Liquidity Pools in Crypto

Today, we're talking about yields in crypto. They are really high, but where do they come from and what are pools? Episode details here. 

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Mark Lurie:
Welcome to WTF Crypto, where we dive in to the crypto ecosystem to understand what's really going on and how it affects your everyday crypto investing strategy and portfolio. I'm your host, Mark Lurie. Today, we're talking about yields in cryptocurrency. They're really high, much higher than you see in a normal bank account, but where do they come from, and what are the pools that provide them?

Mark Lurie:
We're joined today by Noah Jessop. He's the managing partner of Proof Group, a DeFi and crypto-focused investment partnership based in San Francisco. He's also a serial entrepreneur who's built several companies and understands the ins and outs of building, as well as investing. We've invited him because he lives and breathes DeFi and crypto. Besides investing in it professionally, he's been involved in a number of early DeFi projects from UMA to Ampleforth, and he understands math with a degree in Math from MIT. Noah, thanks for joining us today. 

Noah Jessop:
Mark, it's great to be here with you. 

Mark Lurie:
Let's start by understanding what kind of yields exist in crypto. Can you just give us a little bit of a picture for the investment opportunities and what they yield? 

Noah Jessop:
You bet. I'd sort of break it into almost two different buckets as just the starter base rates. In bucket one would be over-collateralized lending pools, which we can get into, and these are very much the safe base rate. Worth noting, we're basically in 1750 London when goldsmiths are trying to build the first whole layer of banking. We're not yet at FDIC insurance. So, this is all super early. It's basically financial history in a Petri dish, and it's all getting made up as we go, but for over-collateralized lending, it's the simple base layer. You can think of that as a base rate.

Noah Jessop:
You put up dollar-denominated tokens, somebody is going to borrow those for finding surplus collateral, and they're going to pay you a rate for that. That's category of return one. Then category of return two would be you are acting as a liquidity provider in an automated market maker and, basically, people are trading from apples to oranges and you are providing both apples and oranges. So, the trading fees that you accumulate, as well as perhaps some other upside provided by the venue represents the return profile. Then since you're probably going to want me to put numbers on it-

Mark Lurie:
That's right. I'd love to understand what kind of yields you can actually get, especially with layer one as we'll call it? Because that's presumably the entry level layer. 

Noah Jessop:
Yeah. I just think from a security apparatus, each layer that you go, you're adding another layer of technical or smart contract risk. So, I think it's all about boiling it down to, what is the simplest layer that you're underwriting and using that to figure out what the base rates are for these different kinds of risk. 

Mark Lurie:
I see. So, it's a little way simple, less likely to be hacked. 

Noah Jessop:
Exactly. Exactly. The fewest moving pieces possible in order to complete the economic activity that actually drives the return. 

Mark Lurie:
I see. So layer one, super simple, you just lend and borrow, and when the people borrow, they're posting collateral so that you know-

Noah Jessop:
Yes. So the simplest example of this would be you have a lot of Ethereum, you put up a million dollars worth of Ethereum, and the price Ethereum has some volatility, so you're allowed to borrow either 70 or 80 cents or 70% or 80% loan to value against your million dollars of Ethereum. So, you borrow a depositor's USDC or USDT, or other stable unit of account. Should Ethereum drop in price, and let's say you go from 70% loan to value, to creeping up above 70%, because the value of your collateral has fallen, rather than in a traditional equities market, instead of getting a call saying, "Hello, this is a margin call. You need to either post additional collateral or pay down your borrowing position," instead these layer one systems allow anyone on the blockchain to show up and repay your USDC or USDT debt and take your surplus Ethereum collateral pushing you back below your 70 cents loan to value.

Noah Jessop:
This is a hyper-competitive market. Multiple people will attempt to do this whenever there's an opportunity within 15 seconds. So, you can think of it as it's very tightly monitored and there's a lot of infrastructure in place to actually enforce that loans remain of the correct size. 

Mark Lurie:
I see. Okay. If I'm just getting into the space, I go to one of these products, and what are these projects or products where you can do these activities? 

Noah Jessop:
Yeah. For lending, I look at the three main marketplaces as Aave, Compound, and C.R.E.A.M. Those are what I would call the early winners in this base rate over-collateralized function. 

Mark Lurie:
Makes sense. Just for context, how much yield could I expect for lending a US dollar back saving coin like USDC.

Noah Jessop:
It varies widely, and unlike traditional financial markets where you have an overnight rate, these are actually pool driven, supply and demand driven, so it varies wildly. But we actually track that very closely at Proof Group, and so as of right now, Monday, September 27th, it looks like a blended rate is yielding 6.48% for dollar denominated across those three markets,

Mark Lurie:
6.48%. That is really high.

