Building the Financial System You Want to See w/ Dion Chu (Term Finance)

**Speaker A:** Foreign. **Speaker B:** Welcome back to the Strange Water podcast. I'm your host, Rex, also known as Haim Salomon or Salomon Crypto. Thank you so much for joining me for our second episode. As previously discussed, I am a die hard believer in Ethereum. I have my own personal journey that transformed me into a believer. But that's a story for another time. Here's what I'll say. It's incredibly specific to my life experiences. The deeper I get involved with this community, the more I realize that everyone's journey is incredibly specific to their life experiences. I mean, I guess you don't find yourself outside of the global financial system without a good story. Today's conversation is with someone with a particularly good story. Not only because of the person it has made him into today, but because it gives him the tools and the knowledge needed to create the financial primitives that Defi needs in order to become stable and scalable. Here's all the background context you need. Fixed income is an incredibly important asset class, far larger than the equity or the stock market. And fixed income basically does not exist on chain. And so, without further ado, let me introduce you to Dion Chu, the founder of Term Finance, for a fascinating conversation of the future of bonds on chain. One final note, please don't take financial advice from this or any podcast. Ethereum and decentralized finance will change the world, but you can easily lose all your money on the journey there. And with that, once again, thank you so much for joining us and I hope you enjoy the podcast. Today we have a very a conversation that I'm very excited about with Dion Chu, the founder of Term Finance. So Dion, thank you so much for joining us. Super excited to talk. **Speaker A:** Yeah, thanks for having me. I'm super happy and excited to be part of your podcast. **Speaker B:** Well, thank you, thank you. So I think kind of before we go to Gigabrain and start talking about like this like super dynamic, like changing world that like we're in and we're helping build. Like I'd love to get like a deeper understanding of your background. **Speaker A:** Sure. So I started my career at hedge fund in New York. De Shaw was there for, you know, a year and a half, but was interested in public policy, so decided to joined the Federal Reserve Board of governors in D.C. and was there from 2007 to 2009, sort of bracketing the financial crisis. **Speaker B:** 2007 to 2009 is probably the most interesting time on this planet to be at the Fed. So we will definitely be circling back to that. What were like the biggest Takeaways that you found or learned when you're working at, like, the Fed and these, like, super institutional businesses? **Speaker A:** Yeah, for sure. I mean, I think one key thing is starting my career in 2006. You know, the entire, you know, two thirds of my career has been centered and focused on financial instability. Right. Start a career into one of the largest financial crises in modern history. You know, even while I was at D. Shaw, there was the first signs, you know, of trouble brewing. And there were some of these. They call it the kerfuffle, where you had some quant funds, you know, entering into statistical arbitrage strategies that led to some, you know, short term, you know, liquidation crunch in the market. And then by the time I got to the Fed, you know, things started to pick up full steam. And so, you know, really early on, the importance of, you know, financial stability, paying attention to liquidity, you know, it's kind of, like, etched into my mind. And I think that's something that is starting to rear its head again. But. But, yeah, I think my whole career has been about, okay, how do we create financial systems that are stable and robust? And also always being cognizant that, you know, there's a very thin line between stability and crisis. So, you know, I think that's a really important part of sort of my career path. **Speaker B:** Let's talk about crypto. So just tell us about the story about how you went from like, managing macro stability to, like, the most unstable, like, but most, like, energetic place that finance is right now. **Speaker A:** Yeah. So, you know, kind of stepping back. My intro to crypto. Crypto story is I got into Bitcoin in 2012, so it was actually a good friend of mine from law school. You know, he was cs, major undergrad, so had been mining bitcoin sort of in his closet. And it was like, my 30th birthday showed up. You know, he's breaking popping magnums of champagne. I'm like, yo, it's cool. You don't have to do all this. And he's like, oh, it's all good. It's bitcoin money. And that's the first time bitcoin hit a thousand. So that was like a big deal at the time, you know. So anyway, obviously not long thereafter, it went back down, ultimately getting as low as thinking the 2002. But he had said, like, look, just buy some every month. It's like, like, coffee money either works out or whatever. You don't lose too much. So, you know, I took the advice and bought into bitcoin. But it's for a very long time, very much a bitcoin maxi. So I didn't touch anything else, you know, missed or avoided the ICO boom, depending on how you look at it. It's kind of like off my radar for, for some time. And then, yeah, this was around, you know, around the