DeFi by Design EP#2: DAI Deep Dive

Transcript

[Music] welcome to d5 by design where we talk all things blockchain cryptocurrency and strive to educate power and enrich welcome back to d5 by design i'm rob uh happy to be talking to you guys today i'm here with andrew and kenton uh andrew how's it going what's going well man i'm uh hanging out staying alive with corona going on yeah i'm here just keep it with it keeping with it but really excited to be talking to kenton today he's from maker dow and you know he's been at maker dow for a long time really interesting project so kenton uh over at maker is an integrations engineer

he has contributed to developing the maker protocol and is actively working on the maker dow ecosystem uh what maker dao is really focused on is dye which is an ethereum based stable coin pegged to the us dollar it's the world's first global unbiased digital cache and it's the core feature of the maker protocol kenton's role is focused on improving the integration experience of dye and pairing it with the maker vault functionality into supporting platforms this stretches from crypto wallets to crypto exchanges all the way across the d5 ecosystem since dye is the oldest stable coin in the industry and this is across d5 uh it's manifested through varying

products such as borrowing lending prediction markets and trading which all bundles into an ecosystem that moves decentralized networks and open source software to improve financial systems through transparent and connectable protocols now a little bit more about kenton uh before joining maker he was actively involved in rocket propulsion systems uh he's worked at spacex lockheed martin and a nasa funded cryogenic lab during his aerospace engineering education so now he's still working with decentralized finance over at maker he's a self-taught coder and adventurer how's it going today ken hey guys uh everything's going great um

thanks for having me on the podcast cool cool really excited to have you on today we want to talk about everything uh d5 and what you're working on so we can jump right into it what is dye first of all since that is the main focus of maker how is it better than other stable coins and what is kind of the 101 on maker and what they're doing in the d5 space sure i think you had a great introduction to what dye is dye is the world's first global unbiased digital cash so what this means is that it's accessible by anyone ranging from on or under bank at any time any place it could be used to purchase goods and services it could be transferred anywhere in the world within

10 minutes or less and it's a stable coin which means that it's soft pegged to the us dollar that is one primary use case of the maker system and the other one is to grab liquidity and so this is how dye is minted and burned the supply can be adjusted by anyone and i think before i i dive into exactly how that works i think it's best to to do this through and uh now so in the legacy world what if you need like a liquid asset like cash what would you do so let's put that into some context say that you're a small business you're looking to expand your operations but you don't have the cash yet in the

legacy world you would go to a bank ask for a loan pledge your business asset as a form of collateral wait for a month go through all these hoops to get your business appraised and finally you will get your loan using maker and defy you can lock up a digital representation of your asset and give instant liquidity to yourself and that liquidity is in the form of die so i think that like again first is stability that's in the form of die and then the second is liquidity and that's in the form of this permissionless loan i think that both of these are the core pillars of what maker dow is offering yeah i mean those are two things that i

think will be quick for other people to pick up on as well in fact i'd be willing to make the argument that the average user of finance uh would be more willing to invest and use die right on a regular basis than than other crypto protocols even including ethereum even though you know obviously all this stuff in d5 is dependent on ethereum i mean i'd be willing to say that i think spreading that awareness and knowledge of what dye can do and does along with the maker foundation um is going to be crucial for the overall growth of diet itself in terms of being more liquid you know and more uh trustworthy records only been around for two years it's supposed to break or it it shouldn't break once in every half century something like that so i think

more like dye could really be something that brings the awareness of uh you know this whole uh craze with d5 you know to the light in the extent of a stable coin that's effectively not backed just by a us dollar um got a little off the rails there but i'm really excited about dying a lot of my friends actually have been asking me about stable coins recently less about you know cryptos more about yo what are these stable coin things how do they work you know how can i earn interest all that kind of stuff well we'll dive deeper into that but i think i'm just i'm really excited to have you here right now yeah yeah awesome dye is one of the first like world's first like true decentralized stablecoin um and so i think it's worth to highlight some of the pros and cons

