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Hi everyone. Welcome to Unchained, your no hype resource for all things crypto.
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I'm your host, Laura Shin.
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Thanks for joining this live stream. Before we get started, a quick reminder. Nothing you hear on Unchained is investment advice. This show is for informational and entertainment purposes only, and my guests and I may hold assets discussed in the show. For more disclosures, visit unchained crypto.com Bitcoin
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Today's guest is Paul Frembo, co founder and CEO at Morpho.
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Welcome to welcome Paul.
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C
Hey, thanks for having me.
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We've had quite a series of dramatic events over the last week and a half in Defi. Since North Korea's Lazarus group drained almost $300 million worth of RS ETH from KelpDAO's layer 0 bridge, it then used that RS ETH as collateral in AAVE, leaving almost $200 million in bad debt. Meanwhile, Morpho had only about $1 million worth of ETH borrowed against the RS ETH in two isolated markets. How did Morpho manage to fare nearly unscathed?
- [01:35]
C
Yeah, I guess you know, the first thing to understand with Morpho and the main difference with like other lending protocols out there like aave, is that Morpho does not manage assets or does not choose which collateral assets are being underwritten. Morpho provides a modular stack of isolated lending markets that anyone can deploy and build their own lending products in the form of vaults for people to earn yield on. Right? So what that means is that in Morpho you can have the safest as well as the riskiest products, right? But they are isolated to the extent that the vault curator is configuring them to be like that. So I give you an example. Like the Coinbase USDC Land products, which is powered by Morpho vault, is actually only allocating into isolated markets that are extremely safe, right? And then at the opposite, you have vaults on Morpho. Right now we have more than 1,000 vaults that have a much higher yield but are underwriting much riskier assets. Right. And we don't pretend to be a single pool of liquidity that is like only up technology. We provide a stack for people to build their own like product to deposit your SDC and earn from. And in that case it turns out that some curators had underwritten kelp and vaults that were meant to be more riskier. And in total I think the ETH exposure is like a million dollar as you pointed out. But I think it's important to understand it's not comparable to the exposure of AAVE because we're not asset manager aave. One should think of the AAVE DAO as like a vault curator. It's like, like also some people like compare Morph and AAVE and try to, you know, put one against the other. But the reality is that we're not really competing with aave. We're just infrastructure for asset managers like aave, but also others. So our builders are the one competing with AAVE in some way. So yeah, that's like the one, the first like, you know, explanation. The second explanation is actually morpho is a stack that is heavily focused towards real World loans. So 90% of our volume is stablecoins in terms of active loans. Right. And like to give you an ex a rough order of magnitude In DeFi lending, 50% on the IS is roughly like 50, 60% is of active loans are in stablecoin. A lot of, a lot of it of the rest is like e restaking loops and e staking loops and, and others with we don't get to focus too much on that amorpho. We think stablecoin loans is what truly is going to be the true scalable market if we truly want to unlock like real world lending and everything. And so this is the only place where we spend our time and energy as a team.
- [04:20]
A
So I know that this question may not apply to how morpho is set up because as you mentioned, it's really the curators who are setting the parameters on each of on what they're managing. But you might have heard that there was a report published on dirt roads by Luca Prosperi which kind of used some different frameworks to kind of analyze how much defi lenders should be compensated for the risk that they take on when they lend on defi. And according to at least one of those analyses, it found that they are grossly undercompensated. And in that model they said that that's because what they're doing is essentially similar to a put option. However, you know there, there's been some disagreements. Steakhouse Financial also kind of had their own analogy for what's happening in, on chain lending and they compared that to actually repo agreements and, and so they didn't feel that, that defi lenders were being undercompensated for the risk. But I'm sure you see there's a lot of Twitter, you know, conversation about this as well. So I was wondering what your opinion is generally on, you know, how to properly compensate defi lenders or even how to sort of calculate what risk they are taking on.
