🎙 Prominent Academic Fabian Schär Says Crypto Regulation Should Happen Only at On/Off-Ramps and Ditch Consumer Protection

Fabian Schär is one of the most prominent academics focusing on blockchains and specifically DeFi. He is Professor for Distributed Ledger Technology and Fintech at the University of Basel, has a PhD in crypto, co-authored the bestselling book “Bitcoin, Blockchain and Cryptoassets” and has published many academic papers, including one outlining the DeFi tech stack on the St Louis Federal Reserve Review.

Fabian has a great deal of experience speaking with regulators and studying different laws and frameworks being applied to crypto. He argues regulators should not be using old laws to regulate new tech. He also says regulation should happen at the off and on-ramp level, and at individual businesses, but not in the non-custodial world of on-chain transactions.

Fabian has the somewhat controversial opinion that regulators should ditch consumer protection as a goal all together, and trust that each individual should be free to decide what to do with their money, and take responsibility for their decisions.

We also talk about re-hypothetication risk in DeFi, CBDCs, and “fake versus true” DeFi.

Podcast audio and video was edited by Daniel Flynn and Gary Leuci. Transcript was edited by Samuel Haig.

🎙Listen to the interview in this week’s podcast episode here:

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👀 Only paid subscribers have access to the full interview transcript below.

Cami Russo: I'm here with Fabian Schär. Welcome to The Defiant podcast, it is a pleasure to have you here.

Fabian Schär: Thank you very much for the invitation, Camila.

CR: Fabian Schär is a professor of distributed ledger technology at the University Of Basel. He has a Ph.D. in crypto, co-authored the bestselling book Bitcoin, Blockchain, and Cryptoassets, published by the MIT press, and has published many academic papers, including one on DeFi, Federal Reserve Bank of St Louis Review, it has a really useful kind of DeFi technology stack that I think really kind of helps frame this space very nicely.

So, Fabian and I also just recently met each other face to face at a conference held by the bank of international settlements. I got to see his presentation and was very excited to invite him on the podcast because your work on regulation and education is very forward-looking. Welcome again and before we dive into all of the different topics that you've been researching and looking at I'd love to kind of learn more about you and your background.

What brought you to crypto?

FS: Well, first of all, thank you very much for the invitation. It's a great honor to be here. I'm a big fan of you and the show and it's great to have this conversation. And yes, we've met recently at the BIS Swiss national bank conference but you forgot to mention one fact.

It was a DeFi conference. I think it's super exciting that the central banks are hosting a DeFi conference. That's something that certainly wouldn't have happened just a few years back.

CR: Absolutely!

FS: So about me, I'm based in Switzerland, Basel professor, at the University of Basel where we are researching public blockchains. This topic is super important to me because I'm not interested in any of the enterprise solutions. In many cases, these are just glorified databases.

So I'm mainly focused on Bitcoin and Ethereum. And with Ethereum, on decentralized finance protocols. I have a background in economics, monetary economics, and game theory. Then, during my PhD which I did on crypto, I felt equally as much as a computer scientist as an economist. And what's going on in the space.

CR: Awesome. But what got you interested in crypto? Did you go into academia thinking about distributed ledger tech or, did you go about it from a different angle and finally get to Bitcoin, or how did that happen?

FS: You know I've always been interested in monetary economics but also in the nerdy stuff. So, I was huge into gaming, for example, and then when you come with these two different backgrounds. On the one hand, you teach yourself programming and your interest in that stuff but also have a background in monetary economics. It was like a logical step at some point but it didn't start that smooth.

I mean, initially, when I got introduced to Bitcoin it was relatively early. It's pretty much the same story as with everyone. You start looking into it and you think it's a scam and it's not gonna work, right? And then you look into math and how it works, and you get more and more excited. So it's the usual going down the rabbit hole story.

With Ethereum, it's pretty much the same because Ethereum was there right from the beginning. And initially, to be honest, I thought it was not going to work. It's going to be a scam and I was super excited when I started to realize what it's capable of and especially in financial applications.

Old Rules to New Tech

CR: Nice, nice. I'm interested in hearing how you explain these concepts. Maybe just narrowing it down to DeFi and web3. How do you explain these concepts to people who are not experts, as a professor looking into the regulatory space. I'm sure you meet this kind of audience very frequently.

How do you go about describing this new weird space?

FS: You know when I talk to students I usually have an entire class, right? It's 25 hours+ where I can talk about these things. And then you have some time to cover it in quite some detail and look at the foundations of cryptography and networks and consensus protocols.

But obviously, you don't have that time when you talk to regulators or to commercial banks. There I take great care that I talk about self-custody. I think that's the most important aspect that you really can store these assets yourself. You can issue the transactions yourself, you can validate them yourself. You don't have to trust anyone.

And in many cases, regulators just get focused on other elements but not necessarily on this aspect. They don't necessarily realize the power this aspect has that you have the option to safe keep these assets yourself, that you don't have to rely on a custodian.