pandemic. Interest rates were really low. Right. Essentially zero. And a friend for mine visit, friend of mine visited from out of town, you know, he was deep in the crypto space, started, you know, talking about different altcoins, started looking on to bringing tokens on chain, which is something I hadn't done before. **Speaker B:** Right. **Speaker A:** Bitcoin was just something you held and didn't do anything with. So that was interesting, like bridging or taking tokens off exchange onto the blockchain. Discovering this entire world or ecosystem where you can swap tokens, you can borrow and lend, you do yield farming. And the yields at the time were quite high. We're talking about double digit yields even among some of the safer protocols. So just kind of comparing those yields to what was available in tradfi, which is essentially zero, was something worth looking into. So that sort of kick started my rediscovery of the crypto space. **Speaker B:** Yeah, that's awesome, man. 2012 miner. That's. Wow. I'm impressed. I'm impressed not only that you found it that early, but that you weren't scared away and all of the downturns. Um, so first of all, like, so excited that you're here and that you found Ethereum and now are like, are ready to build on it. But I guess if once you hear your story, the, the path to term finance is like pretty straightforward and pretty clear. Right. Because it sounds like you entered this space like specifically like looking for yields that were higher than what you could find in the real world and then immediately found them and then probably immediately realize that like they could be gone tomorrow. **Speaker A:** Yeah, that's a huge part. Absolutely. That's a huge part of it. You know, I think another part of the story is part of that journey into rediscovering crypto. Started advising for various projects. Some of us work both on the NFT side and on the defi side. And one of those roles, I served as a Dow Treasury Manager. There's significant operating capital that needed to be managed, you know, in a safe and conservative manner. And when trying to kind of perform the duties of that role, one thing that jumped out at me almost immediately was a lack of fixed income product defi. Right. So as a former bond trader Fixed income, it's what I know very well. It's one of the largest financial markets in the world. **Speaker B:** You know, actually, can we dig into that a little bit? I think like, for, for people that came to this space from tradfire traditional business, like, it makes sense why fixed income is so important. But like, do you have any thoughts on like, number one, why it's so important to like building strong financial systems and two, like, why up until today, like, we really don't see it existing at scale? **Speaker A:** Yeah, I mean, I think it's not exactly accurate to say that it doesn't exist. It was actually quite large in cefi. So Galaxy Digital and Genesis, they had major OTC lending books that were on a fixed rate basis. If you look back at Q2 of last year, I think Genesis originated over 40 billion in a single quarter and Galaxy Digital, you know, similar, similar origination size. So it is a massive market. It was just happening off chain, on chain. It was also. There were also some early attempts, some projects are still around, but the mechanisms weren't particularly scalable. And given how efficient CEFI market was, there wasn't really much of a need to necessarily have it in DeFi. I think recent events have made the need for doing it in defi a lot stronger. It's a much stronger case for it now because people are starting to realize a counterparty risk is something that the blockchain was originally designed for and hadn't really been used. Now people are, you know, suffering from the consequences of relying on third party custodians. So, you know, there should be some tailwind now towards trying to move that market, you know, onto blockchain. **Speaker B:** Yeah, no, that makes a lot of sense. And I, you know, now that you say it, it's like, how could I have missed this? But like, obviously, you know, Genesis and like the centralized lenders, like were like such an enormous business that they might have been like the whole market for a while. And you're totally right that it's not even that the opportunity is there. It's the opportunity has been proven out. The only question is how do we take that activity off chain and put it on chain? And so with that, I guess now finally my question for you is, Dion, would you give us the elevator pitch for term Finance? **Speaker A:** Yeah, I think to really understand term Finance, we first have to see how the existing DeFi protocols address it. All of the existing protocols in the fixed rate barn and lending space rely on AMM mechanisms. And these AMMs require that LPs deposit idle capital that sits in the pool, essentially waiting for bars to show up and perform a transaction in between. It generates no revenue. So the average real return to LPs is about half a percent a year. This is not including liquidity incentives, just the real return. Then on the borrowing side, the way they typically work is a borrower is asked to deposit collateral into a smart contract. But rather than getting loan proceeds from that transaction, all they get are ERC20 tokens that the borrower is then required to take the additional step of selling into the AMM in order to