27 - DeFi in the Eth2 Metropolis | Haseeb Qureshi

welcome to bankless where we explore the frontier of internet money and internet finance this is how to get started how to get better and how to front run the opportunity this is ryan sean adams i'm here with david hoffman and we're here to help you become more bankless david how are you doing today i'm doing absolutely fantastic ryan we had haseeb qureshi on the bankless podcast i am the son of an urban planner my dad's an urban planner and haseeb reminds me of an urban planner

and so we we get haseb on who wrote this fantastic article about ethereum 2 and how the landscape of ethereum 2.0 will kind of stratify and separate into you know a downtown manhattan area and urban urban and suburban lands and then also farmlands and it was a really great piece that kind of triggered our our interest in getting hasib on we also talked a ton about automated market makers una swap curve balancer and how these uh applications these systems really are at the heart of crypto and

why they are so revolutionary and different and what they really have to offer ryan what was your favorite part about this episode you know what i don't know if i like the first half or the second half better because they were both awesome right so in the first half we talked about automated market makers and if it's never clicked in for you like what uniswap actually is and why it's powerful and why it's grown to like you know 30 billion in annualized volume over the past few months i think this will make it clear i think you'll get a clear understanding based on the way

haseeb explains it also a lot of people do not have a vision of what ev2 looks like they know abstractly that it's coming and it's this thing for ethereum but hasseb's analogy where we talk about cities and the suburbs and the farms like nails it at least for me i have a very clear vision of what eth2 with 64 different main chain shards will look like and that's really exciting i tend to think probably like you do with like i think in analogy and i think in like kind of imagery and

pictures and this just paints the pictures on both automated market makers and eth2 hassep is just a fantastic communicator and then we finished off the conversation with an is eth money or is it not money conversation which is always a good conversation to have because getting people's varying perspective on that answer is always how we come to the true answer of whether eath is going to be money or not or what that even means absolutely yeah it was it was a good take by hasid there and i actually probably agree with many of the things that he said in the way in the language

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have on the podcast hasib qureshi he is a partner at dragonfly capital formerly worked at metastable another crypto fund he was a dev formerly at airbnb so he's got some technical background he also has some pro poker playing background i've heard a ton of intros to see if he's got a you know very interesting eclectic resume and the way he got into this space was interesting as well haseeb you are one of my favorite thinkers and investors in this space welcome to the bankless podcast sir

thank you and thank you for having me you know what we're just we're not going to do this like we do typical podcast episodes and do kind of intro and everything like that we're going to get right into the meat here um you had a really fascinating tweet i think uh it might have been a month ago six weeks ago and it and it went like this it was what's the big intellectual miss you've had in crypto within the last year and then you talked about yours which was uh missing decentralized exchanges in

particular missing automated market makers i want to get into automated market makers in just a minute and like maybe explain that run through it but can you talk about why you tweeted that why is it important to talk about the the intellectual misses that uh we've had in crypto as investors yeah i i think crypto is such a weird industry in which to be investing because it just evolves so quickly that as an investor you you need to be

changing your mind every year or two about your fundamental understanding of how the space works like there are so many things that i believed in 2017 that i didn't believe in 2015 and there's so many things i believe today that i didn't believe in 2017 and i'm sure that two years from now many of my assumptions and mental models are also going to get invalidated so you just you have to constantly be willing to change your mind and to listen to what the industry is telling you um and so anybody anybody i know who's thinking very deeply about the space who's coming up with theses and

mental models of how these things work some of that stuff is going to be wrong and the worst mistake you can make is not to notice that your mind has changed that i think is the is the biggest possible error you can make your hyper investing because it's one thing to be wrong everybody is going to be wrong about a lot of stuff um but the biggest thing is to not learn from the fact that hey you incorrectly predicted how this thing was going to turn out and kind of do do a little bit of intellectual postmortem on yourself right of like what did you miss why did

you get that one wrong for me amms were the big miss for me i was a big bear on dexes in 2017 and my whole theory on why dexes were not going to work was beyond the obvious stuff of just like performance and fees and blah blah the big the big thesis that i had about why dexes weren't going to work was because of the huge amount of adverse selection on deficits so if you look at you know you remember like ether delta and fork delta back in the day the the assets that were getting traded on these exchanges

