Invest Like the Best with Patrick O'Shaughnessy - Hash Power – Ep. 2 - Investing in Cryptocurrencies

Starting point is 00:00:04 In episode one of Hashpower, we explored blockchains as a technology, how they work, why tokens, also known as cryptocurrencies, are an integral part of any blockchain, and how these new networks might change the world. In episode two, we spend time with the leading investors in the field. Like any frenzied asset class, there are countless cryptocurrency hedge funds popping up everywhere, but founders from three of the original firms, polychain, metastable, and block tower capital, are our primary guides this week. Once again, this episode is brought to you by Fidelity investments, a company that is constantly researching and experimenting with emerging technologies like crypto assets and blockchain to improve the lives of their customers. Fidelity provides a

Starting point is 00:00:43 comprehensive set of products and services to individual investors, employers, and financial advisory firms. For more information, please visit Fidelity.com. As I speak, the total market cap of all cryptocurrencies is $136 billion. There are hundreds of tokens currently available, but Bitcoin and Ethereum still represent 75% of the total market. 136 billion sounds like a big number, but it's tiny relative to any other asset class, and I use that term with hesitation. To put it in perspective, that's exactly the same size as the market cap of IBM. But IBM has more than $10 billion of earnings. Tokens have none.

Starting point is 00:01:29 As you will hear, valuing tokens is a very hard exercise. I said it emphatically during the introduction to episode one, but given that this is the investing episode, let me say it with even more emphasis. None of what you were about to hear is investment advice of any kind of. Kind. Just as you shouldn't buy Apple stock because you love their products and hope to outperform the broad market, you shouldn't buy any cryptocurrencies without deep personal research and consideration. A big part of my goal with this episode is to introduce you to the players who are shaping the investment ecosystem and how the investing ecosystem with exchanges, trading, and weird custody problems, works in action. Collectively, our guests run hundreds of millions of dollars, likely now approaching a billion dollars in pure play cryptocurrency investment strategies. While we do explore examples of how to think about individual tokens, these are not investment recommendations. Rather, this is an introduction to the various stages of cryptocurrency investing, from early

Starting point is 00:02:22 stage white papers to full-fledged liquid tokens, and the strategies and skill sets being deployed by the pure play investors. Before we get into the investment specifics, I find it helpful to start with one example of why investors are interested in this space. Ari Paul, the CEO of Block Tower Capital, was the first person to explain cryptocurrencies to me in depth over a long lunch in Chicago that ended with my mouth hanging open. I began by asking Ari about his background and the source of his interest in cryptocurrencies. I'll sort of the background because it kind of illustrates why I got interested. I was a trader at Susqueh International Group doing equity

Starting point is 00:03:03 derivatives, commodities bonds, 4x, almost anything to think of, even electricity forwards. I did that for a long time. Then I was a portfolio manager and risk manager at University of Chicago for the $8 billion endowment. I'd like to think of myself as a student of markets. And the most interesting aspect to me has been kind of behavioral finance and the economic side of things. How do we value assets? And not just how should we value them, but how does the market actually value assets? I first heard of Bitcoin in 2011. And like most people, I dismissed it. I didn't see the value right away. What really made me interested was in 2013, the price ran up to over $1,000 from just a dollar not long before. And then the price crashed because there was the Mount Gawks theft, which was the failure of an exchange.

Starting point is 00:03:43 And also one of the big use cases at the time was Silk Road, which was an illicit marketplace. And Silk Road got taken down by the FBI. And a lot of people thought, okay, that's it for Bitcoin. That was its use. That was its purpose. And what was fascinating was the Bitcoin price did fall, but it found a floor that was in many hundreds of millions of dollars of value. And a common idea among kind of students of markets like guys like George Soros are that when an asset collapses, when the fundamental story seems to be really challenged, when it should die and it doesn't die, that tells you something. It tells you at least that there's something to look at there.

Starting point is 00:04:16 So post the 2013 crash, I became really interested and I tried to understand why do people value this thing in hundreds of millions of dollars, is the real value here? And after kind of understanding a little bit of why this thing might be sound money, then the question becomes, well, what's it going to do to the banking system? How might it change society? What other use cases are there for this? It's really a can of worms where you find all these use cases that are going to challenge the financial sector, but maybe also other sectors.

