About this episode
What makes a good Defi investment and why are strong narratives and memetic founders attractive? Michael Anderson breaks down his investment style through Framework Ventures with host Samuel McCulloch.
Michael is a co-founder and partner at Framework Ventures, a venture capital firm focused on building the value of blockchain networks through strategic investment and infrastructural support. Before founding Framework, Michael built and sold Hashletes, the first and only NFLPA-licensed digital collectibles, with co-founder Vance Spencer. Michael’s prior experience bridges investment banking and consumer tech, with experience from Snap, Inc., Dropbox, and Barclays Capital.
Where to find the show
What to listen for
- Why communities build networks and drive adoption in DeFi and why this matters when investing in projects as a venture fund.
- Why Sam thinks synthetic products in DeFi have higher derivative risk because of the inherent volatility in the system.
- How hacks and exploits both expose the different type of weaknesses within DeFi and why the industry is not doing a good enough job preventing or informing users about the risks involved.
- Why token economics is a project’s business model in DeFi and why Framework has a multi-year, long term investment approach.
- Why Ethereum’s huge network effect is because of their developer community and their choice to build on Ethereum 2.0.
- Why decentralised identity is the Web 3.0 component everyone needs, but it hasn’t happened yet.
- Why Web 3.0 stands for transparency and openness in order to break the circle of surveillance with the tech industry.
- Why getting decentralised applications into Google and Apple’s App stores will be a test of whether or not they are ready to allow DeFi to compete with their monopoly.
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Samuel: Today, I’m joined by Michael Anderson from Framework Ventures. Framework is a venture fund focussed on DeFi, and specifically, they’ve invested into Cava’s synthetics chainlink and Edgeware as well too. So, Michael, welcome to the podcast.
Michael: Thanks for having me. I’m excited to chat.
Samuel: How has DeFi fit into your overall narrative of where Ethereum has been and is going and, and also is integrating into Web 3.0?
Michael: Yeah, we view Web 3.0 and DeFi as being intrinsically related. DeFi is really the first category of the building blocks with which we’ll use eventually to build Web 3.0 products on top of, I think We like to call it the financial radios that we’ll be able to use eventually to build different products, but right now DeFi is what’s working in DeFi and especially on Ethereum is really where the industry is focused.
Samuel: I’ve looked into, went through quite a bit, and I’ve always had this kind of nagging suspicion that it’s going to be a lot harder to move away from what has been created with DeFi into non-financial based aspects. When you talk about like domain hosting or social media, or really like any other service that doesn’t have a financial aspect to it, it seems to me that the adoption curve or at least just the ability for the web through products to go out and find users is much harder, in comparison to just building financial products that serve a need for gap finance.
Michael: Okay. I completely agree with you, but I would actually say that maybe we have different opinions about what Web 3.0 is. I think Web 3.0 is actually the financialisation of things that weren’t previously possible to be financialised. This is starting to come through with some of the things we’ve seen around Zora Foundation, which have launched over the last couple of weeks or months. They’re providing access in a financial sense. Two shares of culture, I think that’s how Zora Foundation describes itself, and that’s kind of our view of what Web 3.0 actually is. I don’t expect that we’ll be seeing a decentralised social media network eventually without any sort of financial aspect provided.
Samuel: I mean, so what is the Zuora foundation do?
Michael: Zora. It’s differentiated commerce where your ownership of token grants you access to some piece of limited content or commerce, and this is in the form of limited content in the form of songs. I think there’s a couple of different T-shirts that were put on there. Socks had been put on there. It’s just an interesting way of finding a financial market for a limited supply of goods.
Samuel: I mean, it’s strange that you would like to securitise content, right? When you could just rather have a subscription-based model for it. I mean, I look at what sub stack is doing, and it’s amazing right where you’re enabling all these small content creators to monetise outside of major publications. What would be the need for having a tradeable asset, connected to content?
Michael: Well, I think that question is exactly what we’re trying to figure out right now. I don’t think that these answers or these questions have been answered yet. I think Foundation and Zora are doing really interesting things, but they haven’t hit scale, and they haven’t really found that product-market fit yet, but that, I think if you squint and look into the future is sort of where the Web 3.0 direction is going, that requires there to be these primitives, these foundation layers of DeFi are the backstop to providing and creating that access.
Samuel: My understanding of everything that’s been done on Ethereum, and I’ll give you my thousand-foot view is that the DeFi ecosystem fills a need for gap finance because when you look at traditional markets, they work really well, and they’ve worked really well for a long time.
However, there’s a subset of people who live outside the United States and don’t have access to dollar markets, and DeFi gives them the ability to access, to loan markets, interest rate markets, and pretty much everything else that you can access as an American. So there’s increased risk by using this obviously seen in the weaknesses of smart contracts, but at the same time, it does provide an alternative for people to use.
I guess, my questioning of all the DeFi thing of how it makes the jump is that if this is something solely built for gap finance, how does it get towards broader adoption?
