The Evolution of Financial Markets: From TradFi to DeFi

In a captivating discussion on the Validated podcast, host Austin sits down with Tarun Chitra, CEO of Gauntlet and general partner at Robot Ventures, to explore the fascinating evolution of financial markets. From the ancient history of futures contracts to the cutting-edge world of decentralized finance (DeFi), this conversation offers a comprehensive look at how technology and innovation have shaped the financial landscape.

Tarun Chitra's Journey into Crypto

Tarun's entry into the world of cryptocurrency is a testament to the unexpected ways technology can intersect with finance. His story begins in 2012 when he was working on building custom hardware for protein folding. A surprising encounter with the nascent Bitcoin mining industry led him to mine some Bitcoin himself, though he admits to selling at sub-$10 prices - a decision many early adopters can relate to.

Initially skeptical of cryptocurrencies due to their apparent violation of established principles in distributed systems, Tarun's perspective shifted in 2015 when academic research began to formalize why Bitcoin could overcome known limitations. This academic validation marked a turning point in his journey from a cynical observer to a true believer in the potential of blockchain technology.

The Impact of High-Frequency Trading

By 2016, Tarun had transitioned into the world of high-frequency trading (HFT), where he focused on designing simulation and back-testing frameworks. This experience provided him with valuable insights into how financial markets operate and adapt to new products. He explains:

"When you have a new asset, how do you stress test it? How do you figure out how you take existing strategies and run it against a new product?"

This work in HFT laid the foundation for Tarun's understanding of market microstructure and the commonalities between seemingly unrelated assets. It's this deep understanding of financial markets that he would later apply to the world of cryptocurrencies and DeFi.

The Fundamental Differences Between PoS and PoW Assets

One of the key insights Tarun brings to the conversation is the fundamental difference between Proof of Stake (PoS) and Proof of Work (PoW) assets. While many in the crypto space treated these assets as financially equivalent, Tarun recognized that their underlying mechanisms created distinct financial properties:

"The staking assets could be borrowed instantaneously. Whereas the proof of work assets, yes, I could go to NiceHash or one of these GPU rental places and borrow hash power. But it's not this like instant type of thing. And so that changes the candor of the financial asset, like the payoff properties have to be different."

This observation led Tarun to create simulations to demonstrate these differences numerically, highlighting the importance of understanding the unique properties of crypto assets when designing financial products and markets.

The Evolution of Financial Instruments: 1960s to 2010s

To understand the current state of financial markets and the potential of DeFi, it's crucial to look at the historical development of financial instruments. Tarun provides a fascinating overview of how financial products evolved from the 1960s to the 2010s.

In the 1960s and 1970s, economists began to theorize about financial products that could maximize utility for market participants if there were ways to enforce contract constraints. This led to the formalization of options pricing and the systematic study of what premiums should be for various financial instruments.

Tarun explains:

"The 60s and 70s, first time people try to formalize the question to the question of like, how much should these premium be? Like, how much should I pay for the right to buy Austin's cold batch that he happened to go single origin mine, you know, wherever he was mining."

This period marked a significant shift in how financial instruments were understood and priced, laying the groundwork for the complex financial markets we see today.

The Role of Property Rights in Financial Innovation

An often-overlooked factor in the development of financial markets is the role of property rights. Tarun highlights how the solidification of property rights post-World War II created an environment conducive to financial innovation:

"The solidification of property rights post World War II was actually a very interesting era for why people started pricing this stuff. Like, hey, you have this huge population growth, the resources need to be allocated more efficiently, for sure. But a lot of it also has to do with this idea that like, property rights and enforcement of property rights was became something that people collectively believed in, right?"

This collective belief in property rights and the ability to enforce contracts provided the necessary foundation for the development of more complex financial instruments like options and futures.

The Impact of Computers on Finance in the 1980s

The 1980s marked a pivotal moment in the history of financial markets with the introduction of computers and electronic trading. Tarun explains how this technological advancement revolutionized the industry:

"The 1980s, especially, you know, the early post-Darpanet internet era, that's sort of when you had the first sort of trading of these assets electronically."