as it compares to others like it out there kenton could you give us a little more insight into what you do at maker dao specifically and you know what it's like working for an open source protocol yes of course so i i work as an integrations engineer at the maker foundation where my focus is on improving the integration experience with the maker system i think it's worth drawing a distinction between two commonly misunderstood entities and so the first one is make or dao and the next one is the maker foundation maker dow refers to the set of smart contracts in the maker system that rests on the ethereum blockchain the community mkr governors as well as the ecosystem

of projects that are built on top of the maker system on the other hand the maker foundation which is a temporary organization that i work for that is purposed to bootstrap the make or dao so what that includes is laying the groundwork of technology as well as helping to kick-start some of the covenants processes so that it could eventually live on its own and i'm sure we can get more into this but make or dao is decentralized because its covenants is decentralized as well so not only can anyone come in and use a system permissionlessly but then also one could participate in the governing action of ensuring that a system like this remains

valuable to those in need and is it tough working for an open source like system like that i know you said that you know the maker foundation is bootstrapping maker doubt how does that work does it come with uh some pros and cons that you know you wouldn't necessarily get at a traditional hierarchical job sure i think working for a foundation in this open sourced ecosystem is quite interesting because the foundation is just one voice and it's not the only voice there are other community members and mkr governors out there and when i say mkr governors i'm referring to those who hold

the mkr coin that's our covenants coin basically gives them a share that they can use in the governance process so working for a company on a project that is not entirely controlled or really like more or less influenced by that company means that you have to really really know what you're talking about it's going to be sticky right the foundation may have their own provocative of where the dao should go and like evolve into but the community members and those that are that hold mkr and that are involved in the ecosystem actually have the most influence in this um and so really from my perspective it's been a pleasure working

and also thinking alongside of this open source community yeah and i mean speaking of decentralized and open source you were mentioning just a bit ago about dye and it obviously is the foundational piece of a decentralized stablecoin now real quick the other two stable coins that come to mind are usdt as well as usdc right so from what my understanding is essentially usdt is kind of in the middle of dye and uscc meaning dye is not backed by any sort of dollar there is no one to one as well as it is completely decentralized right in the way that it is in existence and then usdt i believe is decentralized but it is

also backed by a dollar and i believe usdc is completely centralized by coinbase meaning they can freeze the funds at any time and it's backed by a dollar so uh correct me if i'm wrong there and then what do you think about those comparisons and what makes die either better or worse pros and cons in comparison to usdt and usdc sure just for those who don't know usdc stands for us dollar coin which is a dollar representation that's minted and burned by coinbase ustt for short it stands for tether but it's usd tether and that's issued and maintained by a tether treasury and so both of them are actually quite alike the only uh difference really is that there has been some speculation that for

every usdt that is in circulation there's less than one dollar that actually backs it and that's most likely because of the lack of cooperation that the tether treasury has with the outside world but we can get into that in a second let me just give your audience a like a breakdown of what are the flavors of stable coins out there so there are three types of stable coins fiat backed which is the easiest to implement crypto backed this is what dye is and then algorithmic so this is the hardest to implement ustc and ustt and pacs they are all fiat backed so that means that a centralized entity accepts a fiat currency locks it up into

their bank or one of their partner banks and issues a digital representation of that dollar a pro is that it's very simple to implement but a con is that there's much risk that the counter party aka coinbase or the tether treasury will not follow through on its word of dollar redemption or some other form of corruption takes place right so so uh real quick so essentially if there was an incident like a bank run this could be a potential problem with the fiat back stable coin exactly exactly so coinbase is under the u.s jurisdiction and so there's likely larger regulatory scrutiny

on their operations whereas tether is actually operating outside of the united states outside of europe and they're actually i don't even know if they have a headquarters somewhere so they are a remote organization and thus likely do not have the regulatory scrutiny that coinbase has so in the event that there's a massive run on dollars locked up in the tether treasury there could be a bank run type situation where there's a race condition leading to those that arrive late actually don't have any dollars to then redeem so and so how does guys come about to solve this problem of the redemption and of the bank runs

and of everything that we just talked about sure so unlike fiat backed stable coins diet is decentralized so that means that not only the system is permissionless but also the governance is open and accessible for anyone to help to contribute to so what that means is that dye is not created or redeemed by any central third-party gatekeeper or a group thereof and it's always backed by a surplus of a pool of diversified assets and kenton we've talked before about how uh you know different coins have different collateralization factors can you go over kind of how those collateralization factors work and the difference between under

