Robert Leshner, founder of Compound, describes how its protocol will enable people to earn interest on crypto assets, and why he thinks this will be crucial to crypto becoming mainstream. He also describes how the company is currently building an interest rate model — a task so difficult that an early version “blew up” the Ethereum virtual machine — and why using one of its smart contract-based money markets is both riskier and less risky than using an exchange. We talk about who will use Compound and how, which coins they’re going to launch with, and how Compound plans to make money.
Thank you to our sponsors!
AltLending: https://altlending.com
StartEngine: https://www.startengine.com/unchained
Episode links:
Compound: https://compound.finance
Robert Leshner: https://twitter.com/rleshner
Intro to Compound: https://medium.com/compound-finance/introducing-compound-the-money-market-protocol-4b9546bac87
TechCrunch article on Compound: https://techcrunch.com/2018/05/16/cryptocurrency-compound-interest/
Unchained interview with Nadav Hollander of Dharma: http://unchainedpodcast.co/nadav-hollander-on-how-dharma-could-create-new-forms-of-debt-ep80
Unchained interview with Joey Krug of Augur: http://unchainedpodcast.co/joey-krug-on-how-augur-is-like-any-other-tool-ep79
Unchained interview with Danny An of TrustToken, which is creating TrueUSD: http://unchainedpodcast.co/harbor-and-trusttoken-on-why-they-dont-mind-being-unsexy-ep77
Unchained interview with Will Warren of 0x: http://unchainedpodcast.co/will-warren-of-0x-on-why-decentralized-exchanges-are-the-future
Unchained interview with Vitalik Buterin: http://unchainedpodcast.co/vitalik-buterin-creator-of-ethereum-on-the-big-guy-vs-the-little-guy
Transcript:
Laura Shin:
Hi, everyone. Welcome to Unchained, your no-hype resource for all things crypto. I’m your host, Laura Shin. If you’ve been enjoying Unchained, pop onto iTunes to give us a top rating or review. That helps other listeners find the show.
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Laura Shin:
My guest today is Robert Leshner, founder of Compound. Welcome, Robert.
Robert Leshner:
Hi, Laura. Great to be here.
Laura Shin:
On the Compound website you describe Compound as an open-source protocol for algorithmic efficient money markets on the ethereum blockchain. What does that mean?
Robert Leshner:
Sure. So what this means is we allow people to exchange the time value of an ethereum asset, a token, similar to the way that they exchange the time value of currencies and assets in traditional financial markets, and what I mean by that is we allow people to borrow and lend an asset at a specific interest rate for a specific amount of time.
If you look to the way that money markets operate in existing financial markets, almost every last dollar or unit of currency is earning an interest rate somewhere in some way, whether you see that as the end user or whether that’s accounted for through multiple series of middlemen, every last unit of currency is earning an interest rate because there’s a demand for the currency and because there’s a use for the currency, and that doesn’t fully exist yet in the ethereum ecosystem, and what we’re trying to do is we’re trying to bring that concept to ethereum.
Laura Shin:
And how does Compound earn interest for the money that is in the system?
Robert Leshner:
So the way it works at a really high level is that users can supply assets into an ethereum money market, and they can borrow assets from this money market, and the interest rate that everybody is interacting at is actually set by the forces of supply and demand. So when there’s a lot of demand for an asset the interest rate is high, and when there’s very little demand for the asset the interest rate is very low, and instead of users having to negotiate or trade or figure out what the interest rates should be, you know, they don’t have to use any math, what we do is our protocol sets the interest rate in an optimal fashion, such that every market participant has an interest rate that they’re comfortable with.
Laura Shin:
So one thing is that you were saying that the protocol sets the interest rate, but as far as I understand I think at least to start Compound, the company itself, is setting it. Is that correct?
Robert Leshner:
That’s right. So, what we’ve done is we’ve built an economic model or an interest rate model that determines at a high level the way that interest rates behave. We’re basically setting a series of interest rate curves, and then the markets themselves on any given day, any given moment, any given hour, based on supply and demand the interest rate is a product of the interest rate model, and over time we’re actually able to upgrade these models. We’re able to work with professional economists, we’re able to source data from the community and from the market experience, and actually improve and upgrade the models that are used so that the model that starts when we first deploy the protocol will probably not be the model that’s used two years from now.
Laura Shin:
So when you say that the model a few years from now will be different, are you talking about the fact that you guys will be kind of like tweaking the model as it goes on and improving it based on what you see happening in the protocol?
Robert Leshner:
Yeah, that’s exactly right. So, over time we’re going to be using a lot of the data that gets generated. All of the information that gets created from the usage of the protocol, as well as additional input from the community and from economists, we’re going to use that to over time upgrade the interest rate model.
Laura Shin:
So, let’s just go back to how this works. When I put money in a compound where does that money go, and then how does the borrower obtain it?
Robert Leshner:
Sure. So, when you supply a token into a compound money market it’s actually being swept into a smart contract that acts as a financial marketplace, and everything is handled programmatically by a smart contract, there’s no discretion involved. It’s all based on lines of code, and borrowers are able to access those assets simply by requesting them, and proving that they have the collateral necessary such that their borrowing is not considered risky. So, in order to borrow an asset a user has to actually supply assets to the smart contract as collateral, and from there they can simply request any asset that they would like on demand.
Laura Shin:
Oh. And so, in the sense the borrowers don’t have to kind of prove their credit worthiness or anything like that. It’s just they’re dealing with a smart contract, and as long as they put up enough collateral they can take out a certain amount from the money market. Is that correct?
