Crypto in Congress: Jake Chervinsky, General Counsel, Compound Labs
Building a new financial system, protocol governance and the community ownership revolution, and crypto's policy landscape.
Hello!
The sixth episode of HODLpac’s Crypto in Congress interview is available now.
This week, Jake Chervinsky from Compound Labs talks about building a new financial system, protocol governance and the community ownership revolution, and crypto's policy landscape.
You can also listen to it on Apple Podcasts, Spotify, and Soundcloud or read the transcript below.
Enjoy! And be sure to visit www.hodlpac.org to learn more about how to get involved with HODLpac - a community-governed political action committee dedicating to supporting champions of crypto-friendly policy in the United States Congress.
HODLpac:
Hello and welcome to the sixth installment of HODLpac’s Crypto in Congress podcast - I’m your host Tyler Whirty. Like our last episode, instead of interviewing a member of Congress, today we’ll be speaking with another crypto insider with a unique view on regulation and policy.
Our guest today is Jake Chervinsky, who along with being general counsel at Compound Labs – the creators of the Compound interest rate protocol – is also a founding board member at HODLpac.
Just like our guest last week, Jason Somensatto, Jake is one of the best translators in the ongoing conversation between the crypto and policymaking communities and, I think, one of the best people at describing the values of crypto in a way that anyone can understand.
So without further ado, Jake, welcome to the show.
Jake Chervinsky:
Hey Tyler. Thanks for having me.
HODLpac:
Cool, so you’re our second non-congressional guest in a row. Your friend Jason Somensatto was last week. I usually ask members of Congress how they ended up in politics but instead I will ask you, like I asked Jason, how did you end up in crypto?
Jake Chervinsky:
Absolutely. So I am general counsel at Compound labs, which is a software company that builds protocols in the crypto industry. Primarily we are the original developer of the Compound protocol, which I can explain a little bit more about later.
In terms of how I ended up general counsel at a crypto startup, I started my legal career at a law firm called Baker McKenzie in their DC office. And I was doing mostly anti corruption and anti money laundering, compliance, and investigations, and a lot of that for a very large financial institutions. So at the start of my legal career, I got to see sort of how the sausage is made in the finance industry. And this was all very shortly after the global financial crisis, which really shaped a lot of my practice. And you know, my experience of the financial crisis was very much one of watching a lot of widespread misconduct and misbehavior among financial institutions – activities that were very lucrative and profitable for them and perhaps not so great for the rest of the country.
And there were really not a lot of consequences for most of the folks who had been engaged in those activities nor for the financial institutions that had caused so much harm. So, you know, that was sort of my introduction to finance. After working at Baker McKenzie, I took a break from private practice to do a judicial clerkship with a federal district judge. And then I came back to DC and worked for another law firm called Cobre and Kim, which is a litigation boutique focused almost exclusively on financial fraud and misconduct and I really came to think that there was some real innovation that was needed in finance, that the finance industry had become a system that was very slow, very complex, very expensive, and not particularly helpful for the vast majority of people. And really only set up to benefit the few.
Around that same time, I came across cryptocurrency. I started learning about Bitcoin and Ethereum and other blockchain-based crypto networks. And, to me, what it looked like was a technological solution to this problem of what the finance industry had become. You could use engineering to address some of those problems at their fundamental level, by creating an open financial system that was available to everyone and could be used you know, very easily and at very low cost. So, you know, that really got me excited about this technology and made me think that I wanted to jump in full time. And so I decided to to leave private practice and move in house. And I was very lucky and fortunate to find a position at a great company like Compound.
HODLpac:
Absolutely, and Compound is one of the leading projects in DeFi - or decentralized finance - the part of crypto that is focused on creating the new financial system that you were inspired to be a part of. Can you explain to our listeners what the Compound protocol is and how it relates to that mission of creating a new financial system?
