Understanding decentralised finance

Intro:
Hello and welcome to the CPA Australia Podcast, your weekly source for accounting, education, career and leadership discussion.

Dr Jana Schmitz:
Welcome to the CPA Australia Podcast and decentralised finance. In this podcast episode, we will explore what decentralised finance is and how it affects the finance industry. I'm Jana Schmitz, technical advisor for digital economy policy at CPA Australia. And I am joined today by Anouk Pinchetti, Chief Operating Officer at Miner Token and an advisor to a range of organisations in the blockchain space. Anouk is also a member of CPA Australia's Digital Transformation Centre of Excellence.

Anouk Pinchetti:
Hi, Jana. Glad to be here today.

Dr Jana Schmitz:
Thank you, Anouk. Now, Anouk, I have many, many questions about DeFi, but before we start, can you tell us a little bit about Miner Token?

Anouk Pinchetti:
Sure. So Miner Token, it is a project I would say it's based out of the US, but really the team is completely global. And what they're doing is creating a utility token that it represents one minute of mining labour at environmentally responsible gold mines within the network. So they're really trying to push for cleaner and more responsible and ecologically sensible mining practises around the world.

Dr Jana Schmitz:
Yeah. That's very interesting. So the project is about tokenizing the mining of gold, and tokenization is another use case of blockchain technology, I guess. Doesn't really have to do with decentralised finance. Does it?

Anouk Pinchetti:
Not really. No, I wouldn't put it in that basket.

Dr Jana Schmitz:
Okay, great. Well, maybe we can talk about tokenization in the next podcast episode. For now, we'll focus on decentralised finance or DeFi in short, which is another very interesting development in the blockchain world. So Anouk, please go and educate us what exactly is DeFi, and what does it intend to achieve?

Anouk Pinchetti:
So DeFi stands for decentralised finance, and really it is the effort within the blockchain ecosystem to replicate and create parallel versions of a lot of the legacy financial services that you see around the space. Actually, I will say the first building block is stablecoins that allow people to switch in and out of some of the volatility that they see in the space. And the way that tends to be enabled is through lending and also the ability to have decentralised exchange of one token for another.

Anouk Pinchetti:
So the difference is that in the blockchain space, there are a lot of components that are being built as modular units and smart contracts that other projects are then able to leverage. It's often described as money Legos or financial Legos able to construct complex financial instruments. So to recap, it started with stablecoins facilitated by lending and borrowing, which can then be used and compounded together to facilitate different types of trades to allow leverage on different kinds of tokens. Because as soon as you can borrow against something, you can reinvest that. And by default, that is also leverage, but there are different ways of recreating traditional financial instruments like options and other derivatives that you see in the traditional legacy markets that have been created and enabled and are a growing space in the DeFi ecosystem.

Dr Jana Schmitz:
Yeah. Interesting. I guess, you just mentioned quite a few. I'll just refer to it as products and services that are offered within the DeFi ecosystem as you called it.

Anouk Pinchetti:
Yep.

Dr Jana Schmitz:
Who exactly are the participants in that DeFi ecosystem?

Anouk Pinchetti:
So one of the main differences, again, is that in the legacy financial system you have some very specialised roles and certain licenced large operators, such as market makers are a very particular role. In the legacy system you need hundreds of millions of dollars to be able to be a market maker on a share market where you are putting yourself at the opposite end of just about every trade in a particular market to give an impression of liquidity in that market. That in DeFi has been recreated as an example so that absolutely anyone is able to trade, is able to swap one token for another, but they can also pair their tokens together in a platform like Uniswap, which is a most popular decentralised exchange or DEX for short.

Anouk Pinchetti:
There are hundreds of different DEX, which have copied the model or are slightly different variations of the similar principle. In terms of the participants, though, that means that rather than having a market maker and a broker and a user, you just have users that can choose to act as liquidity providers or to just be using the system to swap and to play multiple roles in the ecosystem without the intermediaries and the registrations and the licences and even to some extent the requirement of large centralization of scale and finances that the traditional legacy markets require.

Anouk Pinchetti:
So to answer it briefly, I don't know who the participants are because the vast majority of the participants in the DeFi ecosystem are identifiable primarily by their public key addresses, so not by their registrations and their legal entities as such, although you can check on some behaviours, and some participants such as the centralised exchanges and the decentralised exchanges absolutely have their own entities and their roles that they are playing, but the actual facilitation of these transactions is far more peer-to-peer than the legacy financial system.