Robert Leshner:
That’s exactly right. We’ve seen credit-based systems in crypto not exactly work ideally because crypto is an irreversible transaction and it’s anonymous. It’s doesn’t suit itself well to credit-based transactions, whereas it does lend itself extremely well to collateral-based systems because smart contracts are very capable of enforcing rule programmatically, and our approach at Compound is actually to use an entirely collateral-based system with no credit to any individual user or address.
Laura Shin:
The money markets are pools of the lender’s tokens, so does this create a centralized honeypot for hackers?
Robert Leshner:
In a sense it does. We believe that smart contracts are simultaneously much safer and riskier than call it traditional custodial approaches. The reason for this is if a smart contract is built correctly and properly it may be a large honeypot for hackers, but it can actually be able to resist hackers permanently. It’s immutable code and if it’s built correctly it will always be safe, and if it’s not built correctly it will eventually be broken, and so building a smart contract-based system that holds assets requires probably significantly more audit and analysis than most approaches because you can’t patch it, and that’s simultaneously the biggest strength and the biggest weakness.
Laura Shin:
So, essentially what you’re saying is the security of this depends on the strength of your smart contracts?
Robert Leshner:
That’s exactly right. And we believe that with a long enough time spent building the smart contracts and analyzing them and ensuring their security that we can build a protocol in a system that operates without incident for a hundred years.
Laura Shin:
Interesting. Yeah, I guess this is one of those things where we’ll just have to see how it plays out in the wild.
Robert Leshner:
Exactly. If we get it right we’ll always be afraid, and if we get it wrong we’ll find out relatively quickly.
Laura Shin:
Or maybe not, I don’t know. I feel like sometimes you, or not you in particular, but just people might trust a piece of software and then all of a sudden, you know, two years in realize that there’s a weakness.
But anyway, I wanted to ask also when the money is loaned, so let’s say when that money is loaned that the borrower is a short seller and they end up losing money while trading it for more speculative tokens, then what happens?
Robert Leshner:
So the borrower’s always required to maintain a certain amount of collateral. If they’re not able to replay what they borrowed then eventually the protocol will allow somebody to close out the loan and to seize their collateral. We allow them at any time to supply additional collateral or to repay what they’ve borrowed, but as time goes on and the value of different assets in the marketplace fluctuates eventually if the value of their collateral is not sufficient the protocol can close out that loan.
And so, the risk is really on the users of these assets. If there’s a hedge fund that’s borrowed an asset in order to short sell it, they’re the ones who are taking a financial risk in that action and ideally, most of the participants are sophisticated actors and understand those risks.
Laura Shin:
And how is this value determined because if I did take out, you know, I’m just going to call it X coin and that’s the one that I’ve lost, or I’ve lost money…or wait. How should I phrase this because is it just that like I just need to put X…you know, let’s say I take out 10 of these X coins, then do I just need to put 10 of them back, even though the value’s much less?
Robert Leshner:
We expect you to repay 10 X coins with interest. You might actually owe 10.03 X coins depending on how long you’ve taken out the loan for, but that’s really on you to repay in kind. You know the value of X coin might fluctuate, you might’ve made money. With X coin you might’ve lost money with X coin, but the protocol actually expects you to repay what you’ve borrowed plus a small amount of interest.
Laura Shin:
So the dollar amount doesn’t matter at all, but I know that you guys use like a certain collateral ratio I think also to determine the minimum amount of collateral they need to put up, so is that affected by dollar fluctuations?
Robert Leshner:
That is. So, it’s actually affected by the fluctuation of the assets they are using as collateral. So, if you’re using ether as collateral that might fluctuate in line with whatever you’ve borrowed. If you’re using another token as collateral that might fluctuate in line with whatever you borrowed.
What the protocol does is it looks at the dollar value, both of what you’ve borrowed and what you’ve used as collateral, and it ensures that the value of your collateral is greater than the value of what you borrowed.
Laura Shin:
So what is the amount that I need to put up? Is it like 2X or 1.5 or what?
Robert Leshner:
So when we initially launch we’re going to be erring on the side of caution simply because we don’t want borrowers to take large amounts of risk, so we’re actually going to be requiring a 2X collateralization ratio. That’s a little bit high, and over time our goal is actually to reduce it as low as we can.
If you look at repo markets that exist today, you know, in the traditional securities world, you know, people are borrowing pretty much what they’re putting up as collateral and the ratio is a lot closer to 1 to 1, and that’s based on the volatility of the assets and it’s based on the sophistication of the market. Over time I think we’re going to be decreasing the ratio from 2, closer to 1.5, and then over time eventually to 1.25, but that could be a series of changes over the next few years. That’s not going to be a short-term change.
Laura Shin:
And what happens if the value of the collateral dips below 2X, then what happens?
Robert Leshner:
So at that point, anybody in the community can close out a portion of what you borrowed and take a portion of your collateral to return it to exactly that 2X collateral ratio. So, if you’ve borrowed a whole bunch of X token and you’re using ether as collateral, if over time the value of what you’ve borrowed is increasing or the value of your collateral is declining, any member of the community can repay some of the X coin that you’ve borrowed and take a small amount of your ether.
Laura Shin:
And you said that prior to that moment the borrower has the opportunity to put up more collateral?
Robert Leshner:
That’s right. So, the protocol makes it transparent exactly what your collateral ratio is and how much you’ve borrowed and how much collateral you have, and it makes it easy for you to actually provide additional collateral or to repay your own loan in time. As a user of the protocol, most people won’t choose to be risking anything. They’ll hopefully choose to be minimizing collateral value risk, and over-collateralizing for their borrowing.