Michael: Well, I think that there’s definitely an aspect of DeFi that is gap finance, or what we like to say is financial inclusion, giving access to the rest of the world the same property and financial capabilities that we have here in the United States. The other aspect of DeFi, which I think isn’t something that we should shy away from is the ability to speculate and having speculation be a form of entertainment, but also a form of income, especially in these times when income and income security is necessarily not something that everybody’s available to. That can become a mode of interest in operating where you didn’t previously have that. DeFi presents that opportunity, not in the same way that, you would have necessarily in the financial markets in the United States, but for those that understand these new technologies better than most. They’re able to make a living by speculating on them.
Samuel: But speculation is a zero-sum game where there’s nothing actually intrinsic created is just that price moves in either direction and some people benefit, and other people don’t.
Michael: Yes. The infrastructure that we’re building now around speculation, I think is the infrastructure that can be used later for Web 3.0.
Samuel: This is one of the things that I have trouble wrapping my head around is that unless you start including, I mean, this has to be the next step for the DeFi ecosystem is to start to include non-Ethereum-based assets onto the DeFi products that exist already so that outside money can come in because if you don’t have these cash flows coming in, all you’re doing is creating this.
Samuel: Like a strange bubble of value solely connected to the value of Ethereum and some of the smaller cryptocurrencies that are associated with it but I think this is what has been defined by the Maker team and some of the other guys where they see the Maker contract going in the future and starting to include things like USDC, and other like actual physical assets into these contracts to give more stability to the asset and allow for the asset to grow exponentially.
Michael: Absolutely. We are definitely following everything that Maker’s doing. The other team that’s really executing on this vision is Synthetics, and they just came out with a new spec where they’re going to be able to have a perpetual price feed and therefore synthetic asset for crude oil.
It’ll be the first time that you have oil and oil pricing as an asset on Ethereum. I think those types of moves and changes move this industry from what you’re describing as the circular and self-perpetuating engine that is DeFi speculation within cryptocurrencies. On top of Ethereum, it moves it into interesting products that can expand beyond just what’s in the blockchain.
Samuel: My question is that in these synthetic assets, they’re not really built to be held for the long-term. I mean, you would hold a perpetual crude contract like that. It’s a whole other level of derivative away from a futures contract. And it seems like there’d be a lot more carry risk than the actual product itself.
Because one, there is no physical connection to the asset. And two, you’re probably just making short term trades. It’s not something that you’d want to build out a portfolio with, I mean, am I right in thinking that.
Michael: I think it could go either way. It really depends on your point. If someone who doesn’t necessarily have access to trading the WTI crude oil futures but has access to be able to trade a crude oil or S oil or inverse oil synthetic asset. I think that is a huge reason for financial inclusion and being able to then use that.
Once there is a robust market around it, using that as a collateral asset that can go into other assets, I think that’s the purpose of it. I definitely understand the disconnect between understanding or valuing the underlying assets versus a synthetic price feed, but that’s something that we have right now in financial markets.
I mean, how many people actually settle their futures contracts with barrels of oil in the United States? It’s not really what’s done most of its cash though.
Samuel: Correct, but don’t you think that there’s more derivative risk in these synthetic products?
Michael: Explain derivative risk.
Samuel: Well, I mean that, so all of these products are derivatives or they’re synthetic derivatives of the actual assets themselves. So unlike a futures contract where you have a thousand barrels of oil, which is delivered to your warehouse or wherever you’re receiving the barrels of oil, here, that the entire value of those contracts is based on synthetics and then some of the Ethereum as well, too. If there is a breakdown in the crude oil pricing, right? It goes negative again. I mean, maybe there’s a problem with the smart contract where it’s not able to have negative prices and, for some reason that that creates a bug in the smart contract, which is not able to translate correctly into the price feed because maybe nobody thought that crude oil prices could go negative.
So it could create synthetic derivative risk where the asset itself is not able to price correctly, or the underlying assets are not able to keep the value of the synthetic asset for the people that are trading in.
Michael: Definitely. I see what you’re saying. The different software that needs to be built around this industry is what’s happening right now, much in the same way that interactive brokers didn’t have the ability to go negative on the day that those oil futures contracts went negative and so there were a number of trades that went through at 1 cent and had to be clawed back. We see this with traditional finance and software. There will be issues. This is a nascent industry, but I think the bid point around DeFi is, especially as it relates to centralised finance within the blockchain space is really defined, provides trust because the software that’s underlying all of this to your point is open source and available for anyone to view, you can understand whether or not there’s potentially going to be a bug.
If something goes negative, and because it’s decentralised, I think that’s a huge advantage over what’s happening right now whether it be on Binance, BitMex, or any of these other centralised trading platforms.
Samuel: There’s been several exploits or bugs that have been found out with major contracts over the past six months. I mean, Maker had issues, obviously there, the bZx hack, and there have been numerous exploits that have stolen hundreds of thousands of dollars from these contracts so far. The longer that these contracts operate sure they become more robust and it seems that they’re not open to attacks anymore, but flash loans were a new product or new offering that was introduced into the market, and that gave an attack vector into these contracts which hadn’t been before. Yes, it is open-source, but do you think that there’s a level of risk that is just inherent in the contracts themselves?