Jake Chervinsky:
Sure. So, for starters, the Compound protocol is part of this space that we're all calling decentralized finance or DeFi for short. And basically the idea of DeFi is to do for the entire financial system what Bitcoin did for money; that is, to remove the need to rely on trusted third parties in order for individuals to transact with each other on a peer to peer basis. So the idea really is to disintermediate those financial institutions that I was just mentioning and remove them from the equation of finance.
And so the Compound protocol is a protocol that enables earning interest on digital assets. Basically the idea is if you own digital assets, you can supply them to the Compound protocol and earn interest on them, which is paid by other users of the protocol who are borrowing those assets.
And every user who borrows assets has to first supply assets to serve as collateral for the amount that they borrow. And in that way, the protocol can be self-secured through overcollateralization.
And you know, what's really exciting, I think, about the Compound protocol is, very unlike a traditional financial institution, the protocol is non-custodial. So if you supply assets to the protocol, they still belong to you. They're totally under your control. They're not subject to anyone else's possession or custody. You're not trusting a third party to manage those assets for you. And also the system itself is autonomous. So there is no company that is running or operating the system on a day to day basis.
It's really made up of and consists of a set of rules and procedures for how the marketplace will function. That's what we mean by protocol. And those rules and procedures depends entirely on market forces of supply and demand. So there is no third party that is setting the interest rates. The interest rates are established algorithmically based, purely on supply and demand.
So it is what we would describe as a financial primitive. It's a sort of a base foundation for how this type of financial transaction can be done without the need to rely on a trusted third party.
HODLpac:
And it’s a very important primitive because setting interest rates is a foundational function in a traditional financial system – which is, of course, usually done by centralized third parties. But instead of a centralized third party, Compound uses a set of defined rules.
Moreover, you know, you guys made a big splash recently by turning over governance of that set of defined rules that make up the protocol, to the community, to the holders of COMP tokens. So for those who haven’t been paying close attention, can you talk a bit about what that means and how that process unfolded?
Jake Chervinsky:
Yes, so as I mentioned, the protocol itself is autonomous. It's a set of rules and procedures that self-execute on the Ethereum blockchain. However, there are some parameters of the protocol that are subject to being changed or upgraded. So, you know, this question of governance is much less of a concern for a very simple, or at least relatively simple system like Bitcoin, where there really isn't any human decision making required for the network to continue operating. As it's designed, basically, as long as everyone keeps running the same rules and procedures of the Bitcoin protocol, there's never going to be an issue with the basic financial activity on that blockchain of sending and receiving assets. But once you start applying those same principles to more complex financial activity, like creating interest rates, there are some parameters that do require ongoing human discretion, right. They can't be run completely by machines and algorithms.
So just to give you an example of one of the elements of governance in a protocol like the Compound protocol. I mentioned that the system establishes interest rates through market forces of supply and demand, but that uses an algorithm that selects certain parameters for the minimum amount of interest that can be paid and the maximum amount of interest that that might be paid. And then the curve between those two points depends on how much supply there is and how much demand there is. Well, you could imagine conditions in the world changing so that the interest rate model that curve should be different for a particular asset than the algorithm that we came up with when we first built the system. And so what that means is you need someone who can make that decision of whether those interest rate models should change.
And this is true for a variety of other parameters in the protocol as well, such as how much collateral is required for certain assets to be borrowed and which assets should be supported by the system. And, you know, some other issues like that. Until recently Compound Labs, my company, which originally developed the protocol served as the sole administrator for the protocol. So we were solely responsible for making those decisions, [which was] still very different from a typical financial institution, because as long as we didn't change any parameters, we had no role whatsoever in the operation of the system. But nonetheless, our goal was really and truly to disintermediate ourselves from that role as the administrator of the protocol and the way that we did that was by transferring the power to make those decisions over the protocol to the community, so that the users of the protocol can make those decisions instead of us. And you know, that was a process that we started earlier this year. We did that by creating a token which is another digital asset, which we called the Compound governance token, which conveys governance rights to the holders of the token in order to propose and vote on any changes to those parameters.
