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

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

Nothing said on Empire is a recommendation to buy or sell any investments or products. This podcast is for informational purposes only, and the views expressed by anyone on the show are are solely their opinions, not financial advice or necessarily the views of Blockworks. Our hosts, guests, and the Blockworks team may hold positions in the companies, funds, or projects discussed.

These gentlemen need no introduction, but I'll do it anyways for folks that have been hiding behind a rock and not following the discussion on, on Twitter. Luca from mZero and Adrian from Stakehouse, guys, spend a minute just giving some context before we jump straight into it.

I'll start. Great spending time together, guys. I am one of the co-founders and CEO of a company called mZero. We are one of the, I would say, like most active, at least stablecoin infrastructure companies. So we build on-chain infrastructure for stablecoins that want to be issued and used on-chain with a big on-chain skew. I've been researching and writing about DeFi for a long time, way before my time at mZero on a sub-sac called Dirt Roads, where I nerd out every now and then. And since my Maker times, and actually me and Adrian, we go a long way in crypto years since the time at Maker when we were trying to connect the Maker's balance sheet with the real world of lending. So great chatting.

Yeah. And I'm Adrian. I'm a co-founder at Stakehouse. Like Luca mentioned, we started as contributors to MakerDAO as the strategic finance core unit, as the real world finance core unit, then the strategic finance core unit, then the real world Assets unit or finance unit. There were a number of initiatives that had to do with the real world and with finance in some regard. And since then, we spun out an advisory business that has contributed to protocols like Lido and ENS and Arbitrum. And lately, and at least since the launch of Morpho in January 2024, we've established ourselves as the leading Morpho so-called curator. Operating about $2 billion, slightly under $2 billion in non-custodial deposits on different vaults, mostly on Morpho, but including Kamino on Solana. And we also run one of the SKY ecosystem sub, sub balance sheets, otherwise known as stars, called Grove, with mandate to sort of build out credit infrastructure. For the purpose of, let's say, asset liability management on behalf of a stablecoin. And yeah, I know these both of you, so nice to see you again.

Great.

Thanks, guys. Look, we want to have this conversation. I think the backdrop for this discussion is, look, rates in DeFi are very low. Not all vaults are created equal. Vaults are all the rage. Morpho obviously plays a huge part of that. You guys, Adrian, been accord to that. A big value prop of DeFi is, look, let's bring more and more assets on-chain. But when you're getting paid close to or below the risk-free rate, meaning Treasuries, it really begs the question, like, what are we doing here? Because I think we can all agree that there is way more risk in DeFi, um, some that we may not even fully appreciate, uh, on the back of AI progressing quite a bit. I mean, I think we all saw the announcement of Anthropic and what, you know, their ability to find bugs in code bases of well and far more capitalized companies. And so there's still a lot of risk in DeFi, but nonetheless, I mean, I think we're all here because we believe in the promise of DeFi. There's some interesting properties that make it unique, and that's not to say that— but I think I want to unpack first, why are rates so low in DeFi? Let's just start there before we go into how do we fix it and what are some interesting strategies. But let's unpack like, why are rates 2 to 3 to 4% on DeFi?

I can maybe kick off and I'm beginning to hear Luca's input on this. I think DeFi has matured to a point where it's worth drilling down in exactly what we're referring to. I agree that generally kind of rates are low across the board, regardless of the risk of the collateral type or the type of instrument. But I think if you anchor on something like overcollateralized Bitcoin lending, let's say, or loans against— overcollateralized loans against ETH, that's where you see that rates are kind of at or near or slightly under SOFR, but basically trending around the traditional finance risk-free rate. And I think we would generally expect, one, expect this and to kind of see this as an example of DeFi's maturation. So we're not super stressed about it necessarily. And the reason for this, I think, is worth— so just to hog the mic for a second and give you the Vaults Steakhouse vision. Our view of Vaults is they work. It's not necessarily just about like, randomly bringing capital on chain. It's about recognizing what the unique value propositions of crypto and DeFi are and maximizing that surface of crypto. And so we make a distinction between what we call crypto guarantees and social guarantees. And crypto guarantees would be examples of something that is simple, something like a rule or a very simple set of parameters. And the execution of these is enforced by immutable code or by smart contracts in a very minimalistic way. Liquidation thresholds, NAV accounting, things like this. Basically anything that can't be overridden by anyone and is sort of the purpose and the raison d'être of crypto anyway. And you need these guarantees because the blockchains, although Ethereum has whatever, half an hour or I don't know how long it is to get finality on on Ethereum, there is de facto instant finality. Like when a transaction executes, it's basically gone, you know, and nobody's like trying to reverse the blockchain and, oh, quick, we have to do it before finality. Like once it happens, it's like out there and people assume that it's just going to finalize. And that's the reason that you need these very strong crypto guarantees. And so we view vaults as a way of expanding the remit of all of the things that can be cryptographically guaranteed. And anyway, to come back to your point, like why are rates so low? In our view, a vault that only lends to overcollateralized ETH loans comes very close to essentially maximizing the surface of crypto guarantees that are possible on that specific instrument. And so you really would expect it to be very near SOFR. But in everything else that we call social guarantees, you know, this is obviously far more complex and it actually may be the more interesting area to dig into, because there you go into operational security, smart contract risks, different types of economic primitives and protocols, trust in counterparties. And then obviously, the levers for risk multiply ad infinitum. And there's a very legitimate question of sort of what rate is it— at what rate is it actually worth it to participate in these? But then to like my TL;DR answer for why I rate so low, I have a suspicion, I have an uncorroborated suspicion that because all of DeFi lending has to work on supply and demand incentive equilibrium, because the cost of capital to go on-chain for DeFi has actually spiked in recent days, there's more risks, more hacks, more macro uncertainty and so forth. Ironically, this actually tilts the incentive down back towards borrowers, and it effectively has the effect of making the rates lower, just because people are using it less, lending less and borrowing less, because there's less risk. So yeah, depending on the context and the protocol, this may have some perverse effects for sure.

Yeah, I'll go next. I think let's start from the headline, like why rates are so low in DeFi. I think ultimately the reason is that the DeFi capital markets is disconnected from the traditional one. So you have money in DeFi, you want to keep it in DeFi for whatever reason, convenience, because DeFi is optimized for trading or leveraged trading or taxes or KYC or whatever. And I think that a lot has been written about this, like the convenience yield, like it's easier for you just plug in and out just to put it in a Morpho Vault and it's instant atomic instead of just buying a treasury on-chain or off-chain. So I think there is a disconnection in between the markets and that's what is making the yield so low. But I think that the questions here that I wanted to unbundle when I started writing about this, and again, for me, I have no horse in this race. I am a very good friend and actually indirectly an investor in the Morpho product. I think these guys have been amazing, including the Stakehouse guys that are partnering with me in many other initiatives. But I like to look at things and try to understand what's going on and have a framework. So in my opinion, I would split this into two. Like the first one is what is actually, what are actually lending markets doing? Because like Santi, you were saying like vaults are all the rage and we see like, oh my God, the whole capital markets are coming on chain and vaults are going to intermediate credit for around the world, et cetera, et cetera. Is this true? Absolutely not. Do vaults have all the requirements, the required infrastructure actually, to avoid rug pulling or adverse selection of credit on-chain? Absolutely not. Is it going to happen in the future? Hopefully, hopefully. But this is not where we are, right? Uh, DeFi is great at one thing, which is overcollateralized lending on crypto guarantees, as Adrian was talking about, or looping. These are the two great things that DeFi is doing. If you look at the Morpho TVL, this is not 100% of the TVL. So I think the question here is, first of all, let's look at things for what they are and so that we can build better things. And I mean, the Steakhouse guys are absolutely in the same camp, I'm sure. The second one is trying to understand then whether it makes sense to actually participate in the current market, right? Given that this is the best we can. And I think that it depends, right? I think the reason why I wanted to put the finger on this is that Yes, if you're a whale, if you're like a DeFi large, large protocol, or, or, and you have money stuck in DeFi, this is the best alternative, is the safest alternative you have. Still is not risk-free because there is a lot of unknown unknowns. We have seen liquidation cascading and not going well in the past. But the problem becomes when you're connecting this to CeFi retail front ends, and de facto this is becoming, uh, a very cheap and easy to use and crypto-native deposit account, then you're actually— there is a risk of misleading the user. And then actually, you're actually attracting users, uh, or, uh, and exposing users to risk that they don't really understand. So that's why I think I wanted to point the finger, because it's good to have like smart conversations and understanding exactly what's going on. Um, in this— in the— in the reason why— while yields are so low, I think I'm on Adrian's camp, is a supply-demand thing. There is a lot more demand and supply.