Michael: Absolutely. I think what we do need to do is differentiate a hack from an exploit; because a hack is when something fails and it isn’t going to work as previously thought. An exploit is when it’s a system as designed, and someone takes advantage of a vulnerability in the system. I think for us to get to the point where we as an industry are dealing with hundreds of millions of dollars of value or tens of millions or millions, there needs to be a deeper understanding around all of the interrelated complexities of having these new systems coming about in a permissionless complete smart contract language that enables anything to be built in anything to be connected to each other, so there’s a lot of second-order effects that go on when something like a bZx exploit happens, and I think those are really serious issues. I don’t think that as an industry, we’re doing a good enough job preventing or informing users about the risks. It’s really easy. My crypto has to have this click-through model as soon as you enter the product every single time. Do you understand the risk?
Do you understand this is alpha-level technology? I think we need to do a better job of that before we start putting real value at hand, but the software will get fixed over time. People will develop better processes and better controls and better libraries to leverage to be able to unify all of this code together, but that’s just kind of the development of any software system.
Samuel: I mean, so how do you take that into account when making your decisions as a venture fund?
Michael: It’s a primary factor that we use to evaluate. I think with anything we need to evaluate the software, need to evaluate the technology, need to review the audits of the technology, make sure that that’s part of the strategy of the go-to-market, and then we’re also a little bit different. We don’t just invest in the token, and back the team and back to the community and the network; we also actively participate. We put our own capital at risk, and in using these platforms, we’ll be able to be lead your seed round then also be a huge part of your liquidity. The collateral that’s being used on your system or your trading volume that you’re trying to bootstrap, so we put our money where our mouth is, and we actually get into the weeds and figure out where there could be vulnerabilities, where there could be, exploits or potential exploits. We worked with the teams pretty closely on that.
Samuel: Yeah. How do you establish those close relationships with those teams? Is it just a matter of they let you on the board or is it just that you, because you’re such a big token holder that you can call the team at any time of the day? I mean, how does that work?
Michael: Yeah. In decentralised networks, there are no corporate boards.
Samuel: But those development teams were run by a company, right?
Michael: Those development teams are essentially a company, or maybe they’re a foundation, or maybe there’s an amorphous group of people, but they are the core team. There are controls in place and, and there are usually infrastructure traditional entities set up, especially at the beginning, but it’s really about getting to know the team, getting to know the community because at some point the team is going to have to hand over the reins to the community who’s neurotic into perpetuity. It’s not like Vitalik necessarily has control over the Ethereum ecosystem as he maybe once did, so that transition from centralisation to decentralisation is a huge divide and we try to help with that transition. We try to get involved early and, and develop good relationships with the core teams and the initial community members.
Samuel: Is this a daily thing that you’re speaking with the teams?
Michael: It’s a daily thing that we’re participating in the discord or chatting about different things and whatever communication channel the networks prefer, but, as users you want, or as users and as entrepreneurs, you want that immediate feedback, you want to be able to talk to the people who have an invested interest in the success like you do, who are using it and participating in the same way that you would want other people to. That feedback, especially at the early stage is crucial, so we try to provide it whenever we can, and if we have any insights or thoughts, we’ll chat with the team or call a meeting or just chat in the discord.
Samuel: Has there been a time where you’ve had to come out publicly against the team’s actions yet, with any of your investments?
Michael: Well, we have been fortunate so far where we haven’t had to do that. I think there are definitely points where we’ve had questions as to which direction the team wanted to go in and ultimately ended up getting settled. We’re about a year in, and I think this industry is early enough where we don’t know which decisions are going to be the best ones and that’s part of the excitement about this. We’re still figuring the models out and so who’s to say one way will work in one way. I mean, it’ll probably take a couple more years to figure that part out.
Samuel: I mean, because in some respect, you’re almost like an activist investor, right?
Michael: Yeah, I think activists comes with a negative connotation, especially when it’s activist investor, but we’re not convinced that comes in peace. We have hopefully the best interest of the community and the team in mind with what we do, and that’s how we like to invest, and that’s definitely a part of how we evaluate which investments make sense for us.
If there’s an openness for that feedback, if there’s an openness for participation, that’s something that we really like to do with everything that we do and everything that we invest in. If that’s something that the team also wants, usually it is, that’s a huge benefit to any investment thesis we’re making.
Samuel: Well, I mean, unlike the team, I mean, the team usually has tokens locked away for several years. So in your case, you actually have money on the line. So it would make sense that you could have strong views about things then than them because it would affect you either in the short or the medium term, where the team may be thinking about the long-term.
Michael: We are definitely a venture style investment thesis firm. We take any multi-year approach sometimes potentially even longer than the core team is thinking. I would say we try in everything that we do, whether it’s participation, investment thesis, our outlook on the industry, or on a specific network, we try to be aligned with the core teams and the entrepreneurs because those are the ones that are going to have to stand up and rally the people around the network, get the initial users, bootstraps, liquidity, bootstrap activity. We’ll be there to help, but it’s not going to be something that we do on our own, so we have to make sure that the entrepreneur is aligned with us.
Samuel: How does that process go from identifying projects to selecting them as an investment?
Michael: Yeah, as the two general partners within framework ventures and we use a four-part, evaluation heuristic, and for any other venture investor in traditional technology, it’s very similar, product-market team and their abilities, but the two things that I would say are different, we think that token economics is the equivalent to a business model.
