting because nobody knows >> because where where I think the so I love I love the framework because it's it it kind of go goes through that unbundling approach of let's take the simplest possible you know let's take the spherical cow and then model it a little bit better uh step by step uh and I on prime I think Santi to your question like what could okay so like realistically so our view is the risk on BTC and ETH over collaterized lending is

not zero historically the market risk we found is uh 0.94% so very very very low historically this doesn't say anything about future events the realistic loss risk on BTC and ETH is if there is a failure at the collateral issuer or a failure in the oracle or if Bitcoin and ETH price gap more than 20% within 12 seconds and we we rate for prime markets each of these risks to be relatively low s probably lower than Luca's 100 basis points but I would say we're in the same order of magnitude um where I think this

framework is illustrative is moving out on the risk curve and I Do you think that it's worth like when you paint DeFi with a broad brush, it's kind of I mean you can do the same with traditional finance as well, right? You can say whatever private credit is risky. Therefore, I'm not going to lend into a bank because they lend to mortgages. >> It's like sure but but it is worth to kind of drill into the detail and to see what exactly is happening. I think uh there there's a lot I think that you mentioned which is I don't think the discussion is like as controversial at the very narrow use case of depositing an over like bitcoin or ethereum to your point very liquid

like very good liquidation system robust price oracles and then having a borrower and be very adversarial but um I think where it gets a bit more amorphous is the OBPS risk that you're taking and that's hard to price because it is like a it it's kind of binary in that sense and you see on I'm not trying to paint a broad brush around vaults and and protocols clearly but you know every year we get one to 3% losses in the aggregate TVL which which is like an unfair characterization because obviously you have to drill down at the protocol level that you're interacting with and what's a counterparty risk but to your point I I'm more in the camp of like Luca like you don't have to

approximate at the basis point level, but I think we can definitely agree that it probably is worth a couple hundred basis points above the above s so no matter what you're interacting if you're if you're doing cryp, you know, but I disagree for prime vaults because like even for well again it depends right like it depends on what protocol you're using like you do need to get uh like specific and not to be like the eternal shiller of steakhouse products but in our vaults the like We if we stopped reallocating because we all got caught on a plane and the plane crashed into the ocean, the vault would perform slightly less over time and users would just exit like there's no dependency on.

>> You should have you should have your private plane guys fly. >> We take separate planes just in case. But uh all the same like it wouldn't matter. Uh and but that but that's because we kind of research all of the possible surfaces that could introduce that and morpho is very good because the number of those surfaces are very small. So realistically in morpho the surface the surface for attack is on the curator is quite minimal. It c it does exist but it's quite minimal and it can be very very strongly mitigated. The way that we mitigate this is by making the the users of the vault a check on our our behavior as curators and we use a a trustless Arab to do this. So if we we get

compromised then we onboard a fake token onto a onto a prime vault all of the users of the have seven days of a time lock and they can stop it from happening which would be a realistic scenario if for example there weren't there's there wasn't enough liquidity to withdraw to simply withdraw then they could at least wrap their positions in the Aragon Dow and vote to like kill this on boarding. Um there are you know that gap exists in some golds for sure. So you know no even two prime bolts aren't aren't exactly the same and you know this is what makes D5 very hard to parse like for sure DeFi is very dense jargonistic and full of intricate details but for the prime

vault category in particular I do feel like the obssec risk is relatively constrained and concentrates mostly on the collateral issuer and on the oracle network uh there's less of it less of it on the market so you would have to kind of assume like will bitco or Coinbase suffer an opsec exploit that will allow them to mint infinite bitcoins, you know, or will chain link suffer an obsec exploit that will lead them to gap the price by half. Um, you know, those are certainly real possibilities, but you'd have to evaluate what the likelihood of those is.