- [05:39]
C
Yeah, it's, it's a great question and I think you know, obviously the answer heavily depends on what you know are the, the, the underlying strategy of the vault or of the lending lending protocol. But I, I say the following is that the, the, the risk range can vary a lot depending on the type of assets that you underwrite. We found that you know, over the last few exploits that has been in defi, it's actually mostly related to opsec which is maybe not something that is as well underwritten and priced by the markets as it should be. And so our position as morpho is that we should provide a market infrastructure for lenders and bars to price trust. And what I mean by this is that bars should expose why they should be trusted like the collateral they have or the identity they have or whatever. And then the lenders is an open marketplace. The rate should be determined by, by them. And, and so, and, and in this capacity we don't, we don't have an opinion on like you know, what should be like the, the risk free rate for or like the, the different risk premiums. But we feel like it's for the market to discover that basically within, within the permission that's like morphostack. Now specifically I haven't read the study of LUCA neither. The answer from, from, from Stakers Financial, the put option framing is very weird to me. I think it's much closer to like, I don't, I don't see how that would be close to, to a potential especially as we move towards more and more under collateralized loans in the morpho stack. To me like the analogy and how we explain this to traditional finance etc. Is that it's much closer to a repo agreement and this is the lens through which they understand and think themselves about pricing. And when you think about the risk of such a repo like structure you have obviously the market structure which is the more for protocol contract where you have a risk of smart contracts, which I like to believe as a very, very low premium, then you have the risk of the collateral, the pricing of that collateral and the liquidation loan to value and all this together is actually very few trust assumptions. And if you take high quality collateral like treasury bonds or Bitcoin and reliable price sources, I think there are fair arguments to make that the price of trusting those loans or the risk of those loans is actually can, can actually be very close to the one in TrustPI and does not require crazy premiums. I've seen some tweets like going for like pretty crazy numbers. I won't comment on that, but I think it's pretty far away from the reality.
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And I'm sorry but does that then also compensate for just the risk of sort of those opsec reasons that you discussed? Because you know, as we know a lot of these hacks are not even of the protocol. It's like literally just around key management and stuff like that.
- [08:43]
C
Yeah, no, I think it's just depending on what asset we're talking about. If we're talking, you know, we as collateral on the morpho market priced by an oracle like chainlink, honestly I don't think there is such risk because there is no such thing as a multi sig behind the scenes anywhere in the process. However, if we're talking this new you know, wrapped RWA that is done by a startup that does not even have like you know, basic opsec procedures, then yes, that should absolutely be priced. In the reality though, it's very hard to properly underwrite those assets. Now we've seen like all the fintechs we've been working with are much more careful about this now obviously and so they require curators to like provide know proper due diligence on every single of those assets, including assessment of the opsec best practices, which is you know, not something they would expect maybe a year ago. And so that has been, that has been interesting to see as well.
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Okay, so yeah, one other kind of, you know, aspect of this that I wanted to explore in terms of risk was just you saw that after it was revealed that the Layer zero bridge had sort of out of the box, had a one of one setup for the dvn, then there was some finger pointing going back and forth between Kiltdown Layer zero over who was really responsible. But I was curious, how do you think about that and how do you think users who want to engage in either defi lending or borrowing, how should they, you know, like you know, judge whether or not something is safe for them to engage with.
- [10:31]
C
Right. I think it really comes down to, like, what is the. How much assets your lending protocol is underwriting and how. Right. When you have like a pool model or a hub model that is underwriting like 50 different assets even though the caps are small. Right. We're talking like in the case of AV used to be a very big, like, you know, or $30 billion, like protocol. And the cap for kelp was like, I don't know, but maybe 200 million, top of mind. So, you know, one looking at this would be, oh, actually that sounds like a very minimal exposure compared to the size of aave. But the reality is that even the small exposure or relative exposure can trigger panic, which turns into a very big relative exposure, as we've seen. I think this is really fundamentally duplicating the number of assets underwriting into a single pool model that aggregates the liquidity for everybody. You multiply the black swan risk by. Even though at the high level, those assets individually look safe, then you have to imagine that each of those assets rely on 10 different providers that rely on 10 different providers that relies on RPCs that can be hacked by North Korea. Right. And if you are a lending pool like AAVE of 40 billion, technically you should have continuous monitoring of those 40 different assets, the 10 providers of each of those 40 different assets, et cetera, et cetera, which is absolutely unrealistic, especially if you ask token holders to do it. Right. Which is basically like the process of a monolithic lending pool today is like token owners have to approve those parameters, those risk parameters changes, which to me is not really a good expectation from token orders. Even a centralized risk service provider is too complex, especially if the risk provider can leave at any point in time, as we've seen. And so that creates, in my opinion, too much risk.
