DeFi 101: The What & Why of Decentralised Finance. Interview with Egor Sidelska, Director of Crypto Hedge Fund, Magnet Capital

Transcript

Nick Abrahams:
Hello everyone. My name is Nick Abrahams, and I am delighted to have joining me today Egor Sidelska, who is with Magnet Capital. And we are going to talk today about decentralized finance, or DeFi, which is absolutely taking the crypto world by storm. And so with that I will pass over to Egor to just introduce himself and his involvement in the cryptocurrency world.

Egor Sidelska:
Great, thanks Nick. So, I’m currently the director of Magnet Capital, which is a hedge fund that we started in 2017 as the first licensed crypto hedge fund. We now have three products, so we have OneTrust, which is a multi-asset crypto trust, a passive Bitcoin only trust, and Australia’s first Ethereum only passive trust. We’ve got about 30 billion of assets under management across the group, and our main trust has returned about seven and a half times since inception. But I actually started in crypto a little bit of time before that. So back in 2013, in the very early days, I started mining Bitcoin and Litecoin just to really start understanding what the blockchain technology even was. And then a little bit later on I met with Benjamin, our other director at Magnet Capital, and we started going to businesses and talking to them about how to integrate blockchain into their businesses in 2016, which as you can imagine, Nick, we got laughed out of a lot of boardrooms at that stage.

Nick Abrahams:
I could imagine. Yeah, no, the world wasn’t quite ready for blockchain.

Egor Sidelska:
No, back in 2016 it was very, very nascent technology, a very small market cap, very innovative at that stage, but it’s very different now.

Nick Abrahams:
Terrific. Well, clearly an extraordinary background. So maybe if we just, to set the scene, because we just assume that many of the folks who are listening to this, or watching it, probably don’t have a great understanding of cryptocurrency, other than the general skepticism that exists out there in the market as to what is it really about, but could you just, at a very high level, just talk us through how does Bitcoin work, what’s cryptocurrency, that sort of idea.

Egor Sidelska:
Absolutely, and Bitcoin’s a great start. It was the first iteration of its kind in crypto, and Bitcoin works on what we call blockchain technology, and the blockchain is very, very simple. It is a distributed ledger that is distributed amongst now millions and millions of machines. Each of these machines work in order to add blocks onto the network, and that is what we call the blockchain. The blocks are just a series of transactions that supersede each other and add to what we call the blockchain. So it means the first time that we have ever had what we call decentralized trust, you now no longer need to use a centralized entity in order to be able to send transactions, and the blockchain allows you to do that.

Egor Sidelska:
The unique properties are what really makes it very, very interesting. So the blockchain in Bitcoin’s format is completely immutable, it is completely transparent, it is completely decentralized, it’s not owned by any one government, one institution, it’s not controlled by any single party, and it’s completely finite. So every time that a new block is minted, Bitcoin is given to the person, or the miner, that minted that block as a reward, and only 21 million Bitcoin will ever exist. And we call it secure because right now there are millions of these machines globally in football pitch size data centers that are all working to keep up in that work. So in summary, it’s just a big ledger of every single transaction that’s ever happened, that every single one of these machines keeps up to date.

Nick Abrahams:
Fantastic. That was actually understandable, thank you, that’s quite the task. And there’s a lot of talk recently about crypto currency going mainstream, and we’ve obviously seen a big rise in crypto valuations. What are some of the catalysts that have caused this concept of Bitcoin and crypto going mainstream?

Egor Sidelska:
Yeah, it’s a great question. So, this technology, it will have the same global impact in the world as modern computing, global card networks, as the internet, or even artificial intelligence. And we’re starting to see, very, very slowly we’re starting to see big institutions really take that up. And it’s because of the network effects, it’s because over the last 12 years of Bitcoin’s existence, besides two years, the price has continuously gone up, and the number of users have continuously gone up. The number of machines that are mining Bitcoin and protecting network has continuously gone up.