HODLpac:
Great, and you know, when this happened, it was quite the event on crypto twitter – people were pretty excited to see this moment in DeFi history. You had a front row seat to that so what has it been like to watch it unfold, what was the reception like, and how has it worked in practice so far?
Jake Chervinsky:
It's been extremely exciting in a couple of different ways. So, you know, first of all, I do think that you know, a lot of people were, were very surprised, but also very encouraged and excited about the idea of the developer of one of these protocols giving up control of the protocol. You know, that sounds, I think, very odd to folks who aren't in the crypto industry; the idea that a company would build something valuable and then just give it away to the users of the system is very unique. But indeed that is what we've done. And I think that that's was very encouraging to people who weren't really sure if DeFi would or could meet its goals and really grow into the type of system that is open and trust-minimized that we've all been talking about for quite a while.
So the reaction to it was extremely positive. The system has been working extremely well. There's been an extraordinary level of participation in the governance system. I think one of the coolest things for me personally, is watching members of the community come up with their own ideas about what should happen to the protocol, and then reducing those ideas into executable code that they then have proposed for the governance system to approve. And indeed many of those changes have been approved and then they are automatically implemented once they are approved. So the protocol has been growing and changing truly without the involvement of Compound Labs, which is really exciting to see.
You know, look, honestly, there's also been some discouraging and less exciting aspects of this. I think we all know that the crypto industry is still fairly full of people who view this all as just speculation and are only interested in you know, what the prices of digital assets are and trying to make money by day trading. And so I think, especially on crypto Twitter, which you mentioned, a lot of the conversation has sort of moved away from the fundamental and exciting revolutionary progress in the management of these open source protocols and moved more toward speculative activity. And it's less interesting to us. But by and large, I think the reaction has been very positive and a lot of really intelligent and sharp people coming out with really smart analysis and takes on the future of this space.
HODLpac:
Agreed that its better to focus on the potential of the technology rather than the price stuff. Though we’re called HODLpac and HODL is a meme associated with price movements, I like to say that we can also be HODL for Helping Our Distributed Ledgers but i digress. But to speak to the potential of the tech, you know, we’re recording this on Tuesday July 28th and tomorrow, leaders of some of the largest tech companies - Facebook, Amazon, Apple, and Google- are going to be testifying before Congress about antitrust and probably a host of other things. So i was hoping you could talk a bit about community ownership of protocols in general and what it means for the future of tech and the economy. Why is it an important innovation that we should focus on supporting?
Jake Chervinsky:
I think you're absolutely right to point out sort of what the tech industry surrounding the internet has become, which is a fairly small number of very large and powerful, trusted third parties. And part of the ethos of the crypto industry as a whole is the idea that trusted third parties are security holes, right? There is an extraordinary amount of risk that we take by relying on and trusting these very large institutions either to, you know, manage our identities or manage our data or manage our finances. So, very recently we saw a hack of Twitter in which a lot of very well-known folks, including in the political world, had their accounts taken over. This is a great example of the problem of trusting a third party to manage your credentials. They unfortunately aren't always trustworthy in doing that.
But even going back before that, when you think about the very large trusted third parties in the finance world, I think of things like the Equifax hack, where Equifax was managing a central database of dozens of millions of Americans’ most private and important personal identifying information. And in one fell swoop hackers were able to obtain, I think something like 145 million social security numbers associated with Americans names and other information.
And this is the problem that community ownership of protocols rather than companies tries to address. So for starters, it's really about you know, instead of having to have these intermediaries that we rely on in between our economic activity or in between our financial transactions, being able to use what is essentially publicly owned infrastructure in order to engage in those daily activities or those you know, really important business activities.