We go really deep in total economic but then we also look at the community. What is the community like? How active are they? Is there this sense of the medic culture around the community? Because the community is your initial set of users, your suppliers, your partners, and that is how we’ve seen networks really bootstrap themselves, so the community is essential to the success of most decentralised networks, and ultimately community also becomes governance. Whatever the norms of the community become the norms of governance for that network and so that’s how we see the transition from more of a decentralised community to a decentralised governance model.
Samuel: When you mentioned community, the one that comes into the most is Chainlink right, which is your largest investment, and they have a huge community? But how was the identification of something like Chainlink possible in 2017?
The memes about Sergei and the idea of Chainlink as a company that’s announcing partnerships in being involved with pretty much every crypto project didn’t exist back in 2017. What was the reason for developing this idea back then?
Michael: Okay. I would say that we didn’t have the idea fully fleshed out at that point, but we were active in the community in 2017. We were angel investors in CHainlink back then. The entire chain link community was this Furman group of followers that built a community through Slack, and started sharing memes and started sharing culture around Chainlink and this was when nobody really knew what the development process was. There were no partnerships being announced as you said and there were no crumbs even that were given to the chainlink community in terms of where things were and how things were going, and then you overlay that with this massive run-up and then this massive crash in early 2018. What you have developed is this group of followers who have been figuring out what channelling could potentially be and how it could work in this ultimate future of decentralisation and that has fostered this sense of being the underdog that has built this strong community, and weathering the storm together has made the community even stronger.
It’s not something that you can necessarily identify immediately right off the bat. But like I said, we spend almost all of our time and these different communication channels of these different networks. If you spend enough time in there, you can get a sense of what the norms of the community are. You can get a sense of what they’re talking about, what they care about and that’s kind of where you build this futuristic around whether or not it’s a strong community.
Samuel: How has that translated into your guys’ two most recent investments into FutureSwap and Edgeware into common labs which is developer veteran.
Michael: Yeah. We have made a couple since then, they will be announcing soon, but Cava is another example where the community is extremely strong, and the Carbon Knights have this mimetic culture following carbon, promoting all the different things that the team does or the partnerships that they make. Future swap is another example where the discord is very strong, and people are talking about things like music or weekend plans. You have people provide them with feedback and sharing interesting news related to the product. Commonwealth labs is a centralised entity, and they’re building communication channels literally for blockchains, for communities to vote on proposals for governance or just chat about different things and have this thread live on top of a blockchain. So community and communication is a huge aspect of what we do.
Samuel: I’ve spoken with Brian. He came on an earlier. I agree with him. He said he calls himself a liquidity max maximalist. It’ll be interesting to see how it goes because there is quite a lot of competitors who are trying to bring Bitcoin, in theory, to create cross-chain CDPs is very cool. I think it’s pretty novel and they do have a good idea which they’re running with. We’ll see if it plays out.
Michael: Yeah. It’s so early, and I think it’s really easy to get wrapped up in the vicissitudes of the market and price fluctuations. In reality, It really does take years to develop successful networks. Chainlink launched last year, and they had their initial token sale in 2017.
I would probably describe the product as maybe a year or two away from being a fully-fledged product that was envisioned in the white paper. When you have public market liquidity and market gyrations, how many people are sticking around for those full five years?
I think that in and of itself is an investment advantage and something that we definitely look for in any community, but then also in how we view any investment that we make.
Samuel: Now have you started to look at ETH 2.0, and the effects it’s gonna have on the ecosystem,
Michael: Absolutely. We have a policy around not investing in ETH-killers. I think it’s served us well so far. We view ETH 2.0 today one of the most undervalued aspects of blockchain because I’m combining a number of things into what I’m calling ETH 2.0, but what you’ll have in the short run is a renewed sense of interest around ETH as an asset, as soon as you add staking to it, it’s going to become something that I’m sure Coinbase or any of the major providers will provide as a service generally for free.
What you’ll be able to do is just put your Ethereum tokens in that wallet and stake it, so that sense of interest, I think, will drive adoption and then with some of the new infrastructure changes or hopefully a deflationary value model for fees, but also differential fees based on transaction throughput.
I think that in a matter of a couple of months, it could be something that really helps with situations as we saw on March 12th where there was just complete, slowing or stalling of the network. There are some really huge events for the Ethereum network on the very soon horizon and then the full realisation of ETH 2.0.
I think whether it’s ETH 1.0 or ETH 2.0. it’s going to be what we had all hoped Ethereum would be, but even then, the white paper was released in 2014, and it’ll probably be 2021 or 2022 before we realised full vision of it. Another example of how long these things take, but we’re really excited about it because it really provides the first example of consumer scale applications that can live on a decentralised network.
Samuel: It was the Chainlink Oracle’s, which failed on March 12th, which eventually led to the failure of the maker contract, but the exploit of the major maker contract, and there were $400,000 of liquidations which were able to bid on for just a couple of cents.
