WEBVTT - Bonus: The Crypto Story by Matt Levine - Part 6 0:00:03.640 --> 0:00:06.720 This is Bloomberg Crypto, a daily Bloomberg I Heard podcast, 0:00:07.120 --> 0:00:10.119 and I'm Stacy Marie Ishmael, Managing editor of Crypto for 0:00:10.160 --> 0:00:28.440 Bloomberg News. Let me cut to the chase. Matt Levine, 0:00:28.520 --> 0:00:30.560 my colleague on the Bloomberg Opinion side of the house, 0:00:31.160 --> 0:00:34.959 is perhaps the greatest finance blogger ever to do it, 0:00:35.560 --> 0:00:37.640 and in what is both a flex and a service, 0:00:37.960 --> 0:00:40.920 He's just written tens of thousands of words on the 0:00:40.960 --> 0:00:44.640 subject of crypto for a special issue of Bloomberg Business Week. 0:00:45.840 --> 0:00:49.200 Matt's gone deep into the blockchain to break down its origins, 0:00:49.400 --> 0:00:52.640 it's possible, futures, and the current state of a technology 0:00:52.680 --> 0:00:55.960 that's showing up everywhere in industries ranging from finance to 0:00:56.040 --> 0:00:59.600 shipping too, of course video games. And we're going to 0:00:59.680 --> 0:01:03.360 be bringing his exploration to you in audio form thanks 0:01:03.360 --> 0:01:06.120 to the talents of Bloomberg editor and professional voice actor 0:01:06.319 --> 0:01:10.040 Mark Ledoff. You'll get weekly chapters of the special Crypto 0:01:10.120 --> 0:01:13.679 issue of Bloomberg Business Week. Welcome to the sixth chapter 0:01:13.840 --> 0:01:16.240 of the special audio edition of the Bloomberg Business Week 0:01:16.240 --> 0:01:20.679 Crypto issue, written by Matt Levine and narrated by Mark Ledoff. Mr. 0:01:20.680 --> 0:01:22.920 Previous chapter and need to catch up. You can find 0:01:22.920 --> 0:01:26.039 previous episodes right here in the Bloomberg Crypto podcast feed 0:01:40.240 --> 0:01:44.880 d Defy. The thing about centralized crypto exchanges is that 0:01:44.920 --> 0:01:48.520 they're centralized. Broadly speaking, you have to trust the people 0:01:48.600 --> 0:01:50.720 running the exchange to run it in a good way, 0:01:51.280 --> 0:01:54.080 not to steal customer money, not to get hacked, not 0:01:54.160 --> 0:01:56.520 to take advantage of their knowledge of customer orders to 0:01:56.520 --> 0:01:59.960 trade ahead, not to blow up by allowing too much leverage, 0:02:00.160 --> 0:02:04.440 et cetera. Sometimes that trust is misplaced and the exchange 0:02:04.520 --> 0:02:08.280 does steal the money. Sometimes the exchange is honest, careful, 0:02:08.320 --> 0:02:12.120 and well regulated by the responsible national authorities. But still, 0:02:12.560 --> 0:02:17.639 you're in crypto. You want to avoid trusting centralized intermediaries 0:02:17.639 --> 0:02:23.760 and national regulation. Also, you're in crypto you want smart contracts. 0:02:24.240 --> 0:02:26.720 A financial products exchange can be thought of as a 0:02:26.760 --> 0:02:30.920 computer program. Most stock exchanges long ago got rid of 0:02:31.000 --> 0:02:34.400 trading floors with human traders and are now just computer 0:02:34.480 --> 0:02:39.120 servers matching electronic buy and sell orders. Certainly every crypto 0:02:39.160 --> 0:02:43.680 exchange works like that. A centralized crypto exchange is fully electronic. 0:02:44.120 --> 0:02:47.040 It has computers that keep ledgers of customer assets and 0:02:47.120 --> 0:02:50.639 run the programs, matching orders and moving assets between customers. 0:02:51.560 --> 0:02:54.360 The blockchain is already designed to keep a ledger of 0:02:54.400 --> 0:02:58.400 customer assets, so why keep your assets on an exchanges ledger? 0:02:59.160 --> 0:03:02.400 And you can on computer programs on Athereum or most 0:03:02.440 --> 0:03:06.520 other modern blockchains, why not run the exchange programs there? 