That's something I take great care to explain, even if it's just at a relatively high level, so that they understand the benefits this can have. When you think about commercial banking. Right now, when you think about people, it is the only option they have to own risk-free money without any counterparty risk. It's not risk-free, I shouldn't say that, but without any counterparty risk from commercial banks it is basically cash, right?

And that's something that's going to disappear at some point. We don't know when exactly, but cash will go away at some point.

When cash goes away, we would be in a ridiculous situation where people could not hold legal tender anymore. So, we have to look for alternatives that can have self-custody and are not forced to go through a commercial bank. And that to me is crypto.

And it's obviously not limited to the monetary aspect but just the entire idea that you don't have to trust anyone, that you can keep it, store it for yourself and you don't have to go to a service provider. That's extremely powerful and that's amazing.

CR: Speaking about how policymakers and regulators and banks look at this space, I didn't get a chance to really speak after the conference. I'd love to hear your takes on what was discussed there.

FS: It wasn't too much of a surprise, to be honest, because I talk a lot to regulators all around the world about DeFi specifically. The good thing is they are starting to look into it. I think that's something we should appreciate to some extent and some of the regulators really try to understand the technology.

Unfortunately, that's not true for everyone. And in some cases, they [regulators] just try to apply old rules to a completely new technology that might actually solve some of the issues the regulation was there in the first place.

That's super exhausting and annoying to some extent. I mean, even at the BIS, again I want to say I think it's great that they organize this conference and there are a lot of people who really try to look into this technology and I'm really excited about it.

But even there at the conference, you had some people who were completely confused, for example, Uniswap the protocol with just a UI, a user interface. And then they had claims that Uniswap the protocol controls the tokens and they can just delist tokens which is completely untrue.

And I think that's extremely dangerous when you have these statements on panels of regulators. That's something that happens all the time, then people think that's true, right? These things get stuck and so part of my role when I'm there, as either giving a talk or as an expert witness in some of these calls, is to make sure that these mistakes don't happen and that people really differentiate not just between protocols and frontends.

But also between two other things which are super important to me and that's true decentralization. True DeFi and fake decentralization, because even as someone who is extremely excited about DeFi we have to admit that, unfortunately, some of the protocols in the space really are not that decentralized and have a lot of dependencies.

And in some cases, I think they deserve to be regulated when they are de-facto custodians, but that doesn't mean that there aren't any protocols which are completely decentralized and I think that's something regulators and policymakers have to get comfortable with.

Nothing Less Exciting Than Wholesale CBDCs

CR: For sure. What I got is that there isn't really anything blockchain-related happening or planned. It's just that central banks are planning to have digital currencies.

And most of the time it's not going to be consumer or retail-facing. It'll be used on the backend between central banks and commercial banks to make transactions more efficient.

It will be like digital currencies in a centralized database. Nothing to do with crypto or blockchain. That's kind of the sense I got. Do you agree?

FS: Oh absolutely. Honestly, there is nothing less exciting than a wholesale CBDC, right? It's just a settlement infrastructure between some institutions. They will call it blockchain in some cases, but at the end of day, it's just a regular database between these institutions. It's not public. You cannot verify anything. You cannot even participate as a retail customer.

But then there are some countries which have launched or are planning to launch a retail CBDC as an entirely different focus. That's really for the general public as a substitute essentially for cash, right? Where you can have it as digital cash. But even there, in these cases, it's not blockchain as you and I know it, right? They might call it blockchain but there's nothing to do with a public approach, has nothing to do with immutability or withholding.

Well, in some cases you have your own keys but certainly, someone can change or intervene. That's just a completely different approach, and yeah, I think you're right. We also saw that at the conference.

For those who might not know, the topic at the conference was 'Does safe DeFi require CBDC?' At the opening talk, I made a little bit of fun of this question because when you think about it, the conference question, 'Does safe DeFi require CBDC?' is like asking, does safe decentralization require centralization? That's an absolute no. That's kind of obvious.

I think what we got from the conference is that there is some room for something that could be mutually beneficial because when you look at the current state of DeFi. There is a huge demand for off-chain collateralized stablecoins like USDC and they certainly have some dependencies. They certainly have some counterparty risk and they are USD-nominated. So I don't see why there wouldn't be a demand for CBDC issued on the public chain. This could be a benefit to DeFi when you come from that angle.

On the other hand, when you look at CBDC, they can issue it on their own private chain. But then you would lose things like composability because when there's nothing else running on that private chain then it's nice that they have their CBDC on there. But then there is not too much to do.

So I think it actually would be mutually beneficial, and I think we might see a future where some central bank might test the waters on issuing a CBDC on the public chain.

CR: Yeah, I think that was another key takeaway. If these currencies will play with DeFi. They'll obviously have to be issued on a public chain to begin with. It seemed like that's not in the works, at least at the moment. It's pretty scary to think about that.

Especially if governments start issuing these and blockchain-based currencies and not provide alternatives or don't allow for alternatives and you're stuck with this. These currencies where governments or central banks have really high control over accounts. I think that can become scary. So maybe it's a good thing that they're not going into that space.

