A DeFi OG: It's Time to Take on Centralized Exchanges

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1:35What's up, everybody? It's Ash Bennington. Welcome to Real Vision Crypto Daily Briefing. Joining me today is Cain Warwick, founder of Synthetix. Cain, welcome to the show. Hey, Ash. Thanks for having me. Well, it's great to have you here. Cain, you're a guy who's had an extremely interesting life. Talk about how you got into the digital asset slash crypto slash DeFi space. Yeah, so I came from a retail slash payments background, which I guess made me interested in crypto as a payment method, right? So the first time I kind of got my head around Bitcoin as an alternative to like the fiat payment rails, it seemed pretty interesting.

2:18And then later on, I developed a payment gateway that allowed people to put cash into digital wallets. And one of the early use cases was for crypto purchases because, you know, in Australia, banks were making it very difficult for people to buy crypto, blocking transactions, that sort of thing. And so cash was kind of the optimal way to get into crypto. So that was back in like 2014 that we launched that. Yeah. Okay. So let's talk a little bit about what you were thinking about when you started up Synthetix. What was the problem you were looking to solve? It was the same problem, really. It was trying to create a stablecoin.

2:57So trying to create a token that tracked a dollar that would allow people to make purchases, to buy things, sell things the same way that they would with a Visa or MasterCard or Amex. That evolved from Haven, which was the original project, this original stablecoin project, into synthetics, which became a derivatives protocol. So it was BlueShift, then Haven, then Synthetix. Is that right? Yeah. So BlueShift was a payment gateway. I launched Haven as a separate project while I was running BlueShift. I saw this kind of gap in the market, the stablecoin gap, and I thought it'd be something that would be interesting to work on.

3:37And then Haven evolved into Synthetix once things like USDC and TrueUSD launched, these kind of semi-regulated stablecoins. You know, back in the day, it was only Tether. And, you know, people were very concerned about Tether and its backing and they still are, but they were really concerned back in 2015, 2016. And so, you know, the idea was to create a decentralized version of that that was like provably secured and safe. So tell us a little bit about the functionality of Synthetix today. Yeah. So, initially it was just a dollar as a token on blockchain. And then it evolved into gold, silver, Bitcoin, various other assets that were sort of tokenized essentially.

4:25So, you could trade Bitcoin on Ethereum. And back when we first launched that, there weren't many options to do that. There was no wrapped Bitcoin yet. So, being able to trade Bitcoin on Ethereum was pretty novel. Today, we have, you know, 40, 50 different assets. So, you know, different instruments of spot instruments, derivatives, perpetual contracts, and we've got a whole bunch of different markets as well. So, you know, mainly crypto assets, but also some commodities and foreign currencies. So, you know, euro, GDP, etc. All right. So let's talk a little bit about this. I think in the wake of the Terra Luna collapse, people are always curious about what the mechanism is for maintaining those pegs.

5:09Talk a little bit about how that happens. So, you know, there's a lot of variations on stablecoin designs, but, you know, at their core, you have sort of collateralized stablecoins. So there's something that the token is driving its value from. And then you've got algorithmic stablecoins, where it's just a set of rules that, you know, ideally keep the thing stable. And, you know, with Terra Luna, the rules kind of kept it stable until they didn't. And once the value fell below, you know, some kind of critical threshold, the mechanism essentially printed more tokens to try and prop it up, right, which created this death spiral.

5:54With synthetics, there's a similar issue, you know, kind of looks a little bit similar. The difference is that the collateral that backs the tokens in the Synthetix ecosystem is derived from the fees that are generated. So we are generating about a million dollars a week in fees and those fees are paid to token holders. So the Synthetix token, the SNX token, sort of has this intrinsic value that's coming from the cash flow that the network is generating. And that's what makes it a better form of collateral. But ultimately, the tokens are sort of freely floating tokens. They're not algorithmically pegged to the assets that they track.

