Episode 267

Dharma – A protocol for tokenized debt

Nadav Hollander

Lending is one core pillar of the economy, enabling one person or company to be entrepreneurial with someone else’s capital. However, in the traditional banking system processes in lending are often opaque and the barrier to entry into this market is high. The emergence of easy to use Decentralized Finance is one of the hallmarks of 2018: To date, DeFi has brought us crypto-collateralized stable coins, decentralized exchanges, tokenized credit default swaps, trustless derivatives, and decentralized margin lending.

We’re joined Nadav Hollander, co-founder and president of Dharma. Dharma is a decentralized protocol for credit products which connects debtors with creditors through a transparent mechanism. The protocol itself is agnostic towards the collateral and terms used, however, the team recently introduced a crypto-collateralized margin lending application running on top of the Dharma protocol, Dharma Lever.

Topics discussed in the episode

  • Nadav’s background and how he became interested in both blockchain technology and debt
  • The vision behind distributed lending
  • The mechanics of the Dharma protocol
  • The role of underwriters in the Dharma protocol
  • Dharma lever, an application for margin lending on the Dharma protocol
  • Dharma’s business model
  • The future of decentralized finance

Brian Fabian Crain:  Hi and welcome to Epicenter.  My name is Brian Fabian Crain.  

Friederike Ernst:  My name is Friederike Ernst.

Brian:  We’re here today with Nadav Hollander, so we’re gonna go into the conversation in just a bit.  He’s the founder of the Dharma protocol, which is an exciting, new lending marketplace, and lending protocol on Ethereum.  

Friederike:  Yes. They’ve just started building first application on that protocol namely Dharma Lever for margin lending.  We will talk about that and the business model, and where they’re going to go.

Brian:  Okay, let’s go to the conversation with Nadav.  We’re here today with Nadav Hollander. Nadav is the founder of Dharma Protocol.  Dharma is a protocol for lending, loans and all kinds of debt instruments on Ethereum or on blockchain.  Interesting project, I’ve actually met Nadav together with Meher together in February. We visited him and his apartment.  There were just two people at the time just starting out. In the meantime they’ve made really incredible progress. As I was checking out a little bit what has been built on, and what people are doing over it.  They’ve come an enormously long way in a year. It’s definitely one of those interesting new decentralized finance projects. I’m really excited that you’re joining us today Nadav.

Nadav Hollander:  Thank you so much Brian, I appreciate that.

Brian:  Tell us how did you first become interested in, I guess there’s blockchain and then there’s debt.  Which one of those came first?

Nadav:  Yeah, no, definitely blockchain first.  Let’s talk about that. I was a student at Stanford studying computer science in 2015.  I had heard about Bitcoin, and had, like many in the space, dismissed it initially as just being a bit too fantastical.  I didn’t really see what was particularly interesting about it, or what was particularly useful about it. I never really dove that deep into it.  But in 2015, I took a class at Stanford called Bitcoin and Cryptocurrency that Dan Boneh and Joe Bonneau taught.  I just completely fell in love with the space.  In particular, learned a lot about Ethereum, which is at the time a very new project, and got really, really excited about that.  I actually ended up meeting Fred Ehrsam from Coinbase in that class because he came in and gave a talk. Fred Ehrsam being the co-founder of Coinbase.  Eventually, that led to me working at Coinbase as an engineer. I actually started off as an intern there. It’s been down the rabbit hole ever since, pretty much.

Friederike:  Then you became interested in debt after that?

Nadav:  Yeah. I think where I got into, where I started reading a lot into the history of debt and got interested in the topic in general was as a result of starting to think about the fact that Coinbase is a company that sits on a tremendous amount of cryptocurrency that’s just like undeployed.  It just sits on its coffer. It’s not occurring interest or their users are anyway. I just thought that the idea of having, wouldn’t it be nice if your Bitcoin when it was sitting in Coinbase was earning you some sort of interest rate like it would in a bank. It’s a really powerful concept to have a bank that is effectively globally accessible that is stateless, that anybody with an internet connection can access.  I started to get really jazzed about the idea of interest accruing debt instruments in the context of cryptocurrencies. I was surprised to see that there’s really a lack of formal credit markets or credit market infrastructure in the cryptocurrency space at the time. That led to me both trying to learn a lot about how credit infrastructure has gone built in the legacy financial system over the years, but also understanding what are sort of early green shoots of a formalized credit market in the cryptocurrency world and where it likely will start to go, and eventually end up in the future.  

Brian:  How did you go about learning about traditional credit markets?  Was there any exposure you had to this beforehand?