FS: I completely agree. I'm kind of scared of the future. I think it's quite dystopian when you think about it. I think it is a problem with many policymakers and regulators around the world or just government institutions is that they have some flawed assumptions in many cases. They always assume that common people might have bad intentions and that they try to cheat. You know, money laundering and terrorist financing, and then we need all of these regulations.

But one thing they entirely miss in their picture is that there are also bad actors in the government and even when you're trusting your institutions right now, when you're establishing something like a CBDC, when you have a heavily centralized database where a currency can basically expropriate, where you can freeze funds, when you even have tokens on that CBDC chain where pretty much any assets can be frozen or even small contracts.

That's extremely dangerous infrastructure. Human history is cyclical to some extent, right?

Even if you trust institutions right now, at some point, there will be somebody raising or claiming power which has malicious intent. [They] might misbehave and use this technology to get rid of political opponents and that's just something that's extremely scary. Public blockchains I think are a pretty good counter instrument against this development and that's why I think it's super important from a societal perspective to embrace public blockchains.

Fake DeFi Vs. True DeFi

CR: For sure. I saw a recent report on how the world is becoming less free. It was pretty scary to see measuring different types of freedoms per country. You have places like Russia and China that are increasingly oppressing and limiting the freedoms of their people. And right now, China's response to the pandemic. Yesterday, I met with investors who are based in China but are traveling and they showed me videos of these almost concentration camps where they are keeping people who have tested positive for covid.

So, people are completely helpless when a government turns authoritarian and starts eliminating enemies. You know, Russia is the best example for that. I think it's not a far-fetched far-off future where people might need public blockchains as an alternative. It's happening right now.

FS: Yeah, and I think there are also good historic examples for that, right? It's just a really bad idea when you concentrate power just in the hands of a few institutions. I always say even if you have a completely decentralized foundation, at the end, it might be the case that most people simply don't care about it. They might still go to a custodian, they might still go to a commercial bank and that's perfectly fine. You don't have to force anyone to take care of their own keys if they don't want to.

But what's important is with public blockchains when the foundation is decentralized then they have an option they can choose. They can either choose to go with a service provider or they can do it themselves. That's something that's important whereas when you go with a permissioned ledger and when you don't give people options they are forced into a system.

And they don't have any outside options and that's when things get really dangerous. Also, from an economics perspective, it's a really bad idea because that's how you create monopolies. That's how you create inefficient markets and so on.

I don't see any reason whatsoever why we shouldn't embrace public blockchains. I think it's a fantastic development and something that's going to help us as a society for sure.

CR: And what do you think about the rise of all these competing layer 1 chains? You have things like Bitcoin and Ethereum which I think most people can agree are the most decentralized layer 1s.

But then, because decentralization often includes a tradeoff with throughput, there've been all these other layer one chains that are more decentralized than others.

There is that tradeoff, but at the same time, they are gaining a lot of traction because they are delivering the kind of experience that users have come to expect from this information age where everything is instant.

Do you see a risk in this new blockchain future being limited in its decentralization potential? Maybe these other layer ones that are less decentralized gain traction, or what are your thoughts there?

FS: I think it's great that we have all of these experiments, and I think it's great to see that there's some competition as well. That being said, there are a lot of blockchains which are heavily centralized or more centralized than they may appear at first glance. To me, one of the most fundamental questions I like to ask when I look at a blockchain, whether it's decentralized, is can I validate the transactions just with a simple computer consumer PC. Or, do I require a special hardware in some cases with these Ethereum competitors. It's the case that you cannot validate the transactions because you don't have the necessary hardware in some cases, the mempool is not even publicly observable and they're just all of these drawbacks.

Is that necessarily a bad thing? No, it's just different. Personally, I think it's super important that the base layer is completely decentralized, but there might be different preferences. So, competition is a good thing.

Where I draw a line, and where I think we have to be really careful, is with fake decentralization. Again, I don't necessarily have an issue when they are competing protocols and some which are more centralized, as long as it's disclosed and clear.

Unfortunately, in some cases, and this is true for blockchains as well as for DeFi protocols, it's not entirely clear just how centralized it actually is, and that might be a case where I think regulators have to step in at some point.

Because, when you think of the DeFi stack and the paper you've mentioned, when we start with the settlement layers, or the actual blockchain when the blockchain itself is heavily centralized, it doesn't really matter what you build on top of it.

Even if the DeFi protocols are completely decentralized, when there is some entity you can just roll back the state of the blockchain, it doesn't really matter everything you build On. They will be centralized.

Similarly, on the asset layer when you have tokens with some promises for delivery of some off-chain collateral. For example, when you have tokens with plus blacklisting functions, expropriation functions or admin keys, where somebody can parse the token contract, you name it.

Then it doesn't really matter whether the protocol itself built on top of the tokens being used is decentralized. Somebody can always freeze the assets or claim the assets, right? So, you really have to think in these different layers and look not just at the blockchain but at every single layer to see if something is centralized.