6:43They're pegged to those assets by an oracle. So walk us through how that pegging works and how the cash flows from synthetics play into it. Yeah. So in order to mint the stable point, so let's just talk about the US dollar stablecoin, SUSD. In order to mint that, you need to lock S and X and you can borrow against it. So one of the primary mechanisms we have is very high collateralization ratio. So you can only borrow 20 % of the value of your collateral in the stablecoin. So that creates a fairly large buffer, right? You need a significant drawdown in the collateral value for it to become insolvent.

7:21And then on a weekly basis, in order for you to claim the rewards in the system, so inflation predominantly, you need to have that collateralization ratio above 500%. So each week, the users need to decide if the collateral value has dropped, do they repay some debt? Do they top up the collateral? They kind of need to maintain their margin on a weekly basis. And so this kind of continuously And so on any given week, you know, even if the price has dropped by 10 % or 20%, most people are inclined to repay that loan or to add collateral. And, you know, the network tends to stay fairly well collateralized.

8:02You know, the collateral ratio sort of sits between four and 500 % on, you know, most of the time. And that's because the act of walking away from the collateral based on the collateral rate would actually generate a net loss for them if they were to walk away because of how highly collateralized it is. That's correct. Yeah. In most cases, barring some huge drawdown, you're going to be better off paying down the debt and getting the collateral and then selling the collateral. And we're going to talk about the risks of a huge drawdown because price instability seems to me like it's a risk of any type of stablecoin asset.

8:35Walk us through how this process works, for example, for US dollar stablecoins. What would it look like for someone who wants to come into the ecosystem? So you can essentially just buy the stablecoin if that's what you're looking for. You can buy the stablecoin through AMMs. So you go to Curve, for example, and trade USDC into SUSD. And you can get significant size there into the millions of dollars. And then you've got SUSD within the ecosystem. Once you have SUSD, you have the ability to convert that into other tokens that track different prices. So you could take that SUSD, you pay a transaction fee, and you could convert it into synthetic Bitcoin.

9:17And now you've got an instrument that tracks the price of Bitcoin. Or you could take that SUSD and you could use it to margin a perpetual contract. So you go on and take a 10x leverage Bitcoin long or short position. So how does it work with Bitcoin on the long side and on the short side? Walk us through that. So I get it. You need to own SUSD in order to come into the Bitcoin synthetics contract. Talk a little bit about how that works and what the risks are. Yeah. So, you know, traditional, I say traditional, right? They've been around for five years, but you know, a perpetual contract that was maybe a little bit longer that was invented by BitMEX, or, you know, maybe invented is probably the wrong term.

9:57They kind of systematized it and, you know, tweaked a little bit and, you know, made it productionized, if you will, right? These perpetual contracts were designed to not require rolling over contracts. So you didn't have some future data contract. You could just hold this position and it just runs perpetually. You never have to roll. It's never delivered, et cetera. And the advantage is obviously pretty high there. The disadvantage is not having settlement means that the price can kind of diverge. right? There's no reason for the spot price and this perpetual price to really stay together. And so that's where funding rates come in.

10:37And so the way that funding rates are calculated in a traditional perpetual product is the further the divergence from spot that the instrument is, the higher the funding rate, which is kind of incentivizes people to rebalance essentially and bring the price back into a line with the spot price. So that works fairly well. and it's worked for the traditional perp exchanges.

11:07So, BitMEX, et cetera, and Binance, all of these exchanges have listed these. With Synthetix, we don't have that divergence because it works by an Oracle. So, the price of Bitcoin is always the price of Bitcoin on both the spot and the perpetual product. And what that means is the issue for us is that you can potentially have the market skew diverge. And so, you know, in a very bullish environment, you could have 90 or 95 % of people long and 5 % of people short. And because it's an AMM, what that does is creates this like systemic risk within the network and within the AMM pool. And so what we do is we have funding rates that basically disincentivize longs, right?

