Diving into Real World DeFi
By: Andy Singleton
Tags: Financial Services, Open Source, Crypto, Venture Capital, Defi

DeFi is the best business opportunity that I have seen in my career. It’s a hot market, delivering real consumer benefits. Fortunately, I have been able to persuade seven entrepreneurs to join me in building products for “real-world DeFi.”

Maxos is working on a pipeline of projects that we describe as a “venture studio”. This helps us to break the huge restructuring of the financial industry into specific projects that we can contribute to. We are using a weekly group call, a stage-gate process, and a set of private and public Discord channels.

I’m honored to be working with:

We will invite more people to join this group. Please let me know if you are interested. We are recruiting for React and Solidity and more.

About DeFi

DeFi or “decentralized finance” replaces banks, exchanges, funds, and insurance companies with software. Money and securities become objects that a programmer can use. Participants can pool their resources on short notice, create new money, and muscle out more centralized organizations. They are aiming for benefits such as:

Efficiency. It uses far less labor, mainframes, and real estate.

Access. Any Internet citizen can be a producer or a consumer

Pace of innovation

The DeFi industry grew about 20X in 2020. This is exceptional in business history. The balance sheet or “assets locked” in DeFi software grew to about $20B. Token values also grew to about $20B. Revenues grew to about $1B. The expansion continues in 2021.

Investors are pouring money into DeFi projects. Many of these investors are diversifying their bitcoin gains, and looking for high-risk, high-return bets that might follow a trajectory like bitcoin.

Regulatory uncertainty positions DeFi as a high-risk, high return activity. It also aids rapid growth.

“CeFi” or “TradFi” is tied down by a heavy burden of regulations. Crypto and blockchains form a sandbox that regulators have mostly ignored so far. DeFi has built up around borrowing and lending crypto assets such as ETH and BTC. This is a small market that does not impact legacy banks. However, stablecoins have broken out of the box. Users are moving an increasing volume of their transactions out of the older bank network to stablecoins. This bypasses the web of AML checks that regulators have spent twenty years putting in place. Now regulators want to put KYC and AML checks on more DeFi transactions, and a conflict is brewing.

Resolving this conflict will be important for growing the DeFi market. Crypto assets represent less than 1% of liquid assets. DeFi protocols can grow about 100X if they can provide services for “real world” assets that are not crypto. This will expand our ability to finance centrally managed projects such as delivering vaccines and building out renewable energy.

About Real World DeFi

We are developing tactics to expand DeFi beyond cryptocurrency.

Unregulated DeFi is a rich source of innovation and global collaboration. It will be sad if regulators try to collapse DeFi into the same type of regulated organizations that they are used to. Keep DeFi great! We think that the conflict can be resolved with compatibility rather than over-regulation.

There are points where we can add compatibility between regulated and unregulated worlds. This allows us to combine the energy of unregulated (really self-regulated) DeFi, with the scale of regulated assets.

Some real-world compatibility tactics

For example, there is a demand in the world of DeFi for access to public securities. They can be used as collateral ($100T worth of collateral!), and feed into automated processes for margining, fund formation, derivatives and asset backed-security administration, and governance. Securities are heavily regulated, and many of those regulations provide useful consumer protection. However, any DeFi format for securities also runs into exchange regulations which are obsolete and unhelpful. “Digital” exchange operators that try to comply with these regulations end up making a bad product that does not take advantage of blockchain automation and globalization. Exchange regulations form a specific point of incompatibility. This is an opportunity to apply our “compatibility” idea. We can turn off transfers, and avoid exchange regulations. Instead, public securities can be redeemed by selling them into the regulated (and more liquid) public exchange system. Then we turn on pledging to enter the world of DeFi. If we can buy, redeem, and pledge the securities, we can retain much of the benefit of DeFi automation. This is the insight behind our Redeemer project.

Decentralization is a classic tactic. DeFi practitioners are developing a science of open-source organizations that are “sufficiently decentralized” to use tokens without triggering securities laws. This is important because there is no way to comply with the current generation of security exchange rules and also use a token the way that a token should be used, with exchanges between machines, payments, customer rewards, etc. We don’t know what “sufficiently decentralized” is, but we know how to get there. We need to be good at building open source software. We will apply our skills in distributed team management and continuous delivery.

Federated qualification: A lot of financial activities require an identified and qualified participant. In fact, there is a well-qualified buyer out there for almost any financial instrument. If we run into compliance concerns, it helps a lot to know about the qualifications of our buyers. The primitive solution is to make participant sign up on a project-specific portal, which is annoying. Dozens of projects are trying to supply more portable identification. This process works in the world of public securities, where exchange members agree to share their qualified investor information. Why is it not working in crypto? We’ll find out and figure out how to contribute.

Sandboxing: Our goal is to bring the full benefits of DeFi automation to securities investors, including automated exchange, lending, collateral management, pooling, and governance. This is currently not possible under rules governing public securities. However, it is easier if we start with a market for investors who are qualified as professional and sophisticated investors.

Choices at the point of sale: Futures, perpetuals, options, and other derivatives are heavily regulated in the US. DeFi projects that provide these instruments are typically either hiding behind a decentralized exchange, or banning US customers, or both. We note that regulations are mostly designed to control the sale of these instruments. The regulations provide some risk management and qualification around sales to non-bank investors. Our approach to these instruments will build in choices for sellers to qualify buyers (or not) and build in exchange restrictions (or not) at the point of sale.

Guarantees: MakerDao is producing freely transferrable stablecoins from restricted bonds by adding features such as margin calls and guarantees. This is the same thing that banks do to create savings accounts from riskier bonds and loans. We see a beautiful bank architecture that guarantees returns and convertibility for interest-earning stablecoins or “savings coins”.

Escrow: Our Launch Pools project provides a space to work with investors before making key compliance decisions. It costs money to set up a fund or a company to receive investors. Startups face conflicts between US investors that are forced to take equity in a new project, and others that want unregulated tokens. A launch pool keeps money (stakes) in refundable escrow while working through these issues. DeFi adds capabilities that were not possible in the old world of commitment letters, escrow, and SPACs. For example, investors can stake their own choice of interest earning and appreciating assets, rather than using a SPAC manager’s treasury account.

Please talk to us on Discord.