CR: Yeah, that's a great point. So, fake decentralization is probably one of the biggest risks in DeFi. I'd love your thoughts on what other risks you're seeing.

FS: You know, let me start with one of the issues in traditional banking. When you open an account then you get pages and pages of terms and conditions and legal contracts. And most people just sign it, right? They don't understand it. They don't have the time to really read it and that's something we are quite used to by now. I see a similar dynamic in DeFi not with legal documents but with smart contracts that there are just these blinds closed.

And I think that's somewhat dangerous. Even though I understand why this is the case, I think it's extremely dangerous, and either we get into a situation where there are some kind of quality metrics which are extremely hard to get in a decentralized way. Or, people will lose even more money than they already have. There've been so many hacks all the time and that obviously is a red flag which also triggers a lot of the behavior we're currently experiencing with some of the regulators.

When they are seeing pretty much on a daily basis that some protocol has been hacked and somebody is complaining that they lost a lot of funds then this is the reaction. From the regulators who might not necessarily really understand the space and see the innovative part. They might just have a mandate to protect consumers, for example, and then obviously they will start knocking on the door.

CR: It's true. This is happening and I'm guilty of it because I'm not technical, so when I go to use a DeFi protocol I don't have the skill or the time. And if I don't, then imagine I run a DeFi information platform, when I'm just depositing something on Aave I'm not looking into the contract and seeing how that interest is made and all the intricacies.

So, a regular user won't do that either, so what do you think is a good solution for that, to become a more knowledgeable user?

FS: In the perfect world, everyone would just have the infinite time essentially to educate themselves and look into it. That's certainly not going to happen and it's also not efficient from an economics point of view.

I'm not sure whether I like it, but I have a hypothesis on the direction we're heading and I think we will see fewer and fewer people interacting with the protocols, the contracts, directly.

I think we will probably move towards the future where there will be more institutions coming into the space and people can just access these protocols through their online banking platforms and so on, so it's integrated and then you have some form of quality control which may or may not work.

But again, you could say that it's not that different from what we have today, but I completely disagree. I think there is a huge difference and the difference is that you have options. Even if most people would go through a commercial bank, they always have the option to use these protocols directly to engage with the smart contracts directly. And that's a super powerful thing.

CR: Do you think that in the future people would still be able to interact with DeFi in a non-custodial way? So maybe there's some intermediary interface that's doing all the security guarantees and checks. And provides an interface so that people can still access these interfaces in a non-custodial way?

FS: I hope so. I mean, that's essentially what I'm trying to fight for, as well from a technological point of view. Absolutely, there is no reason why that should not be the case. I think the danger is from a regulatory perspective that policymakers and regulators might step in and say you know there are these two different versions of DeFi. You have true DeFi where you have protocols which are statically deployed, no one has the control over, but hence you also have no KYC and AML.

Obviously, you can use that from a technological point of view. But if you do so, then good luck getting your funds with a commercial bank, for example, or exchanging them. So, that's essentially money you are forced to hide, right? And you cannot get in circulation with commercial banks or use for something in a traditional system. That would be a really really bad decision.

The other part would be something you could refer to as on-chain CeFi. Really, these are regulated protocols where you also have KYC contracts and white lists where the institutions connect to. This will definitely happen. In some cases, we already have been witnessing that with all the Arc as an example, but I really hope that the first part, so that the former will not disappear, and that regulators have to understand the benefits of having this independent infrastructure.

Having these open protocols, and that it's not always a bad thing when you have something running independently that also has a lot of beneficial properties. That's something I try to educate these policymakers on and I'm fighting for.

Common Misconceptions

CR: What are the most common misconceptions that you're seeing that regulators have?

FS: The one I run into in every single meeting is the Uniswap example I just mentioned where they don't understand that there is a difference between the protocol and the user interface of the website.

In many cases, and again, this is not true for all regulators. There are some regulators who do an excellent job and really educate themselves in the space. But unfortunately, for most regulators, they don't necessarily understand even the basics of public blockchains and smart contracts.

And then they have the wildest ideas like taking a statically deployed protocol and just introducing some KYC component in that and why it's important. In some cases, it's really really annoying to be honest. Also, the misconception that they think that smart contracts are legal contracts and really really think it's just something some legal terms you put on the blockchain, essentially.

So, there are lots of wild things. But again, my favorite one is the Uniswap example.

CR: Right. So confusing the protocol with the interface. What do you think regulators are scared of?

FS: Decentralization. I think you cannot blame them to some extent. It's giving up control and something.

I dislike about parts of the crypto community is that we have this really bad idea of regulators and policymakers as bad guys, right? As some almost like dictators and the enemies we are fighting against. And yes, sure, there certainly are bad people with regulators as there are bad people pretty much in any profession, but it's certainly not all of them, I think most regulators.

They are just really stuck in their world and they are stuck with their goals right? And then you know their number one priority. Basically, the incentives they have is to crack down on money laundering and to make sure that financial markets get transparent.