collateralized loans and over collateralized loans kind of how you know these coins um you know some people they can post collateral and then get some sort of loan in return but they can't go over and above so you know for instance with a decentralized uh organization there is no credit and you can't get any kind of loan that would go you know over and above the collateral that someone would post why someone would do that you know what what's the benefit for that in in certain kinds of lending aspects sure sure so lending and borrowing as it exists on the ethereum blockchain right now is largely going to require some form of collateral that backs the loan

amount in the event that the borrower defaults and so why is that important well everyone that has access to the ethereum blockchain has an ethereum address and the ethereum address is typically not linked with a real world identity and even if it was they could be anywhere in the world and they can fall under any jurisdiction that actually may side with them over the lender in a potential litigation and so that's the reason why there is a collateral requirement for borrowing and lending and defy on ethereum now and so uh when you think about like how much of an asset should be

required to back alone you typically think in terms of like cushions so in the event let's look at like a potential default of some sort in the event that a system suspects that a borrower will not be able to pay back their loan be it on compound or the maker system it will liquidate their position and sell off their asset in an auction in order to essentially cover that bad debt okay and so the reason why that the concept of a cushion is important and this cushion it's called collateral factor that is a terminology used in the compound system but in the maker system it's called collateralization

ratio and so that is essentially the usd value of collateral that backs the usd value of the debt that is owned by a given borrower okay and so if you have a really high collateralization ratio then the system is pretty confident that you haven't defaulted on your loan and that eventually you will pay it back but in the event that that collateralization ratio starts to go down then there's going to be a point depending on which system you're looking at where your position is going to be liquidated and so for our system for the maker system the liquidation ratio for ethereum is 150 okay which means that for anyone who

opens up a loan position if the underlying asset decreases in value below that point their position will be liquidated got it yeah so what are some of the reasons that someone would take out an undercollateralized loan or excuse me an overclouderalized loan because we know you know when someone needs money or they need credit that would be i guess the most common reason for an everyday individual to be taking out a personal loan uh what are some of the reasons to take out over collateralized loans in this instance sure so in addition to the kind of like the design requirement of ethereum whereby you can't really avoid

this anonymity expectation other than that where you don't know who you're going to operate with it actually gives you a faster ability to take out a loan if you have an asset that can be properly valued and verifiably locked in a system like the maker system for a type of over couple hat or a last loan and so again it's really just speed and access you can be anyone someone who has great credit or someone who does not if you do not have great credit then this would be your best option but if you do you are still going to be constrained by the amount of time that it takes to evaluate an under collateralized loan and for those who aren't as familiar with what

an under collateralized loan means it's essentially a loan by a lending or financial institution that doesn't require an asset to be locked up and that can be used to cover that loan in the case of t fault and so what they typically look at is the potential cash flow that would come from your income right and so they evaluate who you work for what are your costs what's your monthly income and then look at your credit score as a way of reputation to then calculate a rate that is conducive to the risk profile that you fit into interesting interesting yeah i i found that as one question that kind of stuck in my mind you know going through these

d5 protocols and maker dow you know was also part of this under collateralized versus over collateralized lending question so thanks for kind of giving me a clear picture on that you know that that's one thing that comes to mind when i think of how d5 could improve or give more accessibility would be to you know provide more loans or incentivize more loans that are under collateralized because that would be you know where more people need help they're trying to get out loans are there other problems that you see now that need to be solved before average people are willing to convert you know from their traditional fiat currencies over to a stable coin like die sure sure

so um the two biggest issues that we're seeing in d5 right now that's preventing people to convert the traditional fiat currency to a stable coin like die is that the die peg which is basically saying what is the us dollar exchange rate of die the diet peg is currently not at one dollar so ever since march there has been a constant like kind of like a perpetual state of more demand than supply for the die coin and so what that has done to dipeg is it has increased the exchange rate to like 1.01 and 1.02 dollars and obviously from a consumer's point of view