realize their loan proceeds. So it's a two step process and in that second step they incur significant slippage through the deccs. **Speaker B:** We unpack that a little. **Speaker A:** Basically, the receipt token, when you deposited collateral, what you do is you mint both. You know, you have your asset, your collateral receipt, that's your asset, and you're also minting a liability. But because you hold both the asset and liability, it kind of just zeros out. If you want to actually turn that liability into, you know, usable funds, then what you can do as a borrower, sell that liability into the pool and then retrieve your stable coin liquidity. **Speaker B:** Got it. So what you're saying is that no matter what, that includes like an additional cost on the borrower via slippage because like you have this like extra trading or AMM step in there, like no matter what. **Speaker A:** That's right. The only way you're going to turn that, you know, token into a loan proceeds is by going through the amm. **Speaker B:** Got it. Okay. All right. And that's, that is, yeah, super clear on why that's a problem. Definitely for the borrower and possibly, possibly for the lender or at the end of the day, the slippage is always like two sides of a coin. Right? Somebody is losing and somebody's gaining. And so does this model end up benefiting the protocol? **Speaker A:** Not really. So from the protocol's perspective, the way it works is because they funnel all loan origination through their amm. The total amount of loans they can originate or accommodate at any point in time is capped at 50% of the TVO in their pools. Right. That's the component of the pools that are actually stablecoins. So the idea is you can't take out more than what is already in the pool. Though in reality, given the way the constant product function works for the pricing on the dax, the amount of liquidity available at sort of the market rate is far lower than that 50% number. So in practice, if you go in and try to take out 2 or 3 million as a borrower from a pool, the interest rate is going to go from, say, 4 to 6 or 7%. **Speaker B:** Got it. And in this case, the interest rate is really just like a virtual thing that we're using to think about it. Where it's actually manifesting is in that slippage when you dump your liability token. **Speaker A:** Exactly. You're selling it at, you know, 94 cents on the dollar instead of 96 cents on the dollar. **Speaker B:** Got it. Okay. Super clear. Super clear. **Speaker A:** And then all this works together in a vicious cycle. Right. Because the slippage is so high, there is low utilization. Low utilization means low transaction fees for LPs causing LPs to withdraw capital because they're not earning a sufficient rate of return, which in turn makes the slippage problem, you know, even worse. So you kind of have like this negative flywheel effect where it's very hard to like reach a tipping point. **Speaker B:** All right, so that, that's the problem with fixed rate lending as it exists today. **Speaker A:** Yeah, it's just not scalable and it's very capital inefficient, both for the LPS and for the bars. My insight from being a former bond trader was, look, we need to separate the matching and issuance of these loans, the loan origination, from the secondary market trading. So the primary versus secondary markets, DEXs were designed for trading volume on the margin of tokens already issued. They're not meant for doing ICOs. So, you know, I think by separating those two functions, we can get a more efficient outcome. **Speaker B:** Ah. And so what you're saying, you're saying an ICO is akin to loan original. An ICO is akin to loan origination, which is not appropriate for dex. **Speaker A:** Right. If you want to match large volumes of borrowers and lenders, you know, DAX isn't the best way to do that. **Speaker B:** Got it. **Speaker A:** Okay. **Speaker B:** Yeah. That follows. Yeah. **Speaker A:** So, you know, thinking back to my days as a government bond trader must have participated in hundreds of US government bond auctions. Every G7 country to this day still issues bonds in the first instance through an auction process. So, you know, what we decided to build was an on chain auction that allows us to match borrowers and lenders and use the auction mechanism to determine the fixed rate that comes out of the process. **Speaker B:** Okay, so an auction meth. Sorry, an auction dynamic in loans. I'm guessing what that means is that like people who borrowers put their requested capital and the amount that they're willing to pay their interest rate out into the the marketplace. The lenders do the Same thing. They say, this is the amount of capital I have that willing to lend, and this is the interest rate I'm willing to lend it at. And then Term Finance is a, like a clearing protocol that matches up like these out these loan requests with these like potential loans. Is that right? **Speaker A:** Yeah, that's right. So basic idea is, you know, the auction will typically be open for a period of 12 to 24 hours and borrowers and lenders will be able to come in and submit tenders, so bids and offers to borrow or lend. As a lender, you can specify how much you'd like to lend and what the minimum interest rate you would require in order to do so. Borrowers would specify how much you're looking to borrow and specify what is the maximum interest rate