Laura Shin:
Oh, meaning that you expect…the minimum requirement is 2X, but that they’ll put up like 2.5 or 3 or something?
Robert Leshner:
That’s exactly right, because people aren’t looking to speculate to the maximum extreme. You know, we’ve been speaking with a lot of crypto hedge funds and large traders, and they view this as a tool for supplemental liquidity, to be able to short sell or to be able to increase leverage. They don’t want to use it as a system that increases their own risk, so they might actually supply 4X or 5X the amount of collateral necessary to borrow, simply because they’re not looking to do everything to the extreme. They’re looking for the ability to short sell the quantity of tokens or the ability to buy new tokens in some degree, but it’s generally very sophisticated and responsible users.
Laura Shin:
And how do you determine what the value of any one particular asset is? As we know exchanges can vary pretty widely in their prices, and that’s why so many traders are making off of these arbitrage plays, but there’s also issues with flash crashes and things like that, so how do you figure out what the value is?
Robert Leshner:
So, the way the protocol works is it references a price contract that exists on the blockchain. When we launch the protocol, we’re actually going to be supplying prices to this price contract where we’re taking prices from multiple different exchanges and we’re posting them to this contract every time prices fluctuate by one-tenth of one percent which is very often, and so we’re constantly keeping a contract address on the ethereum blockchain updated and informed with what we consider to be the most accurate prices.
Over time we’re going to be able to decentralize this and actually hand this responsibility to the community to provide this price information, but to start with it’s really a function of our company aggregating and averaging the information from a series of exchanges and posting them on-chain consistently.
Laura Shin:
And so, in the event of a flash crash what would you do?
Robert Leshner:
In the event of a flash crash the contract will reflect this. You know, the speed at which we can update the price information is actually just a function of the ethereum blockchain. It should take approximately 15 seconds to update the prices in the protocol, and this is an entirely automated process. You know, there’s not a human being with paper and a pen writing an update, everything is handled automatically, and so anytime prices move they should be reflected in the protocol in the systems within one to two blocks or 15 to 30 seconds.
Laura Shin:
Oh, interesting. And when you said that you eventually plan to hand this off to the community, what does that mean exactly?
Robert Leshner:
So that’s a complicated process, and we haven’t seen that many protocols evolve to be fully decentralized, but our goal for the protocol is for us to have absolutely no involvement whatsoever a few years from now, and what that means is we would turn over responsibility for the pricing to other institutions or the community. You know, over time if exchanges start posting their own prices onto the ethereum blockchain, we could actually just reference those prices.
If groups form to take this responsibility and start voluntarily posting pricing information with blockchain, we could use those prices. It doesn’t have to be our company that’s providing this information anymore, and that’s our goal. We don’t want to be the ones responsible for this. We want to have no involvement if we can.
Laura Shin:
And to go back to how the protocol works, in the white paper you also mentioned that collateral earns interest. So borrowers earn interest on their collateral, and what do you guys do with the collateral, how does it earn interest?
Robert Leshner:
That’s exactly right. So, by providing collateral to the market it’s the same as somebody supplying an asset to the market in the first place. You’re making it available to other individuals and traders to borrow as well, and so it continues to accrue interest just as if you had supplied it without any other action. It just so happens that you’re using it as collateral to be able to borrow. All of the assets in the protocol earn interest, and all of the assets borrowed pay interest.
Laura Shin:
And then if the value of that collateral falls below the value required by the collateral ratio does it still earn interest, like does the person who gets to liquidate it, do they earn that interest or how does that part work?
Robert Leshner:
Yeah, so if it’s your property it continues to accrue interest. If somebody liquidates you because the value of your collateral has fallen it becomes…a small portion of it becomes their property and they’ll begin to earn interest on that as well.
Laura Shin:
Okay. Interesting. So basically, at any given moment in the system there are two types of money that are earning interest. There’s the money that was put into the compound money market and the money that was put up as collateral.
Robert Leshner:
That’s exactly right, and they’re essentially equivalent. The protocol views them actually as the same thing, whether you’re supplying it or you’re supplying it as collateral, in both cases it’s equivalent to the protocol and you’re earning interest on those assets.
Laura Shin:
Okay. So, what do you think are the primary use cases for Compound?
Robert Leshner:
So there’s two sides of the marketplace, so to speak. The first are users that are supplying assets to earn interest. Today most assets are actually sitting idle on exchanges and in wallets and in cold storage, and they’re not actually being made available to other people to use, and so the interest rate is zero.
The first primary use case are people earning incremental returns in the assets that they own. So this could be an individual who otherwise would be keeping assets on an exchange, whether it’s Binance or Bittrex or whatever it is, and they’re not actively looking to trade it or sell it, they just want an incremental return.
The second could be smart contracts themselves that have token balances. They can actually monetize token balances through Compound, and any on-chain system that has a token of any kind can actually use Compound as a source of incremental returns. It’s actually a new business model for a lot of smart contracts because a lot of people are building smart contracts and don’t actually have a business model or profit model in mind, and simply the act of storing a token and managing AUM is a business model, one that’s actually extremely popular if you look outside of crypto. So that’s the first use case.
And the second use case is on the borrowed side, and there’s three reasons why somebody would want to borrow a token. The first is to be able to use it as it’s naturally intended without having to buy it first. So, we can enable a developer to borrow ether to deploy or to execute smart contracts. We could allow you to borrow a token such as ZRX or Zero-X to be able to trade without having to buy it ahead of time. We could allow you to borrow the Basic Attention Token to interact with a browser and advertise _____ 19:48, and you’re able to borrow tokens without buying which is actually a really interesting use case. It enables smart contracts, you know, not to have to stockpile tokens, but to be able to access any other application on-chain. That’s really cool.