So, it's hard for them to understand some of the benefits. This might also be because they're really focused on just this one task. You know, is crypto being used to finance terrorists, or is it used by Russian oligarchs or money laundering and you name it.

But then again, in some cases or in most cases, they miss a bigger picture. You look at public blockchains that it's extremely transparent, that it's independent, in the sense that it also fosters financial inclusion, that there is a lot of equal access to it, that you know when you have an independent protocol running. There is no custodian you have to regulate. So some of these regulations might not even be necessary.

And I think these are the things we have to highlight. These are the things we have to explain because essentially that's also part of their goal and it might help them to appreciate this technology and really understand what it's all about.

I have seen some really exciting transformations with some of the regulators. Just a few years back, they have been the biggest opponents of this technology and just stated all the time that it's the biggest scam ever. And now they are starting to cross and understand what it's all about and why at least parts of it are exciting.

I think that's the goal.

CR: Can you give us some examples of people who have crossed over?

FS: No, I cannot do that. But there are a lot of them.

CR: That's good to hear.

FS: And that's another point, because that's also important to understand. You know, you have a tendency to talk about these institutions as if they are just this homogeneous group of people. But I think we should also be aware, within every single one of these institutions there are different people with different opinions.

And then, of course, there is the one public, the official opinion of that institution, which will be in line with some of the opinions within that institution but certainly not with all of them. So even if you have an institution that might seem completely against crypto and is issuing, some statements which might seem ridiculous, you have to be aware that within these institutions there are people that might actually appreciate the technology. They appreciate crypto and see some of the benefits.

CR: Maybe the goal would be to at least convince one person in each institution so that they can become advocates for this technology. Like an inside spy. Oh sorry, not a spy.

FS: I wouldn't call it a spy, but I completely agree with you. I think it's super important because, in some cases, it really seems like we're talking a different language. I mean, you have people from the outside trying to explain the benefits, they may not use the right words to convince people within an institution whereas when there is somebody from within the institution who knows the background, the internal politics, who knows pretty much everything about the institution and its history.

Then, this person might have a much easier chance to convince the people. So I think you're completely right? And that's super important and the good news is that I'm not aware of any institutions where there is no one at least interested in public blockchains and acknowledging some of the benefits.

Regulation Should Only Happen at On/Off Ramp Level

CR: So that's great to hear. You mentioned that one of the main focus areas or goals for regulators is to stop money laundering. And also you mentioned the benefit that public blockchains bring to this goal which is the fact that everything is transparent, on-chain, and immutable.

But we see regulators trying to fit old ways of achieving this goal into this new technology, right? So, doing KYC/AML in decentralized applications where it's simply impossible to do. I don't know one example of how this is being done, what do you think is the more effective regulation?

How can these goals be met more effectively using the technology itself?

FS: I always say regulate on and off-ramps. Basically, when you go through a centralized exchange. Let's say to a commercial bank whenever you buy crypto, whenever you sell crypto, for fiat assets then that should be absolutely regulated because of money laundering, but also to have some control of shock propagation, for example.

But within the system, again I came up with my Uniswap example, which doesn't make any sense. I mean I've heard policymakers suggesting that anyone swapping or providing liquidity should be looked at as a contractual party and should be regulated as such.

And then you must have measures in place. Personally, I think even there when you're providing liquidity, let's say to Uniswap and then you have some profits. As long as you can show where the funds came from and you can do that because it's a public blockchain, as long as you can make the case that it's a legitimate source, and you can provide the entire transaction trail to your commercial bank.

That's a lot more than what you usually can do within the financial system. I mean that's another issue I have in these talks when regulators make it seem as if everything would be fine in traditional finance and that there is no money laundering whatsoever just because it's centralized.

It's simply not true. I mean, public blockchains are some of the most transparent systems we have. In fact, I always say that the number one problem of public blockchains is that they are too transparent which is also an issue and I think that's a big issue we have to deal with at some point.

But it's certainly not that it's a good technology for hiding your transactions. I mean, that's simply not true and there is so much misinformation, especially in the mainstream media when you talk to journalists but also in these conversations with regulators.

For some reason, the image of crypto is for bad actors and for people who are trying to hide stuff that got stuck in the public opinion and that's something I hope will change soon.

CR: What about a future where more economic activity can be done on-chain and that maybe people who are using crypto for money laundering or illicit activities don't even need to use an on or off-ramp? How could you regulate this space then?

FS: Even then, when you're accepting a lot of cash, let's say for whatever service. So let's say, somebody buys a car, and then they pay in cash, you are subject to money laundering law. Above a certain amount, you have to ask them and make sure where the money came from. If you're not doing that, then you will have a hard time using it later on.

Even if you have a completely decentralized infrastructure, businesses will always be regulated. They always have to file the taxes, they always have to report. So there is no reason to assume why this shouldn't be the case with crypto and I also think just as most businesses will not hide their cash balances I think there is no reason to assume that most businesses will try to hide crypto balances.