Noah Jessop:
That's correct.

Mark Lurie:
I mean, I think my checking account yields, it has a lot of zeros in front of, even after the decimal.

Noah Jessop:
Well, yesterday was 3.51%. Again, this fluctuates all the time, but you can kind of think of a blended rate, anywhere 3% to 10% during these times where there's a lot of market activity. And this is for simple layer one, these major lending markets, dollar denominated assets.

Mark Lurie:
Well, that seems attractive. You've got me hooked. You'll probably have my brother hooked. I'd love to dig in more and let's really understand where these are coming from, because it sounds a little bit too good to be true, right? I mean, those are high yields. I get they move around, but where do they actually come from? Where's this money coming from at the end of the day? Who's paying them?

Noah Jessop:
There's a few different risks that anyone who's generating this yield is implicitly taking, and we can kind of go through them one by one. Then how these actual yields are being calculated and what's happening on the backend. What's the real economic activity that's driving those yields? We can get to that. I would sort of break down the risk as saying, number one, you have to believe smart contract blockchains work, and that consensus works, and that they're going to be a going concern, I think a lot of people in the community are able to do that. That's one.

Noah Jessop:
Number two, if you think about these dollar denominated assets, whether it's a USDC issued by Circle or USDT or DAI, you have to believe that it's going to trade near par, whatever your expectation of value is. That's sort of fundamental belief number two. Then number three is you're depositing it into these pools, which we can get into what that means, how work, but you're basically saying, I am willing to underwrite that this ecosystem is built correctly, that the collateral that other people are posting to borrow my dollars is sound enough.

Noah Jessop:
So, said another way, if you don't believe Ethereum has any durable value long-term, this probably isn't for you. To believe in the collateral on the other side and the mechanism to actually enforce liquidations. Second-

Mark Lurie:
Okay. First, I have to believe that the software works, right? The blockchain.

Noah Jessop:
The blockchain.

Mark Lurie:
The blockchain. I have to believe the blockchain works. Seems like that's been working pretty well for a little while. A lot of money transacts on that, feels okay. Then I have to believe that if I use a US dollar back coin, that it's actually US dollar backed.

Noah Jessop:
Or a stable unit of account. Whatever it is, you put in some unit of account and you believe that if you have to exit that, that you're going to get it back to whatever you started in.

Mark Lurie:
Okay. Got it. Then I'd have to believe that the functioning of this market, whenever it is, works so that my collateral is properly kept and it's liquidated if it needs to, and that interest is gathered however it's gathered.

Noah Jessop:
Exactly. As an example, so just for the numbers across Aave and Compound today, there's probably an order of 25 billion locked into each of these protocols. They've now gotten some battle testing. Then the key thing for, at least these protocols is, all of the different pools overlap, which is to say, you have to believe in the collateral, that you have to believe in every collateral that these ecosystems allow.

Mark Lurie:
But so 25 billion is locked in these. I mean, that's pretty good. It's something-

Noah Jessop:
I think it's sufficient to say that it's been a large surface area that has probably attracted many smart security researchers to spend some time. That's not to say that it's certain, but it's at least ... It has more track record than it did, and so far, these systems perform pretty well during a couple different days that things gap down upwards of 30% to 40% in the underlying collateral.

Mark Lurie:
Okay. Wow. I mean, this is a lot of money, and this is in the first layer you were describing. How much money is there if you add up all the layers?

Noah Jessop:
It's hard to say. I would say, if you look at some of the meta aggregators that try and track like total dollars in DeFi, we've probably gone from call it 10 to 20 billion total at the beginning of this year, 2021, to closer to 175 or 200 billion or so. I'm not sure that, that fully ... There's a bunch of different way that people count value locked in the protocol, but I would just say simply the number is growing at a pretty astonishing rate despite already getting large in notional terms.

Mark Lurie:
Wow. So, that's total value locked in the decentralized finance or DeFi ecosystem?

Noah Jessop:
Exactly.

Mark Lurie:
Wow. These sound like pretty big numbers. Where are we in the maturity cycle? I mean, to what degree does this matter in the broader world? It seems like people are starting to wake up and pay attention.

Noah Jessop:
I would say, if you go speak to folks at central banks throughout the world and lead with these sorts of numbers, they would say that's small experimental ... There's lots of pockets of financial activity that are orders and orders of magnitude larger than this. But I think the phase we're at, I likened it to the day of like, in mobile terms, the iPhone 3G hasn't come yet, but we're not on feature flip phones anymore.

Mark Lurie:
How will you know when it reaches the mainstream? What would tell you that it's reached the mainstream?