There's also the question of aligning incentives between the owners or managers of the system and the users of that system. So, you know, when we talk about Facebook or Twitter or the social media giants, one of the big issues that has come to the forefront recently is how they are using our data to turn a profit for their shareholders. One way that Facebook does this is by selling access to our information or at least, you know, selling a platform that leverages our personal private information – or at least what we'd like to be private for the benefit of advertisers who can then target us with either sales ads or sometimes political ads. The reason that this happens is because there is a misalignment of incentives between Facebook, the company, and us, the users or customers of Facebook. Facebook has to weigh the question of what is best for them and their shareholders versus what is best for us, the users and customers.
And the idea of community ownership of a DeFi protocol is eliminating that disparity in incentives. It's saying the people who use this system are also the people who own this system. And by aligning incentives between those two groups, you can have at least a better chance of governance decisions being made for the benefit of the users, as opposed to, for the benefit of a company or the shareholders. So when I talk about this being sort of a revolutionary idea to me, that is what is most exciting about it: trying to align incentives between the folks who are managing and the folks who are using these protocols.
HODLpac:
Thank you, I think we all agree that we need to spread that message as wide as possible. And Jake you’re a HODLpac founding board member and as you and listeners know, our goal is to support champions in Congress that get that message and realize that we need to encourage crypto innovation in the US as much as possible.
So related to that, I want to switch to some policy-related topics. And to start off I was hoping you could give us your download on the most pressing policy issues that need to be addressed to enable the future that we're describing.
Jake Chervinsky:
Sure. So, you know, I think when you're talking about something that seems so different from the systems that we've had before it really requires rethinking a lot of the government regulatory approach to the types of economic activity that we are now trying to put in the hands of users, as opposed to leaving in the hands of centralized financial institutions. So I think when you have such a big shift, it becomes very unclear how traditional laws developed for an intermediated financial system can be reinterpreted and then applied to this new type of community owned system. So, you know, I think a lot of the policy issues that the industry is struggling with now is about understanding how regulators are going to apply those traditional regulatory frameworks to the new types of activities that we are enabling.
And, you know, I can jump into some of the specifics about areas where I think more clarity would be helpful. But I think for starters, it's just good to recognize that I think there's a lot more education that needs to be done and, and this rests not on the shoulders of folks in government or folks on the Hill but rather us in the industry.
I think that we need to do a better job of explaining what it is that we're building and why it's important. And I think it's only with that background that we'll be able to make progress in working through some of these policy issues, because if you don't understand the way that the system works and how it is different from the traditional world, then it's pretty hard to make any progress on how the laws can be applied or how they might need to change.
HODLpac:
Agreed, so yeah to jump into some of those specific policy issues, we talked last week about the SEC’s treatment of tokens and the application of securities laws. Another thing that has received a lot of attention is anti-money laundering and bank secrecy act and how those intersect with crypto. As a general counsel at a leading crypto project, what are some of the biggest challenges to navigate?
Jake Chervinsky:
We’ve taken at Compound what I guess you could call a risk averse approach to regulatory issues. You know, we've tried our best, even despite the sort of gray area of regulatory uncertainty in the space in general, to stay so far on the right side of compliance that we don't have to worry about those gray areas. And I think we've done an extremely good job of that.
You know, I think there are other companies out there who are perhaps interested in certain other types of digital assets that they perhaps want to issue or sell. And they're really struggling with understanding how regulators are going to interpret those laws.
I think personally that some of those regulatory frameworks are pretty easy to apply, or at least that they don't need massive changes at this point in order for the industry to continue moving forward.
So taking the securities example as one, the SEC has actually given us a whole lot of very useful guidance explaining how the Howey test, which is the principle of law that courts use to define an investment contract, which is a type of regulated security. The SEC has given us quite a lot of guidance and understanding how to apply the Howey test to digital assets that look like they may imply an investment contract between the issuer of the asset and a purchaser or holder of the asset.
I think where some members of the industry could benefit is getting some more clarity about the SEC approach to specific issues implicated by these assets. So, you know, the SEC has given us, in the form of a framework issued last April, a list of about 60 odd different factors that they consider to decide whether or not a digital asset could be interpreted as an investment contract, which was a very helpful primer.