The second reason that people would want to borrow is because it provides leverage. When we speak to a lot of our hedge fund partners they’re interested in borrowing ether and stablecoins because it allows them to buy other assets. They’re considered to be base pairs for all the other spectrum of tokens, and so they’re borrowing ether and stablecoins to buy other assets to actually increase their own leverage and their own risk exposure. You know, if you borrow a bunch of stablecoins and go out and buy Token X with it, you now have more exposure to Token X.
Lastly, it’s actually it’s actually the inverse of that. It’s the ability to short sell an asset. Right now there’s very limited tools to be able to short sell tokens, and the first necessary step in order to short sell an asset is being able to borrow it. Now Compound is not an exchange, we don’t provide exchange functionality, we don’t let you trade, but we provide in a trustless open source and transparent fashion a mechanism for traders to be able to borrow tokens, to be able to sell them elsewhere. So a very simple workflow is somebody would borrow a token from Compound, they would send it to an exchange, and they might trade it on that exchange.
Laura Shin:
I want to go back to the first use case that you mentioned with ether or just any token that you want to use. I almost am not quite sure I understand why you would do that, but let me take a stab at a guess. It sounds like, so let’s say you want to use ether to run a smart contract. You borrow it from Compound, you’ve put up this collateral to borrow it, and then you spend the ether, but then you have to buy it again in order to repay Compound and get your collateral back. Is the point of that that then you’ve earned at least 2 percent on the collateral, or whatever percent on the collateral, even though you performed this function on ether? Is that why you would do that?
Robert Leshner:
Yeah, so the primary benefit is you don’t have to hold ether or a specific token in order to use those systems. I could have a smart contract that just holds a stablecoin and yet it can operate any other protocol or network, as long as it’s on their blockchain. So, I could hold just a stablecoin which accrues interest and I’m earning interest, and when my application needs another token to interact with their protocol, whether it’s Zero-X or whether it’s Augur or whether it’s ethereum, my application can just automatically borrow that needed resource on demand.
It doesn’t have to predict its own token needs. It doesn’t have to outlay the capital ahead of time to buy these tokens. It can simply operate other protocols on demand by just automatically borrowing them from Compound when they’re needed.
Laura Shin:
But at the end of the function it has to buy them…
Robert Leshner:
At the end of the function…
Laura Shin:
…to return it, right?
Robert Leshner:
…you eventually would have to buy them, yeah. Eventually on the other side you would have to repay that in some fashion, but it doesn’t enable new use cases.
Laura Shin:
Okay. I mean it’s just like sort of, I guess the reason is…what’s that’s expression about the monkey that eats like one banana in the morning versus the evening and what’s the difference, something like that. Is that what…do you know what I’m saying? Like it’s sort of like, oh, well, instead of buying it before you perform the function, you have to buy it after.
Robert Leshner:
Right, but that can give you actually a lot of flexibility. It’s the same reason why corporations have working capital versus permanent capital. You know, why instead of raising more equity or debt you might just borrow it short term in the market to be able to operate. That’s really the biggest difference.
And as the marketplace for smart contracts and applications and use increases, we actually think it’s going to unlock new opportunities that haven’t even really been thought of yet.
Laura Shin:
And I also want to talk about the third use case that you mentioned. So, I totally get the short selling use case here, I see how it would work, but I want to know what are the advantages of using Compound to do something like that as opposed to a peer-to-peer lending platform like Dharma or something?
Robert Leshner:
Yeah. So the primary benefit of Compound, and I truly believe there’s going to be many different systems that exist over time that will co-exist peacefully, but the primary benefit of Compound that you don’t have to wait for a counterpart in order to be able to access the liquidity.
So, with most peer-to-peer systems you actually have to find somebody with the exact opposite view of you at the same time. If I want to borrow Token X I have to specify I want to borrow Token X. You know, in a peer-to-peer system I have to specific I want to borrow Token X for this period of time at this interest rate, and somebody else has to take the exact opposite side of that after negotiating collateral and all of that.
With Compound you don’t have to wait for a counterpart. It’s instant and it’s machine operable, and it’s predictable. You simply specify what you’re looking to borrow and the quantity. All the other parameters are actually decided by the protocol. The interest rate is decided by the protocol, and how long you’re borrowing it for is specified by you. You simply repay your borrowed Token X whenever you feel like it, whenever you’re ready to, and it makes it much easier to access liquidity for a short sale in a peer-to-peer system. I believe that over time both are going to exist.
Just if you look at financial markets you have both money markets and long-term loans and debt and they’re different use cases, and I think that there’s customers who will actually want both and might use both at different times and in different fashions, but Compound is designed to be the easiest source of liquidity for borrowers because it’s entirely encapsulated in a smart contract and there’s no outside interactions that occur. There’s no order book, there’s no peers that you have to find, there’s no online systems, it’s just everything is contained in a smart contract on the blockchain that anyone can operate.
Laura Shin:
We’re going to discuss more about the inner workings of Compound, but first I’d like to take a quick break for our fabulous sponsors.
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Laura Shin:
I’m speaking with Robert Leshner of Compound. And so, this question actually goes back to what we were talking about, about how the money is pooled. So I just want to make sure. So if I am somebody who is just holding bitcoin or whatever, but I want to hold…or not bitcoin, I guess ether, and I want to hold it in a money market account then when I withdraw the money I’m just withdrawing from the overall pool, is that correct?
Robert Leshner:
That’s exactly right. So rather than having an account or a segregated accounting of it, you’re actually contributing your assets to the entire marketplace, and you can see for your own account or address how much interest you’re accruing and your exact balance _____ 28:24 the time, and the protocol denominates your ownership, but the assets are a collective pool that function collectively as a money market.