Noah Jessop:
I think most people worry a lot about when the mainstream embraces crypto, and I think of it very much the other way around, which is, when does this bottoms up new way of wiring up the world for ... Finance makes us all wealthier by distributing risk and providing marketplaces for risk. I just sort of think of it as, when this becomes the default way to access lots of different kinds of risk, then this is the mainstream. It's not that the mainstream will adopt this.

Mark Lurie:
I see.

Noah Jessop:
An example of like a base rate, the risk is you have value, you want to persist your value. You're willing to take some risk on your value to someone who has a more productive use for that value. Capital wants to seek productivity. So, if we just say, in the existing TradFI, traditional finance ecosystem, the miracle of modern finance is that the tractor can sit in the field doing productive work, and the tractor's also a capital asset that can be borrowed against, or otherwise that value can also be used in other places, because we have laws and ways to reposes that tractor if we had to. Those are the base layer below the blockchain layer.

Noah Jessop:
Now we sort of have new rules for people who don't know each other, trust each other, or operate in the same court systems to have this neutral commons to do a lot of that same risk transfer.

Mark Lurie:
People can agree to transfer risk in ways that does not require a court essential to decide.

Noah Jessop:
Exactly, or the trust in some system for resolution if things were to go awry. In other words, there's plenty of ways that people can register to be a lender, and you could face a lender privately, and everyone relies, if somebody doesn't uphold their to the bargain, then, at least in the United States America, we have systems in order to be able to enforce whatever contracts were legal and suitable.

Mark Lurie:
I see. Traditional finance, you rely on courts to interpret and enforce contracts. On the blockchain, you've had similar contracts in the case of decentralized finance for financial instruments like loans, and those are enforced on the blockchain by code that executes and can't be stopped, and thus the delivers the outcome that is intended from the beginning.

Noah Jessop:
Exactly. I sort of say it is like in a little piece of software, you get the court system, you get a custodian and you get bank accounts all built into one. Then, instead of having attorneys make sure that a document is written in a way that works well in the State of Delaware, instead you have security engineers and smart contract auditors say, "We've looked at the edge cases of this piece of software and both parties agree that it should perform the way that is intended."

Mark Lurie:
Okay. That sounds like a lot of cost savings, A lot of efficiencies can work across borders. Is that why yields are so high? Is it that capital can be accessed by more people, can be used more efficiently, and that creates higher productivity in capital and that's why yields are higher?

Noah Jessop:
Well, I think, short answer, yes. Then second answer, it's also allowing people who are able to take those sort of three risks that I described, or we can get into the automated market maker example as well. But it allows people who are willing to take these risks to access more productive uses of capital than perhaps if you just face a bank, which again has insurance in all FDIC insurance, and all of these other systems designed to remove risk. But in some sense, risk is what you want to generate yield, and this is just a different kind of risk that people are able to potentially underwrite for themselves.

Mark Lurie:
Okay, got it. Let's dig into demand side. Who's borrowing this money? And then maybe we can get into the different ways and instruments and pools that are actually generating this yield.

Noah Jessop:
Perfect. I think the simplest version would be there is plenty of wealth that has been created in digital assets, and so you might have a holder of that asset, whether they hold Bitcoin or Ethereum or similar say, "I want to access this capital that I have. I believe that the capital that ... This digital money is going to appreciate, and so I'm willing to pay someone else to borrow their capital against this capital that I believe will appreciate in order buy things in the real world, in order to take on additional leverage positions."

Noah Jessop:
The simplest version is you could imagine someone putting up an excessive amount of Bitcoin or Ethereum, borrowing at this 3% to 12% rate, but maybe they're investing in an early stage company. They can happily sell the Bitcoin or Ethereum that's appreciated to cover that loss, but they believe that angel investing in a private company has a real return profile that outperforms a "high rate of interest," and they're willing to tolerate that.

Mark Lurie:
Do you think that's what most people borrowing on these marketplaces are actually doing though?

Noah Jessop:
I think that leverage probably plays a large role, and then I would defer all of this to people's tax and other legal advice, but also if you had to make CapEx is in the real world, rather than having a sale in either short-term or long-term gain event. I think, for some people, it's allowing them to access wealth that they still believe is at work rather than completing that sort of investment and taking it out to other things.

Mark Lurie:
Those sound like very good uses for capital, that sound very traditional and are done in the real economy every day. My impression was that a lot of capital is being borrowed in this first layer of DeFi protocols, these lending and borrowing platforms, is you used to chase higher yields, either to make bets on crypto increasing a lot, levering up their bets, or to farm yield for higher return, but also higher risk on more complicated layers.