- [12:36]
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Okay. And you know, as you mentioned before, when people are engaging in morpho, you know, they should sort of analyze each vault and like, look at the curator. So how do you assess, you know, whether like a curator is kind of doing their due diligence versus one that maybe is less trustworthy?
- [12:58]
C
Yeah, so it's a great question. One should think of morpho's position as Etherscan almost credit. Right. So if you go to our interface, you're going to have this terrible ux, I'm going to be honest, where you're going to have hundreds and hundreds and hundreds of vaults. Right. And for each of them, we're going to give you A ton of details about what is the risk, what they do, what is their track record, et cetera. We're not providing a consumer easy to use ux, if you are a simple user, does not want to think about those things. You should go to one of the 200ish like you know, partners that are integrating Morpho, that are providing this experience. You know, we integrate with every single exchange, right? You know, whether that is like Binance, akx, Gemini, Kraken, you know, Coinbase obviously and others, they get to the work of picking a curator and you know, making sure that those vaults have the proper risk configurations for their users, the proper, you know, risk isolation. Right? And, and, and, and this is how users that don't want to choose, they use those interfaces, users that are more experts, right, and want to understand and go deep the same way you would go deep on Etherscan if you know perfectly Ethereum and what you would do or through your terminal directly, then you go to the Morpho platform or to the Morpho API or to the Morpho contract directly. That's really how we think about it. And by the way, I think this is the only way to scale Defi lending, right? I don't like, I want 7 billion people on earth to benefit from onchain loans, right? And, and an open credit network. I'm not going to end the right or Morpho is not going to end the right 7 billion people. We're going to need thousands and thousands of curators, banks, Assam managers, whatever. You want to go after each bar in the world and, and give them a price for a loan, right? And we, we don't do all of this. We just provide a connecting layer for everybody and a stack for everybody to do this underwriting so and access global and competitive liquidity. And to me this is what Defi is about. DEFI is not about decentralized underwriting or decentralized brokerage. DEFI is about providing an open marketplace for the financial activities that you have in TradFi. Except now because it's open, you have better price discovery, which means deeper liquidity and better prices for end users and better discoverability of the different products. So in practice it comes down to it's going to be cheaper and you're going to have more types of products. It's going to be the exact same products that you would have before, maybe slightly different, but the pricing is going to be so much more efficient because you connect globally to everybody.
- [15:29]
A
And one other question I want to ask, I know that with all of this contagion that happened in Defi that you had a lot of conversations with institutions and morpho itself is known for being part of one of the. It's, it's actually probably the best known sort of defi mullet setup in all of crypto. You know, with the morpho protocol powering crypto loans on Coinbase. What effect are you seeing that the kelp dao attack and, and the ensuing defi contagion is having on institutional appetite for these types of arrangements?
- [16:02]
C
Right. Well, you know, when, when the kelp situation happened, the first thing I thought, and when AAVE went illiquid and had $12 billion blocked, I felt good about Morpho because of how morpho operates and its position. But I was worried about the institutions reacting to this because in traditional finance, if you freeze more than $10 billion for a week, this is a very serious issue. And so I picked the phone and I started to call them and I was like, hey, you know, explaining what's going on and so that, you know, making sure they understand what is happening. And I think, you know, I was actually there. There's a positive thing and the negative thing, right? The, the positive thing, two positive things is they understand that this technology is the future regardless of, of, you know, what's happening on chain. They understand like having an open global financial system is a promise that is way too big to fail, right? Like this. They are all convinced that this is what we're marching towards as a technology. What they're not convinced by is the current way we're doing underwriting, right? And they're basically, basically their reaction is like, oh yeah, defi, you guys are jokers, right? Like the way you underwrite is not serious at all, right? And you know, to some extent it's hard to prove them wrong. Like currently with like the track record that we have over the last few months with so many hacks happening, et cetera. So I think the question is like, how do we empower them with technology that they can trust, that they can control? And what I mean by control is that they can use and configure without having to rely on trusted intermediaries in order to operate the financial services that they operate in tradfi with the same skill and trustworthiness that they would in the off chain world. And so TLDR is that they are convinced by the technology. A second big reason is that they're convinced by the business aspect of things, which is they see all the fintechs coming on chain. Every single fintech coming on chain and they're like hey all this AUM that I have from the fintechs today I'm going to lose it to morpher vault. So guess what? I need to come on chain and manage my own morpho vault and become an asset manager on chain because otherwise I'm going to lose flow coming from all the fintechs. So they get this right? But now, now and, and they even see this as an opportunity. They're like hey the current asset managers that are decentralized like ah, they are not doing a good job. It's an opportunity for me to come over and take this market powered by like the, the, the the warfare technology if you will and, and so that's the, the, the upside. The flip side is you know obviously the most conservative institutions they're, it's like a huge setback for them in terms of like know how they can trust like how they can effectively go to their leadership and push like the pitch of like hey we're going to move onchain and deposit pounds and it just makes the pitch much harder internally if the organization is not already convinced by the technology and there is no like top down like you know direction that the onchain is the future. If you're not in one of those organization then it's going to be much harder now to sell the onchain vision.