Egor Sidelska:
And you’re starting to see real innovation come out of this, not just in Bitcoin’s format, but in Ethereum and in the other 9,000 tokens that are also available. Just to give you an example, probably the biggest driver to the market was MicroStrategy investing their balance sheet, or $250 million off their balance sheet, back in, I think this was 2020, early 2020, and that really drove a big spike in awareness, not only for bigger institutions, but also wealth advisors, wealth managers, large hedge funds, to get ahead of the curve. Because as you start to see gigantic organizations, like MicroStrategy, or even Tesla, take Bitcoins off the market, you start to get this compression of the supply that’s available.

Nick Abrahams:
Yeah, brilliant, brilliant. It has been interesting, isn’t it, that there’s such interest that’s come around, and folks like the Grayscale Trust, and so forth, and we’ve seen even folks like JP Morgan and Morgan Stanley [crosstalk 00:06:50]-

Egor Sidelska:
Absolutely, yeah.

Nick Abrahams:
About cryptocurrency, which is quite the turnaround, I guess, the Coinbase listing as well, so lots of things pushing. You mentioned Ethereum there, and some other coins. Maybe just a little something, I know it’s complex, but we talk about the Blue Chip Coins, and then we talk about the altcoin. Maybe just a bit of a sense as to what does that all mean?

Egor Sidelska:
Yeah, so altcoin is what is typically referred to as anything other than Bitcoin. Bitcoin was the first, it’s the largest, it has the biggest network, altcoin are everything else that has followed after that. So when we talk about altcoin we mean everything from Ethereum, to Ripple, to Polkadot, to Uniswap, SNX, and the other roughly about 9,000 of them that exist. Most of them are completely useless and no one ever really needs to worry about them, but the top 100 are probably common names, or beginning to be slightly more common names. Like Ethereum is very, I mean, Ethereum is probably the second most popular, and it’s grown its popularity incredibly quickly because of its network effects and what it can do.

Egor Sidelska:
So Ethereum, as a quick summary, is a smart contracts platform, so it still utilizes blockchain technology, and all of the great characteristics that run with it, immutability and transparency, but what it allows you to do is put smart contracts onto the blockchain. So by smart contract it really is just a series of programmable events that allows you to attach it to the blockchain network.

Nick Abrahams:
Yeah, and it is interesting because I was quite cynical of blockchain smart contract propositions a couple of years ago, I was like, I’m a lawyer, I know what it takes to draft a contract, and this could never be done by the machines, but I didn’t really understand the proposition there, and in fact, how we’ve now seen smart contracts underpin the success of particularly decentralized finance, or DeFi. So maybe, could you give us a bit of a sense of on a high level, what exactly is DeFi? What’s the movement all about?

Egor Sidelska:
So DeFi is what we call decentralized finance, and it can be broken down into a number of key categories, everything from stablecoins to lending platforms to decentralized exchanges, vaults, and even insurance. What they’re trying to build is the entire ecosystem of what we think traditional finance is, but without any of the barriers to entry, so you’ve got completely open immutable decentralized finance applications that exist on Ethereum. They do exist on other chains, but in this case, to keep it quite simple, we’ll just talk about the Ethereum ones because they’re the biggest, they’re probably the most well-known. And you would’ve heard of some of these, for example, USDT, so Tether, which is a one-to-one pegged stable coin of the US dollar. It was very famous about three years ago for rising as part of 1exchange’s giveaway for being hacked. So that’s actually how it was born. The coin was given out as an IOU to some of the participants that were affected by the hack of Bitfinex, and they stumbled upon it. Now it’s grown to be a $51-billion coin that really underpins a lot of what the DeFi applications even are.

Nick Abrahams:
I did not know that that is how it came out. It is remarkable, the more that I speak to people, the free coins that got distributed a couple of years ago, that’s been a great source of wealth accumulation for many people who just ended up receiving a bunch of free coins for a whole variety of reasons and airdropping and so forth.

Egor Sidelska:
Yeah. Yeah, absolutely. Yeah.

Nick Abrahams:
So conceptually, DeFi is looking to replicate traditional finance models, maybe dropping into specific use cases. So what are some of the ways that we might be able to… I mean, it’s happening right at the moment, but what are some of the more specific use cases on DeFi?

Egor Sidelska:
Sure. When we, and when I say we, I mean [inaudible 00:11:45] Capital, when we talk about decentralized finance, we really break it down into the first couple of stages of adoption. For adoption to occur, you really need to keep it simple. So you really need to lay the foundation in the basics before you start doing anything really complex. So let me take that into stablecoins, lending platforms, and decentralized exchanges. That’s probably the three easiest ways to start thinking about this.