Michael: So Maker has its own Oracle system. The Maker Oracle, were failing, but what was really happening was that the keepers in the network of Maker who are the ones that are supposed to keep everything in balance, putting these blocks of ease up for auction, those were failing, and so ultimately it ended up being about $8 million of value that was able to be auctioned for free. Yes, there were failures within the entire Ethereum ecosystem which led to a complete stall so anything couldn’t process.
Samuel: So gas prices have been high for the last couple of months and for a company like Synthetics, which is running these expensive smart contracts, they need to update the price feeds what every couple blocks. How has the impact of these high gas prices been affecting your operations?
Michael: Our operations are really largely unaffected. DeFi right now is not a throughput constraint really. There was just a synthetics demonstration of what the exchange would look like if built on top of an OVM, the opportunism virtual machine and it’s a roll-up mechanism, which is a layer two on top of Ethereum with thousands of transactions per second throughput, and that really kind of, once again, shows where this industry is moving in the next call it six, maybe nine months. Everything will be either on top of the side chain or on top of a shard in 2.0. but you’re right in that there are a couple of applications, I think, not necessarily, or potentially nefarious applications that are sucking up all the gas in Ethereum right now, leading to extremely high prices and it’s definitely a concern at least in the short term, and in longterm, it’ll be sidechains in Ethereum that really solve this issue.
Samuel: Because let’s say five out of the 10 top gas users on Ethereum right now are scams. I guess indicative of what’s happening on the network. It’s hard to find these projects. You wouldn’t find them easily. I don’t know. I see these names pop up, but I don’t know actually how to find them without Googling them. They are not really advertised anywhere. TripleM scam has spent three and a half thousand ETH over the past month, which is translated to around $800,000 in gas. That’s second only to Tether, which is handling, you know, billions of dollars of transactions.
Michael: Yeah. Those are the potentially nefarious actors that are sucking up all the gas. But one way to think about that is to say, well, they have a choice of blockchain in terms of transaction throughput, and they’re spending however many hundreds, or hundreds of thousands, or millions of dollars on gas just to have their applications run here.
Why is it that they chose EOS or Tron or any of the other blockchains that have low, what would be lower fees to operate their network? They’re still coming back and choosing Ethereum. That could be a very positive sign for Ethereum in that they still view this as the place where people have their accounts. People are using it every day, and there’s just enough infrastructure there to have potentially nefarious applications run on top of it versus any other blockchain. I think it signifies, even with all of this, that Ethereum has already won.
Samuel: Well, yeah, I don’t doubt you on that. It would take a huge difference in how a scale, throughput or latency would be able to have any effect on a new blockchain that came out and give it an ability to compete with Ethereum. Because at this point, Ethereum just has applications, Tether, and then also the tens of thousands of developers who are building on top of it.
Michael: Exactly. I think that’s the huge network effect. It’s really the developer community that nobody’s going to be able to replace. If you think about the switching costs of a developer, it’s not just about what their environment is that they’re writing their code and it’s about their understanding of the network or understanding of the complexities of the language that they’re using. It’s a skill that they’ve learned over a longer period of time. That’s one of the reasons why we don’t look at any other layer ones and really consider Ethereum to be the only place, especially for DeFi right now.
Samuel: I mean, what do you think matters more? Is that the developer community or the fact that Tether has moved over to Ethereum?
Michael: It’s absolutely the developer community. I think any of these things, it comes down to switching costs, how Tether runs on multiple chains, and people say that that is a causal effect of what has happened within the Ethereum. It’s not something that is leading to Ethereum being the winner. Tether wants to go where the developers are because that’s where the applications are.
Samuel: One of the things that I’ve really liked about 2019 is that you’ve seen some Ethereum applications be built into mobile apps without people actually knowing that they’re using Ethereum. Reddit is the, one of the biggest ones to implement your ERC-20 tokens into their sites so far, but you also had applications like Dharma where people can just save money inside the DSR or inside Compound as well too, and they take a little bit off the top. I think that those are really cool where you able to provide the abilities of what you’re accessing and DeFi, but under a slicker mobile app where you don’t actually know that you’re using any blockchain on the backend?
Michael: That’s the future of DeFi. I think that’s where the consumerisation of DeFi starts to happen. It’s not easy, especially going through the app store and getting your application approved and that whole process, but it is something that I think is a huge moment for our industry to be able to say, here’s this application for other saving or getting access to different financial products, in a mobile experience, much like Robinhood, who knows where Robinhood is routing that order. When you buy a stock, just like, who knows where that saving is coming from, if it’s going through the Ethereum blockchain, or if it’s going through a bank, I think that’s where our industry is joining, and we’re really excited about that.
And, and then the other event that I think is, another kind of bellwether moment is under collateralisation. Tying identity to a decentralised London is another huge opportunity that we haven’t seen done well yet. This is something that we’re looking at pretty actively, but that’s where we get to go from 150% collateralisation to potentially lower than a hundred, and that just means the efficiency in our industry improves by order of magnitude.
Samuel: Well, how would that work? I mean, you would need some sort of lending company in the middle to do the KYC and then also to make sure that some sort of contract is signed in case the debt is defaulted upon.
Michael: Yep. That’s essentially it. I think you don’t necessarily need a lending company as much as a data and identity providing a layer. But as soon as you do that, you can also connect it to a peer-to-peer, or peer- to-contract-based lending collateral pool and then have the ability to tie back into identity.