most of the trading volume was in really low quality assets so it was in the really crappy stuff that basically would never get listed on a binance or on a coinbase or whatever it was all the lemons basically exactly exactly a long tail of assets it was the long tail of like obvious securities or like kind of shady tokens or you know uh you know like spank coin and stuff like that like that was the kind of thing that was really thriving on uh ether delta and the other decentralized exchanges and it seemed very difficult for it to break

out of that loop right like that it's like okay great this this exchange is going to get known for listing and trading the stuff that nobody else is willing to trade that is not a strong like that's obviously not a strong place from which to build a really significant market uh and so i basically wrote off dexes and i remember having a lot of conversations with people back in 2017 who were very excited about xerox and you know on-chain exchanges and idecs and all this stuff and i basically wrote off the entire category because i thought this is just a fundamental

problem that isn't going to go away if anything is really valuable it's going to get listed on a centralized exchange and then people are going to trade it there and liquidity begets liquidity and liquidity the network effect right like i mean all these really obvious arguments and i i missed what amms could do to change that equation and that's been that's been a real educational process for me is trying to trying to sort of do the five wise excavation on why did amms win in d5 all right so let's dig into that so um i'll confess like i missed it too like i

saw uniswap and i saw it as an interesting project but at the time i would not have predicted the success and the rapid success that it has seen but uh you've you've written an article about this um that kind of explains the rise of automated market makers and for folks that have listed the bankless podcast for a while we'll include some other episodes where we explain automated market makers in the show notes and what those are the unit swaps of the world but i've actually heard people in the bagless community tell me has seen that they didn't truly

understand amms until they read your article like you articulated it in a fantastic simple way maybe you could articulate it for us uh here like what the heck are amms we've called the money robots we've called them you know constant function market makers but like what are they explain it like i'm five explain it like you're five okay well i i don't think five-year-olds know what market makers are so that might be a little bit

but but i'll i'll explain it i'll explain it like you're you know uh like you're like you're a financial newbie but you know some of the basics good deal so sorry five-year-olds yeah yeah you're trying to drop off so so basically in amm so when i say an amm i'm really i'm going to be describing it as one because it's the easiest to explain and to understand you know so every market maker uh their job is to provide liquidity for to a

market basically they are willing to buy or sell an asset whatever it is that you want and they're always willing to put you a price or usually always win a bunch of price and the critical question for any market maker uh is how do they price those assets so let's say i've got you know the example that i give in the in the article is let's say that i've got some apples and i've got some bananas and that's the currency of our weird little fruitarian universe and i i'm willing to buy apples for bananas or i'm willing to buy apples or won't buy bananas for apples okay and

what i need to decide is what is the exchange rate that i'm going to offer you based on how much you want and what is in my inventory so there are lots of different ways that you can do this right like you could you know if you're a real market maker what real market makers do is they like look at the big fruit exchanges and they look at like what's the exchange rate and they try to figure out you know can i if i if i buy this from you can i go arbitrage it on a real exchange what's the liquidity what's the volatility all this stuff they're trying to figure out these like 100 different dimensions that go into some big model that decide how

they quote a price to an end user right this this is what market making is and it happens every single day on exchanges all over the world in crypto and outside of crypto it's the oldest thing in the world so amms are a way to create a completely like you said a robotic algorithmic market maker that lives entirely on chain basically meaning that it has a very simple formula that decides how it buys and how it sells all on chain and all of its inventory meaning

all the apples and bananas that it owns so that it can buy and sell to people all that also lives on chain except it's not apples and bananas ethios dc or whatever how does uniswap actually work and the answer is probably a lot easier to read and to see a visual metaphor for this rather than try to hear it explained then through audio but just for the sake of completeness what uniswap uses is it uses a pricing function called the constant product pricing function and basically it means this so i i have some apples and i have some bananas