Dr Jana Schmitz:
Okay. So I'm trying to summarise what you said just now. So DeFi truly basically takes away this value proposition of many of these financial service providers like banks, for example, and what we call disintermediates them. So banks do not play a role in DeFi. And if as a user I can do banking myself or if I can do it in a shared liquidity pool with other people, with other participants of the DeFi platform, then I don't necessarily need a bank, right? Now, I'm wondering, and you have already hinted at it, I guess, how is the finance sector, particularly the banks, reacting to this DeFi movement?

Anouk Pinchetti:
Okay. And yes, you're correct. It's disintermediating a lot of these things. And basically, if you as an individual can figure out a way to generate a return on something to do with tokens, whether that is by leveraging at something, using some of the existing functions out there and combining them together, lending some out, borrowing some here, staking some of it for a return. I'll describe what staking is in a bit as well. And you can create some new, useful thing to do with a token. You can create a smart contract for it that is then a service that's provided to anyone who can offer tokens into that service. So it's true. You do not need the banks, and you have an open competitive marketplace where anyone can borrow ideas from each other and replicate them, which is why you have a space where you can often find you can get 10% return on tokens, occasionally hundreds of thousands of percent return, but like you'll find in most places, if it seems too good to be true, it probably is. And there are definitely risks with a contract that's written by someone you don't know that is brand new and no one's actually tried, right?

Anouk Pinchetti:
So there are risks in that space because we don't always have people that can be held accountable, but in terms of the banks, they've enjoyed a long period of having a monopoly on these types of services and effectively being in a cartel position with governments enforcing their unique right to determine what a currency is and issue the currency in a particular jurisdiction, and not surprisingly, the idea that absolutely anybody could step into their space where they've had that advantage of monopoly has not always been welcomed with open arms, shall we say. So we've seen banks shutting down people's accounts and pushing for more aggressive legislation in terms of the anti-money laundering and the know your customer type legislation.

Anouk Pinchetti:
So we've seen banks pushing for harsher regulations to prevent some of this competition. And you know what they say. First, they ignore you, then they laugh at you, then they fight you, then you win kind of thing. Right? There's been a lot of the playbook in those sorts of things. People are still having their accounts closed for sending money into cryptocurrency exchanges and those sorts of things. However, increasingly, we're seeing regulation, like in the States, where banks are now allowed to act as custodians for cryptocurrency. So banks are now looking to step into this space and take on custodial roles to actually provide services and be able to charge for services in this space, because there's a lot of things that banks do well, right?

Anouk Pinchetti:
I am fairly confident that if somebody hacks my credit card number or downloads it from a previously leaked file somewhere on the internet and makes purchases with it, I can go back to my bank, and there's insurances that cover these sorts of things. And I have a decent shot at getting my money back. If a smart contract that I put my tokens in gets hacked, pretty much I can kiss that money goodbye, right? Some exchanges have returned money in the past. We're starting to see insurance type plays, but it is a very, very immature market. And it remains to be seen how effectively that can offset the risks of operating in the crypto space.

Dr Jana Schmitz:
Yeah. It's super interesting. I was just going to add to the banks that some of them seem to follow the approach of keep your friends close and your enemy closer. So that's certainly what's happening at the moment. And you've already touched on some of the potential user risks. So I guess users of DeFi platforms need to know exactly what they're doing because essentially they are becoming their own bank, and they basically need to trust themselves. And when you become your own bank, then you take full control of your own security, so cyber security or data security, I guess. Are there any guidelines or regulations around that? How do you perceive that risk and user friendliness in general when it comes to DeFi?

Anouk Pinchetti:
Okay. You've compounded a few things there. So in terms of the user friendliness, there's going to be a leading edge and a trailing edge of this space as it moves forward, and every problem that hasn't been solved, there will be a thousand projects that have a shot at it. And most of them will do a terrible job. And then occasionally something will come through like Uniswap did for DEXs, right? And people will see it. It will be clear. It'll be easy. It'll be simple. And that will then get copied by a thousand other projects. And they'll incrementally try to improve on it. And that's how this space moves forward. It's massively parallel because it's open source.

Anouk Pinchetti:
What that means is that there's always new stuff happening, and there's always new experimentation happening where there's risks because who knows if something works and how well it works and those sorts of things. And also, they tend to be the least user-friendly. What happens then is when these things get established, they get tweaked and improved upon and standards emerge for what a user interface should be like and how we can remove the complexity and simplify the user experience.