For instance, someone was to default on their loan and have that actually hit their credit score, and it could be just in the same way that you have a savings rate on top of Dharma, it could be something that looks and feels like a consumer application and affects your real-world credit score in the real world, but it’s all based around Ethereum and pull collateral on Ethereum smart contracts.
Samuel: But first, you would have to have some sort of digital identity that could be built out. And I don’t think there’s anybody that’s done that yet.
Michael: Not yet. It’s something that a number of projects we’re working on.
Samuel: The decentralised identity projects have been long in the running,
Michael: Oh yeah.
Samuel: There hasn’t been one to have product fit yet, but so what you’re talking about right there is shadow banking of some sorts. It’s almost like a lending club or one of the other lending providers where I can go to a lending club and give them money, and then they lend that money out and earn a higher yield than I would by just putting it into my savings account.
Michael: Yeah, and that’s exactly it. I would describe this more as a decentralised lending club than a shadow bank. I think one of the novel aspects about this is with a lending club, you can invest in a pool or a traunch of loans from people that are borrowing, or you can go individual to individual.
I think that there are some interesting things you can do around peer to contract versus peer to peer where you have pooled collateral and then socialised risk essentially, and then all tranches and returns based on that.
Samuel: Yeah. It’s an interesting concept to think about how all of that would be managed and who would be the entity that would be managing it because it almost seems that you would just have a regular company? Why couldn’t a lending club just come on Ethereum and say, here we haven’t pulled the theory of contract that you can put money into, and then we can extract the value of that and lend it out? It doesn’t seem like they would have to make much difference to their existing operations.
Michael: Well, that’s true, but then they take a fee, they take a cut, and there’s a lot of KYC, which is prohibitive as we discussed to getting people around the world involved and I think that is the innovation here. It shouldn’t lessen the effect of not having a fee and having this be smart contract based where you’re paying gas fees. But as soon as it moves to a Layer 2.0, that the gas fees go down in orders of magnitude, there is no 10% or 15% cut that lending club is getting because they’re a centralised company that needs to make their revenue to employ all the people that are working there. It’s all just controlled by smart contracts and programs that are run on Ethereum.
Samuel: Right, but the smart contracts and other developers who are building out this ecosystem would also have to get paid.
Michael: Yeah. This is where a token model, I think has a lot of advantages over a rented, distracted finance company, where the tokens are governance, and the tokens are used as payment for people contributing to the project.
Samuel: But why wouldn’t you just use a dollar-pegged? Okay. Cause like one of the problems with having like a token that is used for payment is that it’s always going to be extremely volatile. It could go to zero, right? But if you have some sort of dollar peg, then you have your value which is preserved.
I mean, I understand the need for governance and thing, but whether that has to be captured within a token, I don’t know. There are a lot of people who push for like decentralised projects and companies and developers building these things out, but a lot of the times, there are a lot of efficiencies that are gained from running a company and having a team and a strong leader that can drive these teams to do things and especially like at least pre COVID working in one place helps to have a team/community and ability to interact with others in a close space to speed along development.
Michael: Absolutely. I don’t mean to say that everything needs to be decentralised. I don’t think that that’s the case. I come to this industry from previously working at Dropbox and Snapchat, two very centralised technology companies where the efficiencies and the advantages gained from everyone being in the same room are palpable. What I do think is interesting is when you have an open-source protocol, and you have a token as a form of incentivisation for open source contributions, that is a novel concept when you’re dealing with things that are potentially open source and could be with this new business model that we’ve developed, not to say that they need to be, or that they should be, but it is a novel concept, and I think that’s some of the things that we’re looking at. It’s also possible that there’s a centralised entity that earns whatever revenues based on the way that they interface with it. We haven’t really seen that either. Having centralised entities built on top of these decentralised protocols, where there is a token, I think is another interesting business model.
Maybe instead of it being a lending club that says, Hey, We’re going to decentralise a portion of our operation and put it on Ethereum. Maybe it’s a decentralised lending club protocol. They’re the ones that are working and building, and they’re earning revenues or grants to do so, but there are potential business models on both sides I would say.
Samuel: Yeah, I think one of the big gaps in the market right now is that you don’t really have too many companies that are coming in and providing a lending club stepped in and started operating. There are almost no companies that have revenue-generating products that work inside of Ethereum right now. I mean, there’s probably, I can count them on one hand, and there has not been this rush of companies to jump in. I think that if you are operating a US-based company where you are going to be offering security.
Because if you’re offering loans to people and then you have a pooled contract on the back end, that investment contract would obviously be a security. The ability of that company to navigate those securities issues and legal issues is very expensive. They’re going to have to spend hundreds of thousands of dollars on legal fees before they even start to get an opinion that they’re within securities laws.
Michael: Yeah. I one hundred per cent agree. I think there is one clarification. The peer to peer lending market does have a specific carve-out, which makes some of the stuff feasible without having to go through the full SEC or CFTC process or FinCEN[CS1] . You’re exactly right in that they’re not being a number of major corporations jumping in into this new technology is two-fold.