0:03:07.160 --> 0:03:10.280 A venue for trading tokens that isn't a company but 0:03:10.440 --> 0:03:13.240 is instead a set of smart contracts on a blockchain 0:03:13.639 --> 0:03:18.080 is called a decentralized exchange or d e X, and 0:03:18.120 --> 0:03:21.520 the broader idea of having a financial system with lending 0:03:21.560 --> 0:03:25.120 and derivatives and everything else that runs as smart contracts 0:03:25.160 --> 0:03:30.360 on a blockchain is called decentralized finance or DEFY. A 0:03:30.400 --> 0:03:35.040 few more points of terminology. Decentralized finance is DEFY, so 0:03:35.240 --> 0:03:39.600 centralized finance, meaning specifically the bits of crypto that use 0:03:39.680 --> 0:03:44.800 centralized trusted intermediaries, mainly exchanges and lenders, is c FI, 0:03:45.560 --> 0:03:49.040 and I will sometimes refer to defy things as protocols. 0:03:49.520 --> 0:03:52.880 A protocol is a set of smart contracts, the computer 0:03:52.960 --> 0:03:56.120 programs that run on the blockchain and do stuff, or 0:03:56.120 --> 0:03:58.920 at least a set of rules for creating them. A 0:03:58.960 --> 0:04:02.520 decentralized ex change isn't an exchange in the traditional sense. 0:04:03.120 --> 0:04:05.840 It certainly isn't a building in New York where traders 0:04:05.880 --> 0:04:08.600 meet in person to shout orders at each other. And 0:04:08.640 --> 0:04:11.520 it also isn't a data center in New Jersey where 0:04:11.520 --> 0:04:14.360 an exchange company keeps its computer service to match orders 0:04:14.400 --> 0:04:17.640 with each other. It's a protocol, a set of smart 0:04:17.680 --> 0:04:22.120 contracts that let people move cryptocurrencies around. There might be 0:04:22.160 --> 0:04:25.960 a company involved, and surely someone is making money somewhere, 0:04:26.520 --> 0:04:29.599 But even if the company goes away, the smart contracts 0:04:29.640 --> 0:04:35.640 will keep running as long as the blockchain does. One 0:04:36.000 --> 0:04:43.080 some background on exchanges and market makers one clob Here's 0:04:43.120 --> 0:04:46.480 what an exchange is. People send it orders buy one 0:04:46.560 --> 0:04:50.120 hundred shares at one hundred, sell one hundred shares at 0:04:50.120 --> 0:04:54.240 a hundred two dollars, etcetera. The exchange is, at its heart, 0:04:54.320 --> 0:04:57.440 a system for matching those orders, finding a buyer for 0:04:57.520 --> 0:05:00.920 each seller, and vice versa. The orders come in at 0:05:00.960 --> 0:05:03.800 different times. When the exchange gets an order to buy 0:05:03.800 --> 0:05:06.479 one hundred chairs at one hundred dollars, it puts the 0:05:06.560 --> 0:05:09.520 order on its order book, just an electronic list of 0:05:09.640 --> 0:05:12.920 orders that haven't been executed yet. When it gets its 0:05:12.960 --> 0:05:15.599 next order to sell one hundred shares for a hundred 0:05:15.720 --> 0:05:18.240 two dollars. It looks at its order book to see 0:05:18.240 --> 0:05:20.719 if there are any orders to buy one hundred chairs 0:05:20.760 --> 0:05:24.760 at one hundred two dollars. Nope, not yet. The one 0:05:24.839 --> 0:05:27.440 hundred dollar buyer doesn't want to pay one hundred two 0:05:27.480 --> 0:05:30.520 dollars and the one two dollars seller doesn't want to 0:05:30.560 --> 0:05:34.000 accept one hundred dollars. It puts the cell order on 0:05:34.040 --> 0:05:37.240 the order book to the one hundred dollar buy order, 0:05:37.240 --> 0:05:39.960 and the one D two dollars cell order rest on 0:05:40.000 --> 0:05:43.240 the order book. Then another order comes in to buy 0:05:43.279 --> 0:05:45.640 a hundred shares at a hundred and two dollars. The 0:05:45.720 --> 0:05:48.159 exchange sees in the order book that a ha, yes, 0:05:48.360 --> 0:05:50.320 there's an order to sell a hundred shares at a 0:05:50.360 --> 0:05:53.400 hundred and two dollars. So the matching engine matches the 0:05:53.400 --> 0:05:55.920 one D two dollar buy and the one D two 0:05:55.960 --> 0:05:59.000 dollars cell order. They pair off with each other and 0:05:59.080 --> 0:06:02.080 do their trade, and then the orders are removed from 0:06:02.120 --> 0:06:05.159 the order book they've been filled, and the exchange waits 0:06:05.160 --> 0:06:08.640 for the next order. In general, a centralized exchange will 0:06:08.640 --> 0:06:10.800 have lots of orders resting on its order book at 0:06:10.839 --> 0:06:14.200 any time. All the resting by orders will have lower 0:06:14.240 --> 0:06:17.400 prices than all the resting cell orders. If a buy 0:06:17.560 --> 0:06:20.560 order has a higher price than arresting cell order, those 0:06:20.600 --> 0:06:23.039 two orders will pair off and execute with each other. 