Egor Sidelska:
Stablecoins provide you within the option to stay within the crypto eco system, but get out of volatile crypto assets. So you can exchange your Ethereum for USDT and you are still within the immutable transparent ecosystem that doesn’t ever close, is completely available on weekends. There is no 5:00 PM shutoff. You still get to keep it within there, but you get to exit out of your potentially volatile position. So that’s number one.

Egor Sidelska:
The second are lending platforms. Now lending platforms have really come up over the last two to three years in a very, very big way. Platforms like Aave, like Compound and Maker, that even Maker who’s probably the first, who’s been around for the longest, but ones like Aave which are now about $11 billion in total lending on the platform. And all they do is provide you a marketplace where borrowers and lenders can interact. It aggregates all of the borrowing and all of the lending to give you an APR and an APY on either side of the equation you take. You can lock up your crypto assets, whether it be Ethereum or anything else, and you can receive stablecoins. That might be Dai, it might be USDC, or it might be USDT. That gives you the ability to take that into real world cash and spend it on whatever you like. So that’s a really, really simple entry level to decentralized finance.

Egor Sidelska:
Then you get decentralized exchanges. So historically, as you mentioned earlier, Coinbase, Kraken, Gemini are your more traditional exchanges. They’re like the NASDAQ, the S&P, the SX. They provide you a marketplace for buyers and sell. Now what decentralized exchanges do is they provide millions and millions of pairs for all kinds of crypto assets to be exchanged whenever you’d like. So, unlike the traditional markets, again, which close on the weekends, which close at five o’clock, there is absolutely no downtime. So they are the leaders in the space like UniSwap, Curve and SushiSwap. These guys have billions of dollars in liquidity on their platforms. You can do everything from a micro transaction up to hundreds and hundreds of thousands of dollars. The volumes are staggering. In UniSwap alone, which has 9 billion worth of liquidity, $1.3 billion gets exchanged every 24 hours without interruptions.

Nick Abrahams:
$1.3 billion.

Egor Sidelska:
$1.3 billion US.

Nick Abrahams:
Wow.

Egor Sidelska:
Massive. It’s massive.

Nick Abrahams:
Maybe we’ll go back to the lending thing and then we can get onto the decentralized. Let’s get, I guess, clarity around the lending transaction. So effectively, if I’ve got Ether, so then I stake the Ether on Aave a or something like that, and so that means for me, is basically I’m providing that as collateral. So I’m saying to Aave, “Here you go. Here’s my Ether. You hold that.” And then through this smart contract, they will give me Tether or USDT?

Egor Sidelska:
Yep. I’ll run you through an example.

Nick Abrahams:
Okay. Perfect.

Egor Sidelska:
A very easy scenario.

Nick Abrahams:
[inaudible 00:16:10] me.

Egor Sidelska:
You’ve got an asset like Ethereum, which you don’t want to sell, but your car just broke down and you need cash for a repair. So what you do is you take your Ethereum and you go to you go to Aave’s application, which is just a marketplace, and you lock your 10 Ethereum, let’s call it $30,000 worth. You lock your Ethereum into a smart contract on Aave, which you lock in an interest rate, and that interest rate, it then gives you USDT or USDC or Dai, whatever you want. Let’s just use USDC for this example. And USDC is a stablecoin. You then take your USDC.So it’s given to you automatically in the same wallet that you use to transact.

Egor Sidelska:
So again, no one controls the staked amount that you have. It’s all done on platform. It’s all done completely automatically. It’s very transparent. And you get $3,000 of USDC. You take your $3,000 of USDC, and you go to a traditional exchange, for example, Coinbase or Kraken. You then exchange your USDC for AUD, and then you withdraw off the platform.

Egor Sidelska:
So right now, decentralized exchanges don’t have the ability to provide you with a FIA offramp, so like a real cash off ramp. So what you need to do is you need to use one of these slightly bigger centralized exchanges that run by companies.