Nadav:  In a formal setting, no.  Definitely, I didn’t work as a loan officer in a bank or anything like that, if that’s what you’re asking.  But I picked up a lot of it from osmosis, just in terms of basically going around to a lot of these margin people that I knew that either worked on the financial industry, or worked in some sort of ancillary financial services, and picking their brains and shopping around the idea of what eventually become Dharma to them, to see what they thought of it.  In conversations like that you learn things like, oh, sub point A of this thing that your coming up with doesn’t make sense. But actually, sub point B solves X, Y, Z problem for us. Just doing a lot of conversations like that until I can pick the part more and more of what are the real gaps in the existing credit market infrastructure of the world, and what are the problems to which blockchain tech is actually applicable.  Something that was very influential on me from a standpoint of getting educated on the history of the world’s debt market was a book called Debt: The First 5,000 Years. This is a very, very popular book in the cryptocurrency industry. Often for actually different reasons than my reasons. It’s not necessarily like people are excited about it because it affirms certain narratives about how money came to be. But yeah, I think it’s a fantastic, extensive treat on the history of debt and how it’s evolved in the modern world.  

Friederike:  Good. This led you to fund Dharma.  Before we actually deep dive into what the protocol actually does, what does Dharma mean, I mean the name?

Nadav:  Yeah. Dharma, at least in the Hindu concept is essentially, I always worry that I’m doing a bit of a butchering job of translating it.  But as far as I have understood it, it’s effectively like the concept of obligations or things that you ought to do. I thought that in constructing a universal economical system of debts or obligations, that it was a fitting concept in many senses.

Brian:  Let’s dive into the Dharma protocol.  First, can you on a very high level describe, how does it work, and what are the parties that make up the main players in the protocol?

Nadav:  I think the best way to think about what Dharma protocol is, is I’d like to think of it as a shared settlement infrastructure for a peer to peer lending.  What does that mean, right? Let’s take an analogous example. I’m sure many of your listeners are familiar with the zero X protocol, which has gained a lot of prominence over the past couple of years.  The zero X protocol can be thought of as a shared settlement infrastructure that is a public set of smart contracts on the Ethereum blockchain that takes a standard order schema that defines Party A wants to sell Token X to Party B.  It takes that message and then executes some sort of action on behalf of those two parties. In the case of Zero X, the action that it’s facilitating is a trade between two parties. It takes a magic sign string of text that says, I, Token Holder A, want to sell Token X to Token Holder B.  Then it swaps those tokens out from their two accounts once it validates the message is correct. AKA, it settles the actual trade. Dharma is a similar concept but for loans rather than trades. It’s basically a shared settlement infrastructure for executing lending transactions. Where instead of that order essentially saying, I, Token Holder A want to sell Token X to Token Holder B.  It instead says, I, Token Holder A want to lend Token X to Token Holder B. When it executes that transaction, it both pulls the tokens out of it. Token Holder A’s account, and sends them over to Token Holder B. But also initiates the loan agreement and kind of creates the contracts that can be used to administer the loan agreement over time. We’ll dive a little bit more into that in a second.  That’s at a high level way to think about what the whole system, what the goal of the system is, what its mandate is. Now, there are several actors in the Dharma protocol that are worth defining. First of all, we have what are known as relayers. What relayers do in Dharma is extremely similar to what relayers do in the Zero X protocol. They essentially host centralized order books that borrowers and lenders can post debt orders and offers onto, in order to find other counterparties.  I gave the example earlier of Token Holder A wanting to lend X tokens to Token Holder B. Them kind of coming up with some sort of magic string that if you give it to the Dharma smart contracts, it would settle the actual loan transaction. That’s not particularly useful if Token Holder A and Token Holder B don’t already know each other. They need some sort of way of finding the counterparty. That’s where relayers come in. A very naïve model, if I am trying to take out a loan, I can go on to a relayer.  I can craft one of the assigned messages and basically post it onto the relayer’s order book so that effectively other cryptocurrency users can go and browse through that debt order book, look at different debt orders and choose which one they want to fill. The reason why these relayers do this is because they earn a fee every time these loans are actually, these loan orders are actually filled. Again, very akin to the concept of relayers in the zero X protocol.

Now there’s another class of actors in Dharma which are called underwriters.  What do underwriters do? Underwriters essentially earn a fee for playing a few roles. One, they originate borrowers. They actually, in some way, shape or form, get the borrower to the door step of the relayer. Be that like programmatically, or be that quite literally linking them over there. Then B, they underwrite the risk of the loan. Meaning that they make some sort of prediction as to the likelihood of the borrower repaying the given loan. They cryptographically commit to that likelihood in a message. They basically say, I believe this borrower has a .9 percent chance of defaulting on this loan and not repaying.  Crucially, the reason why they are held accountable to this prediction is because if that loan is ever actually filled, if somebody eventually does come around and take the other side of the order, then their prediction gets immutably recorded into the blockchain so that you could empirically evaluate over time, the degree to which an underwriter’s predictions have been accurate. Now, there’s some caveats around this, and we’ll probably discuss this a little bit later, but that’s the basic model. Essentially, the end to end flow when you have both an underwriter and relayer, goes kind of like this. Imagine I go onto www.loans.com and the operator of that website is in the backend acting as an underwriter.  Effectively, I just went there, I don’t know anything about Dharma protocol. I don’t know anything about crypto assets. I just want to take out some sort of loan. I fill out some sort of form that says, I want to borrow a hundred thousand dollars. What loans.com is then gonna do is they’re gonna run their proprietary algorithms that are going to determine what my creditworthiness is. They are going to then display a sample term sheet. It’s gonna say, okay, we can give you a hundred thousand dollars at a 3.14 APR interest rate at X, Y, Z terms. If I am on board with this, then I’m going to consent to that. They, in the backend, are going to sign a message that essentially is one of these debt orders that I described earlier.  But they’re going to attach their prediction of my creditworthiness onto there. You can see that they think that I have a .9 percent chance or whatever of defaulting. Then they are going to go and broadcast that order onto different relayers order books, so that therefore a lender can come in and look through those order books, and essentially choose whether or not they want to invest in my loan. Effectively, all in all you have what is basically a decentralized distributed credit market with different actors who are facilitating the pricing and the counterparty matching of different loan issuances.