it doesn't make sense that you're going to exchange from like 100 us dollars into less than 100 die and so i think that like that will add some confusion and ultimately inhibit the amount of like die command from traditional fiat owners but i think it's important to recognize that again this problem is being addressed by the mkr governors and the maker community it is something that's that's front and center in terms of the problems that we have to handle and so there are multiple proposals out there that attempt to fix this issue through the form of increasing the debt ceiling on some of these assets to the potential new type of module called the psm

nice yeah no um i can only imagine actually working right now with all of this stuff that is going on in d5 and trying to be at the forefront of solving those problems that they just mentioned and trying to bring people right into this world of decentralized finance what has it been like currently with everything that's been going on it seems like this uh this whole sector if you will has really blown up and it's getting to the point where people are getting really really excited about this so i mean starting with like the compound protocol obviously with market cap or evaluation if you will of over two billion you know and and all these other platforms you got instant d app and uniswap and uh and balancer and all this kind of stuff what do you think and what's kind

of your take on what's been going on with the recent rally in d5 with the yield farming and liquidity mining on comp and balancer and just overall kind of what's been the vibe with your peers and co-workers amidst this growth that's been happening and seeming like you know towards the end this year it's only going to keep on growing how's that been and kind of what are your thoughts uh right there i know that that's a lot to unpack you can take it in whatever direction that you like sure sure i think that our space is going through another like craze right it's similar to the 2017 ico craze but it comes in a different form and this form is is in the form of yield farming and so what yield farming is is

it's the opportunity for people to participate in defy systems and be given an incentive for that participation so that's the most abstract way to kind of introduce this but what we have actually seen like more concretely is protocols like compound and balancer basically offer subsidies for adding liquidity to their decentralized systems in the context of compound this is a money market protocol on ethereum aka that means you can borrow and lend on open terms again wrapping it back to earlier this type of system requires that collateralist pledge so it's also

an over collateralized loan but what compound is doing is they have actually locked up almost half like over 40 percent of their compound covenants token called comp they've locked it into the system and that system is distributing comp at about like almost 3 000 a day right so if you multiply that by the market price of comp which is about almost 200 dollars a day then that's equivalent to about 500 000 worth of subsidies every day just for parking your assets on the compound system and so when you compare that to the amount of incentives that compound offered previously which was only like between 10 and 20

000 dollars worth of incentives in the form of interest i think that it's fairly easy to understand that we are going through another rally and it's not only a rally in price and new projects but it's a rally in innovation yes this type of subsidy program is not new i think a while ago either jetblue or jet.com in like 2012 or 2014 they offered something similar where they said look we have 100 000 shares if you refer someone then you will get a share right it's not new in an overall sense but relatively if you look at the blockchain space and specifically the d5 industry this is a brand new type of experiment really and that is what's

very exciting so what i'm thinking when i observe all this is like holy crap i didn't even know that like no one could have predicted that the price of comp would be where it is right now and when it was initially added to a luna swap pool at the time of comp distribution it was like 30 or 40 dollars and so the price has 5x and that has led to very like strange types of like inorganic behavior from the user base and so i'm trying to stay like conscious of that and just focused on the innovation part because these the systems and processes that come out of this craze if it ever comes down is going to lay the groundwork for

what decentralized finance is going to evolve into and can yeah yeah that that's really interesting just kind of what's been happening with comp and how we saw the price run up um you know so high when it was actually trading you know at 30 or 40 dollars like you said for quite a long time and then you know had some rapid growth one kind of offshoot uh and you talked about the governance of maker but also of comp you know when this protocol is distributing so many governance tokens per day is that a problem do you think there's too much governance power falling into the hands of people that you know don't actually care what happens with comp and where the

protocol goes um you know i'm not sure if you've seen kind of the governance statistics on maker uh or comp i'm not too familiar with them but what i did here was that you know a lot of these governance token holders don't actually vote on proposals and it and to me that seemed like you know a really deteriorating aspect of the growth that we're seeing in d5 you know can can you speak to that do you see the same thing ultimately is this just a short-term problem that'll get solved kind of what do you think on the government side of things sure sure so the compound distribution plan had two goals in mind or so it seems the first one was decentralized

covenants right if we're going to promote a system that is covered in a decentralized way we want to ensure that there's a large distribution of ownership across the spectrum of those who use the system right and what better way to distribute that compound than to actually reward those that are interacting with the system on a day-to-day basis so that's the first goal the second goal is liquidity so what happens when more assets are parked in compound is the slippage on these loans and trades is actually reduced and so