they're willing to pay up to in order to receive the loan. And at the end of the auction, the smart contracts will determine a market clearing rate where any borrower willing to pay at or above that rate would receive a loan. And any lender willing to lend at or below that rate would make a loan. And in both cases they would transact at the market clearing rate. So at the conclusion of the auction, the borrowers will receive their loan proceeds directly from the protocol and lenders will receive ERC20 tokens. We call them term repo tokens. They're essentially receipts, receipt tokens that the lender will be able to use to redeem for principal plus interest at maturity. And these tokens will be normalized to redeem one for one for the underlying loan token so that, you know, in secondary markets they might trade like discount notes at some fraction of par, converging to par as you get closer to the maturity date. And the idea is that at steady state, we will have tokens for every week, every month, going out to one year. So that when you open up Masari or wherever you go for your crypto data, the first thing you'll see is the term finance yield curve. And this would form the basis of sort of a DEFI benchmark yield curve for the DEFI ecosystem. I think another unique feature of the way our, our SMART contracts are set up is that unlike Compound Innovate, where they have one single large commingled pool of collateral assets, our collateral assets are segregated by maturity. So you know, each token with different maturity, each loan would have its own separate pool so that you don't kind of put all your eggs in one basket. And the idea is that, you know, if there is a secondary market for these tokens, they would Trade, you know, at a discount to par and converge to one as it gets closer to the maturity date. And theoretically there should be buyers because it's, you know, fully collateralized over collateralized in fact by, you know, blue chip collateral tokens. **Speaker B:** So that's super interesting. What you're essentially saying is that like term finance is kind of backdooring into like, I don't know if you're going to take offense to this, but like minting synthetic tokens against like whatever collateral you accept. **Speaker A:** Yeah, you can call them like claims or you know, discount notes. It's very similar to, it's very similar to like a principal token that you see on, you know, some of the strip protocols that are going to be backed by the collateral pool that sits behind it. **Speaker B:** Before we continue, let's just real briefly for people who are following along at home, would you mind describing like what, how these strip protocols work? **Speaker A:** Yeah. So with the standard strip protocol, I think element is one of the, you know, larger or leading protocols in that space. What they do is they'll take an interest bearing asset which in defi currently are primarily floating rate assets that come out of, you know, AVE or compound, so AUSDC or cusdc. And what they'll do is split it into a principal component and an interest rate component. So you know, you know, after a three month period you'll get your initial investment back if you put it into one of those plug in rate protocols. But you'll also earn some interest which remains undetermined. Right. You won't know until, until the end of that period. So with these strip protocols, what they're able to do is take that, a DAI or C die and split it into a principal component and an interest rate component. So in this way it allows people to trade them separately. A buyer who wants fixed rate can buy the principal, typically will sell at some discount because there is a cost to, you know, that time value of money. You're not actually able to access that USDC until the end of that, until the maturity date. And then the variable component will, you know, nobody knows exactly what it will be, but the market can express its views by trading that token around. **Speaker B:** Yeah, yeah. And so just like to put a fine point on it, like the way that these protocols work is they'll take a variable rate asset or you know, variable rate token and they'll just create two tokens. One that says you get back your original investment in X months. Right. And that's the principal token. And then you have the yield token that says whatever Your principal generated, all of the yield will go into the yield token. And so like the cool part about that is that's how you transform a variable rate product into a smaller variable rate product and then a fixed rate product. Right. Because this principal token is saying like I will give you one of your principal in X months. That's the same, that's fixed rate yield. Right. And so what Dion is saying is that when you, what did you call them? The term repo tokens are, are analogous to these principal tokens. Because when you have a term repo token, you, at the end of the time lock period, you know that the, the total amount of the proceeds which are known upfront. That's the way fixed work, Fritz, fixed rate lending works is like if you know the principal amount, you know, the interest rate amount, then you can know how much is supposed to be there at the end of the, at the end of the loan. **Speaker A:** Yeah, no, for sure. I mean if you see, you know, we call it term repo tokens because the model is largely based on repurchase agreements in tradfi. Repurchase