Egor Sidelska:
Then you have your AUD, so you can use your AUD in your bank account to pay for any of the car repairs. The beauty with this model is you still have the exposure to the Ethereum which is locked up in a smart contract. The only thing you need to do is pay back the principal plus interest. So you can pay that back in one day, you can pay it back in 20 days, you can pay it back in three years. It’s completely and utterly up to you. The interest accrues.

Egor Sidelska:
So the next question you should be asking is what happens if you either never want to pay back? It means that your tokens are just staked on the platform forever. The amount of interest that you have will keep accruing. At some point, there will be a drop-dead date where they auto liquidate you. So in two scenarios, if the market starts to come down and your collateral ratio falls below 80%, so as in your one to five, the system will automatically liquidate your position in order to pay the principal back. So it has nothing to do with you. You need to make sure that enough liquidity is available within your smart contract in order so that you don’t get liquidated, or enough collaterals there so you don’t get liquidated.

Nick Abrahams:
Right. Right. So, very similar to, in the offline world, there’s cash collateralization contracts, which you would do. In that case, you’re not talking about crypto, but you are putting, let’s say you wanted some Aussie, but you had US dollars, but you didn’t want to lose your exposure to the US dollar.

Egor Sidelska:
Exactly.

Nick Abrahams:
Because you felt bullish on that.

Egor Sidelska:
Yeah.

Nick Abrahams:
So you could put it into a bank under cash collateralization and then pick up the Aussie dollar and then you could get your staked, as such as it’s called, US dollar back by repaying the Aussie dollar. Okay. So it’s very similar to what we have in the real world.

Egor Sidelska:
So that’s similar, but what isn’t similar is, you can’t easily get cash for your CommBank shares or your NAB shares.

Nick Abrahams:
Yeah.

Egor Sidelska:
Or you can’t easily get cash for the shares that you have in a private company.

Nick Abrahams:
Yeah.

Egor Sidelska:
So if you are a high net worth that has a private banker, then you might be able to get a very, very small loan based off the assets that you have that they can see.

Nick Abrahams:
Yeah.

Egor Sidelska:
But that requires somebody to be able to give you that loan, that requires a ton of friction. You need banking approvals, you need credit rate checks. You also can’t do this on a holiday or a weekend. You simply can’t borrow and repay at speed for any amount of capital that you might have. Now, you can also do this with Bitcoin. So it doesn’t necessarily have to be part of the Ethereum ecosystem. And this is some of the really interesting stuff that’s coming out of that of DeFi at the moment. Bitcoin is acting as a store of value for people right now. And they don’t want to get out of it. You cannot in the real world, collateralize your physical gold into cash. There is no service, or at least I don’t know a service that will be able to do that for you, or do at scale, or do it at speed. But what you can do, is you can wrap your Bitcoin on the Ethereum network. You can stake your wrapped Bitcoin in Aave, and then you can get cash for that. You can do all of that within about 10 minutes.

Nick Abrahams:
It’s fantastic. And the 24/7 nature of it, but also, if you think about it, the closest you get if you’re trying to take out margin loans or something like that.

Egor Sidelska:
Yeah, exactly.

Nick Abrahams:
Which obviously is incredibly risky and can go against you quite poorly. So, yeah, you’re quite right though. It’s very difficult to collateralize things other than, I guess, houses. That’s the closest we’ve got, but there’s plenty of transaction friction there. And just in terms of how big is the lending market, you think? You’ve mentioned, I think 11 billion just through Aave alone, is it?

Egor Sidelska:
Yeah. Yeah. So, 11 billion is locked into Aave. If you look at everything else, like Compound. Compound is $10 billion. If you look at Maker, Maker is another $10 billion. The total value locked in lending alone across all of the platforms is about $32 billion.

Nick Abrahams:
Wow.

Egor Sidelska:
To give you insight as to how that’s changed over time, just a year ago, so this time, 2020, it was about 650 million.

Nick Abrahams:
Okay. Okay. So this market is massively on the move.