0:06:23.680 --> 0:06:26.039 If I want to pay one three dollars and you 0:06:26.040 --> 0:06:29.440 will accept a hundred two dollars, the exchange has found 0:06:29.440 --> 0:06:32.880 a mutually beneficial trade. And this way of running an 0:06:32.880 --> 0:06:36.120 exchange is usually called a central limit order book or 0:06:36.320 --> 0:06:40.479 c l OB. You could certainly build a smart contract 0:06:40.520 --> 0:06:44.080 to do this on the blockchain. The contract would take orders, 0:06:44.240 --> 0:06:47.120 keep them on a central limit order book, and execute 0:06:47.120 --> 0:06:50.719 them against each other. And smart contracts like this do exist, 0:06:51.360 --> 0:06:55.480 but most d x is don't work this way. Two 0:06:55.920 --> 0:07:00.320 market makers. You may ask, where do all these resting 0:07:00.440 --> 0:07:03.719 orders come from? Who's going around thinking up these specific 0:07:03.760 --> 0:07:06.440 prices they want to pay for a stock or prices 0:07:06.440 --> 0:07:10.040 they want to sell for. Ordinary people might not bother 0:07:10.120 --> 0:07:13.040 with this. If they think a stock is a good investment, 0:07:13.200 --> 0:07:16.920 they will often send in market orders just buy from whoever, 0:07:17.040 --> 0:07:21.280 selling at whatever the best prices. Resting orders come mainly 0:07:21.320 --> 0:07:25.640 from professional investors called market makers, who help make fast 0:07:25.680 --> 0:07:29.239 and efficient trading possible. Their job is to sell stock 0:07:29.360 --> 0:07:32.440 or crypto or whatever to people who want to buy 0:07:32.960 --> 0:07:35.640 and buy from people who want to sell and collect 0:07:35.680 --> 0:07:39.280 the spread, the difference between their bid or buying price 0:07:39.560 --> 0:07:42.920 and their offer or selling price. If you send a 0:07:42.960 --> 0:07:46.240 market order to buy, you buy immediately, but you pay 0:07:46.280 --> 0:07:49.040 a bit of money the spread to the market maker 0:07:49.120 --> 0:07:52.520 for that service. The market maker, meanwhile, is in the 0:07:52.520 --> 0:07:56.360 business of providing that service and collecting that spread. It's 0:07:56.360 --> 0:07:58.880 not really betting that prices will go up or down. 0:08:00.040 --> 0:08:03.720 In modern stock and crypto markets, market makers are also 0:08:04.040 --> 0:08:08.440 largely computer programs, and their programs are pretty simple. This 0:08:08.520 --> 0:08:12.360 is oversimplified, but not by that much. One post a 0:08:12.400 --> 0:08:15.760 bid and an offer for a stock. Two. If someone 0:08:15.800 --> 0:08:18.480 sells you stock at your bid price, lower your bid 0:08:18.520 --> 0:08:22.400 and offer slightly. If someone immediately hits your bid, then 0:08:22.440 --> 0:08:24.920 you might worry that your bid was actually too high 0:08:25.000 --> 0:08:28.280 and you could have paid less. Anyway, Now you own 0:08:28.320 --> 0:08:30.160 some stock and want to get rid of it, so 0:08:30.200 --> 0:08:33.439 you might as well put it on sale. Three, if 0:08:33.480 --> 0:08:36.320 someone buy stock from you at your offer price, raise 0:08:36.400 --> 0:08:41.080 your bid and offer slightly for similar reasons. For keep 0:08:41.160 --> 0:08:44.880 doing this. The system is self correcting. The more stock 0:08:44.960 --> 0:08:46.959 people want to sell you, the less you pay them 0:08:47.000 --> 0:08:48.920 for it. The more they want to buy from you, 0:08:49.040 --> 0:08:52.360 the more you charge them. Hopefully it all balances out 0:08:52.600 --> 0:08:55.120 and you end up flat. You sell all the stock 0:08:55.200 --> 0:08:57.679 you bought and buy all the stock you sold, and 0:08:57.760 --> 0:09:01.920 you collect the spread along the way. Five. Also, you're 0:09:02.000 --> 0:09:05.560 probably keeping an eye on general market conditions and raising 0:09:05.600 --> 0:09:08.120 and lowering your bids and offers based on what's happening 0:09:08.120 --> 0:09:12.280 in other markets. Market Makers in US stocks are often 0:09:12.280 --> 0:09:16.560 called high frequency traders or sometimes even flashboys, and part 0:09:16.559 --> 0:09:18.960 of what that means