actually like and i think this applies more to pounds or more compound but it just more or less just improves the value proposition of the compound system once more acids are under the management of the compound protocol so i think you're right to speculate that the compound farmers that are capturing compound dividends if you will are not as active in the covenants process i think one could i think one could agree with that but i think it's also important to remember that this is simply a function of the comp price and this is obviously this is not intended but i think that as more and more compound is distributed through the system and

comes down to the market the float is going to increase and that's going to have a downward pressure on the comp price and once the comp price leads to like an annual yield of less than the 68 amount that we're seeing now and it comes down to like 10 percent or 5 percent and i think that the farmers that are dropping their assets into a compound to secure that compound distribution they are going to be more focused on participating in compound covenants so i think we'll see what happens with the price of course and the future is unknown but if the comp price comes down i think we will see a higher proportion of compound users that are going to

participate in governance interesting and interesting yeah i would think so too i mean you know just watching what's happening with these different governance protocols is kind of like a a big political experiment you know and we're doing it uh in cryptocurrency which i think brings a lot of things together andrew were you uh gonna go ahead and say something yeah yeah so um i i kind of i don't view that as a huge downside uh but it's certainly something that we have to be aware of but i'd like to just touch on some of the downside risks that are uh prevalent right now with this d5 rally so i mean aside from you know prices going down if you're buying on speculation of a lot of these d5 assets which are

on average i believe up about 100 or 200 in quarter two um i would expect that to honestly actually i just i have no idea what's gonna happen there so obviously you know investing in cryptos itself is downside risk because you know price could go down you can lose the value of your tokens but i'd like to touch on the other downside risks kind of what you see kenton that um some problems and some risks that have been uncovered recently all right with this craze obviously there was balancer uh quote unquote hack right there's obviously like the smart contract faults and bugs and fewer things but i'd like for you to touch on that if you will and just kind of educate us as well as the audience on kind of what the downside and the risks are whether it's technical or emotional or protocol risks you know just what kind

of risks we should watch out for when trying to yield farm or use these platforms or invest you know obviously everything we discussed here as i said you know is uh should be educational but as far as risks you know what can we expect with these protocols sure i think when you look at like web 2.0 and you look at the facebooks of the world the amazons of the world etc they have been very successful in adopting an ideology which says like work fast and break things right and so what that means is let's really grind out new innovative technologies and if it breaks and that's fine we'll just patch it up that i think is not as applicable in

web3 because we are dealing with real value that can be lost if things break real value can be lost and so i think that the systems and decentralized protocols of web 3.0 they need to adopt a different type of mentality that prioritizes security and promotes scrutiny among everyone and so we have seen a lot of the largest players in the space including the maker foundation and compound labs we've seen that like both of them have prioritized that over everything even usability in some instances but i think it does not ensure that the ecosystem is immune to

smaller teams that have smaller that are almost startup-like and they don't have as many resources to formally verify their smart contracts right which is another word like it's like a mathematically like proving operation of the smart contracts they don't have those resources to perform such large amounts of scrutiny and so we're going to see issues and we're going to see hacks and we're going to see projects that continue to work a little bit faster than i think is necessary and so when you're looking at t5 systems out there i think that one could count on both of their hands the number of examples of d5 systems that have fallen prey to like a hacking event or exploit and i

think we're still going to see those as the space grows and it really boils down to the technical risks which is like if a smart contract system does not have like a formal audit then it has a higher risk of having a smart contract bug and then the other one which is what we're seeing right now is the economic like risk hike the risk may not be evident up front but it actually may be lurking behind the curtains and that comes from just strange incentives and strange responses that come from brand new incentive structures so what do i mean by this i'm referring directly to compound and the compound price like we have seen that the compound price the volatility of

that has been huge and that's because there's so much interest and so much like game theoretical like responses that's happening right now it's really hard to predict what risk can come out of that so i think those are the two big risks that people need to be aware of but to also recognize that like look this is going to continue to happen and that every additional hack that happens there's going to be like a rebirth that occurs where people are going to improve their processes and there's going to be more innovation long term so i think it's almost like a rite of passage i feel but i think that could be a bounded opinion and can how is maker doubt working on improving these risks you know like each time