Noah Jessop:
Absolutely. All these things are interchangeable. A very reasonable thing to do would be to say, hey, I have asset X, asset X is great collateral. It doesn't generate a lot of yield. I will deposit it into one of these protocols, borrow a different asset that has a known quantity, or that I don't believe will 10X against me. Frankly, that's calculus. Then I'm going to use that value, either in that exact form or trade it into something else to underwrite an additional layer of risk that I have a point of view or I've written models that allow me, or moving to our automated market making, where I'm actually deploying capital that is highly effective, and thus generates a higher rate of return than whatever this base borrow layer is.

Mark Lurie:
I see. Okay. Let me repeat that back to you just to make sure I understand. One way is you have Ethereum, you think Ethereum is going to go off and value. You take your Ethereum, you put it as collateral and you borrow US dollar against it, and then you take that US dollar and you buy more Ethereum, so you hold more Ethereum, and then Ethereum-

Noah Jessop:
Goes up.

Mark Lurie:
You do-

Noah Jessop:
Yeah, that would be a basic leverage scenario.

Mark Lurie:
Okay, good.

Noah Jessop:
But another variant would say, I am able to provide liquidity to a different financial marketplace that is bootstrapping a new kind of risk, and the way I think about this, I was at a firm called Founder Collective, which was an early investor in Uber. Uber would sell equity in the company for cash and then use the cash for rider and driver incentives to try and spin a marketplace flywheel. The same way, all of these new marketplaces for risk are subsidizing the early marketplace participants, typically by liquidity mining or other sort of rewards in their governance token or similar.

Noah Jessop:
I think that savvy people who understand this space and are able to underwrite risk can easily take capital from a base rate and then underwrite a risk in a new marketplace and capture the spread.

Mark Lurie:
I see. That sounds like the very productive use of capital. Can you give me an example of a trade and the protocols involved?

Noah Jessop:
A simple version. An automated market maker, for those who haven't come across them yet, is basically one of these smart contracts. And you say, I'm going to put in equal measures of apples and oranges. I don't know the price of apples to oranges. If I have 10 apples and 10 oranges, I'm going to assume that they're the same price. Then anyone may show up and buy one apple in exchange for one orange. Then suddenly, if I get out of whack, I say, "Well, the next orange or apple goes for 1.1 oranges or apples." We don't know the price in the outside world. We simply know supply and demand, and we're going to use, what's called a constant product, to just make sure that we always get back to equilibria wherever we started.

Noah Jessop:
In these automated market makers, of which shipyard I think are some of the thought leaders in this space, you provide one or more assets. And when people trade back and forth between those assets, the people who provided the liquidity, the liquidity providers in the "pool," so the 10 oranges and the 10 apples, are receiving trading fees, basically the cost of people switching between the two, payable in oranges and apples. After a year, you would hope that you get some value for locking up your oranges and apples as inventory, and that generates yield.

Noah Jessop:
On traditional exchanges people, market makers are paid for buying and selling inventory, but now sort of anyone can do it because they simply provide the apples and oranges to the software, and the software does the market making.

Mark Lurie:
I see, got it. So, it could be apple and oranges. It could be US dollar and yen. It could be E and USDC. Essentially what you're saying is you might borrow these on the lending markets, and then you put USDC and Ethereum in an automated market maker, which is an exchange, right? A decentralized exchange, and people can trade those assets. They pay a fee, you earn that fee.

Noah Jessop:
Exactly. I might have the case where I have a lot of Ethereum, I don't a lot of digital dollars. I would borrow dollars against some of my Ethereum, provide Ethereum and dollar pairs, and then I haven't sold out of my Ethereum position, but I've been able to pay someone an attractive rate for their dollars and underwrite the risk using my Ethereum as collateral of whatever this future exchange is.

Mark Lurie:
I see. Okay. This sounds like a real business. This is one example, but there's got to be a whole lot of examples of various pools and approaches to providing financial services and yields, and that's actually what's creating the demand for capital that's generating high yields for the everyday user.

Noah Jessop:
Yeah. There's just a ton of experiment happening. Is some of it speculative, frothy and crazy? Of course. But I think a lot of it is just trying to figure out, what are the right risks that there should be a marketplace for, how to price those marketplaces, and then frankly, getting a sufficient depth of market for that marketplace to have a price that's reflective of the rest of the world.

Mark Lurie:
Earlier, you talked through a few of the layers. Could we delve a little bit more into that and just tell us a little bit about what types of pools exist and how you categorize them in your own mind?