is that they're constantly changing the 0:09:19.000 --> 0:09:22.600 prices of their orders as their information changes. And the 0:09:22.640 --> 0:09:24.680 result is that when you want to buy a share 0:09:24.679 --> 0:09:27.040 of stock, you can send in a market order and 0:09:27.080 --> 0:09:29.400 you will quickly trade with a market maker at a 0:09:29.400 --> 0:09:32.720 price that's pretty much the market price, one that's updated 0:09:32.760 --> 0:09:39.600 continuously to reflect supply and demand and all available information. Three. Nope, 0:09:40.600 --> 0:09:43.400 this doesn't work on the blockchain. The problem with the 0:09:43.440 --> 0:09:47.600 blockchain is that it's a slow computer. Ethereum runs computer 0:09:47.640 --> 0:09:51.720 programs by sending them to thousands of nodes to confirm transactions, 0:09:51.760 --> 0:09:54.520 and that takes time. You wouldn't want to run a 0:09:54.520 --> 0:09:58.640 self driving car on the Ethereum virtual machine. It turns out, 0:09:58.640 --> 0:10:00.679 you wouldn't want to run a high free concete trading 0:10:00.720 --> 0:10:05.840 platform there either centralized exchanges in traditional finance and in 0:10:05.920 --> 0:10:09.560 crypto have lots of very fast computers with very fast 0:10:09.600 --> 0:10:13.440 connections that allow market makers to constantly update their prices 0:10:13.679 --> 0:10:17.720 in response to trades and new information. Traders build fancy 0:10:17.760 --> 0:10:20.480 fiber optic lines to get their orders to the exchange 0:10:20.520 --> 0:10:24.800 a few milliseconds faster than the competition speed matters, and 0:10:24.840 --> 0:10:27.800 they update their orders many times a second. This is 0:10:27.840 --> 0:10:30.640 harder when the computers are on the blockchain. It's also 0:10:30.720 --> 0:10:35.280 more expensive. Every action in Ethereum requires gas fees, and 0:10:35.320 --> 0:10:38.600 sending a message to a smart contract saying cancel my 0:10:38.760 --> 0:10:41.920 buy order at one point oh one dollars and put 0:10:41.920 --> 0:10:45.320 in a new order at one point two dollars would 0:10:45.440 --> 0:10:49.560 use Ethereum's computer power and cost gas. It turns out 0:10:49.640 --> 0:10:54.080 this is nearly fatal for clob market making. In Ethereum, 0:10:54.280 --> 0:10:58.960 market making is very expensive. Vitallicquterian wrote as creating an 0:10:59.040 --> 0:11:02.120 order and removing a order both take gas fees, even 0:11:02.160 --> 0:11:09.200 if the orders are never finalized. Two automated market makers 0:11:10.120 --> 0:11:15.360 one mechanics. So Vitallic proposed a different idea here. It 0:11:15.520 --> 0:11:18.880 is the mechanism would be a smart contract that holds 0:11:18.960 --> 0:11:22.280 A tokens of type T one and be tokens of 0:11:22.320 --> 0:11:26.160 type T two, and maintains the invariant that A times 0:11:26.200 --> 0:11:29.959 B equals K for some constant K. In the version 0:11:29.960 --> 0:11:33.319 where people can invest, K can change, but only during 0:11:33.360 --> 0:11:38.319 investment withdrawal transactions, not trades. Anyone can buy or sell 0:11:38.360 --> 0:11:40.840 by selecting a new point on the X Y equals 0:11:40.920 --> 0:11:44.280 K curve and supplying the missing A tokens and in 0:11:44.400 --> 0:11:48.560 exchange receiving the extra B tokens, or vice versa. The 0:11:48.640 --> 0:11:51.960 marginal price is simply the implicit derivative of the curve 0:11:52.440 --> 0:11:56.560 x y equals K or y slash x. That's just 0:11:56.600 --> 0:11:59.200 a comment that he wrote on Reddit. Later, a whole 0:11:59.240 --> 0:12:02.480 business model grew out of it. Here's the simplified version. 