>> Yeah, I I wanted to say a couple of things uh here is uh so the first first one is risk- free is an illusion doesn't exist, right? like the risk free is a proxy is the lowest possible thing we can have still the US government can wake up tomorrow and say you know I'm not going to pay out uh you know many many interesting things are happening in the US these days so this is like probably not zero uh but um I think that I'm curious like first of all like I'm going to end with like with a with um uh with with like this like a an interesting question to to you guys but before that I think we need to we don't need to paint D5 with like a like a too white of a brush because DeFi is not

great at landing. Defi is great at doing what exactly is talking about overcolateralized margin land margin lending that is atomic and it's super super optimized for trading and ARB. This is great. This is not lending to corporates. This is not lending to mortgages. This is not lending private to private credit to lend to private credit. DeFi absolutely sucks in so many ways. I can just start now and we have five hours. I'm gonna I'm gonna be finished by then. But it's optimized. So we need to talk about the what we're actually doing. I think DeFi is amazing for overcolateralized uh no KYC super quick algorithmic overcolateralized lending that is great for trading and and ARB. This is this is

amazing. But this is a small subset. So the question is like how big actually is the target market addressable market of defi landing remains to be proven. If it's as big as credit it's we are very very far away and then there is like the the question is I so I know that like the guys the guys take stouts they're optimizing to this single basis point security in order to make this exactly use case as safe as possible because if this was not use that was not your your use case what would you do guys would you just like buy a tokenized money market fund that just give you 3.5% and just sleep over it and forget it or will you put money into like a prime bolt I would buy a tokenized money market fund I recourse. I know what it is. I'm not

going to get rackpoolled by prices. I don't worry about it. That's fine. You know, maybe they break the buck and they come back. So, if you want to have risk-free lending in on chain, there are better ways to do it. If you want to do trading leverage trading or like ARB ARB with your bots, then you cannot do it with tok market fund because these guys, you know, they do not they do not operate in a single in the same time frame. But we should actually define better what we are actually optimizing for because if we're thinking about the defi lending is that the addressable market is credit currently it's not well let's go there because I I wanted to carve out a piece of the discussion around interesting products that I think you mentioned Adrian around hey there's

been since the beginning of time investments in you know let's create a fixed rates and and and and swaps um and insurance you know u you know you've had nexus and a couple other instantiation none of which in my opinion have really gotten much traction um I don't know if you want to respond to what Luca what he said but I I'd actually be curious more like forwardlooking what are some of the things that you're excited about that you think could um you know bring more security to DeFi or attract more demand um like what do you what do you see on the horizon that is really interesting?

>> So I think the it relates to Luca's point because like to date DeFi has a turn structure of 12 seconds and that makes it nearly impossible to have much of a monetary economy beyond like statistical trading and like whatever like speculative activity, right? Uh some some amount of like onchain B2B whatever. uh but you know the the proportion fluctuates where I think the opportunity however I I agree that DeFi still has to prove itself to win credit but I do think that it can win it. It we're just in the perspective that it's going it's not going to be like it next year. uh like I do see a world where

traditional finance and origination and what have you continues you know growing and being very big and DeFi just behind it catching up and maybe at a higher growth rate sort of dependent on the degree to which newer generations of users and consumers adopt stable coins as a natural means of payment um where I it's not a super interesting answer but I feel like we we go back to this crypto versus social guarantee construction. Like whenever somebody talks about insurance or swaps or what have you, it's always possible to build like Rube Goldberg machines and gadgets in crypto. And I I think crypto is like really good for this space

because it has a it's like the perfect inter it's the ven diagram that intersects perfectly the con like mathematicians and scammers. And both of them love like very complicated like Rube Goldberg machines that have bells and whistles and like complicated models. But the models that are going to be the most successful are the ones that lean on the crypto guarantees to make the product better, more transparent, safer, and uh and lean on the guarantees of operating on public blockchains as a value proposition. And when you look at that today, it's true that it's actually there the the addressable space is not that large. It gets larger by the day.