when you multiply those two together the number of apples multiplied by the number of bananas let's say i have 50 apples and 50 bananas uh actually let's make it easy let's make it 10 and 10. let's say i have 10 apples i have 10 bananas multiply these two together you get 100 right and so the rule in uniswop is that the the product of my apples and my bananas no matter whether i'm buying or changing the amount of apples versus bananas in inventory the product of those two numbers must always be equal to the same value so it started with a hundred it has to always be a

hundred so if i let's say that i then uh let's say that i then sell five bananas um so i'm gonna have five bananas less right if i have five bananas i need to figure out how many apples i'm gonna charge for those bananas well we said the rule is that it needs to still equal 100. so 5 times x is equal to 100. solve for that the answer is 20. 5 times 20 equals 100. so i need 20 bananas which means i need to charge uh because i originally had 10 minutes i need to charged another 10 bananas to sell you five apples okay that was a mouthful probably hard to

follow that verbally but if you read the article it's easy easier to understand visually and so basically what that results in is most of the time uniswap given this very simple pricing curve if people are buying relatively small amounts is going to give you a pretty good price but the more that somebody buys and the more lopsided the market maker's inventory becomes the worse and worse price is going to give you um so that's how uniswap works in a nutshell and it sort of automatically tries to rebalance itself by

basically doing what i just said right like if it if it's inventory gets too imbalanced then it starts quoting more and more ridiculous prices going one way and more and more generous prices going back towards equilibrium so it's almost like this like rubber band is pulling uniswap or pulling in this automated market maker back towards the equilibrium of trying to have balanced bananas and apples in the pool assuming that the real exchange rate of bananas and apples is one to one so that's you just swap in a nutshell there's way more that we can talk about but like honestly it's it's uh it's not the

easiest thing to understand from uh listening to it from somebody just talking you're here but that provides me a way to buy one apple without you know the thing i'm trying to avoid which is a bad price you know market makers would call this slippage but it does not provide me a way to buy say 50 because if i buy 50 what's going to happen to me so if you buy 50 well so the example i amended it was 10 apples in inventory right so if you want to buy all 10 apples you want to sell out the market maker one of the properties of unit swap of

course is that it must always be willing to approach you a price so if i want to so you can just do the math right like so 10 times 10 will equal 100. if i want all 10 of the apples then 0 times x has to equal 100. so then you have to divide by z you're basically going to divide by zero which means that literally it's charging infinite in order to get in so you you cannot buy all of the inventory in unit swap that's one of the rules of ninoswap is that as you start buying up more and more and

more and more of its inventory as the inventory gets arbitrarily small the price gets arbitrarily high and so you know if you want to buy uh you know 9.9 apples like uniform is going to charge you some absurd price you're charging like you know 10 000 bananas in order to buy 9.9 apples or something you know in order to make the math work and some people may think this is a flaw right because you know apples will never really cost infinity dollars that will never that's not a realistic scenario however it is important for this

primitive which is uniswap to be able to price things in such a wide uh such a wide discrepancy and and it's largely also just a function of needing to be able to count for like the different uh decimal places or or supplies of tokens that are on ethereum where i can go mint you know 10 trillion tokens and then supply them for over one ether and you know it looks like that that market is completely uh off balance but that's just because

of a function of the the decimal place for that particular unit and so it's actually really important that this uh the automated market maker model can price things out to infinity because it allows for any token to be able to fit somewhere in that curve it doesn't really matter what the decimal where the decimal was placed or where the supply was initially created yes absolutely now that said uh since the invention of uniswap there has been an explosion in different

kinds of amms that use different kinds of curves so you know the the amm uh the unit swap curve is this x times y equals k so the two assets multiplied together equals a fixed constant this is called the constant product pricing curve um but there's a but there's a bunch of other ones that people have come up with so there's one called curve which is now this mixture of constant product and constant sum which a lot which is better for stable coins or for mean reverting assets uh there's one you know the balancer uses kind of arbitrary uh sort

of kind of constant product but across arbitrarily many uh uh or uh pairs so not just not just sort of two assets together and then there's foundation and actually foundation uses a variant of unit swap that actually can run out of inventory because the foundation what it does is it tries to sell limited edition goods and uh if you're if you're selling goods like let's say i'm selling like t-shirts right and i'm like signing each of these t-shirts or whatever uh well i actually do want all of the inventory to get drained at some point like i want i want to sell out like that's kind of the