0:12:02.960 --> 0:12:05.720 I decided to be a market maker in some token pair, 0:12:06.000 --> 0:12:09.640 say ethereum and U s d C. A dollar denominated 0:12:09.640 --> 0:12:13.440 stable coin. Let's say one Ether currently trades for six 0:12:13.920 --> 0:12:17.680 d U s d C six hundred dollars. I set 0:12:17.760 --> 0:12:21.000 up a smart contract. Again, that's a computer program on 0:12:21.040 --> 0:12:23.440 the blockchain, but in this case it might be easier 0:12:23.480 --> 0:12:25.880 to think of it as a pot of money managed 0:12:25.920 --> 0:12:29.440 by the computer program. I can deposit both ether and 0:12:29.600 --> 0:12:33.280 USDC into this pot. Anyone who wants to buy ether 0:12:33.640 --> 0:12:36.920 with U s DC or sell either for U s 0:12:37.000 --> 0:12:39.880 DC can come to my smart contract and make that 0:12:39.920 --> 0:12:42.679 trade with it, and the contract will adjust its prices 0:12:42.720 --> 0:12:45.560 to reflect supply and demand. But it will do it 0:12:45.640 --> 0:12:48.560 in an absurdly simple manner that doesn't require much in 0:12:48.559 --> 0:12:51.920 the way of computation or updating prices. It will just 0:12:51.960 --> 0:12:55.240 try to keep one number constant. When I set up 0:12:55.240 --> 0:12:58.920 the contract, I deposited equal values of ether and U 0:12:59.000 --> 0:13:02.520 s d C. If one ether was worth sixteen hundred 0:13:02.600 --> 0:13:05.320 U s DC, I put in one hundred ether and 0:13:05.480 --> 0:13:08.840 one hundred sixty thousand U s DC each set of 0:13:08.840 --> 0:13:12.719 tokens worth a hundred and sixty thousand dollars. The program 0:13:12.840 --> 0:13:16.560 multiplies those two numbers one hundred times one hundred sixty 0:13:16.600 --> 0:13:19.880 thousand is sixteen million, and then it will just hold 0:13:19.920 --> 0:13:23.840 that product constant. That is, the number of Ether multiplied 0:13:23.880 --> 0:13:26.320 by the number of U s DC will always be 0:13:26.600 --> 0:13:31.160 sixteen million. A trader will try to buy, say ten Ether, 0:13:31.760 --> 0:13:35.200 that would leave ninety ether in the fund. Sixteen million 0:13:35.280 --> 0:13:38.640 divided by ninety is one hundred seventy seven thousand, seven 0:13:38.720 --> 0:13:41.800 hundred and seventy seven point seventy eight. The pot has 0:13:41.840 --> 0:13:44.959 one hundred sixty thousand U s DC now, so it 0:13:45.040 --> 0:13:48.400 will need seventeen thousand, seven hundred and seventy seven point 0:13:48.520 --> 0:13:52.240 seventy eight more U s DC to keep the product constant. 0:13:52.840 --> 0:13:56.280 That's what my smart contract charges. The trader has to 0:13:56.280 --> 0:13:59.480 pay me seventeen thousand, seven hundred seventy seven point seventy 0:13:59.520 --> 0:14:03.280 eight U s d c one thousand, seven seventy seven 0:14:03.320 --> 0:14:06.480 point seven seventy eight U s DC per Ether to 0:14:06.640 --> 0:14:09.880 do this trade. Someone wants to buy ether from my 0:14:10.000 --> 0:14:13.760 smart contract, So my smart contract automatically raises its price 0:14:13.840 --> 0:14:16.840 for Ether. But it doesn't have to go around constantly 0:14:16.920 --> 0:14:21.440 updating prices and posting new prices on central limit order books. 0:14:21.800 --> 0:14:25.800 It just advertises its constant product and that updates prices 0:14:25.840 --> 0:14:29.080 on its own. It's a kind of automated market maker, 0:14:29.240 --> 0:14:33.680 or a m M. That's cool. I don't know it's cool. 0:14:34.240 --> 0:14:37.320 This isn't a thing that really exists in traditional finance. 0:14:37.720 --> 0:14:40.840 It was developed almost by accident, as a workaround to 0:14:40.880 --> 0:14:44.680 a novel problem that the computers are too expensive in 0:14:44.800 --> 0:14:49.600 decentralized finance. You might be asking, wait, how do I 0:14:49.680 --> 0:14:52.840 know the price charged by the smart contract is correct? 0:14:53.600 --> 0:14:57.040 Is the computer program ever checking Ether's price quoted on say, 0:14:57.280 --> 0:15:00.520 coin base to make sure it's price makes sense? No, 0:15:01.360 --> 0:15:04.440 insofar as demand for ether by people interacting with the 0:15:04.480 --> 0:15:07.680 contract reflects demand for either in the rest of the world, 0:15:08.000 --> 0:15:10.880 than the price created by the contract is the price. 