you said we get hacked and then we see a rebirth how is maker now anticipating these game theoretic responses and what do you see coming up for maker dow that's you know trying to improve the system sure so the maker dow and the foundation we've been really focused on iterative improvements right and so from a usability point of view and like a market research point of view the first like maker system that was released was called single collateral dye so what that meant is that psy and its cypher were short acai could be minted and burned but only with

the ethereum asset right whereas now die is backed by like six or seven or eight or eight different asset types and there's an important like distinction there as you increase the amount of assets that back the value of die you effectively diversify the tail end like black swan risk that occurs from a single asset and so sai in itself actually ran for almost two years and what we found like like through that we were able to build our governance processes we were able to better understand how solidity contracts work from a fundamental like primitive point of view and so building

our the prerequisite in haulage and understanding what's the best use case of our system was accomplished with psy with die first and foremost security has been the most important thing in addition to our internal views we have three separate formal audits from three professional auditing and security firms and we have formally verified all of our core contracts and when i say formally verified again i mean that it's similar to a mathematical proof but it's proving the actions of a set of smart contract logic and so i think that like the formal verification has been the like almost the final stamp of approval in the smart contract space and

so that's how we handle those risks cool cool yeah i think that's really interesting on how you guys are still developing you know especially with the way that the dow because it's autonomous and what it prioritizes and what it decides to work on and when i think i have you know just one last question and it is kind of forward-looking i'm curious you know when competition real really boils down the interest rates and the liquidity farming you know what do you see as the benefit in decentralized finance compared to traditional finance when you know ultimately we might see those rates as far as comparable percentages and you know you can keep it quick because i know we're running out of time but

what are you anticipating for that i think that traditional finance has a lot of like fat on it if i'm being frank and that fat comes in the form of cost time and a lack of accessibility and with decentralized finance which stands on the shoulder of the ethereum blockchain of blockchain technology anyone now has access to the traditional finance services such as borrowing and lending and prediction markets and insurance at a fraction of pay cost and they're able to make use of these systems at the fraction of the time that it would take i think i think people take it for granted especially in the west because there

have been many abstraction layers that have been built on top to make finance look easy and pretty straightforward and they have been right but underneath that abstraction it's still ripe with roadblocks and with decentralized finance we could finally fix those roadblocks once and for all awesome awesome yeah and i'm looking forward to it yeah i mean it's already growing i think 2020 is the year or sorry 2021 is the year where the kind of the whole world wakes up to the fact that while everybody once thought that uh cryptocurrency was kind of dead again right with the 2017 pump and the bitcoin this and everyone is still focused on bitcoin what they're going to realize is that there have been just a mass amounts of development on the ethereum blockchain

with ethereum as the contender here uh for the great flipping and all this other stuff and i think even like the centralized like the finance bros even like the suits quote unquote as dave portnoy would call them i think they're gonna come to realize that wow there's a whole there's like almost a parallel infrastructure here that we've just have no idea about and i think 2021 is going to be one that is all coming about so i think i mean overall that the outlook is certainly great for you know this space this sector and being here and yeah that's a thing that's all i've got for you as well man it was a serious pleasure having you on your knowledge of maker and dies obviously top notch well verse it was a pleasure and is there anything else that you'd like to share with us or with our audience or

any closing remarks yeah yeah i'd like to also say thank you both uh so much for giving me your time it was really fun to have this type of conversation and for those that are more interested in decentralized governance you can go on to uh forum.makerdao.com and actually see decentralized governance in action and it's also free right like anyone can participate in this if you have any more questions for me you can reach out to me on twitter at kenton prescott first and last name um idms are open but thank you both thanks ken i learned a lot and i hope everyone who listens learns as much as i did

so thanks for having us and uh i hope again we we can do this again sometime when d5 has 10 billion locked up so we'll do the next one awesome all right guys well this has been defined by design thanks to our guest for coming on today that was ken prescott you can find him on twitter at kenton prescott the integrations engineer for maker down so i'm rob and thanks for listening bye guys thanks thanks for listening to the d5 by design podcast until next time deep fry slate team