So I do think there's a world where private credit could originate uh on chain if for but for that to be true the borrower and the originator and the securitizer would all have to transact in stable coins. Um and then given that ideally they would do it using a protocol or a smart contract layer that was as hardened as possible for all of the elements that introduce things like operational security risk. So like to answer your question like yes insurance would be great. I yeah it still remains to be seen how we price all of these different variables you know and I think that's probably the biggest headwind against the sector really taking off in DeFi because nobody knows how to actually price these blue guys helping

>> you just let the market price I mean that that's the whole point of having a liquid market behind you know a CDS or like you know you have like all these actuaries in the real world trying to price cat bonds and all this stuff but the market just has a real time price to it and that ultimately the market prevails like the market that's why I So when we were back in the day farming with size at like an institutional like level with LPS, we felt pretty comfortable farming because we can go buy uh cover on Nexus and that was grossly underpriced to the point where it was like a phenomenal riskadjusted trade because you could go buy cover Nexus and no one was kind of buying it and there's all these efficiencies that

are still in DeFi today. But I I've been a long advocate and maybe I'm overthinking it around uh like riskmanagement instruments that could give you ultimately more comfort because a lot of these things like you just they're theoretical. The problem with crypto is when something breaks there's like very little recourse and and I think you just to your point if you have some guarantees cryptographic that like you buy insurance and that your payout is guaranteed because a smart contract governs that. To me, that sounds like insurance is the natural next evolution of something that could really instill confidence in a world where AI is finding a whole lot of bugs in systems that you thought were super battle

tested. And so for me, I have no interest in playing in DeFi right now because the Lindy is sort of you're you're reset on Lindy across the board in a system that is like algorithmic and automated. I think you want to have the natural like brakes that you have and circuit breakers and time locks that exist in the real world. Like you want to interact with a human >> for sure >> for now. AI could also make these protocols super sa like much much safer. It's just sort of like a a gap that we're in today that I think is sounding the alarm around every protocol which I sort of posted yesterday around this initiative like how can we create and price risk in response to Luca's

paper. I said okay could you create a a simple metric of how much is a protocol spending per year or per quarter on security versus TVL that it's ensuring. It's by no means a perfect measure. It's very crude, but at least more transparency could allow the market to make that distinction so that it doesn't do a broad stroke right across the board. Well, one of the things that we we're going to try and do as curators is start uh issuers that have been through the stakehouse ringer know it and they often emerge out of it with a hard with a more hardened protocol.

uh not always but you know typically we tend to be quite demanding of the issurers that we underwrite and our approach to improving this space is being harder and introducing like operational security audits as a requirement to be listed in the vaults as a minimum. Uh and I think that raising the bar at that level. But yeah, and then the other thing is having a term structure in DeFi would help the market be a bit more efficient because insurance is a long-term instrument. But DeFi still operates on 12-second blocks and so it's very hard to kind of match the two. So I feel like that's maybe another reason why insurance has struggled to take off despite the you know potential inefficiencies you described.

>> Yeah. I I mean what what I think is like what you're what you're saying something really resonates with me is that I don't think it's too interesting to discuss what is the real the exact parameter we should use right because the re the way it works in defi in in threadfi is every desk has their own models you do your own pricing you have your own expectations and then you express your views through the market and there is a market price and then you think okay this is attractive for me or not attractive for me uh So my views by definition are different from Adrian's and different from yours because I mean I have a different you know whatever like you know set of views of the world and I think so what is important is that we have good primitives to express those

different views I think morpho did this very very well uh for short-term overcerized borrowing different from a because it's easier to express views you can isolate your views uh the problem is that we don't have other tools to express our views and uh few reasons I think The lack of talent in DeFi is one of those reasons. Uh I think now you know I operate in the stable coin space. We are very very onchain native. Uh but now most of the fun in stable coins is connecting with bank virtual accounts and visa etc. Yeah great. But I mean intellectually it's not what we're talking about. This is different. This is piping with uh with payments, right?