- [19:19]
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And if you were to kind of put a number on it would you imagine that this sort of delayed some of those decisions by like three months or six months or maybe not. But I'm just curious.
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It's a great question. It definitely would be some delay even not just from the tradfi institutional player but from the fintech adoption side of things and rightfully so. Right. Like you want to take a step back and understand what happened. You maybe want to change yield provider and loan provider as well and, and then reflects right. And also think you know about the question that we just discussed which is the risk premiums like is it worth it right to move on chain and it's our job to prove that it will be worth it that you'll get better price discovery that you'll get access to opportunities that are much harder to get otherwise. And this is where we need to do work right is like keep like you know the, the security aspect of its flawless but at the same time make it convincing enough from a financial product perspective. So I think if we can fairly say that we've lost three to six months of institutional adoption for I'd say an average. Some people I've seen are not slowing down at all. They get the difference between like a Morpho and an aave, for example, and they understand that things can be isolated and et cetera. But for the most conservative ones, you know, it's probably delaying them even in years, you know, oh, wow. Looks a bit scary when you say this, but, you know, and I'm only thinking, like, specifically I have two persons I, I talked to and they're like, wow. Actually that, you know, that was a big, big thing.
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Wow. Okay. I mean, honestly, it makes sense with the way, like, AI, I think is affecting, you know, the ability for hackers to do these exploits. All right, so in a moment, we're going to talk about some of the sort of rescue operations that happened that were a little controversial. But first we're going A quick word from the sponsors who make the show possible. Bitcoin changed how money works. Citraya changes how Bitcoin scales. Citraya uses Bitcoin as both the settlement and data availability layer.
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- [24:05]
A
Back to my conversation with Paul well after the big hack and the contagion, the Arbitrum Security Council had this moment in time where they saw the stolen funds sitting there for a period and they used that time to freeze about $71 million worth of the stolen funds. This was a pretty controversial move at least. At least I don't know, at least in parts of Twitter I think. Other parts was not controversial. But I'm curious, what was your opinion on it? Did you think that was the thing to do or the wrong thing?
- [24:39]
C
It's a great question to be frank. So hard to answer. It's such a tough decision. So I know the Arbitrum team has put the thoughts into it before taking it and I don't have the full context myself, so it's hard to judge if it's a good or one. But I trust the Arbitrum team like seriousness and thoughtfulness to effectively have taken the right decision. Now generally about censorship, resistance and ability to freeze funds on behalf of users, etc. I think it comes down to personally it comes down to if you can do it, then not doing it feels a little bit immoral. Again, every situation has all its context and it's interesting because as soon as you can't do it anymore, it's not immoral at all because you just can't do it. It's like a little bit like the decentralized Internet versus controlled Internet, right? Like you don't expect, you know, there's no one owning HTTP so you can't prevent them from operating a specific website, which one could think as as a good thing. But. But if someone work you owned HTTP in some capacity and there was like a specific website that was doing army very clearly to humanity overall, then it's hard to justify not shutting it down. Right. So it's very interesting tension where like between control and the morality question that is behind the action that are being taken. So anyway, it's kind of like a non answer. But you know, I have very high trust and respect for the arbitrary team in general and I trust that they did not take the decision lightly for sure. And I also trust that we don't have all the contacts. Right. So maybe that are the reasons we don't know about.