Laura Shin:
Have you modeled what happens if there’s a market crash?
Robert Leshner:
We have actually. So in market crashes, you know, the biggest and only risk to individual users is that there’s a liquidation. This risk, first of all, is only on borrowers, it’s not on suppliers, and because of the over-collateralization, you know, the risk is that people wind up having some of their collateral converted into what they’ve borrowed and their loans are closed. This actually doesn’t impact the suppliers of assets, and it doesn’t impact other users of the protocol. What it does do is it exposes borrowers to risk, and it’s one of the reasons why we want to make sure that everybody using our protocol is incredibly educated on how it works and what the risks are that they face.
Laura Shin:
You mention in the white paper that markets can be suspended. What kind of scenarios would cause a market suspension?
Robert Leshner:
So this is something that we reserve the right for, when a token might migrate off of ethereum. So, there have been a couple of examples where an ethereum token stops actually being a token. A great example of this is TRON. They were a token on the ethereum blockchain that migrated onto their own blockchain. Had that been a market we would actually have to suspend it and remove it from Compound.
You know, one of the things that’s required is that a token actually continues to exist on the ethereum blockchain. If that assumption no longer holds, we can no longer support the market, and we’re starting to see a number of token projects. Think about actually migrating the chain net they’re operating on from ethereum to other chains, whether it’s their own blockchain or whether it’s one of the new smart contract platforms, etcetera, that’s always a risk that can occur. And so in that situation, what our plan is, is to communicate to the community that we will be suspending a market simultaneously with a token migration.
Laura Shin:
And are there any other scenarios in which you would suspend a market?
Robert Leshner:
No, only if it no longer is accessible to users. If there was an extreme situation which is no longer useable as a token such that if there’s a bug found in the token smart contract, we might suspend a market. If somebody discovers a flaw with Token X there’s a possibility it would be suspended. But this is an extreme scenario that hopefully never actually occurs. Our goal is to list assets that will function permanently, but in the event that the token no longer functions it’s necessary to suspend the token.
Laura Shin:
You say that eventually this decision over whether or not to suspend a market will be turned over to the community and stakeholders. Who will that be? Who will the stakeholders be and how will you turn that over?
Robert Leshner:
That’s a great question. So the stakeholders of the protocol are really the users. It’s those who are supplying assets and those who are borrowing assets, and what’s interesting is we can actually measure how much of a stakeholder a user is by the balances that they’re providing to the protocol.
Eventually one of our ideas, and this is still a rough concept, is that we could create a decentralized autonomous organization, really a governance contract that could actually provide governance of the protocol based on the quantity of people’s usage.
Laura Shin:
Okay. Interesting. How would they be organized? Would you use a token to do that?
Robert Leshner:
No, we probably wouldn’t need a token simply because the influence that a user has would be measurable, which is based on their usage of the protocol, and it’s already contained on the ethereum blockchain. What we would have to do to allow the community or developers to actually create an interface and a voting mechanism and a governance mechanism, but all of the building blocks are there so that eventually we can actually hand off control to the community.
Laura Shin:
Interesting. So, obviously to start you are kind of…you have organized it in a somewhat centralized fashion. Does that run any regulatory risk for you? I did see that according to federal regulations, entities operating money markets are subject to certain reporting disclosures, stress testing, other kinds of requirements. Are you guys going to follow those rules?
Robert Leshner:
So everything that we’re going to be doing is completely transparent. The operation of the money markets is interesting because it’s all open-source, it’s all inspectable and auditable and transparent, and so in a lot of ways the crypto financial marketplaces don’t naturally conform to any one regulatory regime, they’re global in nature and they’re decentralized, but we are planning to operate them in such a way that it’s as transparent and open as possible.
The markets operate themselves. The only information that we’re providing to the protocol to start with is pricing information and the inter-frame model, both of which we actually have plans to democratize and decentralize so that it’s no longer a specific company that’s even providing those pieces, it’s the community itself.
So, the hard work that we’ve done has gone into making the markets operate without our company. The flow of funds, the rules, the way that assets operate is actually no longer in our control when we deploy the protocol. The only pieces that we’re going to be interacting with are posting price information and defining an interest rate model.
Laura Shin:
Typically regulators in the US say that you fall under their jurisdiction if you serve US customers, so it seems like you probably do have to satisfy their rules. Do you think being transparent and open-source and auditable will be enough to satisfy them?
Robert Leshner:
That’s a great question. So, there’s two things that we’re approaching this with. The first is that we are not serving customers directly. The entire protocol itself is simply a smart contract that’s been deployed to a blockchain that operates autonomously. The second is that the smart contract only supports utility tokens. The assets that we’re launching with are the ones that are most likely to be true utilities and not securities. And so, we believe that while it’s a global regulatory environment, it should be compliant with every regulatory regime.
Laura Shin:
Yeah. And then around, like I know you have…obviously you have this goal to eventually decentralize. What kind of timeline do you imagine that will take?
Robert Leshner:
You know it’s hard to say and it’s a little bit early. There’s a lot of teams that are looking to fully decentralize their protocols. Most protocols actually still have sponsored organizations in some way. I actually don’t know of any that are fully decentralized. We’re planning to sort of learn the best practices as the community evolves and goes down this path. We’re probably not going to be the first protocol that completely decentralizes, but we’re definitely going to be trying to learn best practices as soon as they’re developed.