I think what also might be helpful is to understand which of those factors the SEC thinks is more or less important. I think one thing that other regulatory bodies have done that the SEC hasn't yet is defined the limits of its jurisdiction. And when it actually believes that the laws don't apply or don't need to apply for the protection of investors.
So, as an example, FinCEN put out guidance last May on the application of the Bank Secrecy Act to crypto networks. And they were very careful to say, “here is where we think the Bank Secrecy Act does apply. Here's where we think it doesn't apply.” And I think what would be really useful on the security side is for the SEC to say, “here are some examples of digital assets that we think do not implicate investment contracts because of certain factors that we think are very important.”
And we've gotten that in the form of a couple of no action letters, where the SEC has said that for example, a token like the turnkey jet token, which is kind of like a reward program for a jet company, that those are not investment contracts, but I think there's more that the SEC could do to clarify when it thinks that some of these assets don't implicate the securities laws.
HODLpac:
Got it got it so that’s a good perspective on regulation from the company side of things, how about from an individual’s perspective? What are some things maybe that Congress can do directly or to direct regulators to do that would make it easier for individuals to participate in these cryptonewtorks, as a consumer or even as a producer?
Jake Chervinsky:
So, I think it's important to remember that the driving principle of a lot of the work that we're doing in this industry is about inclusion, right? We want to create a system that is available to as many people as possible and as many places as possible. I mean, that's why the Bitcoin white paper described Bitcoin as electronic cash, right? So very much like cash is available to anyone who can get their hands on a dollar bill. We want these systems to be available for as many people as possible because the traditional finance industry has really taken a different view and has excluded or underserved a lot of people from that system. And so, one of the barriers to using crypto networks to improve access to the financial system and to address financial inclusion is when users of those systems don't understand what the legal or regulatory ramifications would be if they actually get involved.
And I think the best example where more clarity is needed. And I think perhaps congressional action is needed is on the tax ramifications of using these assets. So, right now the IRS’s predominant interpretation, is that any transaction involving a digital asset is a taxable event; as in, if you get Bitcoin and at the time that you get it, it's worth $10,000, and then you spend it on a coffee somewhere but by the time you've spent it, the value has gone up to $10,005. You now owe taxes on the difference in the form of capital gains. And that I think is really unworkable. And also, as a policy matter, doesn't make a whole lot of sense.
I don't think that the amount of revenue that is raised by taxing that type of transaction, a consumer transaction, where someone is spending Bitcoin as money, rather than holding it for investment purposes is really what the tax code is designed or intended to do. Where the amount that will be raised is immaterial to the budget.
So, you know, I think that for starters, it would be great to get some more clarity either from the IRS or frankly at this point from new legislation that would create an exemption there for de minimus transactions in cryptocurrencies. That's one example of probably many where we could provide more clarity for people who want to use these systems, as opposed to those of us in the industry who are trying to build the systems.
HODLpac:
And another question I wanted to ask regarding policy is around this idea that we need to change our regulations to promote innovation here in the US or else we risk losing it to other countries. Do you think that’s true? And if so, is drastic action needed or is it a matter of stringing together some of these smaller things you’ve alluded to today?
Jake Chervinsky:
I think we are at risk of this industry moving off shore. I think we've already seen this in some aspects of the industry. You know, there are a number of industry players who have decided “we don't understand how we can comply with us regulations. So we're simply gonna leave the country and we're going to build our business somewhere else, because we're going to go somewhere where we know what the regulations are so we have certainty about how we can comply”
And, look, this is not a new issue for the crypto industry. I think one of the reasons that that the United States has still now of course, the best and strongest capital market in the world and is the best environment for most businesses to develop is certainty about how the government will approach their work.
There's a lot of hesitation to set up a business in a place like China, because you just never know when the government might decide to shut you down. And, one of the great things about our economy here in the US is knowing that if you play by the rules, then you will be treated fairly. And I think that there is risk of continuing forward with this degree of regulatory uncertainty that will make some people think “we don't want to do this in the United States. We want to, we want to build a whatever business or develop whatever protocol in some other jurisdiction where we are less concerned about the government coming to shut us down.”