Friederike:  This is decentralized very much on the side of the creditor and on the relayer, but the underwriter and the debtor, you have to know something about them, right?  This can’t be a purely unchained reputation system that you’re bidding up.

Nadav:  Yeah. I would definitely say, I view this version of the system that we built as being heavy on mechanics, light on reputation.  We basically built like the very foundational mechanics of how this decentralized credit market can work, but it has a very loose and weakened notion of reputation.  What I mean by that is that the only reputation metrics that you have on a underwriter for how good they are at predicting defaults, is kind of their historical performance.  Unfortunately for a lot of reasons, that historical performance can be fairly easily gained. I for instance as an example, I as an underwriter could go and generate a bunch of fake, dummy borrower and lender accounts that will basically simulate a bunch of loans that are all just me lending to myself.  Perfectly predict that accuracy every single time and build a false sense of reputation that were somebody to kind of naively trust this reputation system I could use it to defraud them of a certain amount of money. Really, the reputation system that exists in Dharma today is that weak reputation system.  It’s really just some sort of empirical signal that helps you evaluate whether to trust an underwriter. But in all of our documentations, we always heavily communicate that. We communicate two things, A, underwriters need to be trusted entities. They’re not, this is not a protocol in which you should be willing to trust an underwriter on the basis of simply their public key and their history.  You should also want to know what sort of social capital they have. What is their actual brand, their reputation? Are they a trusted company, are they in a regulated jurisdiction, things like that. The second thing that we emphasize is that for a lot of reasons, unsecured lending in Dharma is kind of an experimental features right now. We really, really strongly discourage people from doing unsecured loans, and meaningful volume right now, because kind of as you pointed out, the reputation system that we built in the Dharma is very naïve at the moment.  The other thing that I would emphasize or the last point that I’d add with respect to underwriters being trusted entities is like the way that I like to think about it is if you were to invest into something like a token sale, you would never just invest into a blind address. You would never just go on to a website that just have nothing but an address, said like these are the terms at which we’re raising at. You’re always going to evaluate that investment on the basis of a lot of social cues and signals. Like the quality of the white paper, and the quality of the team.  All of those good stuff. I view underwriters as being very similar in this regard. They are effectively facilitating some sort of investment in which you are going to need to judge on a basis of a lot of social cues, how trustworthy they are. I view them as basically being, the fact that it is not a trustless system doesn’t mean that it’s not valuable in terms of the distribution that it begets.

Brian:  You mentioned before that the main focus today is to build these mechanics of these decentralized credit system.  Now, I would love to understand how does that compare with the mechanics of the normal credit systems? In particular, you mentioned underwriter.  Of course underwriters do exist, in the traditional world. Is there analogous thing to relayers? On the one hand, are there particular things that you add, that are needed in the decentralized server that are not needed in traditional world?  Or maybe things that you’re able to move, and entitle parties that you can cut out?

Nadav:  Yeah. I think it’s important to evaluate this from two perspectives.  One is the perspective of the initial issuance. The second is the context of secondary markets and how these instruments get traded around after they’ve been issued.  If you think about it like the number of hops between when you put your dollar into a bank account, and when it eventually gets utilized by some sort of borrower, is fairly immense.  There’s kind of an insane amount of different intermediaries that stand in between your dollar in, and the dollar out that gets lent out to somebody. The problem is, is that a lot of these intermediaries are not necessarily operating in a highly programmatic efficient manner.  There are very old world financial types. To give a super simplified crude example here. I’ll just say your money is accruing interest in some sort of pension fund. That pension fund then goes and buys a CDO of collateralized debt obligation which contains thousands and thousands of different mortgages packaged up into a fancy instrument.  The administrator of the collateralized data obligation is taking some sort of cut on that. One layer down from there, you have some sort of bank that is actually issuing those mortgages. They’re the ones who sold the mortgages to the CDO administrator. That bank is similarly, in some way, shape, or form, going to be taking a cut from the dollar that went in there.  Then a layer down, you have a sort of originator that actually went and found the borrower, and advertised to them and got them to the doorstep. That originator similarly taking some sort of pound of flesh. So on and so forth. The point is, there are intermediaries in the Dharma credit market, and there are intermediaries in the traditional financial system. But our hope and our goal with building Dharma is that at least in Dharma, those intermediaries will all be kind of entirely programmatically accessible from anywhere in the world.  B, they will be highly minimized, and what they can do as in the sort of trust they need to place in them will be minimized, or the attack service of the bad things that they can do can be minimized. Three, there will be like almost entirely transparent, as any sort of, anything that they may do that is fraudulent, or anything that they may do that is good will be auditable on chain. That’s kind of the way that I’d like to think about what the dharma credit market does for initial issuance in comparison to the existing financial system. Now there’s a whole other type of conversation about how Dharma factors into secondary trading of different debt instruments.  But that’s a little bit of an esoteric rabbit hole that I think maybe we can save for another time.