Is that— so I agree with that. I think that's my diagnosis too. And I think it's been like that since rates go up in 2021. You've just seen a, just the, the, a lot of participants. Well, actually, I don't know what you would attribute that to. My assessment is there's just a lot of the strategies just became less interesting when you can capture, you know, a pretty nice rate off-chain. So there's a whole set of participants that over the course of the last 4 years have decided to exit the market. For a variety of reasons, right? You've had, you know, blowups like Terra Luna and that, you know, uh, you've had, uh, the off-chain world just be more interesting. Um, when you guys see the— this, like, trying to decompose the supply and demand, like, where is the demand coming from? What is that? Is that like mostly retail, or— I'd just be curious, uh, maybe I'll go with you, Adrian. Like, where are you seeing most of the demand on-chain come from today?

We had, until we partnered with Coinbase to power their DeFi lend integration, we had a very small number of depositors and a very large TVL, which was suggestive of the focus that we had on working with integration partners supplying, let's say, a custodian of stablecoins or an exchange or so forth, access to like these prime vaults, or sort of large users and funds that were parking capital for a period of time between strategies. I think the retail— and then there's like a long tail of retail users with whatever the distribution of wealth is. And sorry if I interrupt, Adrian.

And protocols. I think Maker before the Coinbase integration was probably 30-40% of Morpho liquidity.

Yeah, that's true. Yeah, Maker had a— that's true through the Spark curator. Now, like with Grove and Spark, they kind of dip in and out depending on the rates. Yeah, it's true. As stablecoin reserves, Stake USDC was a reserve asset for Angle. Protocol. I don't know if you remember this amazing stablecoin that went down, unfortunately, a few months ago. So yeah, for sure, there's also some DeFi native B2B at play. And I think the Morpho construct lends itself well. Like you were making a point earlier, Luca, about how the infrastructure is not there yet. And I think I generally agree. And like, Vault is, I generally agree, but I do think there are like some bright spots. And the Morpho Vault The Morpho philosophy to the vault is, I think, the right direction, which is to make it as— because vaults essentially, and forgive any vault enjoyers, but vaults fundamentally have to track the nav, not get hacked. It's mostly around downside avoidance and the less they do, the better. And that's kind of been Morpho's philosophy since the outset of trying to find the smallest primitive maximizing the surface of things that you can secure in a cryptographic way. And then kind of releasing the brakes. And then, of course, there's nuances around how you configure those. But I do think that's the right approach. With Coinbase DeFi Lend, that's where we saw like the first influx of like tens of thousands of retail depositors. But Coinbase, I would flag as actually quite a good actor example, of how these integrations are made. I don't know if you've had the chance to sort of use this application, but they don't call it a deposit account. They don't call it a savings account. They call it DeFi lend. And there's a very long FAQ. They explain bad debt, what can go wrong, etc. And this is for a Prime Vault, you know, like they're mostly lending to CB/BTC borrowers on Coinbase as well, for that matter. But yes, there's obviously a spectrum about how you can market these and ourselves, we go out of our way of saying like, this is the closest proxy to kind of the DeFi risk-free rate, but it's obviously not risk-free.

Luca, how do you see it? I mean, I think I do hear you. A lot of the demand is coming from exchanges that unlike the last cycle that they purported that these algo stablecoins were just sort of dollars and the yield was really interesting. I think now we're doing a better job of disclosures. Luca, I read your article that I think everyone should go check out, and I think you just did a great analysis around, look, the yields are just not there. They're like, so, so maybe kind of like give a little bit of context and then we'll love your take on maybe explaining like what is the difference between like Morpho and prior instantiations of like yield farming, like, like Yearn, like what has made Morpho more interesting and how do you, when you kind of, I think the, the TL;DR of your article is, look, we're getting paid 25, 50 bps above the risk-free. You should be getting paid 200, 400. That's not the case. Why is that? And how do you see the risk of interacting with something like Morpho or other protocols?

Yeah, I mean, first of all, I want to start like a couple of comments, and the first one is that we are in a so much better position compared to 4 years ago, right? To Adrian's points, I think that the work that the guys at Morpho has done is phenomenal because they, they have isolated simple primitives and they're building on the one primitive on top of the other. The only thing I'm saying is that there is a long way before we start incorporating more sophisticated assets. And still, the thing that works in crypto is overcollateralized lending on crypto stuff, or yield looping, right? Which is a different, completely different strategy. But the direction is absolutely there, and we are in so much better position. I don't think we are misleading the retail at all in a way that is in any way similar to the Terra days or the CeFi days in general. I think that what I— and then also Santi, like a short comment to what you said, like I think that the lack of interesting higher yielding opportunities in DeFi in the last 4 years is true. I think there is one bright spot that was Athena. I think Athena came out with a very good idea of just tokenizing the basis trade in a way that was higher yielding enough to attract a lot of customers. It was a short-lived trade, but I think it was a very good— I mean, and the guys executed very well. But I think that— so when I wrote this article on my Dirt Roads Nerd Luna Park, like, last week, because what I wanted to do is, like, I wanted to try to decompose risk and try to understand exactly what we were underwriting. Now, this is not my day job. I do this, like, over weekends and nights. So a lot of people came out with— I criticizing the parameterization, criticizing the the model, and I, I loved it because actually that was exactly what I wanted. Like, you know, started like a smart conversation about stuff instead of just like doing crypto Twitter wars between Aave and Morpho and stuff like that. Uh, so it's great that we are here, but what I, what I wanted to say is, like I say, like, what is actually— what actually are we underwriting? What is the risk that borrowers have? I focus on market risk. There is a lot more, uh, that I'm going to touch in a second, but like, just to, to simplify things, to like brute simplicity. For these vaults, like the Prime Vaults that Adrian was talking about, you're putting money in a vault, uh, in the form of like a stablecoin, and then somebody else on the other side is, uh, depositing collateral like Bitcoin or ETH, and they're taking a loan out that is significantly overcollateralized. So there is way more Bitcoin than the loan you take out. Now, if the, if the price of the Bitcoin and ETH goes down above a certain threshold, which is there is a very healthy buffer, a liquidation cascade happens, the collateral is liquidated, and you get repaid. The point here, the reason why the yields are so low today is that first of all, these systems are extremely battle-tested and the liquidity algorithms have been tested. At least the latest vintage hasn't been catastrophically affected. The past vintages, yes, the Maker we remember. Um, so like the, the, the algos work. And also there is much more demand— much more supply than demand. Everybody's very— everybody's depositing, not many people are taking money out because there is not a lot of demand for leverage on Bitcoin these days, right? So I think that is one of the reasons. But the reason why the yields are so low is that the system works very well. The way Morpho does it differently from even Aave is that, and I think that was like absolutely a winner for the team. And actually, in my opinion, they inherited spiritually from another team called Rari back in the day, where they've been isolating those markets. So instead of having one big pot where all the collaterals are there and there is like a DAO or somebody that is doing risk management, they are oscillating this market. So these markets are very simple. You understand them, you can understand them very well. And then they're simplifying and they're creating another layer called the vaults, where there are asset managers like the guys at Stakehouse or Gauntlet that are doing the risk management across those markets. And also like, so the composability is there. I haven't wrote about the vaults. I have another piece coming on vaults like in the next, as soon as I have some time in the next few weeks. But I think that the way the Morpho system works today is that to Ryan's— to Adrian's point is super, super simple markets, simple to understand markets compared to the past. So you don't need to, uh, you— it's difficult to get lost in the DeFi labyrinth of things that are interconnected. That's also why I think it's fair to say that the risk is relatively low. Now, in my opinion, it shouldn't be so low, and I think it's pushed artificially low because there is way too much demand, uh, then way too much supply. There is some inherent risk that is actually embedded in this. Like, you know, if the market moves abruptly, ultimately you are writing, you're underwriting some volatility of the crypto assets, which is not risk-free. There are other risks included, like, you know, that we are not parameterizing, like, you know, hack risk, smart contract risks, like catastrophic risk that can happen. That is definitely not risk-free. So this stuff is not risk-free. Now, interestingly, the reason why we do not have a risk, true risk-free rate on-chain is that The regulator is avoiding it, so we cannot stream yield from stablecoins. If USDC or whatever stablecoin partner on M0 could stream yield continuously for retailers, this is pure risk-free, but you cannot do it. So interestingly enough, what is happening is like Circle is making money, Coinbase is making money, the retail, they're underwriting the risk. So that is like, this is like, this is what is happening. The retail and the borrowers are underwriting the risk, so we could do much better. But in no way, in no way, in no way we are in a position compared to what we had before. Now, this is the— that I'm done. I'm, I'm— I finished with my spiel. But this is exactly— this only focused on overcollateralized prime super safe vaults. When you're starting doing something more exotic, it's different. Like when you have loops, like Morpho spiked in the TVL when Athena and Maker were looping USDE yield. This is different, right? Then you're putting leverage on leverage. Even RWA looping is different. This is putting leverage on leverage, stuff that— there is no free lunch. So when yields is 20%, 30%, it's a different story. But to your point, Santin, I've seen your comment to one of my researches. Yes, I know that these are all the dynamics, but if you're a sophisticated investor, are you getting paid for the risk you're underwriting? This is a question. I wouldn't put my money personally, because I don't think it's enough. I would just park it and probably do a barbell with Bitcoin. But this is my own personal money. So I think everybody should ask whether, based on the market conditions, the money and the emerging yields, is it enough for the riskier underwriting? And everybody has a personal view on this, of course, but they should have a view.

