Episode 2: Financial Contracts Episode Transcript (website) Samantha Yap [00:03]: Hi! I’m Samantha Yap. Welcome to The Story of Money by YAP Cast where we talk about where money is heading. Join me and Hart Lambur on this episode of The Story of Money by YAP Cast. When you think of a contract, you think of signing a document that symbolises an agreement. But contracts haven’t always been the way they are. Nowadays a contract is written by lawyers, enforced by courts, and only partially related to what we might think of as fairness. Essentially, contracts are about each party agreeing to do something, and what pain one will inflict on the other to punish them if they break that contract. In the last episode we talked to Hart Lambur who sees the legal process of contracts as a technology, and one that is ripe for updating. Hart is the founder of UMA, an Optimistic Oracle built to query and verify data for decentralised finance. He saw up close and personal the 2008 financial crisis, and how complicated and opaque derivatives contracts helped drag the global economy down with it; when he saw Ethereum and smart contracts he saw the opportunity to reinvent contracts with a new technology. So what does this look like, and how would it work? Hart Lambur [01:28]: So without getting into like the nitty-gritty of like how a blockchain works, we can say, okay, this blockchain has this consensus mechanism that is no one-person controls. So, it's trustless, and it can execute transactions. And what Ethereum did is implement effectively computer logic so it could execute logic in these transactions, and it could function as effectively a computer that nobody controlled but that everybody agreed was doing computations correctly. So, now if I can write a contract that has like logic like if-this-then-that style logic, I can program this if-this-then-that logic onto a blockchain. That's super cool. Samantha Yap [02:16]: It does sound cool and of course smart contracts are a big thing already. Since 2022 we’ve seen more than a million smart contracts created each quarter. And because they are meant to be Smart - as it’s in the name, do they need any help? Isn’t the technology already good enough? Hart Lambur [02:37]: If I want my contract to reflect things that are happening in the real world, so let's use our insurance example. I want to write an insurance contract that if event happens, make payout to Sam, right? Well, I need to know a way to know whether that event actually happened. And then we can keep going like what else do we want to know in our financial contracts. Let's take a good example of a lot of people can wrap their heads around is just sports betting. My contract here is going to be who won the men's finals at Wimbledon, right? Samantha Yap [03:12]: This is relatively simple in the real world, as that kind of information can be looked up, instantly, from anywhere. But how does it work in crypto? Hart Lambur [03:22]: So in crypto space, this is called like the oracle problem. How do we let a blockchain know about things that are happening outside of the blockchain? So, I'll make an argument that basically the inventions that have allowed us to create this alternative form of contracting are Ethereum and related smart contract platforms that let us do the if-this-then-that logic, and oracles which allow us get data from what the world, what's happening in the world onto a blockchain. And those two technologies combined allow us to write financial smart contracts that can make payouts to counterparties based on a set of conditions. Problem: agreed source of information and solution: the oracle Samantha Yap [04:03]: That sounds easy enough, right? It’s like an API checking the price of a commodity, or the temperature outside, or who won the Euros? Or is it? Hart Lambur [04:14]: The whole premise of blockchains is that no one person controls them; that's why we can trust them. Building an oracle that tells you an answer that nobody controls, no one person controls that is actually decentralized, that's really tricky to do, and I think that's actually what makes it interesting. If you just have a trusted source, you're like, “Okay, cool. I’ll listen to what Hart says, and he'll give me the answers that I'll put in my blockchain.” But if I do that, I lose all the advantages of having a blockchain in the first place. So, it doesn't make any sense…doing the decentralized oracle is super challenging. The tweak: The optimistic oracle Samantha Yap [04:51]: Part of this challenge, I guess, is to not allow consulting the oracle, or data source, to slow down the process. DeFi is all about streamlining and efficiency. UMA has come up with a version of the oracle called the 'optimistic oracle'. Hart Lambur [05:08]: The optimistic oracle is our design which specifically what we try to do is, we assume an answer to be truthful unless somebody says, ‘I dispute that.’ Why do we want to do that? Why do we want to make this optimistic assumption? You can really think of this as just like an efficiency thing. Let's pretend that actually proving that something is correct is actually really a costly calculation. It takes a lot of time and energy and effort, right? Well, if that's true, then if I can design a system where I don't have to prove that it's correct most of the time, that seems like an efficiency savings. And that's what our optimistic oracle is doing. So, it's saying, “Hey, we are going to assume something to be true provided nobody says I disagree.” If somebody does say, I disagree, we are now in the pessimistic path, and we'll do all the work to prove what actually happened. So, as an example, the actual the legal system, the traditional legal system, I would argue does function optimistically. Like, Sam, you and I can write a legal contract, and we could write it, let's say, we write it under the laws of the State of New York, and we assume we are going to follow that contract, and we both hope we do. And if we don't, in the pessimistic case, we sue each other, right? Samantha Yap [06:32]: Yeah. Hart Lambur [06:32]: But vast majority of the time, we're not suing each other because we follow the terms of the contract. So that would be like optimistic enforcement. So, our optimistic oracle follows the same concepts. Samantha Yap [06:43]: That is quite a departure, given contracts are usually written to think up every possible thing that could go wrong and the punishment that will be carried out should any of them happen. Code It’s like an innocent until proven guilty in simple legal terms. And how do you code this system? Hart Lambur [07:03]: Like one of the very cool things about blockchains, in general, is like, there you can involve people in them and there kind of are people involved in them where we have this network that's run by computers doing this work here too. But anyone, any person can see what's going on this network, and so our optimistic oracle allows people or machines, actually, to request data. Say: “Hey, I want to know who won Wimbledon”, right? And then anyone on the network can actually propose the response, right? They can say who they thought the winner was, and that response optimistically will get taken as truthful if no one disputes it. But also, because this is a global network, everyone can see that answer and say: “Hey, you said like Federer won the Wimbledon finals”, and somebody can say like: “No, he didn't. He wasn't even playing in them.” Right? Like you're wrong, right? But again, because the network is globally visible, you just need one honest person paying attention and watching to keep the whole thing honest, which is like a very cool concept in my opinion. Self-policing: Incentives for the honest person Samantha Yap [08:18]: That sounds very cool, but what if no one's watching, because I hear that a lot in you know, with DeFi everyone says, it's open it's transparent, we can see all transactions but I've also heard that transactions can go through. And if no one else is voting against it, it goes through; so, what if no one's watching, how can we trust that it's still going to do the right thing? Hart Lambur [08:44]: If no one's watching, it breaks, Sam. Like I'll be totally honest, right. You need one honest person watching. But the thing that's super cool: we do know people respond to economic incentives. For one person to be watching for one honest person to show up and we've seen this play out. Like it used to be theory, right? That people would actually show up. But in our own network, we've seen this time and time again. It's really cool; people do show up because there's an economic incentive to pay attention and that continues to be true. It's sort of like a truth where if there's an economic incentive to do a thing, people will do it. Samantha Yap [09:24]: Here we're through the looking glass, where things in crypto are done differently to the real world. Economic incentives of course fuel the real economy too, but these incentives are not usually written into the code: they are the outcomes of broader tweaks by the government. In DeFi the incentives are built into the protocol -- the code that makes a network via a token work. What's the economic incentive? I mean like, well, what is it actually in UMA’s protocol? Hart Lambur [09:57]: In our case, it's straight up just cash money, right? When somebody does respond to a piece of data, they actually have to post a bond that they will get back if they're right, or if no one challenges them. But if they're wrong, and somebody challenges them, they'll lose, so they have an economic incentive to be truthful in the first place. And then, what we call disputers: people that are watching the network to make sure people are being honest. Disputers have an economic incentive where, if they see someone report incorrect data, they can dispute them and double their money. A new system, and its implications Samantha Yap [10:32]: So let's talk about law as code, and how you're saying the system works, and people trust it because there's always someone watching because of the economic incentives behind that. Is this levelling the playing field for anyone to come into this financial system? Hart Lambur [10:50]: If we think about this new form of contracting, this new, this new way of writing contracts that is global by default. Well, first of all, we have one feature that I think is super cool and compelling, where now anyone in the globe has access to the same set of rules, and that set of rules is very true clear and very true, and very uncorruptible, which I think is like a big advantage. So now all of a sudden, if you are in random country xyz, that really doesn't have a strong rule of law, there is an alternative now: “Oh wait, I could write contracts using this other system, and I have access to the same rule set, the same enforcement technology as somebody in the US or in the UK does.” That seems like a very big win for our world. DeFi vs CeFi: smart contracts worked! dumb ones didn’t! Samantha Yap [11:42]: This makes sense, it pulls together code, incentives and law. But didn't everything DeFi just fall over? Or was that CeFi – Centralised Finance? Hart Lambur [11:54]: Yeah, so okay, so DeFi got invented to talk about what decentralized finance is, like those way of writing financial contracts on blockchains. And then, the crypto world decided that: “Hey, we should use this word, CeFi, to compare that to centralized institutions operating in and around blockchains or crypto space,” right? So CeFi includes Binance and includes Coinbase; it also includes these centralized lenders. Celsius and, and BlockFi and the hedge funds and investment managers that are also around the space, like Three Arrows, also known as, 3AC. So CeFi is this term for institutions that are all functioning like traditional organizations in and around crypto. And what we have seen in the last, I don't know now, two months, we've seen some of these centralized crypto institutions fail in ways that look very much like traditional financial market failures and they are. The thing is like the way these CeFi institutions have failed. They failed