And I think it's important to remember that one way or another these systems will be built and these businesses will be you know, will be founded.
That's one of the great things I think about open source software, which is: it really is, in sort of an American way, the type of industry where anyone who has a great idea can build it and can see if it will get traction in the market. And that's really what we're seeing in the DeFi industry now: a lot of people who are experimenting with a lot of very interesting and very new types of technology. And that will continue somewhere. And I think we should be very careful to make sure that it happens here in the United States, both because it will be to the benefit of US citizens both in terms of job creation and in terms of building systems that reflect our principles. But also because you know, at scale, these systems, do have relevance on the geopolitical stage. And we're seeing that in a number of places around the world. For example, China is advancing their own centrally planned blockchain based solution for central bank digital currencies.
And I think what we want to do is encourage a fair and free market solution, and that can compete well against the types of systems that a country China is going to develop. So we should take this very seriously.
In terms of whether it requires drastic action. I actually don't think it does. I think that our economy and our capital markets are so strong that if we just let them do their work, then, you know, businesses will want to be in the United States. I think there are very few developers or companies who would say “all else being equal, we would rather not be in the United States.” And that's why we still see the vast majority of funding coming from US-based venture capital firms.
And we still see, I think, the leaders of the industry in any number of different segments, whether it's exchanges like Coinbase or custodians like Anchorage or others who still are and want to be in the United States. So I don't think drastic action is needed. I think what we need is more clarity about the government's general approach to the industry. There is still fear that the government views crypto as a scam or as a threat and folks, and I think you, Tyler, are working very hard to make sure that our messages heard that this technology is for the benefit of the country to its detriment.
And if we just had a little bit more of that type of confidence coming from the government that that would be very helpful. And a model for that might be the chairman of the CFTC, who has been very positive in judging the benefits and the promises of crypto networks and open financial protocols while also explaining that he is going to make sure the CFTC enforces all of the regulations that it needs to and should enforce in the derivative space. And I think that if we got the same type of confidence and clear message from leadership across the agencies, including at the SEC and within Treasury that, you know, that would be really helpful in terms of making sure that that companies don't flee the United States for other jurisdictions.
HODLpac:
Awesome. I think that would be a great place to end in itself, but, for our final question I would love to hear if you have any parting thoughts for any of our listeners, whether they are in the crypto industry, or more DC type folks that want to learn more about crypto. do you have any final thoughts before we end our conversation today?
Jake Chervinsky:
I guess the message I would leave with your audience, especially for everyone else who's here in DC with us, is it's really important to separate the signal from the noise in this industry. I think more than most industries, there's just a lot of garbage out there because there's so much speculation that comes up around what at least originated as unregulated markets for assets that were dominated by hype and unfulfilled promises.
You know, Bitcoin often gets described as a revolution in money wrapped up in a get rich quick scheme. And I think it's really important to look through all of that noise, to see the signal of the value of what we're building.
I think that that's incumbent on both folks in governments and also, like I said, those of us in the industry to make sure that we're boosting that signal. But I would say, we're happy to take the time to explain what it is we're building and why we think that it provides really strong consumer protections, why it is very positive for the US economy, for the strength of the U S dollar abroad, and why the US government should support development in this industry.
So I would say it's worth taking the time to get to that point of understanding. Reach out at any time because we're very happy to help do that education and make sure that our message comes through.
HODLpac:
Awesome Jake, thanks for your time today... I really enjoyed this conversation.
Jake Chervinsky:
Yeah. Thanks for having me. This was great.
HODLpac:
Thank you for listening to Crypto in Congress presented by HODLpac. If you’d like to learn more about HODLpac and our mission check us out www.hodlpac.org or follow us on twitter @HODLpac. Also, be sure to subscribe to our newsletter to get exclusive updates and access to transcripts from each episode. See you next week