Starting point is 00:04:40 So really, I'd say first kind of intellectual curiosity into just this new market, this new potential asset class. And then more recently, what's been incredible to me is how inefficient it is. So we're looking at these cryptocurrency markets that are producing 10x returns and some that are producing 100x returns that shouldn't be very clearly, that are clearly kind of inefficiencies that you'd want to short. Why is it so inefficient? And I've worked at some of the biggest trading firms. I'm friends with managers who manage huge amounts of money who know how to analyze things and usually are willing to throw a billion dollars at something to arbitrage or way. So why aren't they? You know, what are the obstacles to making this market efficient? What are the operational challenges? What are the regulatory challenges? Why do these opportunities that we think

Starting point is 00:05:19 shouldn't exist in markets? Why are they persisting in cryptocurrency? So when I talk to people in the U.S. about the idea of Bitcoin, I often get the question of basically, why do we need it? In other words, I'm fine sitting on cash in a bank account. Why do I need something else? And these are generally people who don't own gold. They're not gold bugs. They're not fearful of the collapse of a government. And I get that, living in the U.S. But imagine if you're a wealthy person living in India, and you just had a large chunk of your wealth confiscated through demonetization. You had government issued fiat and the government just one day said it's no longer valid. Your money's gone.

Starting point is 00:05:49 Or imagine you live in a country that has extreme depreciation. So if you're a wealthy person living in China, you're concerned that your currency could devalue by 30% overnight. A 30% of your wealth could vanish overnight when you think you're storing it in a secure way. And those are only the cases that are directly monetary, right? If you live under a regime that's oppressive, if you have to worry about a government confiscating your money unfairly, I had relatives in the past under oppressive regimes who had to sew valuables into their clothes to escape oppressive regimes and hopefully have a little bit of money so they wouldn't starve to death in the process. So we take for granted living in the U.S. today that we have a relatively stable currency. We're relatively confident that it won't get confiscated by a regime. But a lot of people around the world don't have that luxury.

Starting point is 00:06:26 So one interesting, attractive thing about cryptocurrency is if it's stored properly, it can't be seized. You can store cryptocurrency, for example, basically on cloud services, so it exists everywhere, where it is only significant. secured by a password in your head. You can cross borders with a billion dollars in your head. And no corrupt government official, no thief, no oppressive regime can take that from you, which to much of the world is a tremendous value. We will return to Ari and his investment strategy later. But as you'll hear, it's one of several distinct approaches to investing in cryptocurrencies, one that is more rooted in traditional Wall Street trading. Another style is making investments in early stage blockchain projects,

Starting point is 00:07:02 a style that was pioneered by PollyChain Capital and its founder, Olaf Carlson-We. Holly Chain has the backing of well-known venture capital investors like Union Square Ventures and Andreessen Horowitz and is a fixture of this space. We discuss why token-based blockchain protocols may capture value and why these tokens may represent investment opportunities in the first place. If you had been in the early 80s and been a genius that picked TCPIP over X-25, you couldn't have made any money doing that, right? So you couldn't have invested in that outcome being true. And that seems to be different, which I think it sounds like is because of scarcity. Why will, has or will the value accrue or like someone different or some different profit from

Starting point is 00:07:44 innovation this time around? Yeah, I think that's a great question. So the way I think about this is in public markets, most of the value accrues to actually people who are doing what you do, like quant trading or really deep analysis, like fundamental analysis, like a Warren Buffett style. I don't think that disproportionate value accrues to the sort of average person. Some value might accrue there, but it really goes to the people who know what they're doing. On the flip side in private markets and private equity, venture capital, it all accrues to venture firms, coordinated groups of capital that are accredited investors and go purchase shares of Uber and Airbnb and all the rest.

Starting point is 00:08:25 The interesting thing about cryptocurrency is if you just look empirically, historically, value has not accrued to either of those groups. The people who invested early in Bitcoin and the people who invested early in Ethereum, that have made the kind of the best returns you could ever hope to make with an investment, like a thousand X or more in some cases. Those people were not in general professional traders or quants, nor were those people professional private equity investors. Those were geeks. They were computer scientists.

Starting point is 00:08:57 They were college students, just all sorts of, but it's global, right? And it's just a mishmash of whoever happened to find out about cryptocurrency and get a little bug in their brain that said, this is actually a really cool technology. So to me, that value accrual has been to a completely separate, different group of people to date. Now we're seeing, for the first time, I think, what I would call the beginnings of mainstream money, try to get into this space. So a lot of, and this relates to what I do, which is running the polychain fund, which invests exclusively in cryptocurrencies. And so a lot of groups, right? And so a lot of groups, right now are trying to get exposure to this technology, but they aren't this kind of native

Starting point is 00:09:41 technologist who just finds it interesting. They're trying to apply this investing methodology that they have learned in their more traditional investing careers to this space. The interesting thing is that this is a totally new asset class, and it's very hard to apply these traditional valuation ideas or traditional ideas of what makes a good investment to cryptocurrency protocols. It's very hard to apply those rules. So sometimes, people will ask me, you know, what are the future revenues of Ethereum, right? And they're trying, you know, they're trying to assess, I see you smirk because you know what I'm talking about. It's like, okay, well, how do we assess the value today while we look at revenues tomorrow? And it's like,