Egor Sidelska:
Absolutely. Absolutely. And not only is it on the move, but people are starting to pick up. So as you mentioned, JP Morgan now offering clients the managed Bitcoin fund, whereas before Jamie Dimon said that he would fire any employees if they even talked about Bitcoin. Now they’re structuring products around it. Fidelity is filing for an ETF. Credit Swiss came out with research on why crypto deserves to be its own asset class. Square, along with another 10 publicly listed companies are holding Bitcoin on the balance sheet. You’ve got industry experts, Ray Dalio, Eric [inaudible 00:23:51], coming out and endorsing Bitcoin and the crypto market. And then you’ve got an array of giant hedge funds, like Guggenheim, and AllianceBernstein, and MassMutual, Blackrock, all gaining exposure to Bitcoin.

Egor Sidelska:
And it starts with Bitcoin because it’s the oldest, it’s the most proven. It’s been around for the longest amount of time. And it’s completely and utterly transparent. You can see every transaction that’s ever made. You can see every single node and where it’s based. You can validate every single transaction. Coinbase is a key beneficiary of this. Notoriously, they hold very, very few Bitcoin on the balance sheet, but they’re still an $86 billion US business. And that’s just trading some of the major assets. It’s not even the small obscure assets. These are just mainly Bitcoin, Ether, Ripple. Just the common names that have been around for a long time.

Nick Abrahams:
Yeah. It is interesting, the JP Morgan comment. Obviously there was commentary made a few years ago by the leadership there, that it was a fraud, et cetera. And then JP Morgan were one of the banks that listed Coinbase. So, I think they found the true belief there. [crosstalk 00:25:21] decentralized exchanges. Could you just run through that again and just perhaps a use case as to how that would work?

Egor Sidelska:
Yeah. So decentralized exchanges are again, a marketplace for two different kinds of transactions. Basically, if you want to buy a token, or if you want to buy any Ethereum based token using either Ethereum or something else, there exists a liquidity pool. And that liquidity pool then is able to match either side of that transaction for you. Now, that sounds complicated, it’s really not. All that happens is, if I want to exchange my ether for something called SNX, then I use a decentralized exchange, which is basically a platform. And I type in however many, maybe 10 Ethereum exchange for 1,000 SNX. And I sign the contract, and the contract goes into the pool, pulls out the fee for doing it. And that’s the fee that you pay to the exchange, and then swaps your token.

Nick Abrahams:
Okay.

Egor Sidelska:
So the beauty with the is, in the real world, you can’t swap your CommBank shares for NAB shares. You’d need to go into cash first, and then from cash, you need to put it back on the live market and wait for your order to be hit. So what this does, is it creates a gigantic marketplace for you to be able to exchange frankly, any Ethereum based token, especially on Uniswap. Any Ethereum based token at really large volumes. Now there are benefits to drawbacks to this, because the Ethereum network gets very, very clogged up with these transactions. And that’s been part of the argument has been running for a very long time now.

Egor Sidelska:
It’s the fact that in order to execute this transaction, you essentially need to connect with a smart contract. And that smart contract needs to execute on both sides of the agreement. It sends the token that you’re wanting to swap, and then sends you the one that you wanted to buy. And that process involves multiple steps in the smart contract, which is expensive from a networking perspective. So, there’s been an ongoing debate, ongoing argument as the number of Ethereum users grows, as the network grows in popularity. So does the network fees to make these exchanges. So right now it’s very, very difficult, and really costly to send a $30 transaction, or swap anything less than $300, because the exchange itself might cost you anywhere between 50 and $80.

Nick Abrahams:
Wow. Okay. Okay. Right. And so that money is not being taken by the exchange as such, it’s being taken by the network who-

Egor Sidelska:
The network, that’s right. Yeah.

Nick Abrahams:
Is that where the concept of gas comes in?

Egor Sidelska:
Yeah, exactly. Exactly. So, the gas fee is what you pay the miners in order to process your transaction. So, if I wanted to exchange one ether for 10 SNX, I need to post that into the smart contract, essentially broadcast it to the network. I need to have a miner that scoops up my transaction and processes it on the back end, which means it pulls it out of the pool and sends me my 10 SNX. In order to do that, you need to pay a gas fee. And because there are multiple steps involved, sending an Ethereum to Ethereum transaction is relatively cheap, five to $15, because it’s not a very complex transaction. But once you engage with the smart contract and it has multiple steps, that’s when you start to pay really high gas fees. And for the miners, it’s a supply and demand issue, for the miners, they will automatically pick the highest fees to execute first, because it’s a competitive environment. And that’s where you have this really big debate about transactions per second, it’s called TPS.