The first is regulatory, and the lack of clarity around whether or not these things are securities/commodities. That uncertainty means that there’s a real, tangible risk for a centralised Delaware C corporation based in the United States. The second is really what I’m referring to is just the lack of there being robust business models yet around how to interface with this. There’s no incentive and there’s a lot of stick if you were to be building on top of a blockchain, which just means that it’s crypto native for now. The things that are successful right now didn’t start off as centralised companies that morphed into blockchain technology.
They were blockchain technology through and through from the start. I would guess that in the next few years we will see some model in some interest from centralised companies moving into this space, whether it be exploratory or just technology development based, or actually issuing tokens unclear. I think we’ll see new renewed interest from some of the big companies.
Samuel: People have been saying that for a while, and it’s now 2020. There’s a lot of companies like you see Microsoft and other things providing technology services, but you know, nobody’s really dipping their toes in providing financial services.
Michael: I would, I would say Ernst & Young and the baseline protocol is one that gives me a lot of hope. Essentially the concept there isn’t DeFi specific, but what it is a replacement of traditional ERP systems using Ethereum as the fundamental base layer of data then having connections, either through Chainlink or a number of other protocols, to have systems talk to each other and in the ERP world, having systems talk to each other, usually requires hundreds of thousands of dollars of consulting time and a couple of years to have Boeing and Delta Systems speak to each other. If they were to be built through it, something like Ethereum, I think there’s a huge advantage to that. That’s mostly what I’m referencing.
Samuel: okay. Baseline creates like a side chain to allow for tokenisation and decentralised financial services.
Michael: It’s not necessarily financial services. It’s more enterprise resource planning services, CRM platforms, HCM platforms, those being built and not necessarily in the side chain actually going on to mainnet Ethereum eventually. It’s still very early there, but just that there is a renewed interest in the last 12 months, I think is a huge positive sign.
Samuel: Yeah. So what do you think are the next big trends to occur in DeFi?
Michael: I think under collateralisation is a major trend. But I also think the fragmentation of the decentralised derivatives or centralised derivatives moving to decentralised derivatives is a huge trend. Bitmex, Binance, all of those platforms are, are being exposed to the potential misleading o just unfair practices for people that are using those platforms.
Those are multibillion-dollar companies. I think that’s a huge opportunity for this industry to actually start building and proving out the business models of decentralised networks and revenue tokens. That’s something that I think we’ll see in the next six months, after that, I think it’s identity and as it relates to loans, and then it’s the consumerisation of DeFi. So how do we put this stuff into an iPhone app?
Samuel: If Apple lets us in, in the first place.
Samuel: Because I think that there with the uncertainty about securities laws, it really negates a lot of the ability for any project other than some of these, a project like Dharma or something that could build on in the app store and also the Google app store as well to have strict terms and conditions which prevent them from working with companies that may be offering securities or are not offering securities in a compliant way. This is why there are almost no apps in the app store or the Google store, that are crypto-related because these companies don’t want to take the chance of being associated with them.
I think 2017 left to a deep scar on the minds of these technology providers of the number of scams and the amount of money that was lost from the ICO Boom. I don’t know how long that takes to heal and to move past.
Michael: Yeah. In a previous life prior to starting Framework Ventures, Dan and I co-founded a company called Hashfleets, which was building digital collectables on top of Ethereum. We were licensed by the NFL to create essentially digital trading cards for NFL players. We were actually one of the first, if not the first app to have a connection to Ethereum that was accepted for the iOS app store. Going through that process left scar tissue with us. We were able to make it through and get our app in there, but the opening of the app store or both app stores, I think is something that we’re starting to see based on the level of interest of anti-trust, and the level of potential price-fixing, that’s going on between both Apple iOS store app store and the Google Play store.
I think they’re going to have to shift their focus away from being as restricted as they’ve been and opening up to new ideas and new things. It’ll just be a progression over time, but the fact that we have some things in there, like Dharma, I think is a really huge sign that they’re potentially going to be able to open up. I don’t think that you’re going to be able to speculate through an app. I do think that you could have novel financial experiences built into apps as you have with the savings, or potentially loan, peer to peer loan marketplace.
Samuel: Yeah, it’s an interesting dynamic because you know, one of the questions that I’ve been asking myself is that you know, does Web 3.0 actually break the models that Google and Apple have been able to craft for themselves, the business models of surveilling and spying on their users, to generate content are starting to generate like actionable user identities which they can then sell to a third party company either for advertising or for other services? Does Web 3.0 actually break it can, or is it just a more integration of financialisation into the internet? It just gets absorbed by Apple and Google when they can figure out how to make it into a more, user-friendly environment.
Michael: That’s a good question. I really think that the reason why they have prevented the things from entering into and the different applications for this Web 3.0 ecosystem into the app store, largely has to do with they’re worried that it could potentially break their stranglehold monopoly on this industry.
I think that the tides are shifting underneath our feet, the interest away from the Facebook’s of the world and the Googles of the world, I think is something that is real. It’s a trend that will continue, and if they’re thought of as being people that are upholding those bastions of men or wholistic power, I think that could be a large stain on their reputation and something that they would really consider, especially as they’re fighting multiple fights on multiple fronts.