This shift to electronic trading not only increased the speed and efficiency of transactions but also opened up new possibilities for financial product innovation. The ability to process vast amounts of data and perform complex calculations in real-time transformed how assets were priced and traded.

The Limitations of Financial Models

Despite the advances in financial modeling and technology, Tarun emphasizes an important point: all models fall short of reality. He explains:

"With enough experience of things blowing up, you eventually become very accustomed to the idea that no model is going to be perfect. And all models are sort of wrong in some distinct manner, right?"

This understanding is crucial for both traditional finance and the emerging world of DeFi. It highlights the need for continuous adaptation and improvement in financial models and risk management strategies.

The Wildcatters of 2010s Web2 Tech

Drawing an interesting parallel between the early days of cryptocurrency and the tech boom of the 2010s, Tarun introduces the concept of "wildcatters" in finance:

"There's always a wildcatters of finance. And I think the problem is the brands in finance are generally the ones who are the risk-averse or the midwits. But the wildcatters always exist. And they're the ones finding new products that come from effectively tronching some form of new risk or taking advantage of some form of new types of property rights that exist."

This analogy provides a fresh perspective on the role of innovation and risk-taking in both traditional tech and the crypto space. It suggests that the true innovators are often operating on the fringes, pushing the boundaries of what's possible in finance and technology.

Unique Properties of Blockchain Technology

One of the most exciting aspects of blockchain technology is how it changes the fundamental math of traditional finance. Tarun highlights several key properties that make blockchain-based finance unique:

1. 24/7 Trading: Unlike traditional markets with set trading hours, blockchain markets operate continuously.
2. Programmable Assets: The ability to create and destroy assets on-demand opens up new possibilities for financial products.
3. Transparency: All transactions are visible on the blockchain, providing unprecedented levels of transparency.
4. Composability: DeFi protocols can be combined in novel ways, creating new financial products and services.

These properties create opportunities for financial innovation that simply weren't possible in traditional finance.

The Future of DeFi: Beyond TradFi Replication

A key insight from the conversation is that the future success of DeFi lies not in simply replicating traditional financial instruments on the blockchain, but in creating entirely new financial products that leverage the unique properties of blockchain technology. Tarun argues:

"DeFi will succeed in the long run not by emulating TradFi instruments onchain, but by forging these net new opportunities."

This perspective challenges the common approach of simply moving existing financial products onto the blockchain and encourages innovators to think creatively about what new forms of finance are possible in a decentralized, programmable environment.

The Slow Adoption of Crypto by TradFi Players

Despite the potential of blockchain technology, traditional financial institutions have been slow to enter the crypto space. Tarun identifies several reasons for this hesitation:

1. Infrastructure Challenges: The 24/7 nature of crypto markets is at odds with traditional finance's time-based operations.
2. Regulatory Concerns: Uncertainty around government regulations has made many institutions cautious.
3. Asset Creation and Destruction: The ability to create and destroy assets at will is a fundamentally different power than what exists in traditional finance.

Understanding these barriers is crucial for bridging the gap between traditional finance and the crypto world.

Innovative Financial Products in Crypto

One of the most exciting aspects of the crypto space is the creation of financial products that are not possible in traditional finance. Tarun highlights several examples:

1. Meme Coins as Attention Markets: The rapid creation and destruction of meme coins around events acts as a form of decentralized, incentivized ranking algorithm.
2. On-Chain Options: While traditional options have struggled in DeFi, new forms of derivatives that leverage blockchain's unique properties are emerging.
3. Automated Market Makers (AMMs): These provide liquidity in a way that's fundamentally different from traditional market-making.

These innovations demonstrate the potential for blockchain technology to create entirely new categories of financial products.

The Relationship Between Non-Financial and Financial Metrics

An intriguing aspect of the discussion is the exploration of how non-financial metrics can be transformed into financial ones. Tarun draws parallels between the social media giants of the 2010s and the current state of crypto:

"Facebook is a fucking bank in that sense. Like they are taking this like a liquid thing and selling it to you. This is the closest thing we've ever created to actual alchemy."