It's not. >> Are there are there not enough mathematicians or not enough scammers or both? >> Yeah, both I think. And it's like probably probably both are both are in AI these days. Uh so I think we need we need more talent and I think that the insurance point is insurance is a longdated balance sheet. It's the best balance sheet to express views that take a long a long time to materialize. That's why like the insurance is the best vehicle for the Birkshshire etherways or this word. So we need to have insurance balance sheets. People that there are some that are trying it. People that are saying okay I price my balance sheet on Bitcoin for example and I'm going to take position views on Bitcoin very very long term. I don't care what is going to happen in the in the meantime. So I think we we need we

need those primitives to express views that are very different compared to the block byblock movement of a price or liquidation or a call that is going to break or not. Uh hopefully we start putting it uh like we start we start having them and uh and I think the morpho v2 is an interesting in interesting development but we would we need more we need much more to do interesting stuff. >> So I mean you guys are very talented guys. Um you're still here. Why? Why not? I've had this idea and you guys tell me how dumb it is, but like my the thing I the issue with insurance is like in in the way Nexus and Anchor Protocol and have tried to do it and I think the the more interesting one was like Andre

like allowing like unwrapping of Nexus cover because that gave you more pricing on because you had the KYC on Nexus and so it's kind of antithetical to like the the fluidity of of DeFi and so but it it was interesting because it the pricing on the cover just all of a sudden reflected a more real time like you could see the jump in price and say, "Okay, actually the market's telling me that X protocol is way riskier and that gave you a really good oracle in of itself of of risk." But my issue with cryptonative insurance protocols is is a correlation. In insurance, you want to be uncorrelated.

You want to have property and casualty and you want to have diversified and like you want to build um you know that resilience anti-fragility in in in your balance sheet. The problem is crypto is very correlated and composability if you're interacting with a lot of protocols just tends to correlate really tightly and maybe that's no longer as much the case but my view is like go buy traditional insurance that has very like as far removed exposure from crypto and then slowly start issuing policies and serve the DeFi ecosystem. The problem is again we go back to square one yields are low and when yields are low you can't really offer that right >> composability spreads contagion but also

is isolation and simpler primitives prevented >> that's like like the in 1010 like we've had internally we call these bi-weekly 10 sigma events we seem to have a 10 sigma catastrophe in DeFi every two weeks lately at least since October, if not longer. And in each of these events, we saw high yield repo lending rates spike through the roof as a kind of lagging indicator of risk in these pools, but the Bitcoin rates stay completely unperturbed in morpho because they're isolated. And so I do think that you can have some degree of de, you know, uncoupling of risk contagion if

you build on sufficiently isolated primitives. And what that looks like for a crypton native insurance uh is not super clear to me. But yeah, you would need to have a balance sheet like Luca describes far longer term completely untouched un you know unrelated investing in cut bonds whatever something else for it to really work. >> Yeah. I mean I think I I I would uh separate cryptonative insurance meaning that you're building the mechanisms on chain or that you actually give the possibility to like longdated balance sheets to take cryp crypto assets on board and I think for example bitcoin there's so much to do with bitcoin that we haven't done like so much like imagine even even if you start allowing bitcoin to be reserves of like life

insurers then suddenly you have a very very long-term oriented buyer of bitcoin and suddenly the volatility of bitcoin price goes down massively so I think that even if even if those assets permeate because now the all the holders of I mean Bitcoin is probably an exception but the holders of all those assets are all traders so it's there is the cor the correlation of the prices of those assets is because like everybody is moving with liquidity if you're bringing more buyers in this industry that have a different p different time um horizon then suddenly the behavior of these prices changes so I think even even starting by just having long-term buyers because you know I'm buying Bitcoin insurance bitcoin for like a life insurance that I know I don't need to pay out on average in the next 20 25 years like you know my perspective on

prices and price volatility is very very different I mean that's how Warren Buffet buys companies um so at least for a while so I think that this stuff needs to permeate just stop being only a pure trading ARB ARB asset and just being in the hands of other people and suddenly we start seeing behaviors differently what we can put directly on chain remains to be seen but to your point Santi like if you have somebody that is giving you insurance it is not on chain but it's like an OTC desk that is really able able to take a position against you, you will just do it. You will just negotiate with Goldman. You don't buy it on chain. It's fine.