Noah Jessop:
For listeners who have spent any time in traditional finance, you can think of a pool as a ... Let's go back to this apples and oranges pool. I think that's the simplest one. You can think of it as a mutual fund that has two different names in it. Unlike a mutual fund where you may be able to add to it at the end of each month, or end of each trading day where they strike a nav or they strike the value of apples are worth $200, oranges are worth $300, therefore, $500. If you contribute $50, you now own, whatever, 9%, 11% of the pool.

Noah Jessop:
Instead, at every block, at every block in the Ethereum, blockchain or similar, the nav is always known. At any moment, you can show up and say, okay, there's 10 apples and 10 oranges. I'd like to contribute one orange and one apple, and then I'll own an accordingly that commensurate pro rata share of the liquidity within this pool. So, you can think of it as the value is being remeasured in real time. Why does this matter? If we go look at the lending side where you have, let's think of a simple lending market that only has Ethereum and USDC.

Noah Jessop:
You have USDC deposited on one side of the pool, let's say we can borrow up to 90% of the USDC that's deposited, and then we have Ethereum on the other side, similar thing, you can borrow up to 90% of the Ethereum, or either side can use that as collateral to borrow the other side. The way it works is okay, there's a million dollars in dollars deposited. There's a million dollars of Ethereum deposited, let's say that's us. Then we borrow 500K of 50% of the dollars available for borrowing.

Noah Jessop:
The rate that we pay, so we pay X interest rate, and the rate that we pay X is the depositors earn X divided by two for each dollar that they have because our rate, we borrowed half the pool, we're paying a rate for that. Then the rate that we're paying is spread across the rest of the pool. Then the way that these lending markets work to ease supply and demand, remember I said only 90% can be borrowed. If somebody else shows up, deposits a different collateral and borrows the remaining 40%, the protocol will automatically, dramatically increase the borrow rate of USDC in order to encourage us to either come back and close our position or someone else to provide new USDC to let the protocol grow.

Noah Jessop:
These rates are being cut basically every time that people are adding or removing funds from either side of these pools. Linear nav, all the time, being recut.

Mark Lurie:
I see, I mean, in a lot of ways, it's analogous to interest being a cost of capital.

Noah Jessop:
Exactly. But instead of daily, we're now saying that your rate changes block by block, basically every time a transaction goes in or out of either side of the pool, then you're sort of looking at the supply and demand balance that the protocol designers built and automatically yields are changing.

Mark Lurie:
Wow. It all nets out and it's all kind of mathematically elegant. 

Noah Jessop:
Yeah. It's harder for, I think people coming from a traditional perspective to kind of wrap their arms around it, because you say, what's the rate? Well, we don't know and it fluctuates moment by moment, is sort of a crazy answer in finance. But I sort of think of it as, anyone in the world can show up and access the "street rate," instead of only a handful of institutions that have all signed up to face each other, being allowed to access that rate, and that's really empowering.

Mark Lurie:
I mean, in a lot of ways, it may be complex and a little uncertain, but it's just the reality of the world that now everyone can see, and perhaps isn't as simple as it may be in the traditional world, but that's only because now they have the option to go under the hood.

Noah Jessop:
Yeah, exactly. Or I think of it as like, not all use cases need a blockchain, but a blockchain sort of like adding an extra layer of computerization to things. Just as like a computerized feed is higher fidelity than a paper ticker, we're now able to have higher fidelity pricing for all of these different things, and that's unlocking a lot of new innovation.

Mark Lurie:
Interesting. Okay. Now that we've gone into dynamic fees, could you give us a quick rundown, just so we're even aware of like the crazy up that's out there, the various pools, levels of complexity products, how do you even organize this in your mind?

Noah Jessop:
Off the cuff here, we've sort of talked about the base over collateralized borrowing rate, that's one. Then we have apples and oranges, AMM trading between well-known assets. Then you really go out, the risk curve pretty quickly from there. Other examples of pools, at least that I've been involved in include options underwriting protocols that take a core asset and then write a black show style option on top of that, or there's a number of different ways that folks are thinking about how to offer that kind of risk.

Noah Jessop:
There's marketplaces for leverage using kind of synthetic pricing engines. Again, you put up some collateral, people are able to trade more size against pricing engine. There's a whole host of sort of incentivized pools or basically people are bootstrapping liquidity in a new asset by highly compensating people who are willing to own that asset as well as another pair. Then, not the final frontier, but a really interesting, strange, wonderful place is sort of protocol owned liquidity, where people are finding new ways to direct liquidity to interesting projects, either through Dows or through other protocols that take capital and point it to productive places collectively.

Mark Lurie:
What is protocol owned liquidity?