This perspective challenges us to think about how value is created and measured in both traditional tech and crypto, and suggests that there may be new ways to monetize attention and engagement in the blockchain space.

Memecoins as an Incentivized Ranking Algorithm

One of the most fascinating insights from the conversation is Tarun's perspective on memecoins. Rather than dismissing them as mere speculation, he sees potential in their function as a decentralized, incentivized ranking system:

"It's almost like an incentivized ranking algorithm for a timeline... And there's clearly something there. Like I just don't, I just don't know like how you channel that into something more that gives utility to like the average person who isn't like a DJN."

This novel view of memecoins suggests that there may be untapped potential in using blockchain technology to create new forms of social media and content curation.

Crypto as a Disintermediator

Throughout the conversation, a recurring theme is the potential for crypto to act as a disintermediator, breaking down traditional financial structures and creating new, more open systems. Tarun explains:

"Everyone who's complaining about how journalism is dead, whatever wants to re bundle. Yeah, the revertical wise, right? But I actually think the interesting thing about crypto is it's like trying to continue with the unbundling."

This perspective frames crypto not just as a new asset class, but as a fundamental restructuring of how value is created, transferred, and measured in the digital age.

The Future of Finance: Atomization and Just-in-Time Creation

As the conversation draws to a close, Tarun offers a compelling vision for the future of finance:

"I think the unbundling will continue until we've basically atomized everything. Right. And also made things more easy to make and destroy on demand. I feel like that's the thing people don't get about crypto is that like, it does allow people to like make things just in time a lot more than like the existing world."

This idea of a fully atomized, on-demand financial system represents a radical departure from traditional finance and hints at the transformative potential of blockchain technology.

Implications for Solana and the Wider Ecosystem

While the conversation doesn't explicitly focus on Solana, the insights provided by Tarun have significant implications for the Solana ecosystem and other high-performance blockchains. Solana's high speed and low transaction costs make it an ideal platform for implementing many of the innovative financial products and systems discussed.

For example, the ability to create and destroy assets quickly and cheaply on Solana could enable new forms of attention markets or incentivized ranking systems. The platform's capacity for high-frequency trading could also make it attractive for traditional finance players looking to enter the crypto space.

Moreover, Solana's composability and rich ecosystem of DeFi protocols position it well to take advantage of the trend towards unbundling and atomization in finance. As innovators continue to push the boundaries of what's possible in decentralized finance, Solana's technical capabilities make it a prime candidate for hosting the next generation of financial applications.

Conclusion: The Ongoing Evolution of Finance

This wide-ranging conversation between Austin and Tarun Chitra provides a fascinating look at the history of financial markets and the potential future of finance in the age of blockchain. From the early days of futures contracts to the cutting-edge world of DeFi, we see a continuous process of innovation and adaptation.

The key takeaway is that we are still in the early stages of a fundamental restructuring of the financial system. As blockchain technology continues to evolve and mature, we can expect to see entirely new forms of financial products and services emerge - many of which may be difficult to even imagine from our current vantage point.

For those involved in the Solana ecosystem and the broader world of crypto, this conversation serves as both an inspiration and a challenge. It highlights the vast potential of blockchain technology to reshape finance, while also emphasizing the need for creative thinking and a willingness to move beyond simply replicating traditional financial structures on-chain.

As we move forward, it will be exciting to see how platforms like Solana continue to push the boundaries of what's possible in decentralized finance, potentially ushering in a new era of financial innovation and inclusion.