Friederike:  That should be interesting.  In principle, the Dharma protocol is bare bones as it is.  In principle, any loan can be structured as a debtor and an underwriter together see fit.  As long as the creditor actually buys it. In principle, I don’t actually need to collateralize my loan at will, or maybe with my reputation.  Basically if I borrow money from Brian, Brian will know that we work in the same office, and that we will see each other many days. That will be really awkward if I don’t pay back.   But what collateral do you actually expect to see first? This is moving into the Dharma, you pioneered this Dharma Lever that actually works on top of Dharma.

Nadav:  Right, right, right.  Yeah, the way that we see Dharma evolving is that we think that the first use cases for decentralized lending that are really going to take off are those that have the least sort of external dependencies on the real world.  Those at the moment happen to be kind of collateralized on chain by other crypto assets. They don’t really rely on any notions of off chain reputation or identity. The reason why we think that these are the most relevant or useful in the short term is that as we discussed earlier, the reputation system for underwriters is fairly undeveloped.  It’s fairly primitive in many senses. So though yes, in theory, today, you could go and take out an unsecured loan vie Dharma, it’s not an extremely scalable sort of system for that right now. It would be really hard for there to be thousands of different underwriters that are all doing unsecured loans. It will be hard for a creditor then to be able to evaluate which ones to actually trust.  With that being said, our focus in the short term is instead to facilitate, to essentially like evangelize Dharma’s usage as the sort of economical credit market for collateralized loans. Just so that like the actual distribution mechanism kind of embedded into the cryptocurrency ecosystem. Then over time, to start the layer on more sophisticated notions of reputation that enable things like unsecured loans.  You ask kind of what sort of things would be used as collateral in the context of these collateralized loads. Basically, far and beyond the biggest category here is just other crypto tokens, right? Really, a classic example would be like, I hold a bunch of Ether. I don’t want to sell my Ether. I want to keep holding on to it. I don’t want to incur some sort of tax liability, or what have you. But I want some sort of stable liquidity.  What I can do is I can basically post an order onto the Dharma credit market saying, I am willing to put up X amount of Ether as collateral and get some amount of USD coin or dye, or what have you, lent to me against that. The value of that USD coin, or dye, will be less than the total notional value of the collateral that I’ve put up. There’s really like the lending used cases that are enabled b this, primarily fall into the category of speculative borrowing.  Basically like taking on margin positions, like if you want to lever up your position in a certain crypto asset, or you want to short a certain crypto asset. This is a mechanism for doing that. This is what we see as the primary beach head for decentralized lending today. This is what we are primarily focused on in the moment. If you like, I’m more than happy to dive into Lever and our efforts there.

Brian:  Yeah, I know it will be great.  Of course it’s pretty, on some of that, I totally agree with you.  It makes perfect sense. On some level it is quite funny that in this hyper volatile space, now you can level up more.  

Nadav:  Yeah. I mean I think so.  I think that’s a wrong way to think about it, though.  The reason why I say that is that, first of all, yes, it’s kind of wild that people take on leverage in the cryptocurrency space.  I do it a lot. I can necessarily say that sound investing strategy to do that, and how an extra volatile market as is, but teach their own.  But I think it’s also important to realize that margin loans can be used to short assets as well. To basically bet on them going down in value.  That’s really, really important for kind of bringing maturity to a market. Because if you don’t have a short pressure on an asset, then it is more likely to be extremely volatile.  Whereas like if traitors have a means of actually doing these like shorting Dentacoin, or what have you , they will do so, and that’s gonna pressure the price down. That’s gonna add another price signal to the market that’s gonna help make things more rational.  I think it’s a bit more nuance than saying this is providing hot dice to like gambling addicts. It’s more about building the basic fixtures of a credit market, or a basic fixture of a sophisticated trading market, so that prices can become more rational.

Brian:  Talk about Lever.  Would it be possible to borrow any Ethereum asset and put up any Ethereum asset as a collateral?  How does it work?

Nadav:  Yeah. It’s a really good way.  What is Lever? Lever is the first underwriter in the Dharma ecosystem that we are building.  To be clear, anybody can build underwriters in Dharma. We don’t get that in any way. But we, in particular, for reasons that we can discuss perhaps later when we’re talking about things like business model, have chosen to build this first underwriter.  The market that this underwriter is focused on is basically like high volume margin loans for anybody in the world that has an internet connection. The way I like to think about what Lever is as a product is kind of like a shape shift for loans, almost. Where you can show up on a website.  You say, I want to borrow Eth collateralized. I look at that example again. Lever will then go out and kind of scan through the Dharma credit market and find the best offer that fits your parameters. It will then sort of display that offer to you. You will then be able to go and send your crypto assets to some sort of address.  Then instantly receive your principle kind of center. All the sort of complexity of actually, like filling the loan on the Dharma smart contracts, and interacting with Ethereum nodes and all that sort of stuff, is abstracted away from the end user. You have this like very simple web 2.0 style product that wraps around the entire experience.  That’s what Lever is.