Noah Jessop:
You can really think of it as capital that has been staked into a meta protocol that then, using whatever logic, cadence, rhythm, voting, and redirects it to more value both places. Just as you might have a traditional ETF style product that owns a bunch of things, you can think of this as the modern version of we have many of these different marketplaces, and how do we have some centralization factor, albeit in a decentralized way, that allows somebody to access different pockets of risk from one place?

Mark Lurie:
Okay. I think I understand. This stuff is complicated, I have to say.

Noah Jessop:
It's crazy. It's crazy and wonderful.

Mark Lurie:
And I'm in the space. It's a tough thing to dig into. A lot of times we see these headlines where, on the one hand, there's what seem like very attractive rates, like we talked about earlier, much higher than you get in a bank account. As we start digging into this, it seems like there's some business that make sense that are generating those yields for good reasons.

Noah Jessop:
Yeah, and I think that the other thing that just is sometimes a red herring or adds confusion to this, is there's a lot of firms that are offering what they advertise as crypto lending rates. When actually you're putting up an asset and it's a centralized loan book under the hood. Really, they're lending to a trading desk, or maybe somebody who's quite financially capable, but maybe somebody who's not, and you, the lender, don't know that. Whereas these rates, that I'm talking about with the high fluctuation, you are facing a protocol. All the research is there for the willing to do themselves.

Mark Lurie:
I see. Things may go wrong, but at least there won't be funny business.

Noah Jessop:
Yeah. Or cases where you are getting paid for less risk than you are taking and you can't see the risk that you are taking because it's happening on somebody else's loan book.

Mark Lurie:
I see. What about these really, really high yields we see sometime? I mean, I think I saw a headline the other day with 7000% APY. When I see those, they make me question how real this stuff is, and we've talked to about some elements of it that are very real. I'm convinced that you're preaching to the choir, but still, it's very convincing. What's going on with these absurdly high yields? 

Noah Jessop:
Well, I think that if Uber hadn't sold equity to investors and had instead paid ownership in Uber to drivers or riders, you might have the case that being, providing driving liquidity to the Uber marketplace with Uber's current valuation of ownership in the Uber network, would offer some astounding APY. It's just now that all these markets are liquid, people are able to price it that way.

Mark Lurie:
I mean, that's a good point. What was the APY on a dollar invested in Uber stock option given to employees [crosstalk 00:36:00].

Noah Jessop:
Way more than 7000%.

Mark Lurie:
Yeah. I mean, that's a great point. There's a story of a artist who went to Facebook and painted a mural on the wall of their first office and got paid in Facebook stock, and now is worth hundreds of millions of dollars. I guess that's a very high API.

Noah Jessop:
Yeah. I don't anchor too much on it. I just think of it as, it's a new metric. Of course, whenever there's a quantitative metric, people will play games around it, and so you'll get good games and you'll get strange games. We're in a kind of space where everything's growing and changing really quickly, but there's good and there's crazy, there's wonky.

Mark Lurie:
Huh. Okay. Super interesting. I mean, this clearly seems like an area of huge opportunity and there's clearly sophisticated financial players coming in, yourself included. It seems to me that a lot of people are expecting institutions to in and bring this market to the next level. To your point earlier, it's actually still quite small in the context of international financial markets. What has to happen for that to happen? When will institutional investors come in and take advantage on these opportunities that we've outlined?

Noah Jessop:
I might take a slightly different spin on that, and I'll sort of one, highlight what I think a lot of at scale institutions have to underwrite to get involved here. Then two, I would say, I actually think a lot of the early market participants become the institutions. The key risk that I think most large institutions council has to flag when somebody says, "Let's go connect into DeFi," is the regulatory third rail is all around OFAC and FinCEN financial controls. If you are a financial provider and you allow sanctioned countries or sanctioned peoples, or bad stuff on your network, that's the third rail, people just are not willing to underwrite that risk.

Mark Lurie:
If you lend to Iran ...

Noah Jessop:
That's a no go.

Mark Lurie:
That idea for BlackRock.

Noah Jessop:
Now, yeah, exactly. Now, here's the question. I don't have the numbers in front of me, but let's say tens of thousands or potentially hundreds of thousands of borrowers across Aave and Compound and C.R.E.A.M marketplaces, do any of those count as Iranian finance?

Mark Lurie:
I mean, I guess there's no way to know.

Noah Jessop:
There's no way to know. Okay. If I'm depositing $10 of USDC into this pool, and somebody's borrowing $1 of USDC in Iran, here's the question, is it my capital that they're borrowing and what is my surface area for, at least being the perception of following these kinds of sanctions rules, which again are the sharp end to the stick. I think the answer is we don't know. It's all pooled and balanced. It's pretty hard to say, and companies that feel comfortable working in DeFi are willing to say, we literally don't know it's unstoppable. We can't keep people out of these pools, and that's okay. We're willing to underwrite that risk because that's core to our business.

