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Listen: Next in Tech | Episode 75: Decentralized Finance: Managing risk as markets mature

With the upheaval taking place in the cryptocurrency markets, there’s a lot of confusion about the realities of DeFi. Charles Jansen, head of DeFi Transformation for S&P Global Ratings, joins host Eric Hanselman to focus on the distance between the two and look at innovations aiming to manage risk as the industry matures. DeFi capabilities can speed transactions while reducing cost and are already finding their way into payments channels. Useful abstractions are powering innovation.

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Transcript provided by Kensho.

Eric Hanselman

Welcome to Next in Tech, at S&P Global Market Intelligence podcast with the world of emerging tech lives. I'm your host, Eric Hanselman, Chief Analyst for the 451 Research arm of S&P Global Market Intelligence.

And today, we will be discussing decentralized finance, taking it up to a higher level from some of the technology conversations we've been having with our guest, Head of DeFi Transformation for our Ratings arm, Charles Jansen. Charles, welcome to the podcast.

Charles Jansen

Thank you for having me.

Eric Hanselman

Well, thanks for being on because we've talked in previous episodes about a range of different aspects of the technologies that underpin aspects of cryptocurrencies, DeFi, a lot of the aspects there. We talked a bit about blockchain and Web3 and some of the different aspects of it. But especially now as we've gone through this crypto crash recently, that's raised a lot of thought.

We've been having a lot of discussions with clients about what really is DeFi and what's its relationship with crypto. And I guess, before we get started, for our listeners, I want to get a little bit of background out there just about what decentralized finance really is and how it really fits in that broader perspective.

Charles Jansen

Yes, that's a good question. When I speak with -- so we've been speaking with many protocol roles, so with many clients internally, externally, with regulator, as this new team has been set up in Ratings. And there are some people that, when we say DeFi, think crypto. And when they think crypto, they think Bitcoin.

DeFi is something that did not exist really until 2020. There was this DeFi summer in 2020. And DeFi is really a sub -- I would see that as a subcategory within crypto, which is not necessarily exposed, for instance, to the volatility of the market. In DeFi, if you buy a token from a DeFi protocol, you're not using DeFi, right?

DeFi is a suite of protocol that allows you to get yield in a different way. You can take loans. You can provide liquidity. You can become part of a market maker. You can swap your assets always in those protocol in a decentralized and permissionless way. So that's really DeFi.

And one of the main characteristics that people sometimes do not know is you can get here on a stablecoin. So you can be totally shielded from the volatility of the market and getting a yield in stablecoin. And we can discuss later on this. So new part of DeFi that focus in real-world asset. Will the yield actually come from real-world assets also?

Eric Hanselman

Well, I think the challenge is that many see the headlines about crypto and everything that's been going on and the aspects of how cryptocurrencies themselves are, to your point, very volatile. But yet, the DeFi aspect is the piece that's actually abstracting away a lot of the essences of financial transactions from the traditional financial markets themselves.

And it opens up some really interesting pieces and some aspects and potential for what we can do if you now start to have a lot of those tools and capabilities that step away from the limitations of the traditional market. What do you see as the potential for DeFi in financial markets?

Charles Jansen

The potential is huge. I think if we go back 20, 30 years and we look at how, for instance, people were trading on the stock exchange on the floor and now every single server, the revolution that we had with Internet, which took time, I think DeFi is potentially, we'll see, nobody knows, but the new rail of the future financial system.

There are different reasons for that. So the main one is that it brings a lot of efficiency just to work on top of blockchain. The settlement is instantaneous and do not need to be done by external actors, et cetera. So there is this trust from the smart contract.

There are some new challenges like the hack and issues that you can have from the actual code. But then it's a lot -- so it's a technology itself, and then it's really financial engineering. This is a new -- first, everything that kind of exists in the market right now is slowly replicated in DeFi. But there are also new things that just cannot be done in traditional markets like flash loans. And then there is so many different aspects, which are also potential.