Brian:  So it’s just on Lever, let’s say I want to put in some dye as collateral and borrow some Ether.  This dye gets held in a smart contract.

Nadav:  Yeah, that’s correct.  The collateral is trustlessly escrowed in a smart contract.  The only conditions on which it’s like released is either if the user defaults, in which case like the collateral kind of automatically gets liquidated for the principle, and the remaining principle is sent to the lender.  The remaining collateral is sent to the borrower, or in the case of a margin call. If the price of the underlying collateral drops to a certain point where the loan is no longer over collateralized, then there is a sort of liquidation mechanism for making sure that the lender doesn’t lose their capital.  All in all the system is still, the crypto assets are collateral to buy smart contracts and not kind of custodied by some sort of arbitrary trusted third party.

Friederike:  Okay, so you’re talking about two ways of closing the loan.  Presumably, as a borrower, I can also just return the loan, right?  

Nadav:  Right. Yeah, the third way in which you can access your collateral is just making repayment in full.  In which case your entire collateral deposit is returned to you.

Friederike:  That makes complete sense.  Let me go into the liquidation process.  Presumably, if the value of the asset I have put up as collateral drops in value, or I fail to make interest payments, my asset gets liquidated.  Can you take me through how this liquidation actually happens?

Nadav:  Yeah, sure.  Basically, there’s a price feed that is kind of periodically informing the chain of what the price of the two assets is with respect to each other.  Effectively, what the smart contract is doing is it is using that price feed to keep track of what the loan to value ratio is of that given loan. The loan to value ratio being essentially the ration of the value, of the principle that’s been lent out, to the value of the collateral that’s underlying it.  Once that LTV, or the loan to value ratio crosses a certain threshold, the loan becomes eligible for liquidation. What happens then is that anybody can come to that smart contract. With an amount of the principle that is sufficient to repay the lender, and basically purchase the collateral in the smart contract with that principle at the current price.  Essentially like if, to give a quick example, if I, if we have a zero interest rate loan that is for a hundred dollars USD and is collateralized by $150 worth of Ether, and for some reason we have now kind of liquidated this loan, then I as a liquidator can come in, and I have a hundred dollars. I got a hundred dollars in USD. I can purchase a hundred dollars’ worth of Ether from the smart contract in USD or USD coin, or whatever.  The contract is going to take that USD coin, return it to the lender. It’s gonna take the remaining collateral, and send it back to the borrower. And the reason why I as a liquidator would want to do this is kind of twofold. Either, A, I am the underwriter. In the case of lever, we are initially going to be doing a lot of this because we are underwriting these loans. We have an interest in seeing them be serviced correctly. We have an interest in making sure that lenders aren’t going to lose money, et cetera.  We’re also earning a fee as an underwriter. We’re being compensated for this. There are some sort of optional liquidation discount on the actual underlying collateral, in which case there is an arbitrary opportunity here where we can go and use our hundred dollars to purchase the hundred dollars’ worth of Ether at some sort of discount, and then immediately sell it at the real market rate so that we make some sort of delta there. That’s the basic liquidation mechanism.

Brian:  That’s how it works in a bank.  You have a discount or basically a penalty that gets paid by whoever gets liquidated.  But here, that’s not.

Nadav:  Yeah, I’d say that we, the system, maker system, it has a lot of parameters to it that are sort of optimized for creating a stable coin, and really dissenting the faults to a really big area because they’re kind of like chips away, the stability of the stable coin, every time that happens.  Really like I think maker has a default penalty of 13% of something like that. In the case of Dharma, we don’t have the same sort of constraints. We don’t need to impose these sorts of very sort of draconian rules. You don’t see those same sorts of mechanisms used in the context of Dharma.  

Friederike:  Basically, the discount that you’re given for purchasing this loan, does this depend on the kind of collateral that I put up?  Because basically there are many kinds of tokens that if you actually purchase them, you’re influencing price quite heavily. Basically they just don’t have a good market depth.  Basically if it’s a larger position, and you go on to any decentralized exchange or often even centralized exchanges, you move the price a lot, just by actually purchasing that amount of token at market price.  Is that factored into that somehow?