0:15:11.640 --> 0:15:15.600 Sometimes different smart contracts and different centralized exchanges could have 0:15:15.680 --> 0:15:18.240 different prices for ether, But if they get two out 0:15:18.280 --> 0:15:20.720 of whack, people can try to buy ether where it's 0:15:20.800 --> 0:15:23.200 cheap and sell it where it's expensive for a quick 0:15:23.200 --> 0:15:29.640 profit and close that gap two LPs. In my description above, 0:15:30.000 --> 0:15:32.040 I assume that I want to be a market maker 0:15:32.120 --> 0:15:34.880 in some currency pair, so I set up a smart 0:15:34.920 --> 0:15:37.880 contract to do it on my own. In reality, the 0:15:37.920 --> 0:15:41.080 way d X is normally work is that a MM 0:15:41.160 --> 0:15:44.520 smart contracts pool liquidity. If you want to be a 0:15:44.520 --> 0:15:47.240 market maker in stocks, it helps to be a large 0:15:47.280 --> 0:15:50.960 financial institution in crypto. Anyone who wants to be a 0:15:50.960 --> 0:15:53.520 market maker in a pair of tokens can contribute that 0:15:53.600 --> 0:15:57.200 pair to a liquidity pool and get back liquidity tokens 0:15:57.200 --> 0:16:01.480 representing their stake in that pool. Their call liquidity providers. 0:16:01.960 --> 0:16:05.480 They collect fees in crypto for providing liquidity in the pool. 0:16:06.360 --> 0:16:09.680 There's a risk though in general, if you provide liquidity 0:16:09.720 --> 0:16:13.760 in an asset in defy or centralized finance, in crypto 0:16:13.920 --> 0:16:17.840 or otherwise, and the asset price steadily goes down, you'll 0:16:17.880 --> 0:16:20.320 find yourself buying more and more of it, and it 0:16:20.320 --> 0:16:23.360 will be worth less and less. In an a MM 0:16:23.480 --> 0:16:26.720 liquidity pool, if the price of one token keeps going 0:16:26.840 --> 0:16:29.480 up against the other token, the pool will have more 0:16:29.520 --> 0:16:32.320 and more of the token worth less and less. This 0:16:32.440 --> 0:16:35.800 is a risk that all market makers take in traditional finance, 0:16:35.840 --> 0:16:40.680 it's sometimes called adverse selection. In defy, though it delights 0:16:40.680 --> 0:16:44.640 in the name impermanent laws. I don't know why, but 0:16:44.720 --> 0:16:48.680 I love it. There's nothing particularly impermanent about it unless 0:16:48.720 --> 0:16:51.800 the price bounces back, of course, but that's what it's called. 0:16:52.440 --> 0:16:56.600 Crypto is so optimistic. How can you not be charmed. 0:16:58.400 --> 0:17:00.720 We'll be right back with more from Berg Business Week 0:17:00.760 --> 0:17:03.920 special Crypto issue, written by Matt Levin a narrated by 0:17:03.920 --> 0:17:19.240 Mark Ladoff. Three lending exchanges providing liquidity between different tokens 0:17:19.400 --> 0:17:22.240 are a key function of defy, but there are others. 0:17:22.640 --> 0:17:28.080 One important function is lending one secured. Most defied lending 0:17:28.160 --> 0:17:31.440 is what you would call in traditional finance margin lending. 0:17:32.040 --> 0:17:35.280 You have a volatile asset ether, say, and you want 0:17:35.280 --> 0:17:39.560 to borrow some money a dollar like USDC stable coin, say, 0:17:39.840 --> 0:17:43.720 using that volatile asset as collateral. Perhaps you're borrowing that 0:17:43.800 --> 0:17:47.119 money to buy more volatile assets, or perhaps you're borrowing 0:17:47.160 --> 0:17:49.520 against your ether to buy a sandwich or a house 0:17:49.600 --> 0:17:52.879 without selling your either. If you went to a broker 0:17:52.960 --> 0:17:55.480 for a margin loan against one d dollars of stock, 0:17:55.760 --> 0:17:59.920 the broker might lend you fifty dollars. It's over collateralized 0:18:00.119 --> 0:18:02.680 because the stock is worth more than the loan, which 0:18:02.680 --> 0:18:05.880 makes the broker feel safe. If the stock then fell 0:18:05.960 --> 0:18:08.960 to seventy dollars, the broker might send you a margin call. 0:18:09.480 --> 0:18:12.320 Pay down fifteen dollars of this loan, or I'll liquidate 0:18:12.359 --> 0:18:15.640 your stock. That way, it's less likely the broker will 0:18:15.720 --> 0:18:17.960 end up holding the bag for your loss if the 0:18:18.000 --> 0:18:21.600 stock keeps falling. If you failed to meet the margin call, 0:18:21.920 --> 0:18:25.679 the broker would sell your stock clear, say sixty dollars 0:18:25.720 --> 0:18:28.479 for it, keep enough money to repay the loan, and 0:18:28.520 --> 0:18:32.080 give you what's left. This is pretty straightforward to automate 0:18:32.119 --> 0:18:36.200 with smart contracts. There are robust. Defied lending systems such 0:18:36.240 --> 0:18:40.840 as compound Lenders put up tokens and earn interest. Borrowers 0:18:40.920 --> 0:18:45.719 borrow tokens overcollateralized by other tokens and pay interest. And 0:18:45.800 --> 0:18:48.760 automatic liquidation provisions make sure that if the value of 0:18:48.760 --> 0:18:51.520 the collateral goes down, it's sold to pay back the 0:18:51.560 --> 0:18:57.879 loans two unsecured. What's much harder in defied are the 0:18:57.880 --> 0:19:03.080 main businesses of traditional finance, unsecured lending and lending secured 0:19:03.080 --> 0:19:07.359 by physical assets such as houses. Defy is good at 0:19:07.440 --> 0:19:12.040 lending crypto secured by crypto. The collateral lives on the blockchain, 0:19:12.400 --> 0:19:15.760 the loan lives on the blockchain. They're connected by smart 0:19:15.800 --> 0:19:19.960 contracts on the blockchain. It's all pretty neat, but this 0:19:20.040 --> 0:19:23.880 sort of lending crypto against crypto doesn't do much. It's 0:19:23.920 --> 0:19:28.560 mostly useful for crypto speculation. You lend ether, get us 0:19:28.640 --> 0:19:32.800 DC and use it to buy even more ether. By contrast, 0:19:33.000 --> 0:19:35.320 a mortgage lets you buy a house and then pay 0:19:35.359 --> 0:19:38.640 for it with your future income. An unsecured business loan 0:19:38.720 --> 0:19:40.720 helps you build a business and then pay off the 0:19:40.760 --> 0:19:44.800 loan with the business's future earnings. Finance at its heart 0:19:45.200 --> 0:19:48.200 is about moving future wealth into the present by borrowing, 0:19:48.640 --> 0:19:52.320 or moving present wealth into the future by saving. There 0:19:52.320 --> 0:19:55.679 are deep philosophical reasons that crypto is bad at this. 0:19:56.480 --> 0:19:59.960 An unsecured loan is essentially about trust. It's about the 0:20:00.080 --> 0:20:02.720 lender trusting that she'll be repaid not out of a 0:20:02.760 --> 0:20:05.800 pool of collateral, but out of the borrower's future income. 0:20:06.400 --> 0:20:09.040 She has to trust that the borrower will have future 0:20:09.040 --> 0:20:13.200 income and that he will pay. Relatedly, an unsecured loan 0:20:13.320 --> 0:20:17.159 requires identity. You need to know who's borrowing the money, 0:20:17.440 --> 0:20:20.240 what their payment history looks like, what their income is. 0:20:20.800 --> 0:20:24.600 The default approach and much of crypto is pseudonymity. Anyone 0:20:24.720 --> 0:20:27.280 can set up any number of crypto wallets or bitcoin 0:20:27.320 --> 0:20:30.400 account numbers, and they're generally not tied to a name. 0:20:31.040 --> 0:20:34.280 If you borrow money against crypto collateral, all your lender 0:20:34.320 --> 0:20:37.000 needs to know is that the collateral is on the blockchain. 0:20:37.560 --> 0:20:40.720 If you borrow money against your future income, your lender 0:20:40.800 --> 0:20:44.400 needs to know who you are. That said, there's nothing 0:20:44.400 --> 0:20:48.120 in principle to prevent unsecured lending in defy, and there 0:20:48.119 --> 0:20:51.440 are projects such as Goldfinch that do it. You get 0:20:51.480 --> 0:20:54.680 together a smart contract where people deposit money in exchange 0:20:54.680 --> 0:20:58.800 for tokens and a DOW, a decentralized autonomous organization that 0:20:58.840 --> 0:21:01.840 controls the money. The tokens give them a share in 0:21:01.880 --> 0:21:04.320 the tao's profits and the right to vote on who 0:21:04.359 --> 0:21:09.000 gets the money. People propose potential borrowers, token holders consider 0:21:09.080 --> 0:21:11.520 them and vote, and if the holders vote yes, then 0:21:11.560 --> 0:21:14.719 they make a loan. As with any dow, the token 0:21:14.720 --> 0:21:17.240 holders can get together in a chat room and consider 0:21:17.400 --> 0:21:20.720 off chain information. If they want, they could make the 0:21:20.760 --> 0:21:23.680 borrowers send in a driver's license in two bank statements. 0:21:24.280 --> 0:21:27.480 You can build some incentive mechanism to punish members for 0:21:27.560 --> 0:21:31.919 proposing borrowers who default and reward them for proposing good borrowers. 