I mean, when it's easy enough and when you have a reasonable taxation system and so on. I think most people will actually do so, so what would happen in that case when I assume that a lot of the economic activity would be entirely on-chain is that you would just start to regulate some of these businesses which accept the crypto payments.

You know, when we talk about money laundering then we're not talking about $10 here or $5 there. That's really peanuts, right? That's not a lot of money when we talk about money laundering. It's rather large amounts and you will have a really hard time going undetected with large amounts.

Especially when your counterparty is the one who is accepting the crypto has a really strong incentive to ask you where the money came from because they are well aware that, otherwise, they will not be able to use it because their counterparty, later on, will ask the same questions, right?

But I think that's the future we're heading for if there is a lot of activity on-chain. But, honestly, I don't think that's where we're going. This might be disappointing and might be highly controversial and the unpopular opinion. But I think we're heading in the opposite direction. I think end-users at some point will either use rollups layer 2s, or go through institutions.

But I don't necessarily see a future where retail customers or just ordinary users are engaging with the base layer, the blockchain itself. They have the option. Again, that's important, but they will not do so in most cases.

CR: But even if they use a rollup to me that's still very close to interacting with mainnet. You're just using a scaling solution, but, in the end, you can still use these applications in a non-custodial way and interact with dApps in a very similar way that you would do mainnet.

I mean, the difference is that you have to go through these withdrawal bridges and the different processes that you need to do to actually get your funds on Mainnet. Other than that, I think that's pretty close, right?

FS: Oh, you're absolutely right. There's a big difference between these two cases and I think it will be a mix of the two, right? There will be some people who appreciate self custodial option and they will go through these layer 2 solutions where they still have self-custody.

But there will also be a lot of people who don't care about this at all and they will just go through their commercial banks or whatever company that will provide these services. And again, I don't think we have to force self-custody on people. I think there are really good reasons and it's usually a good decision to go with a self-custodial approach.

But if people don't want to do that because they don't necessarily have the knowledge of how to secure their keys properly, it's okay if they go for service providers. As long as there are options. Well again, what I really dislike is when we are forced into an infrastructure where you don't have this option.

But when the option is there, it's perfectly fine and everyone should be able to decide for themselves if they want to do that themselves or go through a service provider.

Ideal Regulatory Framework Ditches Consumer Protection

CR: Yeah, I totally agree. If you had a magic wand and could create your ideal regulatory framework, what would that look like?

FS: Completely forget about consumer protection, just issue a warning. It's your funds. You can do whatever you want. You have to be aware that there's some risk. I think it's absolutely ridiculous what's going on in some cases with consumer protection where regulators are telling people what they can invest in and what they cannot invest in.

So that would be my number one priority, and then just take a reasonable approach with public blockchain regulation. Don't just apply all laws and destroy all of the innovation. Don't create some random terms like unhosted wallet, for example, which is just a wallet, right? It's completely ridiculous.

And acknowledge that the innovation is that you can have sole custody over your assets. I think that's my number one priority.

CR: When you were talking about consumer protection I remembered the recent Uniswap lawsuit. I'm sure you saw that? tokens.

FS: Did you look at the amounts? Yeah.

CR: And the tokens. It's like, okay, you're investing in EthMAX and I don't know what else, and then complaining.

FS: I mean, I probably shouldn't laugh, right? But still, I think it's ridiculous to be quite honest. Especially because it's so obvious that it's not about the protocol right? Even if they would succeed with that lawsuit.

It wouldn't change anything about Uniswap, right? Yeah, maybe some of these VCs will pay some money. Maybe the more centralized parts of the setup of Uniswap would disappear, but the protocol would still be up and running. It wouldn't change anything and they wouldn't change the fact that when you have a completely decentralized infrastructure there will also be some scams listed on there, right?

It's not for them to decide, and they cannot do anything about it. So yeah, and also when you look at the amounts it seems somewhat unreasonable when you have, I think it's in some cases ninety bucks here and then maybe a few hundred bucks there, when you think about what it actually costs to start a lawsuit like that.

Um, it's just in no relation and, yeah, it's ridiculous.

CR: Yeah, to me, it's the idea of not taking responsibility for your actions. It's tough because it does require an entire shift.

FS: Absolutely.

CR: Mentality shift, both in taking responsibility for your assets with self custody, and with that comes taking responsibility for your actions, right? If you're buying these tokens, you're asking for SEC-type filing.

But there's still public information out there. You can still go and look at their websites and look at their teams behind them. There is public information to do your own research.

FS: And even if they don't like it, the code is up and running, it's famous and you have a protocol that's statically deployed. Nothing's going to change that, right? It's just there and they will be running forever, and I think that's something regulators have to get comfortable with.

And, regarding the other point, I completely agree. I always say, the best thing about crypto is that you have self-custody if you really want it and you don't have to ask anyone for permission and you can really do whatever you want, and in some cases, the worst thing about crypto is, you're completely self-responsible because you have self-custody, right?