agreements have been around for a very long time. They are typically collateralized by high grade securities like U.S. treasuries or mortgage backed securities. Repos are the way that the Federal Reserve implements monetary policy. That's how they control the money supply by taking money in or putting money out into the system. So it's a massive market. And on U.S. treasuries because, you know, they are relatively stable and backed by the full faith and credit of the U.S. government, the over collateralization rate, you can borrow $0.99 on the dollar against the U.S. treasury. So you know, normal markets, U.S. treasuries are not very exciting instruments. They do not move very much. But the way, you know, the macro hedge funds and the large banks trade, it is on a heavily levered basis. Right. So it's not uncommon to see hedge funds and banks trade bonds on like 40x leverage. So that small, you know, movement becomes quite magnified when you're trading with that, you know, that kind of, that kind of leverage in your books. And, and yeah, I mean that's what repo borrowing, collateralized barring is primarily meant for. Right. Allows people to trade large volumes without having to tie up a lot of balance sheet or capital. And the more stable the asset, the more you're able to lever it up. So as you're saying, if you're going to be using stablecoins or you know, fixed rate tokens as collateral that are over collateralized then you know, you can really get some decent leverage on that without very significant risk. You know, one example would be say you want to use ADAI or CDAI as collateral against a term loan. You won't need to put up 125% over collateralization. You might need only 1%. Or maybe it could be one to one because you feel confident that compound and AVE are steady protocols and that would allow you to kind of leverage that up quite significantly if that's what you wanted to do. **Speaker B:** I guess it would make sense to really talk specifically about the secondary market for, for the term repo token. So would you mind like talking me through how that's going to work? **Speaker A:** Yeah. So that's not something that's in our roadmap to do ourselves, but it's something that certainly would be interesting to see and how I think it would work out. I think there are a few different ways. I mean to start, remember my first MD on a trading desk taught me is there are no bad bonds, only bad prices. So you know there's going to be some price if you are holding a term repo token and you need to get out, you know, there's going to be some price that somebody is going to be willing to pay to have, you know, ability to redeem at a fixed state in the future. So you know, great to see this happen organically, let people negotiate between themselves. I think, you know, the way we see secondary market liquidity, there is no magic bullet, right? It's going to happen the way it already happens. It could be on centralized exchange, it could be through RFQ platforms where people can submit for quotes to standing market makers. Or it could happen, you know, in a defi native way through a Dex. I think one complication with fixed rate tokens is, is that they have a life cycle, right? They mature at some point and disappear. In the existing Dex ecosystem doesn't really contemplate anything but evergreen tokens. But you know, there are a lot of interesting developments coming out in the space. Balancer managed pools is a super interesting product. It's a pool that allows the deployer to change the composition of tokens that live within that pool. So it would be great to see in the future a balancer managed pool where say you had a one week token, a two week token, a three week token and a four week token. The idea is as the one week token rolls off and matures, it could be replaced with a newly auctioned four week token. What's particularly interesting about that kind of a Solution is that specifically as it applies to fixed rates, every token in that pool is interest bearing so it's not dead capital as typically the case with DAX pools. So it's almost like a money market instrument that also happens to generate transaction fees on top. So it's kind of like you know, yield plus product. It's super cool and I think would also be really appealing to, you know, passive investors who just don't want to have to deal with, you know, auctions, rebalancing their portfolio. Because that's one of the key frictions of, you know, fixed rate securities, fixed rate products, fixed rate tokens in general. You know, there's a lot of this rebalancing involved and by having that done by a manager, you can kind of simplify that process to something that you know, there's more defi. Native defi users like to just set it and forget it. **Speaker B:** I mean it occurs to me that like whether you guys ultimately like end up deciding to do this with your own treasury or somebody else decides to do this, like there is obvious there for well capitalized people who believe in like term finance, like it makes so much sense to provide liquidity for people to exit out of these, fix these like short term positions because like at the end of the day you know exactly how much you're going to get when it like comes out. And like if people want to exit, they are going to sell it to you at a discount. Like that's just how it works, you know. **Speaker A:** Yeah, no, for sure. I think that's