Nadav:  Yeah, that’s an excellent, excellent question.  Basically, the liquidation discount, or the fee that the underwriter earns, which again they’re kind of interchangeable for how you want to compensate a liquidator for coming in, is absolutely like, it’s parameterizable.  It’s part of the order that gets broadcasted onto different relayers. You can go from zero to infinity, right? At least in the case of liquidation discount, zero to a hundred present. Yeah, what you described is exactly accurate.  It’s like if a big factor that goes into deciding what that discount should be, or what that fee should be is the liquidity of the underlying collateral. Because in particular, if the system is based on the liquidation discount, in order for you to execute that arbitrage, you have to cross the spread twice.  Basically purchase the collateral, and then immediately sell it thereafter. In particularly liquid assets, that spread can be very, very wide. You can be like losing two, four percent or something like that. Just by crossing the spread. For that reason, yeah, you’re a hundred percent correct in saying that the liquidity is a big reason why that fee is parameterizable.  

Friederike:  This is super interesting.  That leads me to my next question.  Basically, where do you get your price feed?  Basically, in principle, liquidation then can be an enormously profitable endeavour.  Basically if you get a price feed and you can somehow manipulate the price feed, as a liquidator, that gives you way to gain the entire system.  

Nadav:  Yeah, absolutely.  Initially, we are going to be like our own price feeds as a trusted operator.  In particular, like I mentioned earlier, we are the underwriter of these loans.  I actually think this is an excellent example of where you have sort of, earlier I spoke about how underwriters are meant to be trusted, but like trust minimized in a sense.  You want to minimize the amount of trust assumptions you have to make about them. I think Dharma Lever is an excellent example on this sense. Because Lever is the underwriter of these loans that it’s originating.  For most aspects of the loan process, you don’t need to trust Lever, the underwriter, right? You don’t need to trust us with respect to making sure that the loan is actually collateralized. You don’t need to trust us with respect to making sure that the load has a sort of liquidation mechanism that’s going to happen to that.  All these things are managed and administered by smart contracts. The only thing you need to trust Lever or the underwriter, with respect to is operating this price feed correctly and accurately. Yes, there is somewhat of a trust assumption. Yes, there is a way in which Lever could defraud you. But you have some sort of auditable track record where you can see, okay, the price feed that they’ve been using for the past two years has always been accurate within some sort of confidence interval.  I view this like an excellent example of what I think the first underwriters in the Dharma network are going to look like. IE, like trust minimized actors. They’re really, they have some trust assumptions baked into them. But they’re either trust assumptions that can easily be verified ex post facto. That’s basically the gist of what I’m trying to say.

Brian:  you mentioned that basically Dharma is a trusted part to some extent in this context.  What does a regular profile look like for Dharma Lever? Is this gonna be accessible to anyone?  Or is it gonna be restricted to accredited investors? Do you guys need some sort of license to do this?

Nadav:  Yeah. I think with respect to accessibility, at the moment we are planning on having the project be accessible to both retail and accredited investors.  With that being said, we’re not going to go full anonymous deck, style origination. We are going to be seeing customers that come in, because we are going to be accepting fees.  If you are domiciled in the United States, and you are accepting fee revenue from pretty much anybody, you need to make sure you’re KYC-ing them. The system will have at least a little bit of gaining in that capacity.  Now, you asked an interesting question about what sort of licenses we may need to get in order to operate this business in a compliant manner. What’s interesting is that the Lever is effectively facilitating the liquidations, and is facilitating the origination of these loans.  Lever is a non-custodial product. We are never actually touching people’s principle, and executing actions on their behalf in any way. It’s not necessarily like akin to say, a lending club as a peer to peer lending provider. Where lending club, like stories are dollars, and in theory, if you, if lending club went out of business, you cannot have access to your dollars anymore.  We are more so effectively an interface for the underlying Dharma credit market from which you are finding your credit liquidity. What that means, I can’t just really drive into this in a super deep manner on this podcast right now. But it really creates a very nuance regulatory analysis of what this product’s role is in from a regulatory standpoint. Because it’s not very accurate to describe it as a money transmitter.  It’s not very accurate to describe it as a money service business. But there’s not an actual sort of component of it that involves us touching people’s money. So much as like us just acting as a nice interface that bundles up the operations of the underlying Dharma credit market in a way that’s easy for users to interact with.

Friederike:  That’s interesting, so there are regulations that actually touch these type of marketplaces.  But I think maybe this is not the place and time to go into that. There are a couple of projects that do very similar things that have sprung up in the recent months.  Such as compound UIDX and Box. How do you see yourself in relation to them? Where do you think your strengths are? Where do you see your position in the ecosystem?