Anouk Pinchetti:
So it starts with you having to basically be a software developer to use something like Bitcoin in 2009 to now anyone can download and instal a mobile wallet onto their phone where they can do a one touch and they can swap their tokens for something else, or they can deposit their tokens to earn interest right within their mobile wallet without having to do a lot of the complexity that it originally took, but that will keep moving, right? This will be a set of moving goalposts that there will always be those that are pushing the boundaries and using the technologies that will be easy to use in five years time without having to go through many hurdles to figure out what insured options contracts might look like today, for instance.

Dr Jana Schmitz:
Yeah, absolutely. It makes total sense. Just out of curiosity, Anouk, because you mentioned Uniswap a couple of times, what's so special about Uniswap, or is it actually that special?

Anouk Pinchetti:
So I've mentioned it a few times. There were a few other competitors in that space, still are, I should say. So Bancor Protocol, Curve Finance they're very similar, and they were decentralised exchanges or DEXs. The way it works is anyone can put the same amount of two different types of tokens into a pool. And if you're looking at Balancer, you can actually put more than two tokens into a pool. And in terms of Curve, you can put different amounts. So the specifics of how the calculations work shift a little bit from platform to platform.

Anouk Pinchetti:
Uniswap is special because it managed to do it in the most simple manner, people understood it, and it gained popularity and traction with literally hundreds, maybe not thousands, but hundreds of projects actually copying it. So what it does is it allows people to put the same amount of same value worth of two different types of tokens. And then absolutely anyone in the world can, well, with an internet connection and a wallet that they can interact the contract with. Usually MetaMask. They can send one of the tokens in and receive the other token out, so they can swap one token for another. And it means that if you've put the two tokens in originally, you are the liquidity provider, which is the equivalent of the market maker, which was the example I was given before.

Anouk Pinchetti:
And there is a generally a 0.3% spread, but sometimes for stable tokens that need to be very liquid, they'll go to a 0.05% spread. But again, these percentages of the spread, which is effectively the earnings that the people who deposit into that pool, the liquidity providers, is what they earn for putting their money in there, for staking their money there. So you can be a market maker and earn 6%, 7%, 8%. It really depends on how much people trade that particular token and whether it's a stablecoin or some other token, how popular it is.

Dr Jana Schmitz:
Yeah. Anouk, I'm not going to lie. I think I understood everything you said, but it is quite complex.

Anouk Pinchetti:
Sorry.

Dr Jana Schmitz:
No, you did a great job explaining it, but I guess this whole process of participating in DeFi is or remains quite complex, but obviously in the future hopefully it will become a little bit more user-friendly.

Anouk Pinchetti:
Yeah. I mean, next to the question of user friendliness, can everyone just jump on a DeFi platform? So it depends how deeply people want to dive into these things. So there are platforms like Nexo where you're still working with a respectable entity with insurance, and they can take some of that complexity out and you can earn 5%, right? The safest thing seems to be to have your money in a bank and you might earn 0.2% interest in a currency that you know is deflating by, say, 10% per year, right? That's the safest thing. You'll lose money over time, but at least all the regulations and all the structure is there unless, of course, the government decides to take that money out of the bank account for you.

Anouk Pinchetti:
However, you go into DeFi, and you're looking to earn 10%. Well, that represents the risk of being responsible for your own money, being responsible for your own keys. And if I lose my password to my internet banking, I can call up the bank and go, "This is my name. And this is my first cat's name or something." And they can turn around and give me access to that money again. But if I lose my private key, then the crypto that was protected by that is gone forever. Right? So being responsible, that is already a considerable risk. If you go beyond that and look at the leading edge and you see a project that no one's ever heard of promising a million percent return or anything above a thousand percent return, then it may be real and it may be true. It probably won't last for a year. So if you're seeing an annualised return of 5000%, then chances are it might work for 24 to 48 hours, but I wouldn't start to plan my retirement on those types of things. Right?

Anouk Pinchetti:
So you're taking on a lot more risk. Unproven projects are a lot riskier. So you stick with some of the well-known projects that have been around a little bit longer and you have a look at when things actually originally started. And if it's two-years-old in this space, it's practically an OG, right? It's a legacy institution in the crypto space, and start with those and get a feel for it and never risk more than you can lose. Right? Speaking of, none of this is financial advice, just general purpose educational awareness of these are some of the risks that you are exposing yourself to. And the other side of this is, of course, your own protection. The biggest vulnerability in all of this is going to be your ability to keep your wallet safe, right?