what's great is you know, you have all these people that are great at what they do. You know, we don't need to do everything. You know, we can focus on our strength. And then people who are good at managing pool pools, people who are good at creating exchanges, they can handle that. We have a lot of asset managers in the space. **Speaker B:** Yeah. Are you familiar with Arrakis Finance? They're, they're like the spin off of Gelato Finance. **Speaker A:** No, I've never heard of them. **Speaker B:** So. So Gelato is essentially just a smart contract automating company and. Yeah, and they are like holding like, like so much of makers liquidity and DAI and like they realize that, that like the automation around uni V3 was such a compelling product that it makes sense to spin it out as like a whole new DAO or project or whatever. And they're calling it Arrakis, like Dune. **Speaker A:** Anyway, that's cool. Yeah, I should look into that. **Speaker B:** Yeah, it's very, very cool from actually you would just love it from, like, a Treasury manager's perspective because it, like, makes Uni V3 accessible. But I was just listening to them on the. They were on the Flywheel podcast this week, I think, and the way they talked about what they're building was very cool because what they essentially said is everything that is on chain, it's just basically smart contract frameworks for managing liquidity for uni V3, and anyone can use those and there's no fees and everything is totally free. But, like, in order to use those, you have to actually, like, purchase program in solidity and be on chain and, like, do stuff. There's no front end. And then so now they're going and building these front ends that, like, you know, in the same, like, kind of Oasis maker model, like, actually provide access to these primitive tools and they can charge fees at that level, but still create this, like, very credibly neutral infrastructure. And so I, I just heard that this week, and I thought that was, like, a really cool, exciting way to think about building on chain. But I don't know, I thought it was worth bringing up because it seems to, like, really resonate with the way that we're talking. **Speaker A:** Kind of like, you know, it's kind of organic and, you know, decentralized in that way where different parties will come in and take off different parts of the, you know, whole chain and. **Speaker B:** Well, yeah, and I just, you know, as I've been part of the space for like a year or two now, right, not that long, but so many, like, protocols or groups or people are trying to do, like, bonds on chain, right? Bonds on chain bonds. Like, I've. I've heard this so often, and I've seen, like, really prestigious vcs give so much money to, like, kids who have no idea what they're talking about. And, like, one of the reasons I think term is so compelling is like, yes, like, you're going to be able to build, like, this business on top of it, but, like, I just want someone who actually understands how, like, buying bonds and fixed income actually works and is supposed to work and then, like, allows that to exist on chain. And like, your point exactly about how the way fixed income works today with the. The decks, and then you have to sell your liability into the decks. And this is like, the perfect insight that, that I just, I think is, like, lacking because, like, we have so many people that just haven't had real experience in the space. So. **Speaker A:** Yeah, I don't want to, you know. You know, you flatter me. I don't Want to. I hope we're doing the right thing. We're trying our best here, but. Yeah, well, I appreciate that vote of confidence. **Speaker B:** No, man, that's like the beautiful part about Ethereum, right, Is that everyone can try their best and like do their thing and like, look, man, I hope it's going to work out for your sake and our sake and like the stability of our ecosystem sake. But like, kind of the beauty of Ethereum is like you guys are going to try it and like it's going to work or it's going to not. And like the only question is like, are you going to be able to like take the punches on the face and like continue building or not, you know, and not like, is anyone going to come in here and tell you you're not allowed to do it? And like, I mean, that's what I love about this space. **Speaker A:** Yeah, for sure. Everybody gets to try and experiment, try to create something cool. **Speaker B:** Yeah, cool. I am going to start to wrap us up right here. But thank you so much for like talking us through term and explaining to us like the protocol and like how I really do think that you guys are going to change like how fixed rate lending works on chain. But before I let you walk away, I just. We're in the middle of a banking crisis and I have someone who is at the Fed during the banking crisis. Like I got to ask, man, do you have any perspective or any hot takes about like what is going on with the economy or the banking system or like whatever we're seeing today? **Speaker A:** Yeah, no, it's really interesting because it's. In a lot of ways it's very similar to the financial crisis of 2008, 2009, but it's also different. You know, they say history never repeats itself, but it certainly rhymes. You know, what's similar between the two, I'd say are two things. I think. One thing is the market getting lulled into assuming what happened in the past will always