And of course, something that is missing right now is a clear regulation on what could be done or not. But if you look at something like a protocol, like Maker, which can just mint as much money as they want as long as they got a safe and liquid collateral. When we see that the Fed will probably continue to raise the rates, initially, in DeFi, you would have better yield. And many would go in DeFi because you could have great yield on your money.

But as the rate could continue to go up, one theory -- nobody knows again, but one theory is it could become less expensive to get financed by DeFi, just because they are not tied to, well, the cost of capital that you have with traditional currency. In the case, for instance, of DAIs, not for all protocols.

And again, we've seen emerging a new type of DeFi, which Chuck Mounts, which I worked with, called tokenization of credit, which is a financing of real-world asset and real economies by DeFi, not touching any cryptos. So there are some use cases, for instance, that Maker have been doing with the Huntingdon Valley Bank, the HVB, which is a community bank from Pennsylvania. They do construction loan, collateralized loan equipment, commercial loans. And they have a line of credit now for Maker.

So basically, Maker is printing DAIs. So DAI are swapped into USDC, USDC are redeemed into USD. And from there, there's no more crypto. The USD go in a trust. The trust by -- well, it would take time to explain everything. But basically, the trust by half of some type of loans and the bank got regulatory capital relief from this.

There are some other initiatives with other banks and other protocols, and it's starting to actually have -- it's getting out of just crypto and DeFi. Because before, the loans were always overcollateralized. Will give me $100 in ETH, and I'll give you $33 DAI. Or I give you access to loan in different ways. Now you have more and more protocol that wants to look at how can you have uncollateralized loan and finance real-word asset or undercollateralized loans.

And that's where, also, we believe that we may have a big role to play. Because how do you do that in traditional finance? You do that with risk evaluation and risk scoring and risk rating. And you may have seen that we had already a rating a few months back on Compound Prime and where we're looking, which fits in our actual methodology and type of ratings.

So we -- as we created this new team, and we're just -- we're now 2 DeFi officer and me. We are looking at what are the adjacency, what are the possibilities. We are really at a strategy level, thinking of the possibility, but the potential is immense.

Eric Hanselman

I think the key takeaway is that we're now in a state in which DeFi is maturing to be able to offer many of the same physical world, traditional financial market capabilities, as you're identifying to be able to look at being able to work with real-world assets and managing them.

I think one of the things that I want to call out, to start, is the fact that once you've taken the regular financial transactions that happened in the markets day in, day out and brought them into an area in which you don't have to have the same intermediaries, you don't have to have all of those delays that working through multiple parties cause, and the fact that now that you can have transactions that take place very rapidly, not -- I don't want to head towards instantaneous because there is real processing time involved, but transactions that can happen within one individual contract.

You talked about flash loans. The idea that you can move value back and forth as part of a full transaction, and the transaction itself has a set of protocols around the way in which it actually takes place, means that you can do, as you were saying, new and different kinds of transactions in which you can transact more efficiently, transact more rapidly and open the world to a whole set of different ways of thinking about how transactions work.

It's one of those aspects that, I think, for me, holds a lot of that interesting aspects of potential about where it can go. But I want to talk about the piece that you were identifying at the end, which is, once you start dealing with real-world assets, I mean, we've seen a lot of the activity that takes place when we were primarily bound to crypto-based transactions.

But in the real world, the big challenge is how do you manage risk in transactions. And historically, that's been overcollateralization. You just simply wound up with enough value in the transaction so that you had sufficient guarantees that, whatever that back-end volatility was, you were protected. But what we've done in markets forever is look to intermediaries to at least manage risk.

And those are things that, I guess, we're just starting to see. But the fact that there are ratings being generated that are based on these transactions, that you've now got the ability to help participants in these transactions, the counterparties, be able to actually manage that in new and sophisticated ways.

Charles Jansen

Yes. So that's definitely -- that's something which is needed, like there is a demand for visibility from every participant. We are a TradFi company. There was some question internally, like, especially for me and Chuck like -- so DeFi, how would we be received? Because initially, DeFi was supposed to just sell traditional finance and change everything. Now...

Eric Hanselman

It will be the end of S&P, right?

