An Open Letter to The Stalwart on DeFi

Or, what DeFi enables today, and how it rebuilds the traditional financial system — but better

Dear Joe,

It would appear that, just as your crypto adventure was starting to lead you to three-letter places like AMMs and MEV, we have hit a speed bump in recent weeks:

Now, I’m not one to get caught up in Twitter arguments. However, in this case I make an exception. I’ve been a long-time Odd Lots listener and I have a lot of respect for you as someone who can navigate financial markets and broader macro topics with ease — all while doing so on TV or some form of media. That’s certainly not easy. I also think the nuance you typically exhibit on your podcasts can get lost — or at least dissipated — on Twitter. And yet I feel like, despite the occasional trolling, you are making a genuine effort to more deeply understand the DeFi space, which I think is tremendously important given your purview, visibility, and ability to bridge traditional finance (TradFi from here on out; bear with me) and crypto worlds.

So, all this to say that I will make the assumption of good faith on your part and, on my end, put in a genuine effort to try to answer your central question: What are the “real economy” use cases of DeFi?

An aside: to be completely frank, what tipped me over the edge into writing this was this tweet:

I think that’s pretty unfair. Your recent podcast guests (Hayden Adams and Aaron Lammer) have both given you honest answers to that question, and most people on Twitter (who are not overt trolls or anons) have engaged in good faith as well. Even if you may be somewhat unsatisfied by the answers, they are not trying to dodge the question. Yours just happens to be a good question that requires some contextualization and understanding of the current maturity of the underlying technology to provide a proper answer. Neither Hayden or Aaron could give you a simple one-word answer. If you’ll allow it, I’d like to take a stab at answering it honestly and comprehensively.

Let’s set the context here (is this what you mean by getting weird?):

With that in mind, I would like to answer the question along two different categories:

And I’ll sprinkle in some truly new and innovative DeFi-native applications along the way.

What You Can Do Today

(Starting simple and building up)

Personal Savings Accounts

It’s somewhat funny that I feel like I have to justify to you that this is a real use case, but from a consumer perspective, the savings account is one of the most basic building blocks of personal finance. Products like Dharma and Rainbow Wallet are legitimate replacements for personal savings accounts that offer higher yields than any bank account by plugging into DeFi. Moreover, this savings account is a one stop shop to access any of your Web3 accounts and applications; sign in once and you have access to all your financial and non-financial properties. This includes access to governance over the financial assets you own in the form of DAOs, access to lending products, as well as more novel products like no-loss lotteries (see PoolTogether). Beyond the very real use case of savings, this type of account creates a tighter and more seamless interaction with the assets you own. Now, I recognize that DeFi-enabled savings accounts might not fully replace the services that a bank can offer you today (e.g. debit cards, checking accounts, wire services, etc.), but all of these services are essentially about payments (to merchants as well as other individuals). This is a very obvious use case of crypto that has been stifled as a result of scalability barriers; with Layer 2 scaling solutions on Ethereum, stablecoins like Dai and USDC, privacy networks like ZK Money, and even payment-focused crypto networks like Celo all in active development, it should not take much more time until payments are a standard feature of crypto wallets. I trust that I don’t need to draw out how we naturally get there.

Governance

Speaking of DAOs, these are another example of a governance mechanism (governance itself is the use case here!) that has been modernized through Ethereum, and I consider this an essential part of the DeFi landscape, as it is an efficient and economically aligning way to govern over financial applications and assets alike. DAOs are used in many ways, from agreeing on which assets can serve as collateral for credit (see MakerDAO, the most famous active example of a DAO) to more “traditional” use cases like coordinating and allocating capital, whether it be for public goods (see Gitcoin) or for-profit investments (see the LAO). In all of these cases, the benefits of the DAO are that they make it incredibly easy to form a capital base; allocate governance rights via tokens; distribute tokens to individuals or businesses outside of the DAO’s original creators — including retroactively to users who have interacted with the DAO / protocol (e.g. the UNI token drop), diversifying the set of stakeholders and aligning interests by making users owners; and then conducting governance via token-based voting. The reduction in overhead and the ability to do this on a global scale is remarkable. For some inspiration, see Jarrod Dicker’s piece on what a DAOified Substack would look like. And this isn’t fantasy! Mirror is a decentralized Substack-like platform that is enabling writers to reach their audiences while also giving them control over the platform itself. Another example is PieDAO, which is a DAO that serves as a decentralized asset manager for tokenized portfolios; in other words, the DAO governs over and administers a set of token portfolios.