And then when something happens, there is no relationship manager or somebody you can complain to. It's just your own fault. That's just when people do that. They're losing some money and then they blame decentralized protocol. I don't understand that.

Risks of Re-wrapping Tokens

CR: Yeah, no, it's ridiculous. Changing shifts a little bit, I wanted to touch on your latest, or one of your latest papers on the creeping complexities in DeFi. And what does that imply for the overall system? You talk about the wrapping and rewrapping of tokens and I think that's interesting.

I've been covering the space since 2019 where it was basically Maker, Aave, and Compound. And then it's slowly, or not so slowly, in the past couple of years has become massively complex.

There's tons of innovation and tons of opportunity with that. But I think it also comes with a lot of risk. We would love to hear your thoughts. What are these kinds of derivatives like? What impact that's having in DeFi?

FS: The paper you're referring to is joint work with [ineligible]. He's a really talented Ph.D. student at the University of Basel and what we did in that paper is essentially what we wanted to get two things.

Number one, we wanted to see when you look at these governance tokens how well distributed they really are. There are these studies where they essentially just look at the ERC-20 token contract and then they say things like, okay, the top 5 holders hold 80% of all the tokens and then they say it's heavily centralized.

But when you look at it, these top 5 holders essentially are contracts themselves and there might be a liquidity pool where you obviously have to look at the individual holders of the liquidity pool owners of the liquidity pool, and so on.

So what we did in the paper, as a first step, was essentially look at the reallocation of these tokens, so we started up with the ERC0-20 token contract, the holder table. But then when the holder was another contract then reallocate these funds to the next level, and then there might be some other contracts.

We reallocate them to the next level and so on and so on until we ended up with the real holder addresses. That was the initial idea. But then we found out that there is something much more interesting and that's what you asked the question. It's the rewrapping right? And in economics, we call that the rehypothecation of collaterals, or the idea that you have some base asset and it gets wrapped and wrapped and wrapped and wrapped again and we see something similar in DeFi.

It was just ridiculous for some of these tokens. How many times they have been locked up in a contract and you have some new asset that gets issued in USD. It also gets locked up in another contract and so on and so on, and this heavily explodes at some point.

And you had for some of these tokens average factors of 5 for example, which means every single one of these tokens has been rewrapped 5 times, which is exciting but also extremely, something we should be afraid of in terms of the complexity you mentioned.

And I later also wrote a companion piece for CoinDesk where I said that DeFi might not be as transparent in terms of data as we think. Yes, it's true, the data is there and that's exciting and that's great. But in many cases, it's super hard to make sense of that data. Many cases you have to manually analyze these protocols to understand where it's going and it's not just that easy.

I think the bigger picture, the second most exciting thing about DeFi just below self custodial features, which is composability, also has a dark side. I call it the dark side of composability. When things get too complex, there is a lot of risk associated.

For example, when you have this wrapping complexity where you have a token on top of a token of a token, it's really hard to keep track of the inherent risk you might assume when you buy one of these tokens just because it has been rewrapped and there is some promise that has some dependency on another protocol.

And there we have not even talked about things like oracle dependencies or the reuse of the code-base. When you look at the smart contracts, it's just ridiculous how some code snippets have been used and used and used again. In some cases, you even find comments from a completely unrelated protocol and some of the depths from a completely unrelated protocol in a new one.

I think there is a lot of risk with composability, to be honest, and that's something we certainly look into as research-wise.

CR: That's so interesting. How? big do you think the problem is? This must be really hard to say, but in orders of magnitude within the assets in DeFi. What percentage do you think has been rewrapped in tokens?

FS: In numbers, I really cannot say that right because it also depends a lot on what exactly you count? One thing we can say for sure is that the total value locked is hugely inflated. Because of that, there's a false impression.

But then again we have to be really careful that we don't frame this as a problem that's specific to DeFi. That's something that has been going on in traditional finance for a really long time with the difference that you cannot observe it as perfectly because it happens on all kinds of different ledgers and all kinds of different core banking systems and infrastructure.

The difference here in DeFi, even though it might be really hard to make sense of that data, is that it's all there, and it can be analyzed by researchers like us or some researching companies.

And I think that's the positive news. Honestly, I still think even though there are a lot of positives, we have to get better at analyzing this stuff. There have to be some metrics except for TVL.

There have to be some alert systems and observation metrics you put in place and we have to make sure that we understand what's going on also in terms of this interplay between these different protocols and the composability. And in many cases, that's just not the case.

CR: Yeah, do you think when a token is rewrapped 5 times, does that mean that the n asset takes on the risk of all the previous 5 layers? Does it take on 5 additional layers of risk, or it's not that simple?

FS: Every minute' locked up when you have, let's say a base asset and then the base asset is locked in a small contract, and the next one is. Well, in most cases, yes. Of course, then it depends on the exact setup, right? when.

That's one of the cases where some centralized control might actually come in handy because when one of these intermediate protocols can just pause the protocol, then you may not lose it entirely.

But when we assume that we are talking about statically deployed protocols, so true DeFi, then yes, of course. Then you would have loudly locked it up and locked it up and locked it up again and assumed all of the risk.