Laura Shin:
And to go back to kind of what the different options are for people who want to engage in these types of behaviors, and tell me if I’m wrong. As far as I understand Compound is somewhat competitive with the margin trading features on exchanges like Bitfinex and Poloniex. How is dealing with Compound different and why would someone choose to margin trade using Compound versus an exchange?
Robert Leshner:
That’s a great question. So there’s two primary differences. The first one is that Compound is entirely on-chain. There is no sort of cloud systems. There’s no servers that you interact with. There’s no company that you interact with. You interact with smart contracts on the blockchain, and what this means for us is that it’s available to any machine or human that wants to use the protocol. It makes it much easier for somebody to integrate their own software on top of it, to interact with it programmatically, or to interact with it without having to sign up for an exchange’s website.
The second thing that it means is that as a user you don’t actually have to maintain an account or position on an exchange. So if I as a trader wanted to short sell an asset on an exchange, I would actually have to trust the exchange with my assets and hold that position on the exchange for as long as I had it. With Compound you can actually borrow an asset from an open-source audited protocol that can’t run away in the middle of the night, and you can take those borrowed assets and do the trade you want on an exchange, but then move the proceeds off of the exchange. You don’t have to entrust any centralized party with your funds, and I think that’s really powerful.
You know there’s a lot of history of exchanges having negative events. Whether they’re deliberate or accidental there’s been a lot of times where user funds disappeared due to exchange error, and ideally you don’t have to take those risks with an exchange. And so, even for the exact equivalent trade, borrowing Token X and then selling it, we think the interest rates should and will be lower through Compound than they would be on an exchange because there’s less, call it exchange credit risk there.
Laura Shin:
Yeah. I mean I think this goes back to the start of like pick your poison because as you did mention there is a risk in whether or not your smart contracts will be reliable enough and secure enough. So, yes, I mean obviously I did give this example of…well, I gave multiple examples, but one of them Bitfinex did have a very well-known hack. I think at this point it might still be the second largest hack in crypto history. I’d actually have to check that, I’m not sure. But as you did mention, it is a matter of whether or not you can trust the smart contract in the case of Compound.
Robert Leshner:
Right.
Laura Shin:
Okay.
Robert Leshner:
It’s a different flavor of, call it security risk. I believe that smart contracts are the better risk because they can be proved safe over time, whereas an exchange are always running that risk whether the code changes or management changes there’s a perpetual risk with a centralized exchange. Whereas with a smart contract-based system I think that a lot of the risk is up front when it’s unproven and untested, and over time that risk goes down until eventually the community realizes that it’s zero if it was built correctly. And so, it is a different type of risk and it does exist for any smart contract-based protocol, but I think long term a decentralized protocol has a lot less security risks.
Laura Shin:
And who do you expect will be the most likely borrowers and the lenders? You did mention earlier the fact that hedge funds are interested in this, so who else, but how do they plan to use it and who else will be interested in in this?
Robert Leshner:
Yeah. So I think there’s always going to be people who are hobbyists in the community, who are looking to borrow a token just to experiment with it, you know, without having to sign up for an exchange and buy a token, different hobbyists have the ability to actually borrow pretty much any asset, use the protocols, experiment. It reduces the barriers to entry of playing around with protocols.
But I think the majority use cases are going to be the professional traders. Most of the interest that we have that’s inbound are crypto hedge funds, extremely small ones, medium size ones, large ones, who are looking for different tools that they can trust to add to their skillset. And I think a lot of the sophistication that exists in financial markets is concentrated at hedge funds, and the different people that are able to capitalize in which we offer really I think centralizes it around the hedge funds themselves because they’re the ones who are looking to put on sophisticated trading positions. They’re looking to borrow an asset and short sell it relative to an asset that they believe in or put on a relative value trade, or to use Compound as a source of liquidity to arbitrage between different markets. I think those are going to be the largest users.
And we actually recently announced that we had partnered with 24 different crypto hedge funds that are looking to move beyond long-only buy-in old strategies that are looking to add a borrowing component to their operations, and so I think that’s the root of the demand, and I think everything else is going to be a lot smaller in comparison.
Laura Shin:
I looked at that list of crypto hedge funds and they’re all like, at least less well known ones and I’m imagining kind of some of the smaller crypto hedge funds, do you think any of the bigger ones that manage quite a bit more in assets will use Compound?
Robert Leshner:
Absolutely. So, you know our initial partners are smaller crypto hedge funds because I think they’re the ones who have the most upside to experimentation. Being able to differentiate in their returns and the tools that they use is really powerful for them, but I think that over time, you know, Compound as a protocol will be used hopefully by the majority of the industry once it’s deemed to be reliable and trustworthy, and the longer that the protocol is live, the more likely we are to be in the hands of the largest asset managers.
Laura Shin:
You are one of coin-based ventures first investments and in total you have 8.2 million dollars in seed investment from Bain Capital Ventures, Andreessen Horowitz, and Polychain Capital, but Compound itself doesn’t have a token so how do you guys make money?
Robert Leshner:
So that’s a great question. Right now we’re a company that’s sponsoring this protocol. The protocol itself sets aside a very small amount of the interest that moves through the system for the protocol sponsor. As we eventually democratize and decentralize the protocol that may change. The excess interest might actually be set to zero, but for the time being there’s actually a business model for our company that’s developing the protocol, which is we keep a small amount of the interest that moves through the system. You know right now that’s an adjustable variable, it’s going to start off being very small, but it’s a natural business model, it’s not a token.
We’re a little bit old school in the way we look at this which is most tokens are unnecessary, they’re fundraising mechanisms, they’re arbitrary in nature. They actually add friction onto the usage of a protocol, and we decided to look at this in a very traditional fashion. Why can’t we have a traditional financial business model which is keeping a very small portion of AUM and having that owned by the developer or the ones that are building the protocol?