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So just to summarize before going further, so it sounds like a lot of the demand is retail, uh, you can attribute most of the compression and low yields to a lack of demand. I almost, as I was hearing you say that, I think about like short sellers. Like if you own a stock And there's like not a lot of like short interest, you're not going to get paid much for lending out your stock. And I think that's sort of the rut where like crypto is, which is you have a lot of these long-term hodlers that have Bitcoin and Ethereum and are saying, okay, I'm going to deposit into AAVE and I'm a long-term holder, so I might as well clip some yield. And I don't necessarily care. It's just extra. Where I think Luca, you and I agree with, or maybe Adrian, I don't know if you would, is there's still some risk, tail risk of that protocol that you're interacting as much as it is battle-tested and has really good liquidations. Like, you know, we're not in a— I still remember the Black Friday event where Maker didn't have a good keeper system. And we're very much more battle-tested than back then. But there's still— I think we can all agree there is a not insignificant probability of impairment and total principal loss. Smart contract hacks, OPSEC issues. You have AAVE go to AAVE v4. There's just more surface area. So when you factor that into whatever sophisticated math or simple math you want to do, it's a very tricky situation. It reminds me a lot of like the staking yield, right? Because I think Adrian, you mentioned that, right? That could be the risk-free. Like you should be staking your assets. I've heard so many institutions say, we actually don't want to stake because there is a non-zero probability of our assets being locked or what have you. So I'm not holding this asset for the incremental 2 to 3 to 4 to 6%. I'm holding this asset because it has venture-like return outcome. And so anyways, a lot there, but what is the, What is the solution to this problem?

I think the solution— so I agree, like in DeFi, but this is kind of what I love about DeFi. Like we can tell ourselves, okay, de facto, the treasury rate is essentially risk-free, right? And within the box of the US monetary system, it may as well be because of the ability to create new dollars. And within that fixed frame of reference, you know, every fiat currency is risk-free and the dollar more than other currencies, to be sure. But what I personally like about DeFi intellectually is that it kind of brings all of these issues to the surface. They get complicated when you conflate them. And when it gets difficult to sort out one thing from the other. So to your example, for instance, of if I put in my Bitcoin in AAVE to earn 2 bips, just because, what are the risks that I'm implicitly underwriting there? I agree that it's more complicated to parse that because Aave is a more complicated protocol. It's bigger and has Lindy and Umbrella and a bunch of other features, but those are all kind of remediations to the central fact that it's just a design that's a bit more aggregated and a bit more difficult to parse out what's what. Not to be the eternal morpho-Schiller, but I think the advantage of doing things in simpler primitives is that it makes it easier to isolate. What the risks are. And so I think that the— I actually— so, you know, when I, when I read Lucas's post, my perspective was, this may well be true for, you know, high yield repo lending, but for Bitcoin and ETH overcollateralized lending, I think it overstates it, because I do think that we're nearing a point of close to efficiency on Bitcoin and ETH overcollateralized lending. And for sure, there is still risk, like the main risk Okay, like a neat example is wrapped ETH USDC overcollateralized loans, because the collateral is about as cypherpunk as it can get. Like the wrapper ETH contract was like deployed by, was it Nikolai Mushegian? And it's like, you know, signature Nikolai, like unchangeable, immutable, completely bulletproof. The only real risk there is, I suppose, if USDC faced some kind of an impairment for whatever reason. So it's not immaterial, but it's not specific to lending. Or if the oracle of ETH price to USD price suffered a loss, which suffered either a gap because ETH— but ETH would have to gap 60% in a block, in a single block. Like we're talking about very, very volatile price gaps, which are not impossible, but very, very unlikely in our view. Or the oracle network would have to fail and Chainlink would have to shut down or have some kind of malicious— and again, not risk-free, right? So what our solution is, is actually this unbundling to rebundle, I think is very helpful. I think in the high-yield repo lending, you have more of the effects of what you're describing. So I also don't necessarily agree with the characterization of like a short sell or put or things like that. In particular for the Prime Vaults, because there is so much credit enhancement that's built into just the structure of the market and the protocol, it does start to take on more of those characteristics with higher risk collateral. And what we see here in the vault space is, in particular if you're restricted just to underwriting repo markets against different types of collateral, is the adverse incentive of I want to print as a curator, I want to print the highest APY so I'm going to add more and more stuff randomly. The lender is not going to get commensurately rewarded for that risk. And the risk starts to take on more turkey-like characteristics. And that's like kind of a bad outcome. In our view, I think there's a point like, we take the view that lending should be a different, like the degrees of risk on lending should be a degree of liquidity. And market size. And if an investor in stable— and if a stablecoin investor wants to take on more risk, they should just take on more risk. In other words, they should allocate into vaults that expose them to leverage looping, for example, because that's kind of the fair price for the risk that they're taking. And in this framing, like the borrower, like it is kind of, yeah, it may sound like Stakehouse has kind of an adversarial relationship with the borrower. And it is to a degree because our main priority are the lenders in the vault. The borrower is actively taking risk. So if they get liquidated, it's kind of their fault. Like that's the risk that they knew they were taking and they were pursuing a reward greater than what they could have achieved by lending into the same vault. So that's like in brief is like more unbundling and more unpacking what the different levers of risk are. And relying more on crypto guarantees than on social guarantees to secure those. But once you get to certain levels of risk, like we release— the bulk of our volume is in lending, but we have a small program to try and launch these kind of leverage looping vaults or term vaults and things like this. I mean, they're risky, and we're not hiding it. And that's kind of the— what we're trying to do is say, like, for different tiers of risk exposure, what is the fair rate that investors will demand to get in. And I think that's a better— like, if you work on that market mechanism, and if the industry trends towards that market mechanism over time, I think we'll get to a point where those risks are adequately compensated.