Samuel: But the question is because they have a monopolistic grasp on their subset of the tech economy, it really limits the ability for any competitor to come in and, be an alternative because typically Apple has so much money on hand that any potential competitor that comes along would just get bought out before they even could reach scale.
Michael: That’s true. I’m referring more to the stranglehold around identity, and in advertising. You know Google is whatever 99 plus per cent advertising-based revenue company. Apple has already come out and said that they don’t want to do things that can create the amount of identity surveilling that could happen for iPhone users. I think there are different incentive structures for both Apple and Google. If they see something coming up, we’ll be able to purchase anything. I think what I’m more interested in is the breakdown of that surveillance of identity as it’s used for advertising as an entrance into the Web 3.0 ecosystem, and Apple could actually be a leader there because they have aligned incentives if there are novel use cases and experiences that iPhone users want Apple would want to supply that to their user base.
Samuel: I guess the question is, would Apple expect a 30% cut of the revenues that were going through any of these applications?
Michael: That’s how it is today. I think it’ll be interesting to see if that’s how it will be tomorrow. They take 30% of any digital content that’s bought and consumed within the app within the iOS app store and then consumed on the iPhone any real-world services or anything that has a value outside of the ecosystem, they don’t charge a fee. I think that the question of the fee is something that’s literally at the Supreme court right now, as it relates to Spotify and Amazon Audible. It’ll be interesting to see how that consumption of digital content in the fee that they take, if that can hold up in a time of Web 3.0, being subversive to this ecosystem.
Samuel: Exactly. I really wrestled with the thought of these monopolistic companies and the inability of our democracy to appear inside of them to understand what’s actually going on and to provide any oversight into their operations, the backend of what they’re doing and the amount of surveillance that they provide both to themselves and then also to the US government is really unsettling for me.
I think that they almost get to have the status because they do provide this information structure. People want the ease of access and easy things where they have a couple of clicks, and then they’re using a product, or they’re investing somehow. There’s always going to be a few extra steps unless you’re building it into an application which makes it easy. You don’t even really know that you’re using blockchain in the backend.
Samuel: It really worries me about the entrenchment of these companies and about where these financial systems that sit outside of Google and Facebook and everything else actually exists because if know Facebook looked upon it in the right way and saying, you know, here we have a developing financial ecosystem. We see that there is demand for Tether and looked at the growth of USDC and said, Oh, we can do this ten times better and then they’ve modified it to be able to meet the regulatory demands of the United States government and also the Europeans as well, too. When they deploy it, it probably is going to be great. You’re going to have access to dollars through Facebook anywhere in the world. That’s huge for people that didn’t have that access before, but at the same time, I think it entrenches them even further, and you know, it’s scary to me.
Michael: I completely agree with you. I think a lot of it went through represents a subversive response to what’s been going on in the tech industry for the last decade or two. I’m sure libra will be a great product when it launches but then I think, whether or not mass consumers care about whether or not they’re interfacing with a financial product developed by Facebook, who’s also advertising to them.
I think it’s a real good question. Most people just won’t even know, and they will continue to go on about their day, without that knowledge and continuing to give up more information to Facebook. It’ll be really interesting to see. I don’t think that this is going to change, at least in the short run.
I do think that what we stand for and what I think DeFi, as a sub industry, stands for creating that transparency and openness in the face of opaqueness and black boxes. I hope that Web 3.0 can do the same. I hope that the companies that distribute technology, whether it be Apple, Facebook, Google, et cetera, I hope that they can get on board as well and figure out a new way of supporting it and promoting it, in the face of their business model being disrupted.
Samuel: No, that’s a really good point. I think that the good thing is that those companies, you know, Facebook, Google have not made any entrance into DeFi yet, and the companies that have been able to develop are really able to break new ground and to exist without a major competitor. Look at what Maker’s done. You know, it was only until synthetics that they were the only provider of a decentralised synthetic dollar in the entire market and synthetics came along and provided a new alternative to what they were doing, and really became their first competitor which is pretty cool.
They do have differences in how they think long-term about what should be the collateralisation base for their projects. Maker is going down the route of integrating physical assets into their contracts while, you know, Kane thinks it’s best to stay fully crypto and fully based on synthetic assets and based on Ethereum and based on the SNX token.
It’s nice to have that differentiation. I think they’ve been able to grow their ecosystems without having a billion-dollar behemoth come in and start their own company with massive amounts of capital and the ability to draw in more users.
Michael: You hit the nail on the head. I think the difference between philosophy and product category is where we are in this industry. We don’t know which models will win. We don’t know which projects will win, right now, and everybody has their own approaches, but that’s just the nature of development in any industry really and the cycle times in DeFi are very short, as they are in early-stage technology ventures. That’s what gets us excited. It’s just able to have many shots on goal to see which ones work and which ones don’t. We’ll see which models are the best and which ones have issues that we can’t see from where we stand right now.
Samuel: So how can people find you and Framework?
Michael: Yeah, we’re, we’re pretty active on Twitter and framework.ventures is our website. If there’s ever any thoughts or ideas, we’re always down to hear more interesting concepts, and Twitter’s probably the best place for engaging in conversation.