And so, for us that might be the only funding that we take, it might be the start of a much larger company. Only time will tell. We’re extremely excited to have the caliber of investors that we have that are able to make a long-term bet on our company. Compound might be a trillion dollar asset management protocol one day, or we could say that this is an experiment that leads to something bigger and greater. Only time is going to tell.
Laura Shin:
Which coins will you be launching with?
Robert Leshner:
So, when we launch we’re going to be supporting ether because that’s the primary fuel of the network, TrueUSD which is one of many stablecoins, and all asterisks by saying I’m a huge stablecoin fan and I think there’s a lot of stablecoins that we’re excited about. We’re going to be supporting…
Laura Shin:
And I just want to jump in and mention that TrustToken, which does TrueUSD, was on the show so people should check out that episode. I’ll link to it in the show notes.
Robert Leshner:
Check out that one as well. ZRX, Basic Attention Token…
Laura Shin:
Also a past guest.
Robert Leshner:
…and Augur.
Laura Shin:
Okay.
Robert Leshner:
I guess I’m going through your guest list here. But these are the highest quality projects, and these are the tokens that we’re going to be listing first, and I think there is a lot of overlap with the awareness in the community and the caliber of the teams, and the projects that we’re going to be listing first.
Laura Shin:
Yeah. And also, I do want to plug a few other shows because Joey Krug of Augur was on the show recently, and also of course Vitalik Buterin was on the show back in the winter. I think that might be my most downloaded episode, so most people probably have checked that out.
One other thing I want to ask about was you mentioned that one time while you were testing out how to set interest rates, in one scenario your team blew up the ethereum virtual machine. What did that mean?
Robert Leshner:
Oh, that’s a great question. So, we’ve done a lot of R&D on how to actually even compute interest rates in smart contracts. It’s not a trivial problem. If you look to Wall Street or finance you would think that calculating interest is extremely easy and it is using traditional tools. If you had a server and a cloud it’s very simple. But a lot of the approaches that we tried to actually create an interest rate system in smart contracts written in Solidity on the ethereum blockchain didn’t actually function, and a lot of the approaches that…a lot of the formulas that you would use don’t actually execute efficiently on ethereum.
And so, we’ve had to spend a lot of time coming up with a series of formulas that actually works to accurately calculate interest for an entire marketplace in ways that doesn’t use up too much computation and storage and resources, and early on in our testing a lot of the approaches that we took weren’t actually technically feasible on ethereum. They, so to speak, blew up the first machine which is what’s computing these smart contracts, and these were things that we weren’t able to even deploy because they were too inefficient, and so it took us a lot of work to get to a protocol and an approach that’s deployable.
Laura Shin:
And I want to go back to the coins you’re going to launch with. How did you choose these coins?
Robert Leshner:
Great question. So, our requirements for the first projects we are listing are that they’re liquid, that they’re listed on multiple exchanges, that there’s a large amount of community awareness, and that they’re likely to be utilities and not securities. And the projects that we’re featuring are some of the most understood projects, all of them are usable today, none of them are pushed for the future tokens, all of them you can actually use when we go live, and all of them are what I would consider to be some of the highest quality projects in the space. We’re not taking too many risks when it comes to asset selection. We’re looking to be a little bit conservative on the projects that we create markets for.
Laura Shin:
And when you launch who will your partners be aside from those hedge funds that you already mentioned?
Robert Leshner:
So we’re launching with 24 and growing hedge funds. We’re going to be working with a number of third-party developers that are looking to build on top of Compound. We’ve already received a lot of interest of people looking to build wallets that sweep balances to Compound, and interfaces that tie together Compound and other protocols such as Zero-X or Dharma or dYdX, and I would say that our partners really are going to be our largest users and developers that are creating new experiences with Compound because for the first time developers can seamlessly earn interest or borrow tokens.
Laura Shin:
Right now Compound only works on ethereum with ERC-20 tokens. Are you planning to work with other blockchains and if so, which ones and how will you incorporate them?
Robert Leshner:
So, I’ll start by saying that, you know, there’s no such thing as an ethereum maximalist, but if there is I’m the closest thing to it. I’m extremely enthusiastic about ethereum. I think it’s so far the most proven smart contract platform. There’s obviously a lot of new blockchains that are being created in order to host smart contracts.
The one thing that I’m going to be looking at as the founder of Compound and as a user and as a programmer are where are the new assets being issued? Right now ethereum is about 95 percent of the asset issuances, it’s where tokens are being created. If another blockchain starts to be the foundation for new token creation and issuance that’s where we’re going to take a very serious look at it to decide whether or not we need to create a version of the Compound protocol on those blockchains.
And so, I think it’s going to be quite some time before other blockchains gain critical mass where assets start to be issued on them. Compound wouldn’t work if there was a single asset or the native token of a blockchain and requires a series of assets to exist, but if another blockchain does start to gain significant traction on asset issuance then we’re interested in bringing our protocol to that blockchain.
Laura Shin:
About the ethereum maximalist comment that you made, I imagine actually Joe Lubin might be an ethereum maximalist.
Robert Leshner:
Yes, I think he would be more than I am, but yes, I agree. There’s a few of us out there.
Laura Shin:
He actually is going to come on my other podcast at a certain point soon, so I will ask him at that point if that’s what he would call himself.
So more about you. You’re a serial entrepreneur. What did you do before launching Compound?
