‘You can use blockchain programmatically to reduce counterparty risk’: Fireblocks’ Michael Shaulov

Today’s guest on the Tearsheet Podcast is Michael Shaulov, co-founder and CEO of Fireblocks. Michael strikes me as one of the smartest guys in finance – Fireblocks, for its part, is a platform to create blockchain-based products and manage day-to-day digital asset operations. Banks like BNY Mellon and BNP Paribas are using the firm’s wallet technology for digital asset custody. 

For an industry in flux, Michael is positioning Fireblocks as an important layer in the digital asset technology stack. Our discussion happened before the failure of SVB and the closure of Signature Bank. Michael’s pragmatic approach is refreshing and speaking to him, you get the feeling that he’s building something for the long run.

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The following excerpts were edited for clarity.

Fireblocks’ genesis story

So initially, to be fair, we ran into this problem. When I was at Check Point, we investigated a breach that happened in South Korea. Back in 2016-2017, the North Korean hacking team hacked four exchanges in South Korea, and they stole $200 million worth of bitcoin. Bitcoin, at that time, was worth $1,000. So you can multiply by 23 at the moment. 

The year before, they hacked the SWIFT system – they are sort of well-known for compromising financial infrastructure to bypass sanctions on North Korea. And that triggered my interest in that domain. 

Honestly, I was not a bitcoin maximalist. Unfortunately, I didn't invest in bitcoin in 2010 or in 2011, or anything like that. What basically happened at that point in time, after we did our part of that investigation, I started going down the rabbit hole and learning about the technology. And what I realized is that it's a transformational technology for finance on one hand, and the second thing that I learned is that there wasn't infrastructure to work in a transactional way with cryptos and digital assets, which was clearly underpinning all the narrative of what you're supposed to do with the technology. 

Counterparty risk

I actually divide the world into two different domains. The first domain is actually the pure decentralized finance that honestly was the exception – of Terra Luna – most of that space was functioning very, very well during the stress scenarios that we've seen over the last couple of months. And the reason for that is that to be honest, decentralized finance does work. It took a while. The last couple of years were a good kind of testing ground and some of the blue-chip protocols like Uniswap and Compound were battle tested and they survived the different collapses and the stressful situations that the market has thrown at them in the last 12 months.

The part that didn't function that well, not unsurprisingly, is part of decentralized finance that underpins some of the speculative environment around crypto. If we take a small step back, it's important to understand that bitcoin is much more of some kind of reserve instrument than all the other public sharing protocols, whether that's Ethereum, Solana or Avalanche, or Polygon. Some of those things that people are familiar with – the fact that they have a token and the fact that that token is valued or has some kind of dollar price attached to it – are actually a bet on the fact that the underlying blockchain will be the dominant rail to represent assets and run financial infrastructure. 

Fixing things moving forward with technology

We argue at Fireblocks that actually for the last two or two and a half years for our clients (we currently service 1500 clients, which is basically all the big players, financial institutions, fintech companies, hedge funds, web3 companies, and so on in this space) that we want to introduce technical capabilities that they will be able to obtain counterparty risk mitigation against some of the centralized players and counterparties, in the form of on-chain escrow capabilities, you can use blockchain and can actually programmatically create an escrow which is visible for both parties. That reduces counterparty risk that you don't need to pre-fund, which is what happened at FTX. 

As an example, we introduced the technology that allowed you to actually have a remote view of the positions of your counterparties, which could have saved some of the lenders at 3 Arows, right? For a long period of time, the space was not that interested in adopting that technology, although you would argue that this is kind of the part of the narrative of the space: they prefer to operate using the existing methodologies that you would see in the traditional financial space. And interestingly enough, now, all of this has been washed out. And there is a huge demand for the things that we were proposing and contemplating for a few years already. So, on that front, it is a bit encouraging.

Fireblocks’ model of custody solutions

The narrative that was created with the inception of bitcoin was this thing around ‘unbank yourself’. That was the first narrative. And there is another narrative over there, which is basically ‘not your keys, not your crypto’. Although both of them sort of led you to this self-custody model – the self-custody model that Firelooks provides is effectively some form of the institutional form of custody. We call it ‘direct custody’. So it is a secure non-custodial model for most cases. And the advantage is that you definitely eliminate counterparty risk from relying on anyone else. You're removing the counterparty risk, you're removing the operational risk. 

And then that very elementary structure can be evolved using smart contracts and using MPC technology that we deployed to extend the model to create trustless structures between you and the people that you interact in your trade with. And that can be in the most institutional form of how a lender will get visibility into a borrower or how a decentralized clearing can work between multiple counterparties. And it can actually be applied to the most consumer-ish interactions that people have on the internet. 

The best example I always give is: imagine you have a ticket for a concert and you don't want to go to that concert. And honestly, you don't want to pay the ridiculous fee that someone like Ticketmaster or StubHub will charge you for canceling that ticket or transferring it to someone else. To sell someone that ticket over Facebook or Instagram or some random messaging platform to someone that you don't know carries counterparty risk. Who goes first? You send them the ticket and they send you the Venmo? Or, you know, they send you the Venmo and you send the ticket and how do they know even though the ticket is authentic? 

The interesting thing about crypto is that interaction can actually occur in a completely trusted way using atomic swap using an NFT and via a stablecoin. You can create something that would cost a fraction of $1. And the rail is just like a regular internet rail that is agnostic to what application you want to do without any intermediary. 

So I think that, when you give this example to people, they can intuitively understand why there is a breakthrough in the most simplistic interaction that exists between two people. We want to trade with each other. And how do we guarantee that neither of us is going to defraud the other person without having a centralized party that we both trust? You can expand from that. And it actually changes the world in terms of how commerce can be done, and how financial transactions can be done, both on the individual level and the institutional level, I think that it's super powerful, as more and more of our life becomes virtual and being conducted over the internet rails.

CBDCs vs tokenized deposits

What is much more appealing for the banks at the moment is what we call tokenized deposits. So effectively, they take a cash deposit and tokenize it. It's still kept under the fractional reserve requirements for the bank. And the advantage for the banks is that it doesn't reduce the leverage in the system. This is why the central banks liked that model slightly more from a scale standpoint, compared to the fully backed. 

We have a few bank clients, like ANZ Bank and two other banks in Australia, that made it already public. We have non-banks like GMO, which is a huge Japanese brokerage, that is issuing Japanese yen. And it's a very interesting example because on the back of those structures, and just generally like things like USDC, we've been working with the top payment service providers like WorldPay, Checkout.com and so on that are using the stablecoins for cross-border transactions.

The US figuring this stuff out

The main question is how long that friction will last, but it may definitely hurt the US in terms of competitiveness in the global financial markets. The US traditionally has been the innovator in financial technology. It's the biggest financial market and the most sophisticated.

Unfortunately, I think everything that is coming at the moment from the SEC, the OCC, the Federal Reserve, and so on, is preventing the adoption. The incumbent players are not piling into this technology. They make it much harder for fintechs to try in the United States. And what's happening is that everywhere abroad, people are moving. And obviously, this technology moves really, really quickly. So at some point, it will start to be difficult to catch up. And that's, I think, the main concern.