In some cases, if I can add something, it's not just that it gets really complex when you have these tokens wrapped and wrapped again. In some cases, when you look at really complex protocols like Maker, I would even go as far as saying that there aren't too many people who understand just this one protocol.

In some cases, it is absolutely ridiculous when you look at the codebase and the abbreviations they use, the special terms they use, and the interplay between these very small contracts. It's extremely hard to understand even when you're full-time in the space.

And then you're analyzing these contracts and that's just the single protocol. And then when you have the entire composability, then, of course, things get even more complex.

CR: So maybe there should be some sort of code standards used in DeFi that everyone should be using the same terms for things. If there's composability but everyone is using different terms then the code is not as composable because it doesn't fit very well with other things.

FS: I mean, it has pros and cons, right? I think it would help when it's at least understandable and when it's well-documented. And that's not always the case. In many cases for DeFi protocols, because they go through such rapid development cycles.

You will find that the documentation is outdated, that it's not referencing the newest version of the protocol, and so on. I think that's probably something we can get better with then I hope that there will be more companies who provide data, research DeFi.

Honestly, I think that's a huge business and basically, analyze these different protocols and then one thing that's super annoying for researchers is that, in some cases, the events are not standardized at all and just somewhat ridiculous.

The events, essentially it's like a lock for smart contracts and something you also heavily rely on in some cases for data analysis. And they are just extremely different approaches to these events.

And that's something where standardization to some extent would certainly help.

CR: Yeah, it's mind-blowing. It's a mind-blowing space, and just to wrap up on that point. Just to bring it down to reality a little bit.

If you can provide an example to help understand why exactly are people wrapping these tokens? What's the use case for this composability and for rewrapping assets?

FS: Well, you can take a really simple example where you say, okay, we have all kinds of different assets. But at the end of the day we want to have something that resembles a mutual fund and we want it to be represented by a single token.

And then you take these different assets, let's call them token A, token B and token C, lock them up in a smart contract, and the smart contract issues a fund token. Then, you have a first wrapping, call it that way, and then this fund token could be used on a decentralized exchange.

So maybe you're providing some liquidity. Alongside with another token and then you get a liquidity provision token and with that liquidity provision token you could use it as collateral in another protocol, or you name it.

But there are really many examples of these several steps of rewrappings. And usually, the way you represent ownership whenever you lock something up in a smart contract, whenever you lock a token, not a smart contract, is represented by a new token that it gets issued by that smart contract and that's the case.

CR: And that's what kind of makes the space. So exciting in part, right? It's like you get these new types of assets that we had never seen before that represent deposits or liquidity.

FS: Absolutely, yeah.

CR: And then capital becomes really efficient because you can use that again somewhere else. But as you said, the downside is you start layering risk upon risk. And then who knows what a black swan event, systemic crash looks like when everything is so tight together.

FS: Absolutely, it's the money legos right? It's super exciting because people can build other protocols. But of course, you're also adding dependencies when you build a protocol on top of another protocol and the same is true for these tokens.

CR: Yeah, great. I think we should be wrapping up. I'd love to ask you a flagship question for the DeFiant podcast which is, Fabian, what makes you Defiant?

FS: I think the interdisciplinary approach. I sometimes feel a little bit like an outsider among economists. But I also feel like an outsider among parts of the crypto community and they try to tackle it from very different perspectives.

And also to connect people, you mentioned the BIS conference. I think the great part about that conference was that you had people from central banks talking to people from the crypto space and that's something that does not happen every single day.

And I think it's super important. What makes me DeFiant, at the end of the day, the idea of self-custody is the most important principle and that it's something I'm fighting for. Something I really want people to understand, and also show them the benefits of it.

CR: Awesome, I love that. Fabian, I know that you have great resources that everyone listening would love to take advantage of, so I'll let you share.

FS: Oh, thank you very much. We have been offering blockchain courses at the University Of Basel for a really long time and we decided a little over a year ago to make it completely open access open source with a creative commons license.

And you can find our blockchain classes, also specific courses just in small contract programming and DeFi protocols on cryptolectures.io. As I said, it's completely free of charge. No strings attached and you can even reuse the material.

CR: That's awesome. So it's free courses on crypto blockchain, DeFi specifically. Is it like programming courses or more theoretical or both?

FS: Both. For the smart contracts in decentralized finance course we start with an introduction to Solidity. We get a chance to develop your own protocols. But then we also tackle specific topics like decentralized exchanges, like lending protocols. We have a detailed look at tokens, different kinds. So it's really a mixed interdisciplinary approach between economics and computer science.

CR:That sounds super interesting. Can you share the link?

FS: CryptoLectures.io

CR: CryptoLectures.io. I might do some of those courses myself. I don't have to rely on others and can start taking on the smart contracts myself. Awesome, Fabian. Thank you so much for joining me. This was amazing. Super interesting.

FS: Sounds good. Thank you very much for the invitation, Camila.