Nadav:  I think compound and UIDX are one or two that I’ll dive into right now, because they’re the ones that I’m most familiar with.  They both are very different in their own respective way. If you look at compound, for instance, compound is a money market. Not a peer to peer lending market.  What that means is that like, any lender that puts their money into the compound market for a given asset, is guaranteed the same rate that all of the other lenders have.  That rate floats over time on the basis of like supply and demand. What’s great about that is that with compound, in one click you can start earning your interest right away.  That’s really, really cool. But the problem with that is that if you have an imbalance in the market where there are a lot more lenders than there are borrowers, which is exactly what the crypto market looks like right now, then there’s this really uncomfortable situation where in order to make sure that all the lenders are getting the same interest rates, the lenders get a really, really low interest rate, like sub one percent.  Then individual borrowers have to get charged really high interest rates in order to compensate all of those lenders. Again, it’s really like you have a sort of trade off here, in the design of compound as a money market, where on one hand, both the lend and borrow side have instant access to what they’re trying to do, which is awesome. But on the other hand, that lends itself to having often like less attractive interest rates. Dharma on the other hand is like an order based protocol.  Instead of there being, you as a lender put your money up, and immediately start earning interest for it. Instead, you as a lender sign a debt offer and broadcast that offer. You basically say, I’m willing to lend this much at this rate. Kind of like you would post in order to an exchange as order. If somebody else eventually comes around and says, I’ll take you up on that. That rate sounds great to me. Then your asset start earning interest for you. Not all lenders in the Dharma system are guaranteed to earn some sort of interest rate.  It’s only those whose orders get filled. What that means is that, again going back to this trade-off analysis, you don’t necessarily have, at least from the lend side, an instant access to earning interest rates. But because there isn’t a sort of guaranteed interest rate for all parties that are in the system, that means that lenders can get higher interest rates on the Dharma credit market, and similarly borrowers can get lower interest rates on the Dharma credit market. It’s really kind of like a trade-off space between those two different projects.  Now with respect to DYDX, DYDX is much more similar to Dharma in this regard in that it’s based on an order protocol. Many different elements of the system are very, very similar to how we designed Lever. But I’d say that the biggest difference is that the underlying smart contracts of Dharma Lever are just the general Dharma credit market, which is built to be a generic credit market that can be used for things other than just margin loans. We view that as like, it’s a strategic differentiator where we can do margin loans, and also crypto kit these back loans, and things like that.  Use the same sort of underlying infrastructure to have that be served by a unified credit market. But with that being said, at this point in time, where everybody is using decentralized lending, the only thing people are using decentralized lending for is for speculative loans. I’d say that the projects do look very similar.

Friederike:  Interesting. As this basement shows, I assume you’ll move into, you’ll move away, or you’ll move to other projects than Dharma Lever, such as applications that look into more eloquent assets.  For instance, say, I want to take out a loan on my company, or a mortgage on my house that are not as easily gaugeable as the tokens that I have to put out as collateral on Dharma Lever. As far as they know, you guys haven’t actually done an ICO.  What’s your business model going to look like? How is it going to be different for those very straightforward Dharma level type applications and for other application building on top of the Dharma protocol?

Nadav:  Yeah, so we definitely, we took an approach where we decided not to do, and I see it during the kind of 2017 phrase.  In particular right now we’re quite happy with our decision because frankly we have enough sort of regulatory issues and analysis that we need to worry about in our day to day operations.  I think adding the whole world of securities law on [Indiscernible] [0:51:20] securities assurance to that is just another reason not to sleep at night. The way in which we plan on making money is building out ancillary services and businesses on top of the Dharma credit market.  The first one being Lever. Lever is an underwriter in the Dharma credit market. We think that it’s going to bring a lot more volume to the Dharma credit market. We think that’s gonna incentivize a lot more relayers to join. It’s gonna incentivize a lot of other underwriters to join.  That’s gonna be great. That’s gonna continue to bring more liquidity to Dharma Lever and make us more money et cetera. The short term business model in this immediate year is very much focused around Lever and making sure we are earning fee revenue through Lever. That fee, mind you, is the underwriter fee that we’re taking.  Which is baked into the protocol. But in the future, I think that we want to kind of start spinning up, taking the lessons that we learn from building Lever in spinning up like other types of underwriters in other sort of related industries. You can imagine that looking like us spinning up an underwriter for lending to minors, for instance.  Or spinning up an underwriter for lending to various crypto protocols that need credit liquidity. For instance like layer to scalability protocols. That’s a whole subtopic in it of its own that can cover. There’s a lot of really interesting business that can be spun up around it. But at the moment, our focus is on, we’ve built and deployed the underlying Dharma credit market.  We are now building the first underwriter in that credit market. It is an open market. There can be many underwriters, but our goal is to kind of earn our pound of flesh by earning fees as that underwriter.

Brian:  Do you think at some point there’s gonna be a role or a necessity to have some kind of token in the Dharma protocol?