Yeah, I wanted to actually touch on a few of those points. And one is actually against the argument I made at the beginning. But the first one is selling put or not. Is this like a repo or is it an option? I don't think it's really relevant. I think the reason why, for example, I took out this, and I don't want to nerd out, promise, the Merton model is like everything is volatility, everything is return. So the way you should The only way to model a credit that is not a continuous payout instrument is like, okay, let's model it as a risk-free plus an option. It's just a way to model. It's just a mathematical framework. It's a very deep in the money option, so it doesn't look like an option, doesn't smell like an option because the option is where there is more volatility in it. But I think that one thing that actually is— and then again, Is it enough? Are you paid enough or you're not paid enough? It's always in the eyes of the lender, right? Ultimately, you do your own underwriting. You decide what is the— you do your own modeling of probability of— and then you do, and then you act upon it. We don't have enough primitives. We don't have insurance primitives in crypto for tail risk. Unfortunately, it's difficult to price, but we're getting there, right? I think we're at least perfecting the basis. We've been at this for like 5 years, less than 10 years. Like, it's nothing. Uh, but the truth is we have perfected the base case. We are far away from perfecting the most sophisticated stuff, especially when it's the social proofs are important. Like, that's— there is so much, so much talking about lending and private credit in crypto. We have been here before many times. We know that how this is going to play out, right? And there are large asset managers that love it. Of course, they have like a great, great, uh, pipe to connect their products to unsophisticated investors. They shouldn't do that. Um, but the last point that I want to make actually is against— which I think is important— is against what I was saying before. I was looking at reading somebody writing on this on Twitter, uh, today, as actually this prod— this, uh, protocols are so good for the, for the borrower— for the lender. They're super safe for the lender, but they're brutal for the borrower. Because if you're sleeping, if you actually have, if you actually have a position, you're borrowing money which is collateralized on ETH and BTC, you're going to sleep, your bots stop working, whatever happens, you get liquidated, you take 5% liquidation cost, you get, uh, you, uh, crystallize your losses because the protocols are protecting themselves and they're protecting the borrowers. So the reason why the, the costs are— the, the yield is so low to lend is because the only way you can actually attract borrowers is that the price these guys need to pay is very low. Because if you're trying to get a Bitcoin, a BTC-backed lumber loan from like an OTC desk, it's way safer. You're not going to get liquidated overnight. These guys are going to call you, they're going to restructure, but I would ask for you for much more money. So maybe the other question is, should we build new protocols that are actually more balanced between borrower and lender so we can have a better better market. And I know that Morpho is trying to do this with the intent-based Morpho V2, where they are matching. But then let's see if there is enough Lindy effect to actually attract liquidity. But the reason— one of the reasons why the, the rates are so low is that these, these pro— these instruments, these mechanisms are brutal for the borrower. So the only way to attract borrowers, they don't need to pay much. That's a really—

100%. And but I would argue Yeah, so maybe the missing piece there is the borrower, the DeFi borrowers that are using it need to be like, we think about borrowers a lot, but obviously the priority is on the lenders from the Curator perspective. So everything is kind of adversarial against the borrower. But again, like if you flip the framing, it's like, look, the borrower is taking risk. So it's kind of like, you get what you pay for. But it's a really good point actually, that the low borrow cost may be the difference between the difference that compensates for the experience of borrowing on variable rate protocols. Because you can do it with like a bank or an OTC desk or something and you get a phone call, you know, and they invite you to like events and stuff. But on Morpho, you just get destroyed, which is—

It's not only they invite you to events, they call you and they say, let's restructure this position instead of just wiping out your position overnight.

Yeah, exactly. And that's a huge advantage for somebody who has a long-term position. But it's like, It's also kind of the only way that you can make variable rate repo work on-chain in 12-second increments, you know, because the prior— I do think the priority should be on the lender in this instance. But I agree, like the fixed rate model that Morpho is experimenting with is going to be an interesting marketplace to figure out whether we can build a term structure in DeFi to compensate for this risk. We're indicatively getting some feelers from very cheeky people who want to capture the variable rate at a fixed term with all of the protections. I do think it'll, you know, it'll require a little bit more than the variable rate. So I expect the fixed rate term structure at equilibrium to settle above the variable rate in that instance, if the market is efficient. And if nobody is doing, you know, underwriting, you know, illiquidity, like the way that this would collapse is if a curator underwrote too much illiquidity for too little yield. But then they would see an outflow from their vaults. So the market will self-correct.

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

Yeah, I can start. And I think that, so as I mentioned, going back to the primitive, these positions are overcollateralized positions deeply in the money backed by super liquid crypto collateral. This is what we're talking about on Prime, right? Again, if we talk about higher risk, completely different business, but let's put it aside. Most of this stuff is Prime on Morpho. Or anywhere currently in crypto. So significantly overcollateralized positions on super safe and super liquid crypto native collateral like BTC and ETH. Now, what is the risk, right? The risk is the BTC and ETH price moves, right? So like if it moves against you, so it's actually reducing in value, at some point you're going to hit a liquidation. So this stuff is, uh, actively managed. So the risk of hitting a liquidation is lower because there are people like the Stakehouse guys that are continuously rebalancing that and just like putting more collateral or taking more— or taking, uh, some money out. So I think there is an active rebalancing. And, uh, but still, like, money is not infinite. If the prices start going down, down, down, down, people that took the position, uh, they if it goes very quickly, they do not really have like perfect, perfect infinite money and perfect timing to rebalance. So if you look at the super, super safe scenario that I modeled personally on market risk, forgetting all the, all the other, all the other risks that I'm going to touch on in a second, my models were like roughly 45, 40, 45 basis points above risk-free. What we're seeing in Morpho is a bit less than that, is like 0, 20, 25, 30 basis points. So what is hap— what is, what is real is like Morpho is pricing perfect scenario. So are we in a perfect scenario or not? I don't believe in perfection, so probably there is some, some friction that hasn't been priced in. Now we need to do the debate here between me and Adrian is going to be— is going to— it's 20 basis points, this imperfection, or it's 200 on 500. But there is, is that— there is definitely something there. And where this could come from, like, you know, uh, imperfect, imperfect, uh, bots, like, or like operations not working, not infinite capital. Liquidation systems not working very well because the prices move super fast and the gas prices spike and everything gets congested. So you cannot really move. So there can be some friction in the liquidation process where the buffer you have is not enough. And if that is not enough, then you're going to have some sort of loss given a default case. My model will say, okay, the LGD is 5%. That was my model. So if there is a default, if there is a liquidation, you're going to get hit by a 5% loss. Adrian's point was this is too, too harsh. It's probably close, closer to zero, is a few basis points, 20, 30 basis points. As usual, probably the truth is in the middle. Uh, it's just you need to do the calculations yourself. The good thing of doing, uh, what we think is good quality analysis is that I put a model out, Adrian took my model, changed the parameter. You can do it yourself, right? You can put your GDP that you think is one that makes makes sense and is going to spit out the yield that you should have, whether it's 400 spread, 300 spread, 20 spread, zero spread. Now this is only market risk. There are other risks like, like Santi was mentioning, hacks, uh, like OPSEC. Somebody's hacking somebody, like the multisigs are not working. This stuff is not fully, fully permissionless, not fully, fully immutable. The base, the base level is immutable. So there is some like, how then you need to price it How you price it, very, very difficult because this stuff is not statistical. You probably need to do some sort of like probability scenario. What do you think is the risk of hacking? Like, you know, 5 years ago was 30%, now it's probably 1%, 0.5%, but you need to do your math. Uh, the, the, the point here is that what I think my analysis was interesting for is that put like, uh, at least like a quantifiable, uh, uh, floor which I quantified at 40, 45 basis points above risk-free, and that is everything is perfect. So if everything is perfect, you should get paid SOFR plus 40 basis points. Now, that was my assumption. Maybe I'm wrong by a few bps, but let's say that that is right. And then you can do your modeling, right? You can change the parameters and understand exactly what you think should be. Uh, in my opinion, this spread should actually be between a— I think it's fair to say it's probably a couple of hundred basis points if you think everything, if you consider everything together. Market risk, hack risk, and cat risk, etc. But again, you do your own math, right? What I think we should, we should do is good— give good frameworks to the market so they can do their own calculations. So like, I have Luca's position, Adrian has his own perspective. I'm sure these guys are using it. Now the point that Adrian is making is the more you go higher in the risk profile, then the more interesting these models are, because then you need to really understand what you're underwriting, because nobody knows Because where I think the—