Starting point is 00:10:19 okay, well, Ethereum actually has no revenues. That's not how this works. And the analogy of these being currencies, i.e. in the word cryptocurrency, is basically a lazy intellectual comparison. In reality, these really aren't currencies. They're sort of like commodities in that there are some similarities to something like gold, but ultimately they're really different from gold too because they actually do something. Gold's use in jewelry or manufacturing is relatively limited relative to its market value. Something like Ether in Ethereum can actually, you know, be used to execute these smart contracts or pieces of code that live in the blockchain. And so how do you value that, Ether? Well, the reality is you can't use any of these existing methodologies. You kind of have to

Starting point is 00:11:02 come at it natively and think about it from first principles as a person who this has been natively involved in this, which is how many of the people who value has accrued to in cryptocurrency growth. And that's how they think about it. It's really a new arena. The other interesting thing about this value accrual versus value capture is that open source traditionally has created a lot of wealth for the world. This is the internet. This is also like Linux, Wikipedia, all sorts of projects. And it saddens me to see, for example, Wikipedia need to kind of put banner ads on the page looking for two, three dollar donations.

Starting point is 00:11:43 Meanwhile, we have this project, Tazos, which is an open source blockchain protocol that just raised over $200 million in a crowd sale. And this is super disproportionate, you know, in terms of financing. And part of it is that Wikipedia creates a whole lot of value, but it doesn't, really capture it. It doesn't really have a means of capturing it. And these cryptocurrency or token protocols can create that kind of wealth, but also capture that wealth, much in the way that private businesses do. So private business, like a service like Uber, the reason people use Uber is because they like the service. And it helps them out in their daily life. Well, that also enriches

Starting point is 00:12:19 Uber shareholders and the people who built Uber. ICOs versus IPOs, tokens versus equity. What are the useful similarities for people to wrap their mind around it? And what are the key differences A token is basically a scarce unit. So they'll say be an outstanding number of units, called it 1 billion tokens. And so if you own 1,000 tokens, you in a sense, one way, a metaphor, like a way to look at it is that you own 1, 1 millionth equity ownership in a protocol. But really what you own is the right to interact with that protocol. So think about if we go back in time, suppose there was like an email token. and it might cost one token to send an email. And so then holding a thousand tokens is really the

Starting point is 00:13:06 right to send a thousand emails. And the value of those tokens is basically a multiplier on how do you value the ability to send an email. And that's sort of how I think about the price of, say, ether or Ethereum is when you're holding ether, you really have the right to execute smart contracts and interact with smart contracts. And so the value of that ether is based on the expected value of those smart contracts and being able to interact there. Now, of course, tokens and cryptocurrencies across the board today remain relatively speculative. So the values are even a bit more hard to calculate because of that. But I think that it's sort of like equity in that you have ownership in something larger and you own a little piece of this kind of large

Starting point is 00:13:52 machine that's out there operating. The difference is that equity is not useful. Equity is just a paper contract that the company will pay you something. In this case, there is no company. It's just an open source protocol. And the quote equity, it's not really equity, but in this kind of metaphor, is only valued insofar as it allows you to interact with that protocol. So that's one way to think of it. Honestly, the analogies, though, they run so thin because the technology is so, it's just so different than really what exists today. While valuing a token is a don't wanting task, one clear path is understanding the token's parent protocol. What does it do? Why might it be useful to customers? How does it scale over time? I asked Naval Robicant, CEO of Angelist and

Starting point is 00:14:38 partner in Crypto Fund Metastable, about comparing protocols to platform businesses like Uber or Airbnb, because in some ways, protocols feel like these matchmaking businesses that have been so successful by pairing consumers and producers. Nival also provides us with good perspective, urging all investors to be very cautious when approaching cryptocurrency investing. As I'm sure you've ascertained, this is very hard. As I've tried to explain this whole idea, or explain it to myself, first and foremost, but to others, I kind of keep coming back to the rise of the platform business model, so, you know, Uber, Airbnb, Angelist, where you're connecting consumers and producers and effectively the piece in between what's now been companies, you could kind of think about

Starting point is 00:15:21 like a protocol. So there could be a protocol that sits in between, in the future instead of a company. Do you think that that is an appropriate way to describe, I know analogies suffer from leaving a lot out, but do you think that that's an appropriate way to describe how the potential for new protocols as people design them in the future, like a platform business? Yeah, I thought pretty hard about this because it was like, why can't every intermediary be replaced by a crypto economic protocol? And at least the criteria that I came up with, which are just my personal criteria, I don't mean this as some sort of industry-wide thing. But when I see a well-designed crypto economic protocol, I've noticed that there's a couple of things that that protocol has going for it.