continue into the future. With, you know, the great financial crisis centered around mortgage bonds, you know, it's based on the faulty assumption that housing prices always go up. With the more recent crisis, I think the assumption there was that government bond prices always go up. If you look back over the past 40 years since Volcker, interest rates have gone down from 18% to essentially zero, essentially monotonically for the first time now, we're seeing a pretty big regime shift where rates are starting to go back up and bonds, government bonds have taken pretty significant losses. You know, in the banks they are allowed to mark US Treasuries as held to maturity assets so they can mark them to par. When in reality government long bonds are 30 year, you know, at the trough was down 50%. I'm thinking this is a government security, government Treasury Bond down 50%. **Speaker B:** Essentially saying is that they're allowed to market as down 0%. But in actuality if they were to sell it, they would have gotten 50. **Speaker A:** It would take you know, 40 to 50% loss. **Speaker B:** Yeah. **Speaker A:** Wow. Which is unbelievable for something you think are pretty sleepy. Boring. **Speaker B:** Yeah. **Speaker A:** The problem here is that banks take deposits. Deposits are short term liabilities. Right. As a depositor I'm allowed to take out my money whenever I need it. And the idea is that they'll be able to make good on that. But the only way banks can make money is by taking these short term deposits, paying a low interest rate on it and try to attempt to lend that capital, you know, longer term at a higher interest rate. We call this the carry trade. The idea was back when interest rates were zero, they took in a lot of deposits, they paid zero interest or very little interest and they went out and bought long term Treasuries that were yielding, you know, 3, 4%. You know, I don't think they expected that rates would rise so quickly and that they'll be looking at, you know, 50% mark to market losses. But you know, as rates started to rise, you know, with the Fed raising interest rates, people started, you know, pulling out deposits, you know, investing them in money market funds yielding 3, 4, 5% now. And at some point, you know, they have to think about maybe we need to sell these bonds that we have seen on the books. And when they go to sell that, they're selling it at, you know, 50% haircut to where they're marking it. And as it became clear this was happening, you know, it's only logical for depositors to rush to the exits. Right. What is the upside if you stay in the bank? Nothing. But the downside could be that you lose everything. So when you're kind of in that kind of equilibrium, it's not logical to keep your money there. So there's a lot of news articles where people were kind of blaming the VCs, but you know, it's just game theory in that situation. Get your money out, there's no upside. It's not, they don't get you a special star for staying in the bank. You know, so, you know, this kind of liquidity crunch is kind of common across all financial crises. Right. You know, you do need to do this maturity extension to kind of profit from the carry trade. It's how the economy is able to leverage itself. It's also inherently very unstable. And that's why the Federal Reserve was created initially. Right? It was meant to be a lender of last resort. You know, when a liquidity crunch reared its head, the Fed would step in to provide some short term liquidity to try to shift that equilibrium back to a stable one where, you know, depositors aren't kind of all running from the bank. I think, you know, very interestingly the, I think one thing they learned from the first financial crisis was a need to act very quickly. You know, during that time they let Bear Stearns fail. I think for moral hazard reasons. They didn't want to create the impression that they're gonna bail out everybody who runs into trouble. But ultimately that led to, you know, what they call contagion. Right? Everybody just gets figured who is the next, what's the next shoe to drop? Ultimately they had to come in to kind of turn the tide. And this time around they acted much more quickly because I think they recognize and learn from the previous crisis that if you don't act quickly, it's just going to continue to snowball and ultimately they're going to be in the same place. And their solution here is pretty interesting. Basically they forced everybody to, well, force in the sense that they impose regulations requiring banks to hold U.S. treasury securities, securities and allowed them to market at par. So what they've done is they stepped in and said, okay, well you can give me those securities that are trading 50 cents on the dollar and we'll lend you 100 cents on the dollar against it. In the process of doing this, they've, you know, essentially created a lot of money out of thin air. I think the idea is that, you know, they would do this for one year. After a year, likely they're going to have to extend it because I don't see where else, you know, the banks are going to get the money for that. **Speaker B:** So quick question, I mean is like if you put the inflation question aside, which, like we don't have time to go down that rabbit hole, but like if you just snap back the rates to zero, does this problem go away? **Speaker A:** Oh, absolutely, yeah. As they snap the race