so I love the framework because it kind of goes through that unbundling approach of let's take the simplest possible, you know, let's take the spherical cow and then model it a little bit better step by step. And on Prime, I think Sandy, to your question, like what could— okay, so like realistically, so our view is the risk on BTC and ETH over collateralized lending is not zero. Historically, the market risk we found is 0.004%. So very, very, very low historically. But this doesn't say anything about future events. The realistic loss risk on BTC and ETH is if there is a failure at the collateral issuer or a failure in the oracle, or if Bitcoin and ETH price gap more than 20% within 12 seconds. And we rate for PrimeMarkets each of these risks to be relatively low, probably lower than Luca's 100 basis points. But I would say we're in the same order of magnitude. Where I think this framework is illustrative is moving out on the risk curve. And I do think that it's worth like, when you paint DeFi with a broad brush, it's kind of I mean, you can do the same with traditional finance as well, right? You can say, whatever, private credit is risky, therefore I'm not going to lend into a bank because they lend to mortgages. It's like, sure. But it is worth to kind of drill into the detail and to see what exactly is happening.

I think there's a lot I think that you mentioned, which is, I don't think the discussion is like, as controversial at the very narrow use case of depositing and overcollateralizing, like Bitcoin or Ethereum, to your point, very liquid, like very good liquidation system, robust price oracles, and then having a borrower and be very adversarial. But, um, I think where it gets a bit more amorphous is the OPSEC risk that you're taking, and that's hard to price because it is like a it's kind of binary in that sense. And you see on— I'm not trying to paint a broad brush around vaults and protocols, clearly, but, you know, every year we get 1 to 3% losses in the aggregate TVL, which is like an unfair characterization because obviously you have to drill down at the protocol level that you're interacting with and what's a counterparty risk. But to your point, I'm more in the camp of like Luca, like You don't have to approximate at the basis point level, but I think we can definitely agree that it probably is worth a couple hundred basis points above SOFR, no matter what you're interacting, if you're doing crypto.

But I disagree for Prime Vaults because like even for, well, again, it depends, right? Like it depends on what protocol you're using. Like you do need to get specific and not to be like the eternal shiller of Stakehouse products, but in our vaults, if we stopped reallocating because we all got caught on a plane and the plane crashed into the ocean, the vault would perform slightly less over time and users would just exit. Like there's no dependency on performance.

You should have your private plane, guys.

We do take separate planes. We take separate planes just in case. But all the same, like it wouldn't matter. And, but that's because we kind of research all of the possible surfaces that could introduce that. And Morpho is very good because the number of those surfaces are very small. So realistically, in Morpho, the surface of— the surface for attack is on the curator is quite minimal. It does exist, but it's quite minimal, and it can be very, very strongly mitigated. The way that we mitigate this is by making the the users of the vault a check on our behavior as curators. And we use a trustless Aragon node to do this. So if we get compromised and we onboard a fake token onto our Prime vault, all of the users of the vault have 7 days of a time lock and they can stop it from happening, which would be a realistic scenario if, for example, there wasn't enough liquidity to withdraw, to simply withdraw. Then they could at least wrap their positions in the Aragon DAO and vote to kill this onboarding. There are, you know, that gap exists in some votes for sure. So, you know, even two Prime votes aren't exactly the same. And, you know, this is what makes DeFi very hard to parse. Like, for sure, DeFi is very dense, jargonistic, and full of intricate details. But for the Prime vault category in particular, I do feel like the OPSEC risk is relatively constrained and concentrates mostly on the collateral issuer and on the oracle network. There's less of it on the market. So you would have to kind of assume like, will BitGo or Coinbase suffer an OPSEC exploit that will allow them to mint infinite Bitcoins? Or will Chainlink suffer an OPSEC exploit that will lead them to gap the price by half? Those are certainly real possibilities, but you'd have to evaluate what the likelihood of those is.

Yeah. I wanted to say a couple of things here. So the first one is risk-free is an illusion, doesn't exist, right? The risk-free is a proxy, is the lowest possible thing we can have. Still, the US government can wake up tomorrow and say, you know what, I'm not going to pay out. Many interesting things are happening in the US these days. This is probably not zero. But I think that I'm curious, first of all, I'm going to end with this, an interesting question to you guys. But before that, I think we don't need to paint DeFi with too wide of a brush because DeFi is not great at landing. DeFi is great at doing what exactly Adrian is talking about— overcollateralized margin lending that is atomic, and it's super, super optimized for trading and arb. This is great. This is not lending to corporates, this is not lending to mortgages, this is not lending private-to-private credit. To lend private credit, DeFi absolutely sucks in so many ways. I can just start now and we have 5 hours, I'm gonna— I'm gonna be finished by then. But it's optimized. So we need to talk about what we're actually doing. I think DeFi is amazing for overcollateralized, uh, no KYC, super quick, algorithmic, overcollateralized lending that is great for trading and, and ARB. This is, this is amazing, but this is a small subset. So the question is like, how big actually is the target market, addressable market of DeFi lending? Remains to be proven if it's as big as credit. It's— we are very, very far away. And then there is like the question is, I, so I know that like the guys, the guys at Stakehouse, they're optimizing to this single basis point security in order to make this exactly use case as safe as possible. Because if this was not used, that was not your, your use case, what would you do, guys? Would you just like buy a tokenized money market fund that just give you 3.5% and just sleep over it and forget it? Or will you put money into like a Prime Vault? I will buy a tokenized money market fund. I have recourse, I know what it is, I'm not gonna get rug pulled by prices, I don't worry about it, it's fine. You know, maybe they break the buck and they come back. So if you want to have risk-free lending on-chain, there are better ways to do it. If you want to do trading, leverage trading, or like arb with your bots, then you cannot do it with an organized money market fund because these guys, you know, they do not operate in a single— in the same time frame. But we should actually define better what we are actually optimizing for. Because if we're thinking about that DeFi lending is that the addressable market is credit, currently it's not.

I'll say, let's go there because I wanted to carve out a piece of the discussion around interesting products that I think you mentioned, Adrian, around, hey, there's been since the beginning of time investments in, you know, let's create fixed rates and swaps. And insurance. You know, you've had Nexus and a couple other instantiations, none of which in my opinion have really gotten much traction. I don't know if you want to respond to what Luca, what he said, but I'd actually be curious more like forward-looking. What are some of the things that you're excited about that you think could, you know, bring more security to DeFi or attract more demand Like, what do you see on the horizon that is really interesting?