Now, I recognize that these DAOs are fairly primitive, and most are missing a key piece of infrastructure: legal recognition. But that is changing fast! The LAO has paved the way by being the first DAO that is organized as a legal entity (a Delaware limited liability company); it is a “member-directed venture capital fund organized in the United States, with an aim to be compliant with U.S. law” and whose members must be accredited investors. Moreover, this is just a first step towards fully compliant decentralized entities; in April of this year, Wyoming passed a bill allowing the state to recognize DAOs as limited liability companies.³ Regulation is coming, yes, but that is good news for legitimizing legal structures that improve over the status quo.

Collateralized Lending (Consumer)

Moving onto more complex and useful applications, we arrive at collateralized lending. I know that you’re already quite versed in what’s out there, including the staples — MakerDAO, Compound, and Aave. Your criticism is that these products typically require over-collateralization in the form of crypto collateral, which limits the addressable market of users and uses. I won’t deny that; however, allow me to respond in two steps:

First, for the growing population of crypto asset holders, taking out a dollar-denominated loan (in Dai or USDC, for example) against one’s assets (even though they may be overcollateralized) is a completely valid use case. Let me provide a personal example. I recently had to finance my MBA program. Because I’m based in the US but my school is not, I had few options in terms of TradFi student loan facilities: a roughly 8% APR loan from a school-sponsored financial institution, and a roughly 12% APR loan from Sallie Mae. This dearth of options led me to actively consider alternatives on the DeFi money markets; in particular, I was looking at roughly 5.3% APR variable rates on Compound and Aave or a roughly 10% stable APR rate on Aave. Now I’ll be honest, I didn’t want to deal with variable rates and I was really just looking for the lowest interest rate. In the end, I managed to obtain a scholarship and finance the rest of the tuition myself, but the point is that I was actively considering DeFi alongside legacy financial options, and it was a narrow decision. Student loans are just one example, but I know other folks in the community who have used their crypto collateral to finance other real world purchases, like the deposit on a mortgage. I recognize the user base for this kind of use case is still restricted, but the point is a) it’s possible and valid, and b) the general idea here is that crypto will make personal loans against assets of all kinds incredibly easy; this is non-trivial. Moreover, DeFi enables novel mechanisms to optimize debt repayment; see for example Alchemix, which allows you to take out a Dai-denominated loan that pays itself back through the yield your collateral generates in DeFi protocols. Similarly, refinancing can be a breeze with one-click loan providers like Instadapp — see here.

Second, we shouldn’t expect overcollateralization to be the norm forever.⁴ Stablecoin collateral aside, we are now seeing the next logical step in terms of collateral base with the introduction of Real World Assets (RWAs) on MakerDAO. There are two categories I want to cover: real estate and invoice financing. The former is only starting to become viable; here is an example of a collateral application on MakerDAO for a plot of agricultural land. It shouldn’t be too long until we see mortgages on DeFi. The latter is our final use case in this section.