Anouk Pinchetti:
So if you're carrying around a mobile phone that has a four digit pin and is automatically logged into all your different apps and all those sorts of things, then how secure is that? How easy would it be for someone to take your phone and ask you for your pin number potentially under duress, right? What are the security processes and principles that you have in place to make sure that your mobile phone, your laptop or your desktop these things can't be hacked? Do you have a hardware wallet? How much money are you comfortable in each, right? My general rule of thumb was always don't carry more money in a mobile wallet only than you would keep as cash in your pocket for fear of being robbed. Right?

Anouk Pinchetti:
If you wouldn't walk down the street comfortably with $20,000 in cash in your pocket, then don't carry that on your mobile phone. I have known people who've set up wallets on their mobile phone and had them drained almost instantaneously after setting up a new wallet, right? There is malware on phones that actually goes after people's crypto. So be careful with that. Test it out with small amounts. If you're going to put anything more into it, then seriously consider getting a hardware wallet, right? They're 150, 200 bucks, and they will never give your private key to your laptop that you're plugging into WiFi everywhere around the world that is exposing who knows what information. So 150, 200 bucks, right? And there's an indication right there.

Anouk Pinchetti:
I wouldn't pay 200 bucks to protect $20, but I would pay 200 bucks to protect $10,000. Right? Where is that boundary for you in terms of the level of protection and safety you want? And I think that was probably about it for now, I believe.

Dr Jana Schmitz:
No, that was super helpful, Anouk. I guess, that are some really essential protection or risk mitigation strategies that you outlined there. And yeah, I guess many people don't really take that into conservation. There needs to be a lot more education in that space, not only about how to buy cryptos and exchanges, but also where to store them. And so, yeah. Thank you very much. So Anouk, fast forward. Where is the DeFi movement heading, and what are the biggest challenges to overcome?

Anouk Pinchetti:
Well, the biggest challenges is regulatory overreach. Where is it, right? People trying to regulate a lot of things very early and very aggressively. And a lot of this is an attempt to slow down the space and allow central bank digital currencies to jump in and create a surveillance capitalism ideal for vision for the world. So there's far more a very controlled and centralised version. It's far easier for governments to deal with a single entity that has 100% percent control of everyone and use all the information from that to keep a lid on a population, whereas a completely open space with millions of projects, some of which are ethical, some of which are trustworthy and some of which are just money grabs, Ponzi schemes, scams, all manner of things, it's very difficult to understand a space like that and much less actually try to control a space like that.

Anouk Pinchetti:
In terms of the future, I see a lot more growth ahead. I see that the sheen and the hype has actually gone off the DeFi space a little bit. You could say 2021 was the year of DeFi. 2022 is starting out as the year of NFTs and might end up as leaning more towards the Dow and the governance type things. And I'm very excited about decentralised governance going forward, but still early days in there. I'm excited about the fact that when the spotlight and the excitement of the bull market is a little bit off, that's when far more building and development actually happens only to be revealed in the next bull market hype cycle that a lot of projects have gotten a lot further with a lot of things.

Anouk Pinchetti:
I'm excited about the multi-chain interoperability that's happening. I'm excited about the different architectures we're seeing because blockchains are not really architected to scale to massively decentralised global payment systems. So there's a lot of scaling solutions happening, and there's some different chains that use different architectures. If we can get the interoperability working between those seamlessly, then there's no limit to what the future looks like. And I won't even try and predict out 10 years because things that are completely impossible now may be the next obvious steps two years from now.

Anouk Pinchetti:
What else? Real world assets in terms of the NFT space. Pretty pictures are cool, but real world assets are going to be a massive thing in that space. And for me, personally, I actually think the use of NFTs as identifiers for governance I think is an untapped piece that I'm looking to build something in. So that's something a little bit more. And yeah, the challenges. I mentioned regulation. Central bank digital currencies may end up being competition for decentralised crypto, and that will bring with it more regulation in that space and also some of the more centralised corporate versions that add a whole lot of the issues that we see now in terms of the lack of privacy and the data tracking that we see on the internet, not to mention some of the manipulation and marketing and salesy type side effects of what we've seen with Facebook. Them now moving into Meta has got some of those red flags over it when ultimately the majority of people will just go with whatever is easiest to use, and that may have unintended consequences down the track.