11:56So, you know, the shorts will be paid, and they would come in and collect that funding rate to take a short position, which then brings the skew back into alignment. And so that's the case for all of these perpetual markets, and that's to reduce the risk to the debt pool, to the AMM pool. And what about the converse when you see the short positions? I assume, I mean, it's the same basic mechanism, but things can move down short side faster, a lot quicker than they They can't move to the upside in the event of a catastrophic risk to it for any one of these real world assets that you're tracking.

12:25How does that work? And how do those funding rate mechanisms begin to bring into balance of the supply and demand dynamics? Yeah. So there's a secondary mechanism as well, which is the further a trade is going to bring the market out of alignment, the more like the price slippage is induced essentially. Right. And so you're getting a worse fill as you get further away from that, which creates a disincentive. And then obviously you got the funding rate on top of that to discourage long-term holding of that. And so what we've seen empirically, I mean, probably the best, most recent example is Ripple.

13:05So XRP moved up in the space of several hours. The volatility increased significantly, moved up 50%, then pulled back and then moved up 50 % again. And during that time, the funding rate was fairly effective and this sort of slippage mechanism, directional slippage mechanism was fairly effective at keeping the market in alignment. And I think across something like$50 million worth of notional volume, there was$200 ,000 worth of price impact in the AMM pool itself. So it was very tightly align between longs and short that entire time, despite that volatility. Yeah, it's like 60 to one. So there are about 20 trading pairs right now.

13:52Is that right? In terms of real world assets that you can trade on Synthetix? Yeah, there's a range of perps and spot. So I think it's over 40 now, just across the perps and spot. But that's growing every day. And in an ideal world will have the top 100 assets, crypto assets, plus some real world assets like forex and commodities. Ideally, when we launch the new version, perhaps v3, we'll start scaling out those assets again. And the target is to have the top 100 assets. So it's about 20 pairs and then perps and spot for each? Is that sort of? Yeah, that's correct. There's a few where there's spot tokens, but not perp tokens.

14:36And a few with those perps and those spots. So, you know, it's not perfectly symmetrical. Now, is this something that users are able to do without being KYC? Yeah, so it's an AMM. So it runs on the Optimism Network, which is a layer two network on Ethereum. And so, you know, like Uniswap, like a lot of the DEXs, a user is just transacting against these contracts. You know, they self-custody, they have signing keys and all of the things that you sort of associate with DeFi trading. And this is an ERC-20 token, right? So some of them are ERC-20s. Some of them are positions that are held in a contract.

15:18So they're not actually tokenized. So the perps themselves, you have a position, but the position is maintained in the contract. It's not actually tokenized. You can't transfer it out or move it around or use it as collateral or anything like that. Does the absence of KYC present, in your view, or risk to the protocol itself. I know that we are in this environment right now of obviously increased surveillance, increased regulatory sort of oversight and activity right now. How do you think about that? How do you think about the risks and how do you think about the ethos of the space? So, you know, there's the contracts and then there are the front ends, I guess, right?

15:59And they're, kind of distinct things. So the contracts themselves, they're deployed, they're managed by governance. So Synthetix has a fairly robust decentralized governance framework. It's split into different components. So the treasury parameterization, grants and various other things are kind of separated out. Are these the three distinct DAOs that you're referring to? Yeah, they're like a council that's elected by token holders, essentially. All this stuff happens on chain and allows token holders to govern the protocol. So at a protocol level, there is, I guess, not much that could be done to stop the protocol.

16:43It's just this set of contracts that run on the blockchain. Then when you start considering the front end, those front ends are hosted in various different places. So some of them are hosted centrally. There's some front ends that are running on decentralized networks. And so you have this range of front ends. And for the front ends, it really comes down to, I guess, their risk tolerance. So all of these different interfaces need to make decisions around what they want to implement in terms of KYC, geoblocking, things like that. But the contracts are pretty agnostic to that. Anyone who turns up that has tokens on Ethereum or tokens on optimism can interact with them.