Charles Jansen

No. Yes. So -- but we never had that kind of conversation. We never had that kind of answer. I think it's a new platform, which wants to mature, wants to evolve and wants to thrive. And they know that they need, well, component that might come from traditional finance.

And what we think, well, internally on our team is that it will become a hybrid, which I actually already started, which -- well, right now, the DeFi piece is way smaller than the actual traditional TradFi, but it's going up. You've got protocol that did not exist 12 months ago that now originated billions in loan. So it's growing pretty fast. There's a lot of interest.

Just basing myself on news, and I think I can share. In 2017, Goldman Sachs created a trading desk, then they killed it. Then they created again in 2020 or 2021. They're not killing it now. If you look at the news, it was mentioned not long ago that they were trying to raise $2 billion to buy back the assets from Celsius.

And I think that's what we're seeing across the board is everybody is still speaking about that from an institution perspective, from a developer perspective. It's not going away, and people now acknowledge that and look at how they can -- will participate in this for themselves, adapt, partner, merge, et cetera. So this is really happening.

And on your point before, so quickly on the flash loan. The biggest crazy thing about flash loan is you can -- so you do everything in one transaction, but you can also -- and mainly get billions from liquidity pool, basically, everything which is available in the pool. You can take that as a loan without any type of collateral.

And then you can have transactions with those billions. If you made some profit, then you keep it by the end of the transaction. If you lost money, then you cannot repay the loan. And then there is a rollback of all the transaction because it just creates an error, and you lost only the gas that you spend on this transaction. So these do not exist.

And speaking of payment, you touched on payment. Well, payment is the one that is most due to be disrupted by everything in Bitcoin Miami. So it's not really DeFi, but it's related to crypto and finance. You have the company Strike, which struck a deal with Shopify and I think it's NCR, like the one that provide access to credit card...

Eric Hanselman

Yes. Point-of-sale terminals, yes?

Charles Jansen

Yes. And they created something which the user do not even know that they are using Bitcoin Lightning under the scene, you will pay with your -- or there's different wallet that participate. Or you can do it with, for instance, Strike itself, but they have like 6 different other app, fintech that participated. And you can just pay with the money you have on your app in dollars, and it's immediately converted into Bitcoin. It goes on Bitcoin Lightning, and it's almost instantably given to the shop.

And for the shop, what is extremely interesting is, first, you didn't touch any crypto yourself, like nothing, and it's settled immediately. You don't have to wait for 90 days or pay a high percentage for that. So we actually saw it on the next day. So we were at the Bitcoin Miami conference. We saw this announcement from Strike. And the next day, people were ordering coffee and paying with that. So we actually see -- seen it in action.

So there is a lot of new technology that is being done. When you look at trends since Apple Pay and fintech in general, they abstracted the credit card, but the rails that the money was using was still the same. Now there's different companies that are looking at just attacking those rails and use what blockchain are really good for, which is not the only thing they're good for, but like instant settlements, in a way that everybody can agree and confirm that it has been done the way it should have been done.

Eric Hanselman

You have hit on what, of course, our listeners will know is one of my favorite technology concepts, abstraction, which is that you've got what Stripe is doing is integrating crypto back-end as part of their overall financial transaction in ways that the end user doesn't even need to know or understand, and that they're leveraging what are some very useful primitives to be able to manage that transaction in new and different ways.

And as you're identifying it, the transaction closes straight away. They don't have that dependence on whatever the clearing banks happen to be in card transactions. Suddenly that you've delivered a whole set of benefits for both the merchant and delivered it in a way that the end user, that consumer, doesn't actually even need to understand any of the aspects of how the transaction is managed. But now we've got much more efficient, much more effective, much faster transaction processing, what technology is supposed to do.

Charles Jansen

The benefits are mostly on the seller side. It's more or less the same for the buyer. But on the seller side, it's really interesting, especially for small shops. But that's also why you got a company like Visa, which are extremely present in the DeFi world, where they were presenting at permissionless. They had boosted permission. They are present. They know that, and they're investing in the field.

Eric Hanselman

That's the interesting thing that when we think about the technology that's involved, the best way to advance that -- those capabilities are to make them as frictionless as possible to the various parties that are using them.