point if you're selling assets um so for you know if i'm selling apples and bananas maybe i want to make sure the the amm never runs out but for other amms actually maybe it's completely reasonable that the amm should at some point run out of inventory because when it does you know what happens is just okay well all that's left is profits that can be they can be taken you know the fees that were generated by the pool can be taken out and then other people can come in and recapitalize the pool so there's no uh issue in principle with a with an amn uh running out of inventory

uh but it just so happens that that you know most of the amms today balancer uniswap and uh curve they are designed to never run out of inventory so one of the there's a few things about the amm model that formalizes different market participants and i see the efficiency of the amm model comes from this formalization so in in the old world in the world of order based uh exchanges uh or just the

order book model you have market makers and you have traders and they're kind of just lumped together like they have different behaviors but they're really this the same participant they're they're all looking at the same exchange they're all doing the same thing in the amm model they have been placed into two different buckets and that's actually where a large amount of efficiency comes because the market makers can are their job is much more simple which is to simply supply put deposit assets into a contract where on the order book model uh you they uh the

market makers have to actually do things they have to actually engage in activities right and that actually requires like actions over and over and over again and the when the amm model has just relegated this to a a money robot right where you just deposit your money and then the algorithm takes care of that that for you and what really is innovative about this is that uh it turns going from a peer-to-peer model which we like we like the terms peer-to-peer but in terms of exchange

that's actually relatively slow and it goes from it goes to a peer-to-contract model uh are you i'm assuming you're familiar with the term peer to contract yes yeah can you go into the peer-to-contract model what that is and then just the implications behind a peer to contract model versus a peer-to-peer model so in a peer-to-peer model the idea is that you know you can sort of imagine like let's say there's 10 000 people who all want to trade right and in order for those 10 000 people to all want to trade each of them needs to get matched up on the other side you can

imagine left side and right side of your you know imaginary wallpaper here uh 10 000 people on the left side if you're doing a peer-to-peer model you need those 10 000 people to somehow get matched up on the right side and to get this big web of connections all going together to match them up with people who are taking the opposite side of the trade and while in principle like that makes sense and that's how most exchanges in the real world work and how most crisis company works trying to translate that into an on-chain environment basically means lots and lots and lots

of transactions lots of gas costs lots of people having to to you know post orders and take orders and fill orders and uh there's there's an enormous amount of complexity that's to be foisted on chain and it wasn't obvious three years ago that that was going to be a big constraint but in the pure contract model it looks a little bit different so you have the ten thousand traders on the left side but on the right side you just have a single contract and everybody on the left side is just talking to this single contract you can imagine this like big web of like a thousand threads all pointing to one

node uh and that and that's this one or a curve or balancer and in this world it's a one it's it's much more uh transaction and gas efficient there are many fewer things that need to happen on chain when everybody is just talking to a single contract and the second thing of course is that the the liquidity uh meaning like the amount of capital that actually needs to get locked up in the orders and put in different places it's much easier for all that to get aggregated in one place and the network effect of hey here's

where all the money is and therefore here's where all the liquidity for trading is it's very easy for that to not get splintered into a bunch of different places so you don't have to worry about oh well you know am i going to find this token on ether delta or on idacs or on radar relay or on this thing or that thing uh instead it's like look unit swap is just like the natural point of convergence for all of the liquidity that that wants to coagulate onto each usdc or you know whatever are the big markets in crypto um

uniswap has sort of served as this national shelling point for all of that it's it's the other thing that i think is also very different about providing liquidity to uniswap versus providing liquidity in a peer-to-peer model is that of course providing liquidity in a peer-to-peer model on an order book uh your the peers need to themselves be very active in putting up that liquidity the makers the people who are actually putting up the orders uh they need to be constantly deciding okay what exchange i'm going to put the order on when am i going to put it on how am i going it's a very active