just like hedge funds or kind of banks have always traditionally failed. And it goes back to what I was saying about the Lehman moment and me sitting on the Goldman trading desk watching Lehman Brothers collapse. What Three Arrows did is identical; it's like they ran out of money. Nobody knew they were running out of money until it was too late because there was no transparency. It was completely opaque, and then a bunch of people didn't have money they thought they had because there was no transparency, and this is all happening in the tools of traditional finance with just unsecured loans and agreements. It had nothing to do with DeFi; it just happened that some of these institutions played around in decentralized finance. Samantha Yap [13:43]: I think that's a point that needs to be made clearer, you know, especially even with the media, because things got a little confusing. So, do you think this episode, this collapse makes the case for DeFi even stronger? And what would you say, like how would you kind of make the case for DeFi from lessons from this CeFi collapse? Hart Lambur [14:06]: Yeah, so this collapse is bad - capital B Bad. It's one thing for institutions, for like a hedge fund to lose money. But I really am not okay with some of these crypto lenders, like losing the money of the average person. And I don't know all the details, but this seems like straight fraud, so I'll just, I'll point out that again, this has nothing to do with DeFi. You were telling these retail investors one thing, and then you were doing something completely different with their money that was way riskier, and you lost it, and that's just like very bad. The case, though, for DeFi here is strong where, if this was a decentralized system, you couldn't do that. It would be an impossibility because everyone would be able to see: “Hey, money came in, here's what you did with it, here's where it went.” There's just total transparency into what's going on and you've seen that like in this whole episode the, the DeFi lending protocols, like Compound and Aave have done great. They've done just fine. There was an interesting stat I saw on Twitter today like Celsius, which is unable to pay people back, has actually repaid 500 million of DeFi loans they had, and they paid them back first. It was just what they couldn't negotiate with it. They couldn't just say: “Sorry, I'm not going to pay you.” If they did, it was actually going to hurt them economically. So, I think it's counter-intuitive because everyone's confusing DeFi and crypto, and these collapses they're all getting kind of bundled up together. But truly, when you just go like a level deeper, DeFi is like the solution to these types of problems where you wouldn't even be able to have this happen in the first place. And so, I'm very hopeful that the public and regulators and the media do grapple, do understand this and understand here that: “Wait, this was just bad fraudulent financial things.” I hope it doesn't taint DeFi because it just wasn't DeFi. Is this going to change the world? Samantha Yap [16:13]: How do you see smart contracts changing the way the whole global financial system operates? Hart Lambur [16:21]: Our global financial system is very big and very integrated into our lives, into how like nation states work, like how into everything. And the global financial system is based around legal technology, like legal recourse is how the whole thing operates. I think it's actually useful to use this framing of DeFi and crypto as inventing a new, a whole new contracting technology. If you think about that, like for the global financial system to upgrade or to migrate to this other technology, this is like no small feat; this is a big deal transition that is very tricky and hairy and has all sorts of implications. And so, I am very much a believer that the advantages of DeFi, in many circumstances, are really real, and they will like this idea of software eating the world that will play out in finance too. But this is a long and slow process. I think it just takes a long time. Things that need to be done: the undo button Samantha Yap [17:27]: What do you think needs to be addressed for more people to open their eyes to it, adopt it, learn more about it? Hart Lambur [17:35]: I probably have a laundry list for you, Sam, but I think like it's a super compelling and interesting technology, and I think people should push hard at the things it's supposed to really offer. So, truly being decentralized. Is there truly no centralized point of control? Because if there is a centralized point of control, there is then the opportunity for manipulation and fraud if somebody can change things around, so you've got to be able to point to that. I also think people should look at DeFi systems and understand like: Hey, what if something does go wrong? Is there some concept of an undo button, of some sort? And for me, like in our optimistic oracle, we've actually kind of embedded this. There is a concept of an undo button which is: “Hey, somebody said something to be true, and now I can dispute it.” The dispute function is, as like an undo button, much in the same way in the traditional legal world somebody says: “Hey, my contract's fulfilled;” and you're like: “No, I disagree,” and you go and you sue them, right? think some of these concepts need to be much more fully developed in DeFi. And I think that will happen over time. I'm pretty excited about it. Samantha Yap [18:50]: This is interesting, because the reason why there are lawyers, laws and lots of cases is that the contracts themselves are not water-tight. The lawyers were able to find enough wiggle-room in there to dispute a contract. And I guess the optimistic oracle is trying to bake in some of that ‘dispute mechanism' by allowing someone to challenge the data coming from the oracle? Hart Lambur [19:14]: One of the things that I think is very difficult/impossible to do is to have truths be perfectly accurate in real-time. There's so many different edge cases or things that can go wrong that are really hard. It's, it's