And from a consumer perspective, as you pointed out, Apple Pay, a great abstraction. You don't need to be able to have a specific credit card. We were talking actually a couple of episodes ago about buy now, pay later. Again, the financing gets bundled into the actual transaction itself.

And heading towards retail, you've now got the ability to have benefits for the merchants themselves of simply leveraging that technology from an intermediate provider, like Stripe, who can optimize it. And presumably, other payments entities are going to want to be able to do that as well.

Charles Jansen

Yes. And there are many other examples. So for instance, going back to real-world assets, there are different protocol. They got Maple, Centrifuge, Goldfinch, TrueFi and many others. They have all really different niche and focus.

So for instance, you have some of them that focus on third-world country, and they all lend to other institutions that then lend to end users. And for instance, one was lending to PayJoy, which is a company that provides phones in third-world country, for instance, in Nigeria, in Mexico and India. And they just give you a phone, and it's uncollateralized.

So why would you just repay? Well, because if you don't, the cellphone would shut down with the software they had inside it. And they had, based on what I heard, excellent repayment. And what nobody really knew, when they got their phone, et cetera, that, well, the actual financing, the actual money that came in along, that was coming, at least, partially, from one of those protocols.

And you have that in different way. There is some -- another protocol, which was financing, well, another entity, which allows you to bring you your house. And it's just a normal consumer loan, but the money comes from DeFi, and you don't even know that. And you don't really need to know that because not really affecting you, but that's how everything is slowly emerging.

And that's how it should be, right? It's a big conversation. There is also around GameFi and how -- you've got application, for instance, WeChat. In WeChat, it's not just like WhatsApp, right? You will order a pizza, and you have your bank account in WeChat.

And there are many different, well, future game, which are looking at how can I do the same? How can I have something immersive in which then people will be using DeFi within it and interact with money and NFTs and potentially even ordering pizza at some point without even thinking about it, without maybe even knowing they're using DeFi, right? So there's a lot of focus also on that. Like technically, terms like NFT and blockchain and Layer 1 should disappear and then it's going to be just the product.

Eric Hanselman

Well, and we think about blurring those lines between what now are relatively distinct. If you think about gaming ecosystems, that's everything that's happening in gaming systems today, It has a fairly narrow connection with the outside world. You're buying whatever tokens exist in that world.

But the fact that you could then start to make that line much fuzzier in terms of what exists in the physical world, what's the value that gets moved back and forth between each of those various realms, there -- right now, it's the limitations of the transaction mechanisms that exist between them that are -- or the gateway between them that limit what that flexibility is. But if you're able to transact value in more flexible ways, you've got a lot of different things you can potentially do.

Charles Jansen

Yes. And that's what many groups are trying to do. For instance, Immutable is a Layer 2 on top of [ SAM ] dedicated to NFT and now mostly gaming. And they just had the deal with, I think, MoonPay so that people can just use their credit card.

Like you need those on and off ramp so that, at the end of the day, the same buying a skin on Fortnite or buying a skin in another game. And you don't necessarily need to call it NFT, just the skin that you own and could sell and so earn money.

Eric Hanselman

It happens to be that there's an NFT that anchors behind it, but you don't need to actually understand that that's -- there is, right?

Charles Jansen

Yes, you don't need to necessarily know that, right? So it's probably going to evolve. It's like when you go on, I don't know, Spotify or that kind of thing, you're not thinking about, "Oh, I bought it. I listened to an MP3." You listened to a song. So this will evolve. But everything is very, very new, but there is a lot of potential everywhere.

And what is really interesting is there's a lot of investment. There's a lot of real-time spend on the developer side. And I think it's really the difference with what we may have felt in 2018 when -- well, different big players were going out. I still, at least, on my side, I haven't seen anybody going out. I think, on the contrary, people are using the bare market as an opportunity to, well, get back in the game. Some -- there's so much noise in...

Eric Hanselman

There were consolidation, retrenching. Yes.

Charles Jansen

And it's cleaning the field also, right? All that it was not that real and that sustainable is going away. Now they are really building the next thing. And nobody knows really what the next thing is going to be. DeFi is 2 years old. GameFi barely exists.