>> Luca opened this discussion with how regulation was actually forcing a lot of the regulation is forcing stable coins to be narrow banks and therefore pushing all of this risk on chain. It would have been interesting to have a world with more tethers because tether is essentially the only issuer that can actually take long-term balance sheet risk and in the real world this is like typically one source of like long longdated balance sheets that could serve that purpose or originate these products. So we are forced to contend with doing it ourselves.

But I actually love that because I'm a big I'm a passionate believer. I may be the last believer in free banking, but >> but isn't the issue with Tether though that the yes, they're like less regulated than a lot of the like Circle, but they're buying and they're doing some at the station, but not not to the level that you'd want, you know, but they're not fully collateralized. They have some other instruments in there and so and they're and they're not passing through the yield over to the holder. So, you know, you're as we think about where the risk sits squarely, that's the holder of USDT.

Yeah. We've seen a mult but I I >> I I think Adrian's point if I because I've done some research on Tether's balance sheet as well uh for fun uh and published on it. Um but I think Adrian's point is like I don't think I don't think Tether is going to do it because as you were saying Santi, they they have the best trade in the world. They have loan they take longdated risk and they don't pay anything out to anybody. Uh amazing. But what I think what I guess Edan was saying is that Tether is actually one of the few institutions that is in a position to issue long-term paper because they have dated >> on their ass. So they could actually issue loans like five, six, seven%.

>> They are to like trade fun not to crypto like it's it's tiny but they're doing it to like commodity traders. They're like Tether is in a different universe than Mortals. Like this might be the best business in history. Uh but it's a shame that regulation has kind of forced regulation has obligated Tether to not have any competition which is crazy and it would have been interesting to see a world where more stable coin issuers in a free banking type of environment could have competed on similar terms and offered. It would have brought on different types of risk for sure. U but instead we have to contend with building this ourselves which again as a free banking enjoyer I'm all for like I love the idea that the regulator is forcing

us to have free banking like it's great because now we have to come up with all of these solutions ourselves >> I mean the the only institution that is trying to do it is is micro strategy right they are trying to create a like um a term structure on on Bitcoin >> 11 and a half >> there's also uh meanwhile um this is such an interesting company. Yeah, I'm sure you guys are aware. Building a life insurance product on Bitcoin. So, their their balance sheet has like enormous duration and nowhere to put it. >> Yeah. I want to go back to something that I found interesting that I don't want to gloss over. You said that after 1010 there's been every other week a 10 sigma event. You said

>> calling it jokingly a bi-weekly 10 sigma event. >> Why is that? because they seem to be the type like drift protocol blowing up for $250 million is quite a and these events have a binary characteristic. So whenever you know the actual exploit is relatively minor but the finality of blockchain's settlement means that the loss is almost total and so when they happen they're like traumatic for everybody and they seem to happen all the time. Both of you guys interact with the real world financial institutions and others and I want to make not not the exchanges and folks that stand a profit no matter what, right? You have a principal agent problem in that like exists in

traditional finance. But does an event like drift update like forces you to reunderite and really question Lindy strategies to your point Luca what DeFi should be really good at and what it should just maybe not or if you're going to do it maybe do it in a different way because to your point Adrian it is very binary and catastrophic. So I'm Yeah. Maybe like your reaction to the drift hack with AI like anthropics release and also like how are you seeing the market react to that especially people that have been curious about DeFi that you're interfacing with? Like do