back to zero, all Those bonds trading 50 cents on the dollar go back to par. But you have the inflation problem, Right? **Speaker B:** Right, yeah, yeah. I mean, this is, again, I don't want it. This is a rabbit trail for a different time. But like, I really believe that, like the inflation problem is that like for the first time in our like modern history, we gave money to people that would spend it and not just to rich people who would like continue to hoard it. And so like the stimulus checks, like all the stuff that went around Covid, like that is the stuff that is like reflected in inflation and not like. So anyway, I don't know, I, I have like a soapbox on this and like it's hilarious that I would even try to get on top of it in front of somebody who knows so much more about the system than me. But again, something for a different time. And I just, it is like really fascinating for me to hear you say like that at the end of the day, like what we're seeing here just is like what happens at all financial crisis. Right. Which is that you essentially all financial crisis boiled down to this duration mismatch between the where your assets were invested and like when your liabilities are due. And especially relevant, like when your liabilities can be due at the whims of. **Speaker A:** Like people that people short term, you know. Yeah, yeah, just short term, I guess. Dynamics. Yeah. And like one shock kind of put that equilibrium. **Speaker B:** No, I mean the Silicon Valley bank thing is like super interesting because it's like, look like, I think like the most mid curve take you can have is like, well, why wasn't Silicon Valley bank like hedging the interest rate, you know, against like why weren't they hedging the interest rate going up? And it's like the entire economy can't hedge interest rates. Like there has to be someone taking the other side of the trade. And so if it wasn't Silicon Valley bank, like, well, I mean it's also. **Speaker A:** You know, if they hedged interest rate, then they're not earning any money. Right, Right. The only way earning a spread on their deposits was by lending it long where you earn a premium. If you say don't lend it long, don't own a premium, they're going to say, well, how am I going to stay in business? **Speaker B:** Yeah. And so I just, it, it's like pretty incredible to like, it's so easy to call like backseat driver on Silicon Valley bank and just be like, how irresponsible. Look at all this stuff. But like, I mean really what it boiled down to is that, I mean I was, I'm not part of these groups. Like, I don't know if Peter Thiel like really reached out to all of his like friends and told him to get them out. But like, it seems like Silicon Valley bank like kind of did the right thing and then like all their depositors got spooked and that that just resulted in the destruction of a bank. But like who did anything wrong? **Speaker A:** Yeah, I mean, I guess the only thing you could say is that, you know, not every bank is, you know, in the same position. So you know, maybe they took a little more risk than they needed to. You know, really hard to know unless you actually get to see the details of their book and compare it to other banks. But there are some, there's certainly some systematic forces that are government policies that kind of encourage this behavior. **Speaker B:** Well and I think that is like kind of the purpose way perfect way to tie us off because like the way one thing that we can do differently is like only work with banks or financial institutions or protocols in which we can see all their books. And that really wasn't possible before. But that is the future that we're trying to build with Ethereum. And that I think is maybe a way out of this endless cycle if we can figure it out before this country bans it first. **Speaker A:** Yeah, for sure. I mean I think that's what I love about being able to build in defi is that you know, I can try to create a protocol that you know, implements policies that I think are financially stable and robust. And so you know, to that point kind of touched upon this earlier but all of the loans on term are non callable loans, meaning that there isn't a duration mismatch. You know, the lenders are locked in for lending for the same term that the borrowers are negotiating for. And you know that, you know, there are some downsides. It means that lenders have to sell their repo tokens if they need liquidity. But insurers robustness of the system and you know, avoids these bank run flights of liquidity situations that cause so much trouble. **Speaker B:** Yeah, wow, okay. That is our send off. Come work in Ethereum found your own protocol because you are able to implement the policies that make a more stable and a better world. So man Dion, thank you so much. This is such an honor and such a pleasure and such an opportunity to learn about like what term finance is and like how to recreate like the financial system we have today. But in a way that's just better like, and whether that's like more transparent or less susceptible to herd mentality or you know, like whatever you learned in like your real world experience dealing with these crisis like you're fixing it on chain and like that's what I love about this space and these conversations and. And just want to say thank you, man. Thank you so much. **Speaker A:** Thanks for having me, Rex. It was a pleasure.