So I think it relates to Lucas's point, because like, to date, DeFi has a term structure of 12 seconds. And that makes it nearly impossible to have much of a monetary economy beyond like statistical trading and like whatever, like speculative activity, right? Some amount of like on-chain B2B, whatever. But you know, the proportion fluctuates, where I think the opportunity— however, I agree that DeFi still has to prove itself to win credit. But I do think that it can win it. We're just in the perspective that it's going— it's not going to be like next year. Like, I do see a world where traditional finance and origination and what have you continues growing and being very big and DeFi just behind it catching up and maybe at a higher growth rate, sort of dependent on the degree to which newer generations of users and consumers adopt stablecoins as a natural means of payment. Where I— it's not a super interesting answer. But I feel like we go back to this crypto versus social guarantee construction, like whenever somebody talks about insurance or swaps or what have you, It's always possible to build like Rube Goldberg machines and gadgets in crypto. And I think crypto is like really good for this space because it has a, it's like the perfect, it's the Venn diagram that intersects perfectly the like mathematicians and scammers. And both of them love like very complicated like Rube Goldberg machines that have bells and whistles and like complicated models. But the models that are going to be the most successful are the ones that lean on the crypto guarantees to make the product better, more transparent, safer, and lean on the guarantees of operating on public blockchains as a value proposition. And when you look at that today, it's true that it's actually— the addressable space is not that large. It gets larger by the day. So I do think there's a world where private credit could originate on-chain. If for, but for that to be true, the borrower and the originator and the securitizer would all have to transact in stablecoins. And then given that, ideally they would do it using a protocol or a smart contract layer that was as hardened as possible for all of the elements that introduce things like operational security risk. So like to answer your question, Santi, like yes, insurance would be great. I, yeah, it still remains to be seen how we price all of these different variables. You know, and I think that's probably the biggest headwind against the sector really taking off in DeFi because nobody knows how to actually price these. BlueGuy is helping. You just let the market price it.

I mean, that's the whole point of having a liquid market behind, you know, a CDS or like, you know, you have like all these actuaries in the real world trying to price cat bonds and all this stuff. But the market just has a real-time price to it. And that ultimately the market prevails, like the market. That's why I found— so when we were back in the day, farming with size at like an institutional level with LPs, we felt pretty comfortable farming because we can go buy cover on Nexus. And that was grossly underpriced to the point where it was like a phenomenal risk-adjusted trade because you could go buy cover Nexus and no one was kind of buying it. And there's all these efficiencies that are still in DeFi today. But I've been a long advocate and maybe I'm overthinking it around risk management instruments that could give you ultimately more comfort. 'Cause a lot of these things, like you just, they're theoretical. The problem with crypto is when something breaks, there's like very little recourse. And I think you just, to your point, if you have some guarantees, cryptographic, that like you buy insurance and that your payout is guaranteed 'cause a smart contract governs that, to me that sounds like insurance is the natural next evolution of something that could really instill confidence in a world where AI is finding a whole lot of bugs in systems that you thought were super battle-tested. And so for me, I have no interest in playing in DeFi right now because the Lindy is sort of— you're, you're reset on Lindy across the board in a system that is like algorithmic and automated. I think you want to have the natural breaks that you have and circuit breakers and time locks that exist in the real world. Like you want to interact with a human. For sure. For now, AI could also make these protocols super safe, much, much safer. It's just sort of like a gap that we're in today that I think is sounding the alarm around every protocol, which I sort of posted yesterday around this initiative. Like, how can we create and price risk in response to Lucas's paper? I said, okay, could you create a a simple metric of how much is a protocol spending per year or per quarter on security versus TVL that it's insuring. It's by no means a perfect measure. It's very crude, but at least more transparency could allow the market to make that distinction so that it doesn't do a broad stroke across the board.

Well, one of the things that we're going to try and do as curators is start issuers that have been through the Stakehouse wringer know it, and they often emerge out of it with a more hardened protocol. Not always, but typically we tend to be quite demanding of the issuers that we underwrite. And our approach to improving this space is being harder and introducing operational security audits as a requirement to be listed in the vaults as a minimum. And I think that raising the bar at that level. But yeah, and then the other thing is having a term structure in DeFi would help the market be a bit more efficient because insurance is a long-term instrument, but DeFi still operates on 12-second blocks. And so it's very hard to kind of match the two. So I feel like that's maybe another reason why insurance has struggled to take off despite the potential inefficiencies you described.

Yeah. I mean, what I think is like what you're saying, Santi, really resonates with me is that I don't think it's too interesting to discuss what is the real, the exact parameter we should use, right? Because the way it works in DeFi, in TradFi, is every desk has their own models. You do your own pricing, you have your own expectations, and then you express your views through the market, and there is a market price. And then you think, okay, this is attractive for me or not attractive for me. So my views by definition are different from Adrian's and different from yours because, I mean, I have a different whatever, like a set of views of the world. And I think, so what is important is that we have good primitives to express those different views. I think Morpho did this very, very well for short-term overcollateralized borrowing, different from AAVE, because it's easier to express views. You can isolate your views. The problem is that we don't have other tools to express our views. And a few reasons. I think the lack of talent in DeFi is one of those reasons. I think now I operate in the stablecoin space. We are very, very on-chain native. But now most of the fun in stablecoins is connecting with bank virtual accounts and Visa, et cetera. Yeah, great. But I mean, intellectually, it's not what we're talking about. This is different. This is piping with payments. Right.

Are there not enough mathematicians or not enough scammers or both?

Yeah, both, I think. And it's like probably both are in AI these days. Uh, so I think we need, we need more talent. And I think that the insurance point is insurance is a long-dated balance sheet. It's the best balance sheet to express views that take a long time, a long time to materialize. That's why, like, the insurance is the best vehicle for the Berkshire Hathaways of this world. So we need to have insurance balance sheets. People that— there are some that are trying it. People are saying, okay, I price my balance sheet on Bitcoin, for example, and I'm gonna take views on Bitcoin very, very long term. I don't care what is going to happen in the meantime. So I think we need those primitives to express views that are very different compared to the block-by-block movement of a price or a liquidation oracle that is going to break or not. Hopefully we start putting it— like, we start having them. And I think the Morpho V2 is an interesting development, but we need more. We need much more to do interesting stuff.

So, I mean, you guys are very talented guys. You're still here. Why not? I've had this idea and you guys tell me how dumb it is, but like, my— the thing I— the issue with insurance is like in the way Nexus and Anchor Protocol and have tried to do it. And I think the more interesting one was like Andre, like allowing like unwrapping of Nexus cover because that gave you more pricing on— because you had the KYC on Nexus. And so it's kind of antithetical to like the fluidity of of DeFi. And so, but it was interesting because the pricing on the COVID just all of a sudden reflected a more real-time— like, you could see the jump in price and say, okay, actually the market's telling me that X protocol is way riskier. And that gave you a really good oracle in and of itself of risk. But my issue with the crypto-native insurance protocols is a correlation. In insurance, you want to be uncorrelated. You want to have property and casualty, and you want to have diversified. And like you want to build, um, you know, that resilience, anti-fragility in, in, in your balance sheet. The problem is crypto is very correlated, and composability, if you're interacting with a lot of protocols, it just tends to correlate really tightly. And maybe that's no longer as much the case, but my view is like, go buy traditional insurance that has very, like, as far removed exposure from crypto, and then slowly start issuing policies and serve the DeFi ecosystem. Problem is, again, we go back to square one. Yields are low. And when yields are low, you can't really offer that, right?

Composability spreads contagion, but also isolation and simpler primitives prevent it. Right. That's a fair point. Like the intent 10, like we've had internally, we call these biweekly 10 sigma events. We seem to have a 10-sigma catastrophe in DeFi every 2 weeks lately, at least since October, if not longer. And in each of these events, we saw high-yield repo lending rates spike through the roof as a kind of lagging indicator of risk in these pools. But the Bitcoin rates stay completely unperturbed in Morpho because they're isolated. And so I do think that you can have some degree of deep, you know, uncoupling of risk contagion if you build on sufficiently isolated primitives. And what that looks like for crypto-native insurance is not super clear to me. But yeah, you would need to have a balance sheet like Luca describes, from far longer term, completely untouched, unrelated, investing in cat bonds, whatever, something else, for it to really work.