you think there's like a material setback because of that? >> I think I don't know what Luca thinks. Uh I'd be keen to hear what Luca thinks. My experience has been this type of event has the effect of dramatically increasing the cost of capital for operating on chain for sure. They're very public. They're very transparent. Um they're very unique to crypto in that regard. Although I will like to kind of lower the tone of self flagagillation a little. You didn't we didn't have the luxury of monitoring's positions in insolvent hedge funds before it went under. And so the lack of frequency of like you know you you get

updates on Khalis you know four times a year. It's not like these events don't happen ever in traditional finance. So like we can also take cold comfort in that. I think the reaction from crypto Twitter has been encouraging. Frankly there's been a lot more discussion about the risks a lot more appreciation of operational security as a vector. uh and it seems like there's at least a genuine intent to take it more seriously in particular with like AI attackers, AI powered attackers. You know, part of the it may well be that the increase in frequency of bi-weekly 10 sigma events is just like people with AI spotting exploits where you know nobody caught them before. So it kind of stresses the importance of having stronger operational security for sure and maybe

keeping things more minimal like instead of building protocols that do more harden the layer that has to rely on crypto guarantees to make it stronger because I have uh I don't have the statistics on hand but my impression from reading different reports was that the smart contract audit side is gradually hardening and we're getting better at it over time and that's exposing the remaining surface which is operational security into these protocols which will hopefully harden as a result and as a reaction. >> Luka before I go to you one thought is um back to like a CDS which I find really interesting like in Nexus it would almost sell out and it's almost like a I think cozy Sherlock OPM there's

been a lot of like iterations of this but none that in my opinion have really taken off. Um, how do you your point around credit su is really a good one, but I think you had like the market was telling you that there was something there if you looked at like just CDS or just like because I remember like there there was whispers in in in in the financial like problem with crypto is like it just in it it happens and it's like catastrophic and it it doesn't and everything's automatic and so it doesn't allow you to like respond.

Um, is there an opportunity for prediction markets to play in a role here of like pricing in a way to be like a market sentiment of like if you if you spin up a world where like you have all these prediction markets on like hey is there going to be a hack on DeFi and you see a spike that that's revealing in of itself. There was a before I I seed the ground Tuga, there was a parallel the only the only the nearest parallel I can think of of something like a crypto hack in traditional finance was the attempted heist on the Bangladesh central bank by North Korea. probably the most talented OBSse operators in the world frankly and they were able to social engineer access

to the accounts of the Bangladesh central bank time the time zones to ensure that nobody was watching and I think they were successful in evacuating like a couple hundred millions of dollars out of it but they were thwarted at like the last second like that's like they are much more rare because these transactions can be reverted and they are not final to your point like the finality of the blockchain settlement makes the what's at stake much higher in crypto. >> Yeah. And I think there is an incentive exactly because of the way crypto works to keep stuff super super super confidential until the second when everything happens. So I think that the leakage of information is way less but I think your point Santon on prediction markets is actually uh great. Again I I

I don't shield my business but sometimes I shield my writing. I've been writing about prediction markets for a long time. Uh I think the prediction market is probably one of the best ways to express uncorrelated risk out there. Uh is a very good primitive. Now unfortunately prediction market is very is is very fancy today but they're not doing that just doing sports sports batting right. So it's a diff different use and uh the valuations are pricing uh the retail access uh to do like to to gamble but I think prediction market is a very very is a very very interesting primitive to actually express uncorrelated risks and cover. I also think that the what we are seeing now in crypto I agree we are we we see in treadfi the difference is treadfi has a

significant capital buffer that because there are unknown unknowns there are you need to know that there are unknown unknowns and accept it and just somehow price it and buffer it with like a with a cushion we don't have it in crypto we don't have the luxury if you do have insurance make a lot of money >> you have you have some insurance funds but that you could argue hardest >> but it's is minuscule right so like I think if you had more if you had more money that's why whales in crypto make a lot of money because they have their own insurance funds personally like at the fund level and they can take positions and they take there is not an algorithm that is super optimized like you're like you have your own balance sheet and that's why venture smart venture investors like have been good at this