really hard to say this is a hundred % accurate and correct, right now, in real-time. A lot of DeFi actually does kind of function that way. And that's something that, if I'm gonna offer my personal opinion, does, it's very cool but it scares me a little bit because I don't believe that you can say: “Hey, I got this figured out right 100 % of the time, all the time.” And the optimistic oracle concept appeals to me because you do have this out, this escape valve where if somebody says: “Hey, this is what happened,” somebody else can go, “I disagree” and then it goes to this other dispute resolution process where things get slowed down and you can you have more time to understand like what the right outcome should be. Samantha Yap [20:14]: So, does this help in a case where if you accidentally send a payment of maybe you're meant to send a thousand, not 10,000, and then you added an extra zero? Does it help in those instances? Hart Lambur [20:28]: That wouldn't be what like our oracle would do, but you could design a system like that, I think that's the type of stuff that if DeFi grows, would be useful where, when I go and I send money, it doesn't actually go through right away; it says: Okay It goes through, and then you can look at it again and verify, and be like, oh yeah, that's right or not right, and kind of undo it. A bit like how Gmail has the sort of undo button when you send an email now. It's kind of useful sometimes to be like, “Shit. I wrote that wrong, let me, let me undo that.” In our oracle sense, the oracle is useful here for now like say, there's a liquidation and I'm going to get liquidated on a loan that I've provided based on some price, but I could be like, that price isn't right, I disagree with that. And so, I could dispute it, and then you go and you figure out was that a correct liquidation or not? DeFi: a revolution in law Samantha Yap [21:20]: Because I heard that you've said this, but you've said that DeFi is a revolution in law, not finance. But I'd claim it if I were you. Can we talk about that? Hart Lambur [21:32]: I will claim it. I don't know when was the last time we invented a new contracting system? I think it's been hundreds of years. Doesn't happen very often, and I think that is really cool and really compelling. The financial aspects of DeFi, in some ways, are less interesting to me, because you look at like with some exceptions, right? But what has DeFi done? They've recreated lending markets Compound and Aave are just like money market lending. They've recreated like trading, right, that already exists, that's not new. There are aspects of it that are new. Uniswap and the concept of an automated market maker doesn't exist in traditional markets, and I think that's pretty compelling. But for the really big innovation in my mind is inventing this new system of writing contracts. The other advantage of this this contracting system, is that it's very easy to access. So, unlike the traditional financial system, where inventing a new financial product costs like tens of millions of dollars or hundreds of millions of dollars, here anyone in their basement can go and like code up something new. Samantha Yap [22:36]: Yeah, that's certainly pretty cool, and it shows that anyone can access it, wherever you are in the world. So, it's kind of lowering the barriers to entry to the financial system, which the current global financial system, as you said, it's just gotten so complicated and convoluted, and there's so many layers to it. But yeah, you've also just described that we're building this new financial system you know, like you said Aave and Maker have or Compound has changed the way lending is done. Instead of it changing the current system, are we seeing this alternate universe forming and just growing? Hart Lambur [23:16]: I think for now; and I don't think that's a bad thing. Sometimes people think that means like what's the point of this thing, right? Why are we? Just like you're reinventing this system in parallel, and the example: you go back to the early days of the internet. What the early days of the internet was, was actually a bunch of people on the internet talking about the internet that was it, it was very self-referential and circular. But that process built the tools and built the plumbing and built the infrastructure for all of these other innovations to emerge. Like with the internet plumbing, then you started getting, you know, streaming video, and then you got YouTube, and then you got social media and you got all these things that emerged, that have no parallel in like the traditional world, or the world before it. So, I think the path for DeFi looks quite similar, where you have people using DeFi to trade, DeFi to like talk about DeFi, to just very self-referential, but it builds the plumbing and infrastructure required to allow totally new things to emerge that haven't even been invented yet. Samantha Yap [24:30]: To bring it all home - We saw in the 2008 crash a failure of a complex system that relied on obscure, opaque contracts which built an obscure, opaque market where no one really knew how exposed they, and the parties they were dealing with, were to banks and institutions that were collapsing. So, the financial system came to a roaring halt. Hart believes that this was a failure of legal technology, but smart contracts, and optimistic oracles, can help fix it, if they take some elements from Traditional Finance (TradFi) and use the technology and principles of DeFi to build something better. DeFi for sure is still in its early stages, and we’ll have to do a lot more talking and building before it feels in any way permanent. The trick is going to be how we manage the difficult bits, such as agreeing on the data, and resolving disputes. Hart has come up with one solution, and there are going to be lots more. He's also helped us think differently about the most basic question in finance: what is a contract? Thanks for tuning in to another episode of YAP Cast. I’m Samantha Yap. For new episodes, follow The Story of Money by YAP Cast.