Invoice Financing

Figure 1 — Centrifuge Originations from Dune

The most exciting real world use case in DeFi in my opinion is what companies like Centrifuge, Paperchain, and MakerDAO are enabling with invoice (and revenue) financing. Centrifuge provides the legal and smart contract infrastructure to turn RWAs of all kinds into crypto-compatible assets, unlocking the liquidity of those assets. In practice, individuals and businesses can use Centrifuge’s Tinlake marketplace to tokenize their assets, which can then be collateralized into a MakerDAO pool, against which Dai can be issued.⁵ In Figure 1 above, you can get a sense of the current scale and types of origination: Consol Freight for freight forwarding invoices, Bling for micro payment advances, Paperchain for music streaming invoices, New Silver for real estate bridge loans, Harbor Trade for trade receivables, FortunaFi for revenue-based financing.

Paperchain is worth double clicking on. In brief, Paperchain allows music artists to access their future streaming revenues right away, using real-time data from streaming platforms (see Figure 2). Paperchain then plugs into Centrifuge to tokenize those streaming invoices, which are then used as collateral in MakerDAO to issue Dai, which itself is distributed to musicians as payment advances based on the underlying collateral. In this scenario, MakerDAO is effectively the lender providing credit to artists based on real-time stream data.⁶

Figure 2 — Paperchain

I like this example because a) it solves a real problem and actually works, and b) it’s a great illustration of how different communities in the DeFi space (broadly speaking) can each focus on the narrow problems that they want to solve but come together and construct entirely new use cases or systems using the building blocks they’ve developed. Again, this is just the beginning, and we should expect to see many more examples like this one in the near future. Speaking of which — time to move onto what’s coming next.

Coming Soon to DeFi

So we’ve covered savings, various forms of lending, and governance, but of course these examples are still rather restricted, with the biggest gaps around capital formation and commercial lending. As a business, when I want to finance my business operations, I have three basic choices: dip into retained earnings, finance via debt, or finance via equity (and of course you have various permutations on these options). I posit to you that in the not so distant future, you will be able to use DeFi to accomplish those latter two options.

Now, on top of these basic financial functions that power growth in the real economy, you have an entire financial industry that has been built up to make markets efficient: enabling liquid markets, driving price discovery, providing insurance, allowing for risk management, facilitating the financialization of asset classes, etc. This field of crypto (the TradFi counterpart) is undergoing fast development precisely so that the financial infrastructure is ready to support the real world economy in the way that businesses expect it to — what I mean here is that businesses won’t just pivot to DeFi if the infrastructure lacks maturity — this is why you see so much of the development happening within the circular crypto economy. And this will continue to be a gradual process: applications pull infrastructure forward, which enables more use cases; the logical successors to those use cases (ie. more complex and advanced ones) again require more mature infrastructure, which pushes the development even further — and the cycle repeats.⁷ With what’s been developed already, and the amount of human capital pouring into the space at the moment (Druckenmiller and others have noticed!), it should not surprise us that the financial infrastructure in crypto will eventually be sound enough to pull in legacy institutions and businesses. With that said, let’s touch on a core use case at the intersection of business and finance: capital formation (both equity and debt financing).

Capital Formation & Markets

Capital formation was the earliest form of a “killer use case” on Ethereum since the proliferation of ICOs in 2017. After the ICO wave came Security Token Offerings (STOs), which allowed for the distribution of tokens that typically conferred the same rights as equity; a notable example was Blockstack’s offering in 2019, which was SEC-qualified under Regulation A+. Even in the private rounds, many crypto companies are opting to raise in USDC (including, at least in part, ConsenSys). Given these examples, you might ask why I didn’t include them in the section above. The truth is this phenomenon has been largely restricted to “native” crypto companies, with very little bleeding into the real world economy. Basically, the infrastructure and the ecosystem broadly is still too immature for a full-fledged migration onto DeFi rails. There are technical roots to this issue (particularly around settlement finality and UX), but in large part the problem is around regulatory hesitancy and the lack of bridges to the legacy systems that dominate the financial system. Hence, as mentioned above, the development of legal and technological infrastructure is chugging along to meet the requirements of the real world economy.