Nadav:  Yeah, that’s an excellent question.  I think that we spent a ton of time thinking about like token models in which ones do and don’t make sense.  I think that the two categories, so first of all, to give the quick answer, the quick answer is like maybe, I don’t know.  There’s that possibility that at some point in the future it will become clear that there’s a gap in the protocol in X way, and that a token would help solve that gap.  If we truly believe that there’s a good model that would add value to our ecosystem, and also capture value to some degree then we probably would use something like a token.  What are the models that we think potentially makes sense in this regard? I will have a caveat by saying, this is highly, highly speculative. We don’t have any plans of digging ICO right now.  We don’t have any plan of issuing a token or anything like that. This is just totally a hand waving speculation. Those two models are either governance tokens, or what I would define as like, almost like an insurance token.  I’ll talk a little bit about what I mean by that in a second. The first is the same, when we’re talking about governance tokens in the context of a public settlement infrastructure like Dharma, the best sort of analogue to think of is zero X.  CRX is the governance token of the zero X settlement infrastructure. It can be used, in theory it will be used in the future to govern upgrades to the zero X protocol. Now, the problem with this model is that it’s unclear the degree to which it is valuable to govern upgrades to that settlement infrastructure.  Even if it is entirely broadly adopted by everyone in the industry. It’s not clear that the switching costs between using zero protocol, or using a forked version of zero X protocol are that high. The switch in cost were super high, then there would be a very compelling case to be made for why we need to have some sort of governance mechanism in place.  But if it’s just a question of setting my token permissions to some other set of smart contracts, then it’s not entirely clear whether it’s necessary for there to be a community governance of the actual settlement infrastructure. But again, what I’ve also emphasized is like it’s very possible that I’m wrong here, it’s very possible that there is value to these sorts of governance token, et cetera.  Again, all the more reason why we have not rushed into building something like this into our protocol. The second token model that I think is really interesting is what I would define as kind of like an insurance token. This is a really crude word to describe it, but the best analogue that I can think of is MKR in the context of maker. MKR is actually a governance token and also an insurance token in this regard.  What I mean by insurance token is that like the token holders act as the sort of lender of last resort to the maker system. If the maker system, and basically in certain cases, the MKR token will be inflated and sold in order to facilitate some sort of action in the maker system or to compensate some people if something goes really, really badly wrong. I view this as being kind of an interesting token model where basically a bunch of people purchase what is effectively a share in their belief that the smart contracts of this system are soundly designed, and the economics of the system are soundly designed.  It’s almost like they are earning some sort of premium on an insurance policy in a sense. Where in theory, if the system is very, very like, is functioning very well, the value is going to go up. If the system actually ends up kind of defaulting or breaking in some way, then your token is going to get basically inflated to zero. I think that these are actually very interesting token models that will probably start to see a lot more frequently in the wild with maker being probably the best point for it.

Brian:  In the context of Dharma, the idea would then be that if I’m an underwriter, can opt in to using some sort of almost premium insurance service by leveraging this token, or would this become a mandatory?

Nadav:  Yeah, that’s kind of the way I would think about it exactly.  Is like you’d have a sort of like opt in insurance policy that you could be looped into.  Again, highly speculative. Really, there’s a lot of questions around how do you underwrite that risk, how do you underwrite the risk of different, like how do you permission which underwriters can use that, things like that.  I think that those sorts of models are very interesting because yeah, I just think that it’s something that uniquely leverages the abilities of tokens to be inflated and deflated programmatically.

Brian:  Cool. Well, we’re about coming to the end of our conversation.  But it would be just good to hear from you a little bit, what is sort of the long term vision you have for both Dharma and decentralized finance in general?  What impact do you see this having on the world in the next ten years?

Nadav:  I think what gets me really excited about decentralized finance is that effectively it really drastically lowers the barrier of entry to building and delivering financial services to people.  If you think about it like today, if I want to spin up some sort of financial services company, let’s say I want spin up a lending company, there’s a lot of hoops that I have to jump through, right?  I have to not only get all the sort of regulatory licensure that is required to be a lender. But I have to actually go and like raise lending capital. I have to go and get a credit facility. I have to and knock on a lot of bankers’ doors and convince them to lend me a bunch of money so that I can be able to lend that money out myself.  That’s like a really be spoken, sort of like road process. If you look at what the internet did to most businesses, what it did to e-commerce, what it did to social networks, et cetera, is it really, really drastically lower the barrier entry for building a business of delivering products to people. All you had to do is go and spin up a website have a little stripe checkout flow.  All of a sudden, I can sell anyone in the world digital product. Even deliver it directly to them through the internet. It’s a really powerful idea. What I think decentralized finance is going to is it’s going to extend that to the world of financial services. Where now, all of a sudden, it becomes very, very easy to spin up a lending company. It becomes very easy to spin up like an arbitrage hedge fund that arbitrages different markets in the decentralized finance world.  It will become very easy to spin up like an internet based kind of bank where people can earn interest rates from anywhere in the world. The idea here isn’t necessarily to say that each one of these financial services will be better than their analogue counterparts, so much as to say that there will just be a lot more competition. We will have so many more entrance into the financial services market that the quality of them will go up, and the prices of them will go down at the same time.  My vision for what I think decentralized finance is going to be, is essentially a world in which the same sort of hyper globalization that the internet did to consumer products, and the massive increase in quality and decrease in price that you saw come from that when you lower those barriers, its entry in the context of consumer internet products, is going to happen in the context of financial services as well. Our hope with Dharma is to kind of build an economical lending infrastructure that sloughs into that broader decentralized financial vision.  On top of which kind of the financial services of the future are built.

Brian:  Cool, that’s well articulated.  Yeah, thanks so much for coming on, Nadav.  It was, I think, absolutely amazing project and great how quickly you progressed.  I look forward to seeing what you guys will build in the years to come.

Nadav:  Thanks Brian, I really appreciate it.  Thanks for having me on. Thank you Friederike.  

Friederike:  Thank you.

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