game because they know how to do portfolio management um but I also think that there are things which where it's clearly the it's clear that crypto is is way way better than thread fi and there are things where it's not. I think crypto is great is way better than thread fi in doing like super super fast margin lending. I mean we're discussing here about single basis points of LGDS uh parameterization. I mean this stuff is boring as [ __ ] guys, right? Like because it means that it means that we're pretty good at it, right? I think the other the other thing that we are good at is just reinventing the bank deposit. Everybody loves stable coins because it's safer than a bank, faster than a bank, easier to transact, cheaper, and hopefully they're going to get some yield or you get some yield from back door. On this, we are so much

better and there is so much m so much stuff to do because now we are revolutionizing the banks. The banks hate us because now we're eating their lunch. Uh maybe we're better at per trading because it's very good to take very quick leverage and price. There are things where crypto is so much so much better. >> Uh there is a lot stuff to do. Maybe we're not going to be better in so many other things where there are other primitives that are better than crypto. I think this idea of cryptomaxing the world and everything is going to go on decentralized rails probably is not true, right? And um we are better. The reason why we're talking about it because crypto is a great distribution channel because everything is permissionless and is global from day one. You have a great product and suddenly you put it in the market and

everybody can buy it. Uh but that doesn't mean necessarily that we need to have every product in the world on crypto rails uh including private credit. I used to be a priv private credit investor. I love the asset class. Now, do we need crypto rails for private credit investors? Not really. If you're like a hedge fund, you just buy it yourself and you know how to price it. So, but there are things where we are much much much better. Uh I think prediction market is one of those surfaces. I just hope that we go back building very smart things on prediction markets because now we're not right now. We're just transforming prediction markets into partially unregulated >> gambling stuff. What? So like my thinking around that just to extend it a bit further is you have to sell insurance at the point of sale. So if

you're going to deposit it in a vault, you should then simultaneously buy a contract and a prediction market that hedges your position in case there's a catastrophic event because otherwise people forget about it. It's like it is like flood insurance. The reason why there's a reason why when you buy a car you can't step out of the dealer unless you have insurance. When you buy a home or you're a tenant you have to furnish proof of insurance. I think there could be an interesting mechanism here that you could you could by default not all strategies at least some provide some protection for the user automatically embedded. I think it's it hasn't been adopted or it won't because if it is very circular rates are low it just >> rates are low. Exactly.

>> It is it is again it goes it's difficult to do this. I don't want to see >> I don't want to see the world where you have a prediction market that incentivizes people to hack protocols beyond just >> but that's protocol >> true I guess you could say like Immunifi has been pretty good like I think there's a pretty good stat like protocols that have bug bounties and healthy ones like are are you know get just inherently get hacked less right but yeah it's like a bit of like an quasi assassination market what um so just this has been a fascinating discussion. I get the feeling that we could go on and on and on and on. Maybe we should do another series here because both of you individually could come on the pod and

just talk so much about your respective fields. Want to make it practical for users, but also introduce some more excitement. This is not meant to be a DeFi is dead. um if you picked up on the nuance um it's not but what um what are you guys doing in your respective companies or how you see the market that I think you've hinted at this a bit in the pod but that you're really excited about and you think is probably not talked about as much in the market but will probably grow and and be and be you know very successful.