Noah Jessop:
Whereas a BlackRock, to your point, they're going to have to do some more work to get comfortable before they too are willing to do that.

Mark Lurie:
My personal view is there's an element of, they have more work to do to get comfortable with that. There's an element of, well, that they're just not going to get to an answer, and they're going to look to the regulators before they're willing to make the call themselves. And the regulators are not going to give them the answer either because the regulators have a bias too, of winning transactions with the Iran and other sanctions entities. So, these institutions may just never get over that hump.

Noah Jessop:
I don't know about that. I would say a lot of the regulators that I know are very thoughtful and forward minded and have a lot of great things to say about DeFi. The question just becomes, it's a huge surface area and how do we provide clarity to the right things in the right order? That's a harder piece. Then back to institutions underwriting this, there's a number of people who have started to think about or work on KYC roped off pools of liquidity, where you're really only facing known entities.

Mark Lurie:
Like a white list.

Noah Jessop:
Exactly. I think that there's something there. It's, I think nominally interesting, but it probably will diverge from the "real street rate" that the open protocol is. It helps people get onboarded, great. But I don't know if that's the finals state of the world.

Mark Lurie:
Does that mean you do think institutions like BlackRock will get over the hump and start putting their capital in space eventually?

Noah Jessop:
I can't speak to them specifically. I would say that the people who are able to face these protocols will become institutions if the institutions don't arrive.

Mark Lurie:
I see. It's not necessarily that the existing institutions will enter the space. It's that those new upstarts who-

Noah Jessop:
There will be institutions and we just don't know which ones they are yet.

Mark Lurie:
I see. And they may be native to the space and the capital just shifts over from one institution to the next institution instead of the institution itself switching over.

Noah Jessop:
Precisely.

Mark Lurie:
Okay. Makes sense. But at the end of the day, that's still institutional capital switching over and coming in. Would that be fair to say?

Noah Jessop:
Yeah. I really think that like in a world of zero, or soon to be negative rates, institutional capital is going to have to look for something. I just think it's a natural progression and it's, who's the makeup of people? Who are the upstarts that fit the bill and who are the institutions who are willing to really dig in and understand the stuff and take the right risks?

Mark Lurie:
Do you think if that capital came in today, there's a deep enough market to serve it?

Noah Jessop:
The institutional markets are tremendous. Short answer, yet ... There's enough space for the people who are willing to underwrite these risks, one. And two, these spaces are growing so rapidly and the digital ecosystem as a whole is growing so rapidly that frankly, Bitcoin will take care of any capital that institutions aren't willing to pony up in short to midterm.

Mark Lurie:
Interesting. Okay. How do you think about timing? I mean, I'm sold, you're sold, when does this ecosystem get to the next level and we see that in crypto markets?

Noah Jessop:
Well, I would really argue that, in some sense, it doesn't matter so long as the rate of great talent and great people building to make this stuff better continues or improves. I would just say, on anecdotal sample size of one human, there's just a shocking number of wonderful, talented people, both from traditional engineering and traditional finance backgrounds pouring into the space. Are these interfaces easy to use yet? Not quite. Are things clunky at times? Absolutely.

Noah Jessop:
Again, I'm not sure the iPhone 3G has come yet, but the rate of people who are here to wire up these new rails is ... That's really the thing that's pretty easy for me to underwrite. I don't even worry about when the "market," as near term voting long-term weighing machine really weighs in here.

Mark Lurie:
Fair enough, and sounds very wise. This sounds like a big shift. Sounds like something we may look back on in the future and realize was a historical macro trend. I wonder if there's other historical episodes you've seen that are similar, and if you take any lessons from them.

Noah Jessop:
I think I'd really have to call in some of my financial historian friends to do this justice. But I would say broadly, one, we're kind of in 1750 London. The Goldsmiths have a lot of gold. That is to say there's a lot of early digital assets. The landed gentry are saying that gold is no good because you can lose it and you can't have people work the land to generate crops. And we kind of had to go through some Scottish free banking and a whole bunch of different innovations.

Mark Lurie:
They used to say that about that?

Noah Jessop:
Absolutely.

Mark Lurie:
I didn't realize that.

Noah Jessop:
Absolutely. In finance, I think, every new real innovation is completely feared for some period of time. I'll give you an example that I came across just in the last few years is junk bonds or high yield debt from companies that are not in the Fortune 500, at various points in time, US senators tried very hard to make it that you had to be in the Fortune 500 or S&P 500 in order to take on debt or borrow capital, because there was so much of lending money to these small upstarts that one could take over the incumbents, but two, represented a dangerous way that that lenders could lose all of their capital.