17:26So you think of it as sort of that's the layer at which you have anonymity and credible neutrality. And then on top of that, the front end, the ability to access it is where you see the potential for the regulatory component to exist. Yeah, I think, you know, the fact that front ends are still not as decentralized, they're more distributed. So, you know, you have multiple different front ends, but the front ends themselves need to run on, I guess, more traditional infrastructure. that's changing. And, you know, we have some better tooling to run front ends on more decentralized infrastructure, but that's definitely the break point for me.

18:05You've got the contracts on one side, and then you've got the interfaces on the other. And, you know, they have sort of different properties and different considerations. Ken, are you talking to regulators about this? Are you talking to legal, regulatory, and compliance folks about this? What's the feedback that you're getting when you talk to lawyers about this? So I think the reality is that we've been operating in an environment that is fairly uncertain for a long time. And it's unclear what the DeFi version, if you will, of each of the TradFi components is. Is the contract on Ethereum the exchange?

18:45Is self-custodying you know, different to having a custodian in a TradFi environment? You know, where's the break point there? Is an exchange that, you know, is a full stack exchange, so it operates the contracts and is a custodian and, you know, has front ends? Is that something, you know, that doesn't have sort of, I guess, analog in the TradFi world, right? Where the things are typically separated out. And the reality is there's just a lot of uncertainty. So I think to operate in DeFi today, you're sort of forced into a situation where you need to make the best guess as to what the ideal approach is.

19:31But I think there's also an ideological component, which is that regulators, the outcome that they want is fair and transparent markets. I think there's some people that question some of the motivations around regulations at times, But my personal view is that I think most regulators are well-meaning. They just want open, transparent markets that are fair. That's it. And in TradFi, that takes a lot of work because there's a lot of places where people can cut corners or do things that are maybe not in the best interest of their counterparties or whatever. And so you really need a lot of oversight.

20:08You need to be able to inspect what people are doing. You've got a lot of opacity in different systems. In DeFi, you don't have – Let me just ask you this, though, in terms of this idea that all they want is open and transparent markets. I mean, I think that that's certainly one of the concerns. But another thing that we hear coming up is AMLKYC and the ability to geofence out actors from certain states. Now, that's just the framework that they have to it. And it seems as though it's something that they are interested in pursuing rather vigorously. And it's interesting to see these sort of two worlds colliding and to see how this gets negotiated out, because it's a very distinct difference between the way the traditional financial services system work and the way DeFi works.

20:48Yeah, that's a very fair point. And so I think, you know, obviously different regulators have different approaches, right? And, you know, I would still argue that wanting to geofence, for example, falls into the category of wanting fair and transparent markets. Because if you allow people to come from a jurisdiction where there are less regulations, you have less oversight and interact with people in a jurisdiction where you have high oversight, then you create this sort of distinction, right, where they can maybe outcompete a regulated entity. I think from a regulatory perspective, that's very problematic, right?

21:28Now, then you've got other things like counterterrorism financing and, you know, uh, and any laundering issues. And, you know, I think that's a distinct set of issues, but, you know, when it comes to, uh, geofencing and saying, well, if you're going to operate in this, uh, more lax regulatory environment, we don't want you interacting with the people in our regulatory environment. We want to, you know, wall that off, right. And keep you out. Well, some of it, some of it's more than lax regulatory environment. Some of it is, uh, states that have been sanctioned, uh, through OFAC regulation here in the United States and the agreements that exist across the Western world more broadly.

22:03So it's not simply a question of regulatory arbitrage. In many cases, it's about OFAC compliance and not funding states that the authorities in the West believe are involved in things that they don't want money flows going to. For sure. And I put that again into the category of sanctions, right? So sanctions against various parties being able to participate. typically that works the other way. You don't want a sanctioned entity interacting with a US bank, for example. They're like, well, we're regulating the banks and we say, banks, we don't want you interacting there. I would say less likely that the concern is an Iranian derivatives exchange that they're trying to stop from interacting with US persons.