Yeah, I mean, I think I would separate crypto-native insurance, meaning that you're building the mechanisms on chain, or that you actually give the possibility to like long-dated balance sheets to take crypto assets on board. And I think, for example, Bitcoin, there is so much to do with Bitcoin that we haven't done, like so much. Like imagine even if you start allowing Bitcoin to be reserves of like life insurers, then suddenly you have a very, very long-term oriented buyer of Bitcoin, and suddenly the volatility of Bitcoin price goes down massively. So I think that even if those assets permeate, because now the holders of— I mean, Bitcoin is probably an exception, but the holders of all those assets are all traders. So there is the correlation of the prices of those assets is because like everybody's moving with liquidity. If you're bringing more buyers in this industry that have a different time horizon, then suddenly the behavior of these prices changes. So I think even starting by just having long-term buyers. Because, you know, I'm buying Bitcoin insurance— Bitcoin for like a life insurance that I know I don't need to pay out on average in the next 20, 25 years. Like, you know, my perspective on prices and price volatility is very, very different. I mean, that's how Warren Buffett buys companies, um, so at least had for a while. So I think that this stuff needs to permeate. Just stop being only a pure trading arb asset and just being in the hands of other people, and suddenly we start seeing behaviors differently. What we can put directly on chain remains to be seen. But to your point, Santi, like, if you have somebody that is giving you insurance, it is not on chain, but it's like an OTC desk that is really able to take a position against you, you will just do it. You will just negotiate with Goldman. So you don't buy it on chain, it's fine.

Luca opened this discussion with how regulation was actually forcing a lot of the— regulation is forcing stablecoins to be narrow banks and therefore pushing all of this risk on-chain. It would have been interesting to have a world with more Tethers because Tether is essentially the only issuer that can actually take long-term balance sheet risk. And in the real world, this is like typically one source of like long, long-dated balance sheets that could serve that purpose or originate these products. So we are forced to contend with doing it ourselves. But I actually love that because I'm a big I'm a passionate believer. I may be the last believer in free banking, but—

But isn't the issue with Tether though that the— yes, they're like less regulated than a lot of the— like Circle, but they're buying and they're doing some at the station, but not to the level that you'd want, you know, but they're not fully collateralized. They have some other instruments in there, and so— and they're not passing through the yield over to the holder, so as we think about where the risk sits squarely, that's the holder of USDT.

Yeah, we've seen a— I think Adrian's point, because I've done some research on Tether's balance sheet as well for fun and published on it. But I think Adrian's point is like, I don't think Tether is going to do it because as you were saying, Santi, they have the best trade in the world. They have long— they take long-dated risk and they don't pay anything out to anybody. Amazing. But what I think— what I guess Adrian was saying is that Tether is actually one of the few institutions that is in a position to issue long-term paper because they have long-dated— long-term— on their ass. So they could actually issue loans at like 5, 6, 7%.

They are to like trade funds, not to crypto. Like, it's tiny, but they're doing it to like commodity traders. They're like, Tether is in a different universe than mortals. Like, this might be the best business in history. But it's a shame that regulation has kind of forced— regulation has obligated Tether to not have any competition, which is crazy. And it would have been interesting to see a world where more stablecoin issuers in a free banking type of environment could have competed on similar terms and offered it would have brought on different types of risk, for sure. But instead, we have to contend with building this ourselves, which again, as a free banking enjoyer, I'm all for. Like, I love the idea that the regulator is forcing us to have free banking. Like, it's great, because now we have to come up with all of these solutions ourselves.

I mean, the only institution that is trying to do it is MicroStrategy, right? They are trying to create a term structure on Bitcoin.

11.5. There's also Meanwhile. This is such an interesting company. Yeah, I'm sure you guys are aware, building a life insurance product on Bitcoin. So their balance sheet has like enormous duration and nowhere to put it.

Yeah. I want to go back to something that I found interesting that I don't want to gloss over. You said that after 10/10, there's been every other week, an 8 or 10 sigma event, you said?

Calling it jokingly a biweekly 10-sigma event. Why is that? Because they seem to be the type, like Drift Protocol blowing up for $250 million is quite a, and these events have a binary characteristic. So whenever, you know, the actual exploit is relatively minor, but the finality of blockchain settlement means that the loss is almost total. And so when they happen, they're like traumatic for everybody. And they seem to happen all the time.

Both of you guys interact with the real world financial institutions and others, and I want to make— not the exchanges and folks that stand to profit no matter what, right? You have a principal-agent problem in that, like exists in traditional finance. But does an event like Drift update, like, forces you to re-underwrite and really question Lindy strategies, to your point, Luca, what DeFi should be really good at and what it should just maybe not, or if you're going to do it, maybe do it in a different way. Because to your point, Adrian, it is very binary and catastrophic. So I'm, yeah, maybe like your reaction to the Drift hack with AI, like Anthropic's release, and also like, how are you seeing the market react to that, especially people that have been curious about DeFi that you're interfacing with? Like, do you think there's like a material setback because of that?

I think, I don't know what Luca thinks. I'd be keen to hear what Luca thinks. My experience has been this type of event has the effect of dramatically increasing the cost of capital for operating on-chain for sure. They're very public, they're very transparent, and they're very unique to crypto in that regard. Although I will like to kind of lower the tone of self-flagellation a little. You didn't, we didn't have the luxury of monitoring Credit Suisse's positions in insolvent hedge funds before it went under. And so the lack of frequency of like, you know, you get updates on Credit Suisse, you know, 4 times a year. It's not like these events don't happen ever in traditional finance. So like, we can also take cold comfort in that. I think the reaction from crypto Twitter has been encouraging, frankly. There's been a lot more discussion about the risks, a lot more appreciation of operational security as a vector, and it seems like there is at least a genuine intent to take it more seriously, in particular with like AI attackers, AI-powered attackers. You know, part of the— it may well be that the increase in frequency of biweekly 10 sigma events is just like people with AI spotting exploits where, you know, nobody caught them before. So it kind of stresses the importance of having stronger operational security for sure. And maybe keeping things more minimal, like instead of building protocols that do more, harden the layer that has to rely on crypto guarantees to make it stronger. Because I have, I don't have the statistics on hand, but my impression from reading different reports was that the smart contract audit side is gradually hardening, and we're getting better at it over time. And that's exposing the remaining surface, which is operational security into these protocols, which will hopefully harden as a result and as a reaction.

Luca, before I go to you, one thought is back to like a CDS, which I find really interesting, like in Nexus, it would almost sell out. And it's almost like a, I think, Cozy, Sherlock, OPM. There's been a lot of like iterations of this, but none that in my opinion have really taken off. Um, how do you— your point around Credit Suisse is a really good one, but I think you had like the market was telling you that there was something there if you looked at like just CDS or just like— because I remember like there was whispers in, in, in the financial like Problem with crypto is like it just, it happens and it's like catastrophic and it doesn't, and everything's automatic and so it doesn't allow you to like respond. Is there an opportunity for prediction markets to play in a role here of like pricing in a way to be like a market sentiment of like if you spin up a world where like you have all these prediction markets on like, hey, is there going to be a hack on DeFi and you see a spike? That's revealing in and of itself. There was a—

before I cede the ground to Luka, there was a parallel. The only, the nearest parallel I can think of, of something like a crypto hack in traditional finance was the attempted heist on the Bangladesh Central Bank by North Korea, probably the most talented OPSEC operators in the world, frankly. And they were able to social engineer access to the accounts of the Bangladesh Central Bank, timed the time zones to ensure that nobody was watching. I think they were successful in evacuating like a couple hundred millions of dollars out of it, but they were thwarted at like the last second. Like, that's like, they're much more rare because these transactions can be reverted and they are not final. To your point, like the finality of the blockchain settlement makes the what's at stake much higher. In crypto.