With that said, the foundations are there with Uniswap at the center of it all. As you know very well by now, Uniswap is a decentralized exchange (DEX) that uses an Automated Market Maker for its exchange engine, allowing liquidity providers to pool assets in the protocol, thereby creating markets for pairs of assets. The key here is that Uniswap provides most of the functionality of a secondary market while removing layers of intermediation that would typically be filled by exchanges, clearing houses, custodians, and other financial institutions. Why should the NASDAQ, NYSE, and clearing houses retain their dominance if any kind of asset can eventually be traded and settled atomically on a DEX like Uniswap, which suffers zero downtime?

But secondary markets are only half the equation, you say. Companies want to be able to conduct an IPO on an exchange and might need a banker to advise on price⁸ and sell blocks of equity to their clients — that is the core function of equity financing after all. I agree with you, we are not quite there yet. But as I’ve mentioned, solving the legal and compliance gaps are a top priority in the space, and DEXes built on crypto rails already provide global access to investor capital, retail and institutional alike.⁹ We are not far from a world where companies can conduct an IPO by offering their equity as digital assets directly on an exchange like Uniswap, without needing to pay NYSE, clearing house, or investment bankers’ fees. And not only that, but these digital assets will be programmable and natively connected to the existing DeFi infrastructure, meaning, for example, that company equity could immediately and frictionlessly be used as collateral for debt on a platform like MakerDAO. The example above has focused on equity financing, but we could easily extend it to cover corporate debt issuances and commercial paper broadly. In fact, corporate and municipal debt offerings have already been a core focus for companies like ConsenSys (with Codefi Assets) and Securitize.

Ok, this has become much longer than I originally anticipated. I’ve officially spent a whole day on writing this¹⁰ — so, if you were just trolling the whole time, then you win.

There’s just one last bit to address. I’m sure a big part of you remains skeptical and thinks that much of this is just regulatory arbitrage, and eventually regulation will step in and there won’t be all that much left in terms of novelty or benefits. First of all, innovation precedes regulation, and the regulations that fill the new void are not necessarily about preventing or reversing that innovation — it’s not at all clear that regulation would wipe out the activity that’s been created in crypto. Regulators will adapt, and they are being helped by organizations like Coin Center, Coinbase, ConsenSys, and the like. Second, different jurisdictions will rule differently, which should still permit much of crypto to live on even if some regimes enact draconian measures. Finally, regulatory arbitrage is only part of the value add. The core benefits remain: disintermediation (which should still exist in more regulated environments), composability, and transparency.

Maya Zehavi’s tweet above is the key question for me at this stage. I’m optimistic.

Sincerely,

Tom

Endnotes

[1] Quartz, “A complete guide to the evolution of the internet” and National Telecommunications and Information Association, “Exploring the Digital Nation

[2] A full exploration of risk in the space is out of scope for this one, but see Raoul Pal’s tweet here. I know you two aren’t besties, but the point is relevant.

[3] See Regulation Tomorrow, “Wyoming to Recognize DAOs as LLCs

[4] Note that it is possible to obtain under-collateralized loans in crypto today via leverage; you can, for example, lock up ETH in MakerDAO, take out Dai, buy more ETH with that Dai, lock it up, and repeat — you’ll end up with about three times as much ETH as you started with if you stick to the minimum collateralization ratio of 150%. That of course comes with its own risks and tradeoffs, but technically it’s feasible.

[5] For more details on the mechanics of this process, see Tinlake’s documentation here and an example of a MakerDAO collateral onboarding proposal here.

[6] For a more detailed look at this system, see the proposal on MakerDao.

[7] This is well documented by Dani Grant and Nick Grossman of USV in “The Myth of the Infrastructure Phase” on the waves of applications and infrastructure.

[8] This works out so well!

[9] With the coming of MetaMask Institutional and already established custodial wallets (see Coinbase Institutional and Gemini Custody), there is only regulatory uncertainty preventing institutions to use these rails.

[10] Ok just kidding, I spent three days on this.

Office of the CEO, ConsenSys 👹