Mark Lurie:
Sounds like a terrible idea, basically just means, once you're in the Fortune 500, you have a much lower cost of capital, you acquire all the small businesses, we end up with only 500 firms.

Noah Jessop:
Exactly. Just whenever finance, broadly set of distributing risk and creating a marketplace for risk unlocks due market participants, I think it's just very natural that there's a lot of fear and uncertainty and it just takes a while for people to one, get comfortable, and two, price this kind of risk.

Mark Lurie:
I read a book a while ago called Red Notice, and it's about the founder of Hermitage Capital. My recollection is that, when the Soviet Union fell and they privatized a lot of businesses, he went over and started buying and investing in a lot of formally nationalized businesses, a lot of these privatized businesses, and it was a little bit of a wild west and there were great returns and there were strange things happening. There were a lot of landmines and there was a lot of goal to discover.

Mark Lurie:
Russia ended up with Oligarchs, a lot of good, but also lot of problematic market structure and economic structure. On the other hand, there's lots of emerging markets that have attracted foreign investment capital and turned into thriving developed countries. Where do you think crypto is going to take us? Are we going to have oligarchs? Are we going to have liberal developed nations? I mean, what do you worry about and what are you most optimistic about as this shift happens?

Noah Jessop:
Yeah, let me start with the worry case. I think the worry would be, during the pandemic, I like to grouse that, in a time where all the roads were shut down, able-bodied smart people working in front of a computer screen should have been building new bridge spans and building new real infrastructure that makes us all wealthier, except that's totally, frankly, captured difficult to do and painful. Instead, we're making these new digital, what some would call fake money and internet money kind of stuff. At its worst, I would say the physical world is not kind to innovation.

Noah Jessop:
So, we're going to get a lot of innovation in these digital lands that aren't connected to real prosperity, real wealth increases, and it's kind of a shame. That's the negative case. Frankly, like you could say, NFTs are a sign that we're creating assets to soak up surplus inflation or any other sorts of cases. But I take much more the positive sign, which is, unlike emerging markets as a geopolitical space, where rather than underwriting a blockchain, you're underwriting, what is rule of law in that country? Or sort of say, proof of violence predated proof of work.

Noah Jessop:
Rather than underwriting that, you're saying, hey, this is all powered by math. Everyone in the world has an equal start. If you're a stakeholder, your claim, no matter who you are or where you sit is equal. With that as a starting place, I think that there's a lot of tools to builders and just some wonderful things that'll get built. The simplest version that's working right now, perhaps in a surprisingly good way is, the last stats I saw was El Salvador's official Bitcoin wallet app had 3.2 million active users. That's a country with 20% of their GDP is powered by remittances.

Mark Lurie:
That's amazing. I had no idea it was that successful already.

Noah Jessop:
Who knows? Again, the iPhone 3G isn't here yet. You can't build the Uber yet. The phones aren't good enough for it. So, we're still in very, very early moments, but I think these fair rails are going to be pretty kind to people who haven't been able to go sign, what's called an [inaudible 00:50:49] agreement and face a bunch of Wall Street banks to buy and sell whatever risk they want to buy and sell. And there will probably be some speculation that happens to ... The speculation is the bootstrapping that builds these risk markets that are open and fair and accessible.

Mark Lurie:
In the meantime, those who dig in and do their own research, and there's a lot of research to do, lot more to learn here than there may be in other types of markets, we'll see a lot of opportunity, and it sounds like a lot of these pools are where it's happening now.

Noah Jessop:
I just think of it as the building set has gotten sufficiently interesting enough that now the speed at which smart people can come and build new marketplaces that are interesting and compelling is really high, and people coming to the space, shouldn't expect to be able to understand all of it, see all of it, know all of it. None of us can. It's like saying, do you follow what's happening with computer? It's just too big of a space to follow everything.

Mark Lurie:
Well, to the extent we can follow it, it's by listening to thoughtful people like you, Noah. Thank you very much for joining us.

Noah Jessop:
Mark, such a pleasure. Thanks for having me on the show.

Mark Lurie:
For those who want to hear more from you, how do they follow you? Do you handle Twitter?

Noah Jessop:
Yes. My handle is @njess. That's N-J-E-S-S. I'm always there, and I also live on telegram as well, so find me anywhere and everywhere.

Mark Lurie:
Amazing. Noah, thank you for joining us for a very thoughtful conversation. Really appreciate it.

Noah Jessop:
Thanks again.