22:56right? It's more likely that it's going to be some entity that's operating out of the Bahamas or something like that. And they're saying, well, we're concerned about the oversight in that region and we don't want an exchange or we don't want some, we don't want counterparties there operating with our citizens. So I think there's a number of different considerations. But when when you focus on, we don't want our citizens in our jurisdiction to interact with a less regulated entity, DeFi kind of avoids that a little bit, right? Because if it's something running on the blockchain, you can see the rules.

23:35It's transparent. It doesn't need the same level of oversight. But the unfortunate thing, I think, is that there's like a fundamental assumption, I suppose, of regardless of how the system is constructed, we want the same level of oversight. And I think in DeFi, we say, you know, there is a distinction here, right? Like you don't need the same level of oversight of Uniswap as you do of Goldman Sachs. They just are distinct types of entities, right, that are interacting with people. Yeah, I mean, I guess we'll see ultimately regulators get to make those determinations and we'll see how that shakes out.

24:09I want to talk a little bit more about your vision for the future here, big picture. I know that your plan is to take on some of the centralized exchanges. Talk a little bit about how you see this in terms of your vision for what the future will look like in both the DeFi space, as well as the interaction with traditional assets. So, you know, for the longest time, I think it's been the case within crypto that the vast majority of people interacting with crypto are doing it with centralized entities. Right. You know, which is just a problematic situation. But it's easier. And by the way, we should say we saw we saw some of that with the collapse of FTX and precisely the points you're speaking to.

24:51Absolutely. You know, there's a significant counterparty risk, right? Like my view is that something like FTX feels more to me like Goldman Sachs, right? It does need regulatory oversight, right? If you have people that have counterparty risk and are custodying assets and have minimal oversight, that's the problem, right? Like that's something that I think needs to be solved. Whereas if you have something that's on chain, it's self-custody, ideally it needs less regulatory oversight because everyone can inspect it and see that it's operating as expected. And so my sense is that when it comes to crypto, you've got this ethos of decentralization and self-custody and everything.

25:35And yet, the vast majority of crypto is held with custodians and is subject to this counterparty risk. And we've been trying to play catch up with this for more than a decade. But it's always easier to build a centralized database and store people's assets in that than it is to build decentralized decentralized infrastructure, right? The decentralized infrastructure has been playing catch up. I think in the last cycle, we've finally caught up where we're close to feature parity. So we can - Close to feature parity with the centralized exchanges. With centralized exchanges and other like CeFi entities, whether it's a CeFi lending platform where you hand over your Bitcoin and they essentially lend it out or whatever the category is, I think we've got robust DeFi infrastructure that can compete.

26:28Where I still think we're lagging is on the user experience. So if a user who was coming into space for the first time in 2024 turns up and they've got two options, they can go to Binance and they can create an account with a username, email, password, and deposit some fee and buy some tokens and start trading, or someone can explain to them how to download MetaMask plugin for their browser, create a private key, save their seed phrase and write it down on 24 sheets of paper and bury it in their backyard and do all of these additional steps, right? And most likely not do that and lose their money and all of the friction that we have right now for a new user are coming in, then all things being equal, the vast majority of users are going to flow down that centralized pipeline.

27:23Right. They're going to go to buy this because it's just easier. Right. And there's also a forcing function here, which is the person that they're probably relying on who is helping them to understand crypto for the first time is going to try and optimize for the least likelihood of that person coming back and asking more questions. Right. And I've done this myself where I'm like, someone's like, hey, I want to do it. I'm like, you know what? Honestly, go on to Binance. It's easy. You just want to buy one Bitcoin? Just go to Binance. Otherwise, you get drafted into tech support with the MetaMask.