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A
Yeah. And just to make clear, it was the arbitrum Security Council, which is like outside people, so.
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C
Yes, yes, that's right.
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Yeah. So yeah, it wasn't actually like off chain labs or anything like that. But yeah, I do believe there was a lot of discussion around that. And for people who are interested to learn a little bit more about how it went down behind the scenes. Griff Green came on the show on Friday and talked about from his perspective as a Security Council member, how he felt it came about and he also described technically how it worked, which was also actually really interesting. So after that rescue, we then saw this Defi United effort that began picking up steam earlier today. On Monday it finally hit its goal or really exceeded it frankly. So the amount pledged by the likes of. So, so the people who pushed over the edge were Joe Lubin and Consensys. They pledged, you know, ether to. To help make people whole. Lido Caldao, obviously etherfi. I think the Solana foundation pitched in. There were a number of entities, you know, that, that wanted to help cover this bad debt in AAVE from. From the attack. I wondered what you thought of that as a way to address what happened.
- [27:52]
C
Yeah, it's a great question and I gotta be honest, I don't fully know what is Defi United. You know, I saw the announcement on Twitter but I also heard like it's a donation and then I heard it's like a loan that is under collateralized and you know, so I, I'm not exactly sure what happens with the funds and so I don't know if I can, I can provide a good perspective on this.
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A
Yeah, I saw somebody tweet. It's a mix but I myself, yeah, don't have all the details. But I saw it was a mix, right?
- [28:21]
C
And then you know, every time like we got proposals on this, it was like a different, different terms for the loans, etc. So I'm, I'm not entirely sure. It's hard to give a perspective on this. It's also hard to know what are the incentives of, of, of. Of people like yeah, for sure. If you have like a 200 million bad debt, oh, you're going to donate for yourself. So of course you're going to contribute. What's in it for the other people to contribute in there? And just not having this full transparency for me is a bit weird. If it goes public and anyone can deposit into it. It actually was one of the conversations I had with some institutions is like having the same concerns as I have is like not truly understanding what's happening, which is by the way very different from a recovery process that you will have in traditional financial world. And again like they don't mean because Stratfire, it's another way that we can't innovate and do new things. I just, yeah, I'm just not sure what it does exactly, to be completely honest.
- [29:22]
A
Yeah, I mean I agree, like it's not ideal. Like it would have been better to just, you know, have prevented the hack obviously. But on another show that we have decks in the city, some of the lawyers were saying that if the industry doesn't kind of like self regulate then the regulators are going to come in. So in that regard, like maybe, maybe it's good that there is some industry effort to kind of, you know, remedy what happened. But you know, let's just now zoom out a little bit because obviously this has been a really rough month for DeFi. There was the Resolve hack, there was Drift, now it's kelpdao which had this sort of massive contagion effect. So now with all of that going on, are you just having thoughts as a DeFi founder about what the industry needs to do, how this sector can stabilize and what sort of steps need to be implemented to grow into mainstream adoption?
- [30:22]
C
Well, for what it's first, from our selfish perspective, we had the best months in terms of enterprise adoption of morpho. Right. We're at all time high in terms of every enterprise integration that we have that is directly plugging into the protocol, which is the thing I care the most about is how can we take DEFI to the masses, et cetera. And this is working and working well. If you take the Coinbase isolated lending markets, we reached a new all Time high yesterday. Right. Despite the price being super down like in general. Right. So to me it's not just that Defi is at risk. I think DeFi 1.0, like the old era kind of maybe, but I think, you know, it's just metamorphosizing without playing words. Like before what it was, you know, supposed to be and now what it is is like you know, financial infrastructure for fintechs, for traditional financial institution that is live and growing and has immense potential. Immense potential. We're talking like the credit market is $200 trillion. Right. And we're just, with crypto backlogs, we're just 50 billion. It's like tiny. And there's so much, you know, room, room to grow in that direction. Yes, the very crypto native, you know, leverage loop is, is in a tougher spot. I, I agree. But it's also not where we spend too much time nor what we get excited about. Right. And so as a result, as the Defi founder, to answer your question, I'm just worried about the perception. Right. That's the only thing. Right. The fundamentals are here. I'm very, very convinced about Defi upgrading the financial system for everybody. It's just how long is it going to take to get there? And will the short term events of DeFi 1.0 going to impact the perception that will prevent DeFi 2.0 to thrive? And this is what I try to mitigate as much as possible.