0:21:32.560 --> 0:21:36.280 Decentralized finance is made up of smart contracts, but it's 0:21:36.280 --> 0:21:38.600 also made up of people, and if they want to 0:21:38.640 --> 0:21:42.800 do unsecured lending, they can. We've talked about web three 0:21:42.880 --> 0:21:47.000 as a source of online reputation about soul bound tokens 0:21:47.000 --> 0:21:49.920 that could be used to verify a person's actions, connections, 0:21:49.920 --> 0:21:54.280 and characteristics. A soul in this terminology is something close 0:21:54.320 --> 0:21:56.879 to a credit report. It's a list of stuff that 0:21:56.920 --> 0:21:59.520 a person has done that should make you trust them. 0:21:59.560 --> 0:22:03.760 A decent centralized and blockchained source of reputation information. The 0:22:03.840 --> 0:22:06.879 right assortment of degrees and endorsements might make you feel 0:22:06.880 --> 0:22:10.080 good enough about a person or rather a soul an 0:22:10.080 --> 0:22:13.280 address on the blockchain that you give them an unsecured loan, 0:22:14.000 --> 0:22:16.800 and then I suppose if they default, you can take 0:22:16.840 --> 0:22:23.760 their soul four token omics of defy. The basic mechanism 0:22:23.840 --> 0:22:26.159 of defy is that you put some tokens up in 0:22:26.200 --> 0:22:29.679 a smart contract to generate fees or interest. You put 0:22:29.720 --> 0:22:32.600 your tokens in an automated market making contract to get 0:22:32.640 --> 0:22:35.879 liquidity provider fees, You put your tokens in a lending 0:22:35.920 --> 0:22:40.080 protocol to get interest, etcetera. Generally, this is referred to 0:22:40.160 --> 0:22:43.800 as locking your tokens because they're being used for lending 0:22:43.920 --> 0:22:46.600 or whatever, you can't get them back for some period, 0:22:47.080 --> 0:22:49.960 and people often talk about defy protocols in terms of 0:22:49.960 --> 0:22:55.000 their TVL or total value locked. Mechanically, the way this 0:22:55.119 --> 0:22:57.760 generally works is that you send your tokens to the 0:22:57.800 --> 0:23:00.879 smart contract and it sends you back other tokens that 0:23:00.920 --> 0:23:04.959 are basically receipts for the tokens you locked up. Instead 0:23:05.000 --> 0:23:08.920 of having ether or USDC, you have liquidity provider tokens. 0:23:08.960 --> 0:23:12.639 Saying you've put some ether and USDC into a smart contract. 0:23:13.560 --> 0:23:17.480 What do you do with those liquidity provider tokens. Well, 0:23:17.600 --> 0:23:20.240 in theory, you hold them until you want your locked 0:23:20.280 --> 0:23:22.840 tokens back, and then you hand them in and get 0:23:22.880 --> 0:23:26.639 back the underlying tokens. The liquidity provider tokens are just 0:23:26.680 --> 0:23:30.200 a receipt. But at some point people realized that those 0:23:30.240 --> 0:23:34.600 tokens represent something of value. We can do something with them. 0:23:34.640 --> 0:23:36.720 If you have a token representing a receipt on some 0:23:36.800 --> 0:23:39.720 ether that you locked into a smart contract, then that's 0:23:39.880 --> 0:23:42.960 almost as good as having some ether, and someone might 0:23:43.000 --> 0:23:45.840 give you some money for it. Now you can borrow 0:23:45.920 --> 0:23:51.040 against those receipt tokens and defied too. Everything is like this. 0:23:51.720 --> 0:23:54.760 In proof of steak ethereum, you can steak ether to 0:23:54.920 --> 0:23:59.200 earn staking rewards. A protocol called Leedo runs a big 0:23:59.240 --> 0:24:02.679 steaking pool. If you stake your ether with Lido, it 0:24:02.720 --> 0:24:04.800 will give you back a token called s t e 0:24:04.960 --> 0:24:08.720 t H, basically a receipt for your staked ether. The 0:24:08.800 --> 0:24:11.760 ether that you staked with Ledo will earn staking rewards, 0:24:12.000 --> 0:24:14.280 while the st E t H that you get back 0:24:14.560 --> 0:24:17.560 can be sold or invested in other defied protocols to 0:24:17.680 --> 0:24:21.800 earn more money. More broadly, the business of DeFi is 0:24:21.840 --> 0:24:25.880 about reusing tokens as much as possible. You have some tokens, 0:24:26.119 --> 0:24:28.280 you lock them up in a smart contract that does 0:24:28.280 --> 0:24:31.160 a thing and pays you a return. The smart contract 0:24:31.200 --> 0:24:33.720