I will start um you know I'm I've been in the stable coin space for very very long time before it was fancy uh I mean we started M0 in January 2023 with a very strong stable coin infrastructure thesis and most people outside of the core investors we had that no clue what stable coins why we were so hyped about stables. Um but we there are two two elements. One that are still that are very important I'm fighting for. One is super popular these days and the other one not so much. The one that is super popular is like we need stable coins to pass risk-f free on chain. If we if we if we allow stable coins to stream risk-f free yield

on chain we are repricing the whole curve on DeFi. I think then then you can really start doing like smarter stuff because the the market is more efficient and banks are fighting it. Everybody's fighting it. Everybody has a horse on the race. But I think it's absolutely in the interest of the of the whole space if we do that. Uh and I'm going to keep fighting for it to do it in the safest and most direct way. Uh I mean at M0 we have systems that allow the streaming of yield of risk-free rate on chain on a continuum basis. uh we can do it offshore, we cannot do it on shore sadly, which is crazy uh because it creates ver these weird situations where like retail is taking a lot of risk and they're forced to do that. The second

one that we don't talk about too much is stable coins in my in my field. Like stable coins are are the whole are the hype today, but we spend a lot of time just bundling stable coin with fiat and most of the stable coin so-called infrastructure company. I'm not going to name names, but very successful companies and profitable. They're just patching tokens with accounts and cards and effects and making spreads. This is okay but I don't I think the in our our thesis M0 is that st and stable coins are onchain infrastructure. So you need to build infrastructure primitives on chain to do liquidity to do effects to do yield programmability create accounts move move stuff create applications

around it. I think we should spend much more time on that. Uh we feel we are alone in this field which means also probably enough capital to build it and be a couple of years ahead of everyone. But I think now most of the effort in stable coin is just doing on and off ramping. It's like we're building scanners and printers. We're not we are not writing Photoshop. We should spend more time writing Photoshop. Yeah. And on my end, we're really focusing on the nerdy parts around plumbing. We view like crypto and DeFi as plumbing. And what we're excited about is either replacing or building adjacent plumbing that will allow financial markets to flourish on DeFi.

And I think one of the well coming back to the point about the long-term balance sheets uh you know as as a team that's been entrusted with a part of the balance sheet of Sky through the Grove Star. this is not as big or as long-term focused as Tether or as an insurer, but it's not that far off. And I think that allows us to take uh to do very interesting experiments that can help increase the accessibility of things like the risk-free rate on chain and take on more duration to try and lengthen the term structure of DeFi beyond the point where it's just a 12-second increment.

Uh yeah, nothing nothing that I can like discuss publicly now, but uh you know, a few projects that we have in the works that will be released in the next few weeks and we'll hopefully and to to your point like for people thinking that this is a DeFi doom and gloom, I hope I didn't give that impression like as as DeFi burns to the ground, we will be the last people standing in the ashes defending it. We're we're like super committed. We're a family business, not venturebacked. We grew up in this space and will die with it and we're very excited uh about DeFi going forward for sure.

>> Now is there I mean you talked about a lot about the the frameworks and the analysis you guys do are is that open source. Do you plan on publishing um I mean because I think >> we publish all the time on our substack the steakhouse kitchen so kitchen.stakehouse.financial financial um and we tweet about it all the time. Every time we onboard an asset issuer, we you know underwrite them, talk about it. We have our risk management framework updated on a daily basis on our uh docs page. So there's plenty of material. Yeah, like you said, we could talk about this for hours. So, you know, God forbid. Yeah, >> that's amazing, guys. Well, look, really really appreciate you coming on and u

you know, we'll we'll link to your blog post, Luca and Adrian. We'll um we'll definitely post to that dashboard. Um sorry. Um and I think we'll love to have you guys on. Like there's just so much that we didn't talk about like rating agencies. Is there going to be like rating instruments? Uh you know, insurance like we can go on and on and on about a lot of the different things that we like that we talked about in this pod. But we'll have to leave it there for now. Really enjoyed the conversation and um yeah, we'll u appreciate you guys coming on. >> You should see the prediction market on what we will talk about next time.

Definitely. Awesome, guys. Well, thanks so much for listening. Have a great weekend and uh we'll see you next time.