Dr Jana Schmitz:
Yeah. Super interesting. I want to touch on one point you mentioned, which is the multi-chain ecosystem and the interoperability. I guess, at the moment, there is a tendency to think, "Okay, which project is going to win?" Rather than to think about or to compare the different projects to the software world, for example, where companies like Oracle and Microsoft and Apple and IBM Google, and the list is very long, so I'm not going to try to list them all, they all coexist.

Dr Jana Schmitz:
And so I guess it's fair to say that as the DeFi space or the blockchain environment or ecosystem in general matures and more institutional investors, as you mentioned earlier, enter the space and capitalise on different blockchain platforms or projects, the more likely it will probably be to see more interoperability. And yeah, that's something that I'm really excited about to see this real network emerging basically and of course the regulatory space. And I guess Australia is moving quite quickly now to also establish some rules and frameworks and whatnot in order to capture that development, which is great.

Dr Jana Schmitz:
Anouk, we are approaching the end of the podcast, but I do want to ask you one last question. What are you most excited about in the DeFi space? Or are there any particular projects that you consider very promising or very interesting?

Anouk Pinchetti:
Well, there's a few deFinitely. I actually think I like the concept behind Yearn. That's not the newest or anything. I really like that. I'm inspired by DAI and the potential move towards pushing sustainability through choice of collateralization. Actually, I took a lot of inspiration from that in a stablecoin project that I'm working on as well called Spendy. The other things in terms of the multi-chain stuff for chain, I actually think has got real potential to make a difference there. And Polkadot as well is a very popular one that seems to be doing well.

Anouk Pinchetti:
I'm looking forward to that interoperability. But really in terms of what inspires me in future, it'll be the decentralised governance. I think that's ultimately the challenge that we need to solve as a species is actually how do we make decisions? At the moment we're seeing that we can't even agree on the basic things, and people who have different views than us are increasingly the enemy. And I think decentralised governance, that is what we need to solve as a civilization. And I think all the decentralised, all the Dow projects that are finding different ways to govern themselves will actually increase our whole cultural knowledge commons, if you will, around how we actually make decisions together equitably, fairly and effectively and efficiently. And that's the space that I'm most keen on seeing develop.

Dr Jana Schmitz:
Yeah. So I know DAO stands for a decentralised autonomous organisation.

Anouk Pinchetti:
Autonomous organisation. Yeah. This is a DeFi podcast, but sorry, it's all part of the picture.

Dr Jana Schmitz:
No. Exactly. I was just going to ask you, could you provide a very simple overview or definition of what a DAO exactly is?

Anouk Pinchetti:
Okay. So DAI is a good example, right? DAI where a centralised company that has a legal entity that developed some code. Then they bake into the code ways for members of their user base and their community to make decisions as to what the organisation should do. And then over time, they've managed to phase out, and they're completely phasing out and disincorporating the company now because there's no reason for there to be a company with a bank account because all the incentives are baked in so that members of the community can vote on what happens and how to spend the resources of the organisation.

Anouk Pinchetti:
It is decentralised because any member can join or leave at any time. So the membership can change far more easily than shareholders in an organisation and far more easily than, say, a board of directors in a company and far more frequently. So the membership can change. It's autonomous because no one has to allow it to exist or do anything for it to continue to operate. And it's an organisation because it's got a whole lot of contracts and incentives built in to make sure all the participants within the ecosystem around it, its users, its members, the people that vote on it, are actually incentivized to do the right thing for it to continue to exist.

Anouk Pinchetti:
And that's the same model that I'm following in terms of setting up Spendy is really to start off you need to have the code developed centrally, but over time, more and more of the decisions can be made by the actual users of the system. And I think this is one space where ... Yeah, it's crazy how one sided the relationships are that we have with our software service providers. And I think the blockchain space is starting to show us another way of having those relationships.

Dr Jana Schmitz:
Yeah. Thank you so much, Anouk. That was extremely insightful. Thanks very much for sharing your DeFi expertise with us.

Anouk Pinchetti:
My pleasure. It was a pleasure to be here, Jana.

Dr Jana Schmitz:
Thank you. Just a quick disclaimer, that what we have discussed today is not investment advice and the views provided are our own. Be sure to visit our show notes under CPA Australia Podcast webpage for links and more information on this week's episode. Thanks for listening.

Outro:
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