- [32:11]
A
And so you talked a little bit about how institutions are sort of like changing their approach or changing at least their thinking around this area. But what are you seeing in terms of user behavior change?
- [32:23]
C
Great question. So I mean very clearly it's like, hey, if you're like, you know, and have conversation, many conversations like this last week is like basically people only want to exposure to bitcoin Yield like the 2 USDC yield that is just powered by Bitcoin. So when you talk to fintech, some of them are like, hey, well you know what, actually we're going to change our strategy. It's going to be a single, not even multiple isolated morpho markets, a single morpho market which is Bitcoin as collateral. Because we know this is like a good risk reward trade off. And so the short term implications for us is that they're going to be much more careful about growth and, and just risk taking in general and rightfully so. Right. In general. So isolating as much as possible their risk, understanding their risk much more. Like we've seen them hire a lot and upgrade a lot their competency level on those matters as well, to the point where I feel like now they have sometimes much higher crypto native talent density than the crypto native projects themselves.
- [33:28]
A
And so I'm not even sure if this question applies, so tell me if it doesn't. But as we mentioned with AI and even the quantum threat, which I know is further out, but still there's just clearly more ATTCK vectors that are being found. Also, as we're seeing, the human aspect of all this is being exploited with social engineering being a major avenue for dprk. So I was wondering if, you know, how is Morpho adapting in this sort of new era? And I'm sure there's probably some aspect that you may not want to reveal, but I'm just curious, like, you know, how are you thinking about how to make sure everything, you know, stay secure and your users stay safe?
- [34:11]
C
It's a great question. I think, you know, one of the biggest depends of the traditional, like, you know, financial system is the lack of transparency. Right. From a cyber security perspective, there's nothing you can see, so it's much harder to attack. In Defi, everything's open. So if you start having very powerful tools, well, Defi is like kind of like an obvious target. It's like open. You can audit everything, you can send your best LLM and spend $2,000,000 of compute on finding bugs everywhere. And that is very interesting because the force is shifting way too much into the hands of the attacker versus the developers on the other end. I think on the flip side, we have one tool that I think is extremely powerful to re establish balance between the two, which is formal verification. AI can break a lot of things, but it still, until today, can't break math. Right. And so if you build a protocol like we did, which is extremely simple, with specifications that are formally verified, well, it doesn't matter if you're MITOs like V5 or if you're like a junior security researcher, you won't break this bank, right? Because it's math, right. And what's interesting about this AI era for Morpho is that we've already thought of our models and like our code as deployed forever. And it's extremely different when you put in, from the developer's perspective, immutable protocols from the gradable protocol we have both before Morpho and the old era of Morpho is upgradable. And we've thought about it very differently because if you're immutable, you're going to be here forever. So if there is just a small chance that you'll be hacked, well, if you integrate this risk over infinite period of time, you'll be hacked eventually. So you have to change your thinking and say, hey, it's like a zero risk model. It has to be flawless right to the eyes of any researcher in the future, including AI mythos like V10. And so we feel good about the on chain side of things, regardless of the power of the AI gods that we're going to summon. What I'm worried about generally for Defi is also is like all the offchain stack of things, right? And this is where we've been spending a lot of time internally upgrading all of this and Morpho, you don't need to rely on the offchain stack of Morpho to do stuff. But the reality is like we have a front end, so if you go to morpho.org it's actually a phishing scan. We've seen so many DNS attacks of like other are the players. So we need to double down and be very careful about this. But that's like, you know, the $12 billion that are on Morpho that are on the smart contract, not our front end obviously. So we feel good about that.
- [37:12]
A
All right, well, Paul, this has been such a pleasure talking with you and learning more about other ways that borrowing and lending occurs in DeFi and also the institutional reaction to all of this. Thank you so much for coming on Unchained.
- [37:27]
C
Thank you.