Facts + Figures

• Tarun Chitra first encountered Bitcoin in 2012 when a mining operation interfered with his chip manufacturing order.
• Tarun sold Bitcoin at sub $10 prices in the early days.
• Academic research in 2015 formalized why Bitcoin could overcome known limitations of distributed systems.
• Tarun worked in high-frequency trading by 2016, focusing on simulation and back-testing frameworks.
• The 1960s and 1970s saw the first formal attempts to price options and calculate premiums for financial instruments.
• Post-World War II solidification of property rights played a crucial role in the development of modern financial markets.
• The 1980s marked the beginning of electronic trading of financial assets.
• Reg NMS, introduced in 2005, requires market makers to find the best price across all exchanges.
• Trading volume in traditional markets often concentrates at the beginning and end of the trading day, forming a U-shaped distribution.
• Blockchain markets operate 24/7, unlike traditional markets with set trading hours.
• Meme coins are often created rapidly in response to current events, acting as a form of decentralized news feed.
• Facebook and Google's ad markets can be viewed as a form of futures market for user attention.
• Traditional finance players have been slow to enter the crypto space due to infrastructure challenges, regulatory concerns, and the novel ability to create and destroy assets at will.
• Automated Market Makers (AMMs) provide liquidity in DeFi in a fundamentally different way from traditional market-making.
• Tarun suggests that the unbundling of financial services will continue until everything is atomized and easily created or destroyed on demand.

Questions Answered

How did Tarun Chitra first get involved in cryptocurrency?

Tarun Chitra's journey into cryptocurrency began in 2012 when he was working on building custom hardware for protein folding. A Bitcoin mining operation interfered with his chip manufacturing order, leading him to mine some Bitcoin himself. Initially skeptical, Tarun became a true believer in 2015 when academic research began to formalize why Bitcoin could overcome known limitations of distributed systems.

What are the key differences between Proof of Stake (PoS) and Proof of Work (PoW) assets?

Tarun Chitra highlights that PoS and PoW assets have fundamentally different financial properties. Staking assets in PoS systems can be borrowed instantaneously, while borrowing hash power for PoW assets is not as immediate. This difference changes the financial characteristics of the assets, including their payoff properties, which is crucial for understanding how these assets behave in markets and for designing appropriate financial products.

How did the introduction of computers impact finance in the 1980s?

The introduction of computers in the 1980s revolutionized finance by enabling electronic trading of assets for the first time. This technological advancement increased the speed and efficiency of transactions and opened up new possibilities for financial product innovation. The ability to process vast amounts of data and perform complex calculations in real-time transformed how assets were priced and traded, laying the groundwork for modern financial markets.

Why have traditional finance players been slow to enter the crypto space?

Traditional finance players have been hesitant to enter the crypto space for several reasons. First, the 24/7 nature of crypto markets is at odds with traditional finance's time-based operations. Second, regulatory uncertainty has made many institutions cautious. Finally, the ability to create and destroy assets at will in crypto is a fundamentally different power than what exists in traditional finance, requiring a significant shift in thinking and operations.

What are some examples of innovative financial products that are possible in crypto but not in traditional finance?

Crypto enables several innovative financial products that aren't possible in traditional finance. These include meme coins acting as attention markets or decentralized ranking systems, new forms of on-chain options that leverage blockchain's unique properties, and Automated Market Makers (AMMs) that provide liquidity in ways fundamentally different from traditional market-making. These innovations demonstrate the potential for blockchain technology to create entirely new categories of financial products.

How does Tarun Chitra view the future of finance in relation to blockchain technology?

Tarun envisions a future where finance becomes increasingly atomized and on-demand. He believes that blockchain technology will continue the trend of unbundling financial services, allowing for the creation and destruction of assets in real-time. This represents a radical departure from traditional finance and highlights the transformative potential of blockchain technology to reshape how we create, transfer, and measure value in the digital age.

What role do meme coins play in the crypto ecosystem, according to Tarun Chitra?

Tarun Chitra views meme coins as more than just speculative assets. He sees them as a form of incentivized ranking algorithm or decentralized newsfeed. The rapid creation of meme coins in response to current events acts as a way to gauge public attention and interest. While acknowledging the current limitations, Tarun suggests that this mechanism could potentially evolve into a new form of social media or content curation system.

How does Tarun Chitra compare the ad markets of companies like Facebook and Google to financial markets?

Tarun draws an interesting parallel between the ad markets of tech giants like Facebook and Google and traditional financial markets. He argues that these companies are essentially creating and selling futures on bundles of advertisements, with the underlying asset (user attention) only existing when a specific user shows up. This perspective frames these tech companies as operating sophisticated financial markets, challenging the traditional view of what constitutes a financial product or service.