When you think of a contract, you think of signing a document symbolising an agreement. A contract written by lawyers and enforced by courts. Essentially, contracts are about each party agreeing to do something and what pain one will inflict on the other to punish them if they break that contract. But is there a better way? Can contracts be innovated?
This episode of YAP Cast embarks on a journey to discover a better way ahead for financial contracts.
We pick up where we left off in episode 1 and continue our conversation with Hart Lambur, co-founder of UMA: an optimistic oracle built for decentralised finance (DeFi). It was up close and personal for him to see how derivatives contracts contributed to the 2008 financial crisis. Lambur now sees contracts as a technology that needs to be updated.
The limitations of Smart Contracts
Blockchain technology executes actions through a consensus mechanism. No one person controls it, so it’s trustless. Ethereum created a platform where everyone could write a contract that uses “f-this-then-that” style logic onto a blockchain.
Hart shared that limitations arise if someone wants the contract to execute when certain real-world happenings occur. For example, a betting smart contract that releases winnings when the results for the Wimbledon final are out.
The referral to real-world happenings is relatively simple in the real world, as we can look that information up instantly from anywhere. But how does it work in crypto? In crypto, this is called the oracle problem. How do we let a blockchain know about things happening outside of the blockchain?
Hart shared that the whole premise of blockchains is that no one person controls them; that’s why we can trust them. Building a decentralised oracle that tells you an answer that nobody controls are a tricky and interesting problem.
The solution: Optimistic Oracle
UMA has developed a version of the oracle called the ‘optimistic oracle’. According to Hart Lambur, the optimistic oracle assumes an answer to be truthful unless somebody disputes that answer.
Why does UMA want to make this optimistic assumption? Efficiency. Taking the time, energy, and effort to prove a correct answer utilises many resources. By assuming, the answer is correct; improves efficiency. That is essentially what UMA’s optimistic oracle is doing.
If somebody disagrees, then they would be on the pessimistic path, and they’ll do all the work to prove what actually happened.
A real-world example would be the actual legal system, the traditional legal system. Hart argues that functions optimistically. “Like, Sam, you and I can write a legal contract, and we could write it, let’s say, we write it under the laws of the State of New York, and we assume we are going to follow that contract, and we both hope we do. And if we don’t, in the pessimistic case, we sue each other, right?“
Incentives, Self-policing, and Implications of the new system
But what if no one disputes the answers given to UMA’s optimistic oracle? Hart shared that the system needs one honest person watching, or it’ll break. But one thing is certain; Hart knows that people respond to economic incentives. This is proven repeatedly in UMA’s network.
He discusses incentives in further detail: comparing economic incentives by government systems vs economic incentives by DeFi. The role of honesty in this system and the concept of ‘disrupters’ is also discussed.
There are interesting questions about law & code, the workings of the system, people’s trust, and levelling the playing field. Hart points out that the application of the same set of rules across all countries: is actually a huge global win (especially for countries with a weak legal system).
DeFi & CeFi: Clarifications
The discussion then delves into the downfall of centralised institutions (Celsius, BlockFi, 3AC) operating in the crypto space.
Hart compared the downfall of Three Arrows(3AC) to the Lehman Brothers collapse. “Nobody knew they were running out of money until it was too late because there was no transparency. It was completely opaque, and then a bunch of people didn’t have the money they thought they had because there was no transparency, and this is all happening in the tools of traditional finance with just unsecured loans and agreements. It had nothing to do with DeFi; it just happened that some of these institutions played around in decentralised finance.”
Hart shared that those downfalls had nothing to do with DeFi and shouldn’t taint DeFi.
The public, the regulators, and the media confuse DeFi and crypto. These collapses are all bundled up together. However, on a deeper level, DeFi is the solution to these types of problems because it’s a transparent system devoted to avoiding such issues.
DeFi: A Gradual Global Revolution
Hart believes that the advantages of DeFi are genuinely real, and like the software envelope around the world, there would be a DeFi envelope too. However, this will be a long and slow process. He also explains the similarities between the journey of the internet and the probable journey ahead for DeFi.
DeFi is still in its early stages, and we’ll have to do a lot more talking and building before it feels in any way permanent. The challenge is going to be how we manage the difficult bits, such as agreeing on the data and resolving disputes.
Hart has come up with one solution, and there are going to be lots more. He’s also helped us think differently about the most basic question in finance: what is a contract?
Find out more about UMA here.
Follow Hart Lambur on Twitter here.