Nick Abrahams:
Right, right. Fantastic. I mean, that is extraordinary insight. Thank you for that. Just and with part of DeFi, there’s now insurance available on DeFi. Could you us through just a use case for insurance?

Egor Sidelska:
Yeah. Yeah. Nexus Mutual is a great example to use here. Nexus Mutual is building a two-way insurance company. It allows you to be able to take either side of the insurance claim. Now, that’s fantastic. It doesn’t really exist apart from PTP insurances, which again, is very different because then you need to assess individual insurance risk.

Egor Sidelska:
What makes Mutual do is they ensure against smart contract failure. Smart contract failure was of the Dow hack back in 2015 or 2016. And what it does, is it protects you from the smart contract code that’s written and people being able to hack the funds out of that state. In our your AAVE example, your Ethereum is staked in a contract, now people will attack that contract to try and get the staked AAVE out or the staked Ethereum out of that AAVE contract.

Egor Sidelska:
What it does Nexus Mutual is provided an insurance policy to pay out if that smart contract attacked. Now you, as a participant will say, “I’m very happy to pay 3% extra on my vault, on my smart contract, in order to have the insurance policy.” And on the other side, you might say, “Well, I think that the Yearn Vaults haven’t been hacked ever, and they’re made by very sophisticated platform engineers. And I think they’re very safe, so what I’m going to do is provide collateral into that.”

Egor Sidelska:
And what happens is, the people that take out that insurance policy pay interest and the people that provide collateral net interest. There is a very, very small fee for the Nexus Mutual contracts as a business. They’re revenue driving, but it gives you a platform to be able to be able to not only ensure crypto products, but also collateral them if you want to take the other side of it.

Nick Abrahams:
Fantastic. It’s the, so you’ve then got the insurance. If you are concerned that your underlying lending transaction might be subject to hacking, then you take out insurance on that. Fascinating. It’s creating a whole ecosystem of providers. Just, we of come to a close then. But I guess maybe just one final bit, and it’s without wanting to go into a great amount of detail, but non-fungible tokens, NFTs. There’s been a lot of talk about that recently. People paying $60 million for digital art and so forth. Slightly outsider, I guess, the DeFi world. But could you just explain just briefly what the NFT story is all about?

Egor Sidelska:
Yeah. NFTs, as you mentioned, non-fungible tokens, they provide a way for you to create art that belongs on the blockchain that is owner specific. It is a token of ownership that you get to your piece of art. It may be a GIF. It may be a JPEG. In the case that somebody paid nearly $70 million, it was a series of artworks that was created by someone called Beeple.

Egor Sidelska:
And what it does for artists is it allows you to make art programmable. It allows you to put in things like, every time the artwork is sold to a new owner, you will take a 1% clip of that. Every time that the artwork is transferred to a new ownership, it allows you to take recognition for that. And while the image can be copied, the ownership card. So the ownership belongs to the keys and whoever holds the keys is the beneficial owner of that piece of artwork.

Egor Sidelska:
And we’re only really scratching the surface of what NFTs are. CryptoKitties was the first iteration of that, I think back in 2018. And they have blown up. There’s CryptoKitties selling for 40 Ethereum and 400 Ethereum. And there are thousands and thousands of these, but it allows you to take ownership like you haven’t been able to do for on pieces of art. It allows you to digitize that entire process.

Nick Abrahams:
Yeah, no, it’s a fascinating area. And I must say, obviously, for you, it’s a natural evolution. I think for others of us, the last year has really been a tremendous revelation as we’ve seen cryptocurrency move, beyond a bit of a mystery into a genuine solution to a lot of problems out there.

Nick Abrahams:
Of course, we should say that, whilst there has been a good run in cryptocurrency recently it’s an incredibly volatile area. And so, people should obviously be very cautious about that. But Igor, thank you very much for your time today. Being very generous with your knowledge and also explaining the seemingly impenetrable in a way that we can all understand. Thank you very much for your time, Igor.

Egor Sidelska:
No problem at all. Thank you.

Nick Abrahams:
Thanks.