process to do that market makers generally charge money for the obligation to provide liquidity on your platform and if it's not worth it to them if it's not profitable for them to do so then they're going to charge you a lot of money because it's not in their interest to just do it anyway uh whereas with uniswap it's incredibly easy you just click one button you send a transaction and boom now you're providing capital to the market and this sort of one click set it and forget it experience that near swap has created

that has been i think a big boom to making the uniswap market more and more liquid and thus more and more competitive with other alternatives for for uh trading some of these assets so i think we've seen unit swap just become the shelling point of liquidity and especially over the last like month or so where unit swap volumes have started to really get competitive with centralized exchange uh volumes right and so uh is it where does the role in a world where the amm model really just takes

over and it kind of positions itself as kind of a center point of ethereum and and liquidity on ethereum what what is left for the world of the order book model like is does the order book model still provide something useful or is it kind of just inferior in in every way so i don't think the order book model is dead i i believe personally that the the dominance of amms has really resulted from the extraordinary constraints of ethereum 1.0

basically if you're if you're constrained to highly expensive transactions uh you know sort of not a lot of computation that you can do per unit time um and you know all the other things that we understand about what makes ethereum fairly difficult right like being being a maker on ethereum if you're actually posting transactions on chain continually to an order book uh that that is just very expensive and it doesn't really work well for the model that that uh ethereum ethereum uses and so of course most of the order book exchanges that we see today are using

off chain order books that then get only only settlement really happens on chain so dydx idex most of the most of the order book exchanges that we see today they actually host their order books off chain so there there are a couple things that i think are important to understand about why order books have not been successful in ethereum and what would make them successful so the first thing is that right now order books are too expensive and if they're too expensive and you can basically get lower trading fees and better liquidity through amnes then people people are

going to they're about to do that um which which is is unsurprising in some sense right like an amm um an amm is almost like the otc desk experience basically says like look instead of us going on an exchange and having all these complicated moving parts of you know orders and limit orders and and you know these these various different kinds of trading types which are very difficult to implement you have to worry about gas costs have to worry about settlement time to worry about trusting the coordinator all that stuff you know the coordinator itself like they might be operating in exchange or is that

illegal what do they need to do in order to protect themselves there's all this complexity that goes into running an order order book exchange on ethereum today and if you're willing to do all that why not just run a centralized exchange and like make your life a lot easier right so to that end uh i think order book exchanges have a much more difficult time competing today and so uniform kind of just looks like an otc desk it's basically like hey come here tell me what you want i'll fill it using using some set of rules right and it's unsurprising that the otc desk experience is simpler and it's easier to

implement and there's less moving parts and it works better in a very constrained environment but there are two things i think that will change that one is that there's going to be of course more scaling solutions on top of ethereum so talking about layer twos you can talk about you know uh interoperability solutions like polka dot or cosmos and of course there are other layer ones that are i'm sure we'll get to talking about this other ones that uh want to you know sort of build bridges with ethereum and take on some of the ethereum overflow traffic uh so that's that's one thing is that the scalability constraint is going to at

some point get ameliorated but the second thing is that uh uniswap works very well for certain assets and works less well for other assets so what i mean by that so one is that derivatives which i think are a big thing that that uniswap or the trading demand in crypto is going to increase for uh already in centralized exchanges derivatives account for the vast majority of crypto trading volume relative spot uniform works reasonably well for spot trading but it's not particularly well

suited for trading derivatives and a large part of the reason for that is that derivatives uh because the fact that they're often traded with very high leverage uh it's they're extremely sensitive to relatively small changes in the in the price and they need fast liquidations right your ability to get highly leveraged is contingent on your ability to unwind a very highly leveraged position in a time of high volatility that's what constrains you from being able to offer 2x leverage to 5x leverage to 10x leverage to 50x leverage to you know

bitmex 100x leverage um nothing on chain today can offer 100x leverage it's just absolutely impossible because the amount of capital you need to liquidate would be way way too much for you to do in a reasonable amount of time on on ethereum today and that's one of the reasons why you know uh you just that kind of thing would not work through a pure amm model amms aren't sensitive enough to quick changes in price and volatility uh order books are designed exactly for this right the ability to cancel orders move