Robert Leshner:
So my co-founder, Jeff, and I had founded two businesses prior to Compound. Another one has been what I would consider to be a massive success, but we spent years building software startups in Silicon Valley building teams of engineers and bringing products to market. Before that I was actually a professional economist which was a very large change of pace from the world that we have now, but Compound really brings both of those experiences together as an economist and as a Silicon Valley software founder, and it’s really exciting to be able to build what I would consider to be, you know, a very product-driven company focused on blockchain in Silicon Valley today.
Laura Shin:
How did you get into crypto?
Robert Leshner:
You know this is a great story, and it’s going to show my natural skepticism I think. So, I remember vividly reading the Bloomberg article that said bitcoin reaches parody with US dollar, bitcoin is now one dollar, and I scoffed at it, and you know I’ve read the bitcoin white paper, you know, I brushed it aside. I said this is never going to succeed and I was proven a little bit wrong.
Laura Shin:
Just a little.
Robert Leshner:
When the ethereum white paper came out, I read the ethereum white paper and I said, oh, this is too complicated. You know, it’s an order of magnitude more sophisticated than bitcoin, this is never going to succeed, and I was proven wrong again. And it actually wasn’t until the Dow hack/implosion that I actually got really interested in ethereum. It proved to me that not only did ethereum launch, but that it was functional as really fertile ground for a whole new ecosystem of financial applications and use cases, and I started digging in around the time of the Dow hack and I was just blown away by the fact that it worked.
There was a tragic incident that forked to the blockchain, but it was proof that you could actually really start to program assets and program new financial experiences, and it was just so amazing to me that I immediately started getting involved, started learning Solidity even though I’m not truly a programmer, and just learning as much as I could as quickly as I could, and watching the ecosystem develop has been just so staggeringly impressive. I think at this point I’m a completely true believer in what ethereum has built and it really didn’t start that way.
Laura Shin:
How did you come up with the idea for Compound?
Robert Leshner:
That’s a great question. So Compound started from a thesis, and the thesis that drove Compound was the idea that if ethereum succeeded eventually more and more real-world assets would migrate to ethereum and would be tokenized and securitized. Eventually at the extreme end of this thesis every real-world currency and every real-world security would become a token on the ethereum blockchain. And the question that I posed to myself was if this is true, if every currency and every security is on ethereum has a token, what stops that and what prevents that, and what are the gaps that need to be overcome, and actually the first and most powerful one is as simple as an interest rate or the spot rate, and the reason is the US dollar yields 2 percent, whether you’re earning it or whether a bank is earning it or whether a middleman is earning it.
Every dollar that’s not physically paper in a wallet earns the same thing if you’re not taking credit risk and you’re not taking duration risk, and until there’s an equivalent interest rate in crypto a dollar is not going to migrate over. You know capital flows to where it has the highest returns, a traditional digital dollar that yields 2 percent won’t want to become a crypto token if it yields zero percent, and that there has to be interest rate equivalents. And so Compound started off as a thought experiment of how do we create interest rate equivalency between real-world assets and ethereum.
Laura Shin:
So I know that you have this vision for what Compound will look like and which types of assets will be trading on it. So in your most idealistic vision, what will this all look like if everything that you hope for comes to fruition?
Robert Leshner:
In the most idealistic vision, and this could be 10 to 20 years down the road, but I think we’re slowly working our way there and we’re on the path, I think eventually there’s going to be 50 to 100 trillion dollars of assets that are tokenized. They’re not, you know, new utility tokens per se. It’s traditional currencies and traditional securities. You know every asset eventually will be a token, and in that world, you know, Compound is really interest rate infrastructure that powers all of these assets, where every currency is able to behave like its offline equivalent, and every security has interest rates that are equivalent to its offline equivalent, and we enable the individuals and traders and applications of the world to seamlessly monetize and borrow pretty much any asset.
Laura Shin:
And just out of curiosity, I find this a sort of different take in the crypto world, you believe that traditional assets in tokenized form will be larger than crypto native or additional native assets, why is that?
Robert Leshner:
Well, it’s because if you look at the world there’s already hundreds of trillions of dollars of real-world assets. I think there’s very limited room for new crypto-first, crypto native assets to compete. There’s so many new crypto currencies trying to compete on the same value propositions that, you know, I don’t think the world is looking for 50 different crypto currencies. I don’t think they’re looking for 50 different stablecoins. I think they’re looking for better versions of what we have today that are more secure, more portable, more transparent and programmable. Digital versions of traditional assets are kind of the best of both worlds, and it’s kind of in my mind, you know, what is most likely to happen in crypto.
Laura Shin:
Interesting. Well, we’ll see. This has been such a great discussion, I’ve really enjoyed it. Where can people learn more about you and Compound?
Robert Leshner:
So if you’re interested, you can come to compound.finance. We have a white paper, we have ways to learn more about the protocol, and in late September or early October we’re actually going to be hopefully shipping the very first version of the protocol for users to interact with.
Laura Shin:
Well, great. Thanks so much for coming on Unchained.
Robert Leshner:
Laura, it’s been an absolute pleasure. Thank you for having me on Unchained.
Laura Shin:
Thanks so much for joining us today. To learn more about Robert and Compound, check out the show notes inside your podcast episode.
New episodes of Unchained come out every Tuesday. If you haven’t already, rate, review and subscribe on Apple Podcasts. If you liked this episode share it with your friends on Facebook, Twitter, or LinkedIn.
And if you’re not yet subscribed to my other podcast, Unconfirmed, I highly recommend you check it out and subscribe now.
Unchained is produced by me, Laura Shin, with help from Raelene Gullapalli, Fractal Recordings, Jennie Josephson, Rahul Singireddy, and Daniel Nuss. Thanks for listening.