Yeah. And I think there is an incentive exactly because of the way crypto works to keep stuff super confidential until the second when everything happens. So I think that the leakage of information is way less. But I think your point, Santi, on prediction markets is actually great. Again, I don't shill my business, but sometimes I shill my writing. I've been writing about prediction markets for a long time. I think the prediction market is probably one of the best ways to express uncorrelated risk out there. It's a very good primitive. Now, unfortunately, prediction market is very fancy today, but they're not doing that. They're just doing sports betting. So it's a different use. And the valuations are pricing the retail access to gamble. But I think prediction market is a very, very interesting primitive to actually express uncorrelated risks and cover. I also think that the— what we are seeing now in crypto, I agree, we are— we, we see in TradFi. The difference is TradFi has a significant capital buffer that— because there are unknown unknowns, there are— you need to know that there are unknown unknowns and accept it and just somehow price it and buffer it with like, uh, with a cushion. We don't have it in crypto. We don't have the luxury. If you do have— you have to make a lot of money.

You have some insurance funds, but you could argue hard to save.

But it's minuscule, right?

So like, I think if you had more, if you had more money, that's why whales in crypto make a lot of money because they have their own insurance funds personally, like at the fund level, and they can take positions and they take— there is not an algorithm that is super optimized. Like you're like, you have your own balance sheet. And that's why venture, smart venture investors like have been good at this game because they know how to do portfolio management. But I also think that there are things, one, which is clearly the— it's clear that crypto is, is way, way better than trad fi, and there are things where it's not. I think crypto is great, is way better than trad fi in doing like super, super fast margin lending. I mean, we're discussing here about single basis points of LGD parameterization. I mean, this stuff is boring as fuck, guys, right? Like, because it means that— it means that we're pretty good at it, right? I think the other, the other thing that we are good at is just reinventing the bank deposit. Everybody loves stablecoins because it's safer than a bank, faster than a bank, easier to transact, cheaper, and hopefully they're gonna get some yield, or you get some yield from backdoor. On this, we are so much better, and there is so much, so much stuff to do because now we are revolutionizing the banks. The banks hate us because now we're eating their lunch. Uh, maybe we're better at perps trading because it's very good to take very quick leverage and price. There are things where crypto is so much, so much better. Uh, there is a lot of stuff to do. Maybe we're not going to be better in so many other things where there are other primitives that are better than crypto. I think this idea of crypto maxing the world and everything is going to go on decentralized rails probably is not true, right? And, um, we are better— the reason why we're talking about it, because crypto is a great distribution channel, because everything is permissionless and it's global from day one. You have a great product and suddenly you put it in the market and everybody can buy it. Uh, but that doesn't mean necessarily that we need to have every product in the world on Crypto Rails, uh, including private credit. I used to be a private credit investor. I love the asset class. Now, do we need Crypto Rails for private credit investors? Not really. If you're like a hedge fund, you just buy it yourself and you know how to price it. So, but there are things where we are much, much, much better. Uh, I think prediction market is one of those surfaces. I just hope that we go back building very smart things on prediction markets. Because now we're not, right? Now we're just transforming prediction markets into partially unregulated gambling stuff.

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

So I don't want to see, I don't want to see the world where you have a prediction market that incentivizes people to hack protocols beyond just— but that's true.

I guess you could say like Immunifi has been pretty good. Like I think there's a pretty good stat, like protocols that have bug bounties and healthy ones, like are, are you know, get just inherently get hacked less, right? But yeah, it's like a bit of like a quasi-assassination market. What, um, so just, uh, this has been a fascinating discussion. I get the feeling that we could go on and on and on and on. Maybe we should do another series here because both of you individually could come on the pod and just talk so much about your respective fields. Want to make it practical for users but also introduce some more excitement. This is not meant to be a DeFi is dead. If you picked up on the nuance, it's not. But what, what are you guys doing in your respective companies, or how you see the market that— I think you've hinted at this a bit in the pod, but that you're really excited about and you think is probably not talked about as much in the market? but will probably grow and be very successful?

I will start. I've been in the stablecoin space for a very, very long time before it was fancy. I mean, we started M0 in January 2023 with a very strong stablecoin infrastructure thesis. Most people outside of the core investors we had that no clue what stablecoins are, why we were so hyped about stables. Um, but we— there are two, two elements. One that are still— they're very important, I'm fighting for. One is super popular these days and the other one not so much. The one that is super popular is like we need stablecoins to pass risk-free on-chain. If we stay— if we, if we allow stablecoins to stream risk-free yield on-chain we are repricing the whole curve on DeFi. I think then, then you can really start doing like smarter stuff because the market is more efficient. And banks are fighting it, everybody's fighting it, everybody has a horse in the race, but I think it's absolutely in the interest of the, of the whole space if we do that. Uh, and I'm gonna keep fighting for it to do it in the safest and most direct way. Uh, I mean, at mZero we have systems that allow the streaming of yield of risk-free rate on-chain on a continuum basis. Uh, we can do it offshore, we cannot do it onshore, sadly, which is crazy, uh, because it creates very these weird situations where like retail is taking a lot of risk and they're forced to do that. The second one that we don't talk about too much is stablecoins. In my, in my field, like, stablecoins are the whole— are the hype today, but we spend a lot of time just bundling stablecoin with fiat. And most of the stablecoin so-called infrastructure company— I'm not gonna name names, but very successful companies and profitable. They're just patching tokens with accounts and cards and effects and making spreads. This is okay, but I don't— I think the— in our thesis at M0 is that stablecoins are on-chain infrastructure. So you need to build infrastructure primitives on-chain to do liquidity, to do effects, to do yield programmability, create accounts, move, move stuff, create applications around it. I think we should spend much more time on that. We feel we are alone in this field, which means also probably we have enough capital to build it and be a couple of years ahead of everyone. But I think now most of the effort in stablecoin is just doing on and off ramping. It's like we're building scanners and printers. We're not— we are not writing Photoshop. We should spend more time writing Photoshop.

Yeah, and on my end, we're really focusing on the nerdy parts around plumbing. We view like crypto and DeFi as plumbing. And what we're excited about is either replacing or building adjacent plumbing that will allow financial markets to flourish on DeFi. And I think one of the— well, coming back to the point about the long-term balance sheets, you know, as a team that's been entrusted with a part of the balance sheet of Sky through the Grove star. This is not as big or as long-term focused as Tether or as an insurer, but it's not that far off. And I think that allows us to take, to do very interesting experiments that can help increase the accessibility of things like the risk-free rate on chain and take on more duration to try and lengthen the term structure of DeFi. Beyond the point where it's just the 12-second increment. Yeah, nothing that I can discuss publicly now. But, you know, a few projects that we have in the works that will be released in the next few weeks. And we'll hopefully— and to your point, like, for people thinking that this is a DeFi doom and gloom, I hope I didn't give that impression. Like, as DeFi burns to the ground, we will be the last people standing in the ashes defending it. We're like super committed. We're a family business, not venture-backed. We grew up in this space and we'll die with it. And we're very excited about DeFi going forward for sure.

Now, is there, I mean, you talked a lot about the frameworks and the analysis you guys do. Is that open source? Do you plan on publishing?

I mean, because I think that would be huge. We publish all the time on our Substack, the Steakhouse Kitchen. So kitchen.stakehouse.financial. And we tweet about it all the time. Every time we onboard an asset issuer, we underwrite them, talk about it. We have our risk management framework updated on a daily basis on our docs page. So there's plenty of material. Yeah, like you said, we could talk about this for hours. So, you know, God forbid. Yeah. That's amazing, guys.

Well, look, really appreciate you coming on and we'll link to your blog post. Luca and Adrian, we'll, um, we'll definitely post to that dashboard. Um, sorry. Um, and I think we'd love to have you guys on. Like, there's just so much that we didn't talk about, like rating agencies. Is there going to be like rating instruments? Uh, you know, insurance. Like, we can go on and on and on about a lot of the different things that we unpack, like that we talked about in this pod. But we'll have to leave it there for now. Really enjoyed the conversation. And, um, yeah, we'll, uh, appreciate you guys coming on.

You should see the prediction market on what we will talk about next time. Definitely.

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

Ciao, guys.