The tokenization of credit, what I was mentioning, of financing of real-world asset with DeFi money, it's 1 year old, more or less. What is next? Well, I don't know. But there are probably things that will come that will be extremely disruptive that nobody is speaking about just right now.

Eric Hanselman

Well, and these building levels of abstractions give us the tools to be able to think about transactions in new ways. I mean, if we think about what the foundations are, I mean, underneath all of this, hey, we've got blockchain technology that is building on the crypto that built on top of some of those abstractions. DeFi is basically taking blockchain and using contracts, smart contracts, on chain to be able to go -- actually run the protocol that's taking place.

But those -- the protocols themselves are masking the complexities of what sits on top of that. We've now got folks who are taking DeFi protocols and starting to incorporate them into the back ends of regular transactions. Once those transaction pass are there, we can then integrate them into payment systems. And it just -- but it takes time to make those possibilities exist long enough for people to take advantage of them.

Charles Jansen

Yes. And it's all about like incremental step. Again, if we go back to the example of some of those protocols that provide real-world asset, well, financing, right now, there's a lot of people that just want out of liquidity pool. But if you loan the money to a real-world asset lender, it is not giving you back the money immediately, right? This is an agreement, and there are repayment. And...

Eric Hanselman

But the term of that loan that you've got to satisfy.

Charles Jansen

Yes. It's like, "Oh, now I want the money back, sell your house." No, it's not happening, right? So there are repayment. Everything is working well. But as the repayment are done, people get the money immediately because, well, nobody knows where the market will go in the very short term. So there is uncertainty on that aspect.

But what is really missing here is a secondary market of loan. All this protocol, right now, they issue loans, but then you cannot really sell them. You don't have any kind of liquidity. And one of the reasons you don't have that is because there's no easy visibility on the underlying and the risk.

So as a new type of risk assessment would start to be created, then it enables this -- somebody to create a secondary market of those loan, which, in turn, enable the field itself. Because as you got more liquidity, even for normal investors or for something like Maker, which has unlimited money, but they need this liquidity, they need a good collateral but also liquid collateral. Well, this secondary market of loan would change everything.

Also, in DeFi, you don't have a long-term duration just because of the way, well, things are. You cannot commit in a pool for 10 years for long or something like that. But if you had liquidity and you could have a secondary market for this, whatever you call it, loan bonds, et cetera, then it would be different. So there's a lot of potential things coming. We're trying to see where we can help and where we fit the best.

But the potential is huge and many, many players are looking at how it can evolve, including regulation. The regulators are all looking into this. I think in most countries, sometimes with guidance, like we have the executive order of Biden. It's just a new technology. It's a new opportunity. It's a new field. It's a new platform, and it's on everybody's sight right now.

Eric Hanselman

Well, and as you're identifying the extent to which we can reduce risk, increase confidence, the involvement of regulators, again, helps to give an expectation that there are going to be guardrails or some protections. But the fact that we can actually start to assess risk opens opportunities, like the flexibility that a secondary market for whatever those transaction products wind up being bonds, loans, what have they, that, that commitment of the transaction, if you've got confidence that that's actually going to pan out successfully, that's what helps markets to evolve. So I guess we've got something to look forward to, or many things, in fact.

Charles Jansen

Exactly.

Eric Hanselman

Well, thank you so much, Charles. This has been great. And there -- as always, there are so many different places that I'd like to be able to dig into. But given our time constraints, we are at time, but love to have you back to dig into the whole host of additional capabilities that we really haven't talked about in the aspect of potentials [ in peace ]. But thank you very much.

Charles Jansen

No, thank you for having me.

Eric Hanselman

And that is it for this episode of Next in Tech. Thanks to our audience for staying with us. And thanks to our production team, including Caroline Wright, Caterina Iacoviello, Ethan Zimman on the Marketing and Events teams; and our studio lead, Kyle Cangialosi.

Join us for our next episode, where we're going to be talking about inflation and interest rates. I hope you'll join us then because there is always something Next in Tech.


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