Starting point is 00:16:02 Firstly, the resource of the protocol is allocating and aggregating is provided by the participants in the system. The actual organizer is doing very little other than laying down a few rules and enforcing them. They're kind of a very thin platform. Secondly, the resource that has been provided by all the participants is a fungible resource. In other words, that it can be easily compared. This is where Airbnb kind of breaks down because if you try to build an Airbnb with a crypto-economic protocol at the center,

Starting point is 00:16:29 how would you know what a house was actually worth or if it was actually available? So the houses are fungible with each other. And then they're also not verifiable. You can't verify the inventory digitally. You can't say, oh, yeah, that house is actually available and not being occupied right now. There's no way to confirm that people can lie.

Starting point is 00:16:47 So the best design crypto-economic protocols, you can digitally verify if the capacity is available. That's why my solar power example works. That's why a cell phone grid built on Wi-Fi would work because you can verify as the bandwidth available. The resource provided is fungible. The main resource is provided by the distributed participants, not by the central entity.

Starting point is 00:17:08 And then finally, couldn't this be done just more easily by Bitcoin or Ethereum doesn't need its own token? A lot of these tend to have their tacked on tokens that developers get paid, but the reality is the underlying protocol would be better served by just paying in Bitcoin or Ethereum. So that's kind of my model. It's not super well-baked. I use it to figure out what I think are the good crypto-economic protocols versus the not-good ones.

Starting point is 00:17:30 So that's where I think the platform analogy you have to be a little careful with. There's some platforms that I think will be very difficult, if not impossible, at least in the next 20 years, to replace the crypto-economic protocols. I'm curious just how you think about your interest in actually investing in cryptocurrencies. I know you're a partner at a cryptocurrency investment fund. How do you think about that? And how does the pure investing side fit into this equation for you? I mean, it's really scary.

Starting point is 00:17:57 These things are incredibly volatile. They're very hard to hold on to. They're very risky. They're very hard to assess. So I actually don't do it myself. My cryptocurrency investing, yeah, I'm part of a hedge fund. I go through the lead trader on that hedge fund. He makes the decisions on what to buy and what to sell.

Starting point is 00:18:13 We outsource our custody, which is, you know, held in like, like vaults by third parties. So essentially it's still a hairy enough space. The average person can't get into it safely and easily, at least for right now. And so I try to outsource that as much as possible so that I can just kind of reflect upon the nature of where this whole thing is headed. I just really don't feel comfortable telling anybody to put their money into it or how to do it. They got to make that own decision that's got to come through information. I mean, you got to spend a minimum of two to three months of obsessive reading in this space. by everybody who's smart before you buy a single coin.

Starting point is 00:18:48 It's a knowledge project. It is a learning exercise. If you're intellectually curious about it, you can dig into it. Eventually, you may learn enough that you also feel confident to risk a very small amount of money. I would just say to the extent that you can outsource it to the pros and just understand everything you can on it. It's surprising to me how many people get into Bitcoin and they've never read Satoshi's Bitcoin paper.

Starting point is 00:19:10 Unless you can read that and understand it at a high level, at least understand all the concepts involved and verify for yourself through your own intellectual logic and reasoning that those are valid, you have no business being in this space. This may be the single most complicated, large-scale endeavor yet created by humanity. So yeah, it's not going to be easy to figure out one kind of throwaway line that I use, which I don't mean. This is facetious, but it's slightly true, is that blockchain may be the first indication we have of large-scale AI, it's artificial intelligence bootstrapping itself into existence. In a sense, a market is an AI because a market makes decisions, allocates resources, and does things that no human can predict or explain,

Starting point is 00:19:55 but it does them better than any human can. So for a certain form of decision making, a market is always better than any individual participant in the market. And blockchains are a much more extreme version of that. So blockchains will be making decisions and allocating resources and capital in ways that no human can match. So, of course, we're never going to figure it out. Even the number one blockchain expert in the world, whoever that is, is just describing one part of the elephant. Nobody knows the whole thing.

Starting point is 00:20:22 What's the counter argument to all this? So if there are clear and obvious benefits to open protocols and decentralization, which, you know, we've covered a lot of them, what do you find the most compelling counterargument? I think most of the arguments that are out there are just from people who are poorly informed. They just don't understand cryptocurrencies. And there's almost every argument that I've seen I could sit down and I could counter given enough time and if it's a rational person the other side. They're usually just under-informed because it's a very complicated topic.

Starting point is 00:20:54 And if you don't understand all sides of it, it's sort of like imagine we're talking about capitalist markets, like we're talking about the stock market before any stock market has ever existed. Right. Like it would just seem like such a crazy idea. or we're talking about a bond market or something like something of that magnitude, like some organization of human beings in a new novel way that's never been done before. And we're talking about in advance.

Starting point is 00:21:17 We'd just be shooting holes in left and right. But the reality is it's so complicated that I don't think you get the right to criticize it unless you understand it. And I have not yet met a critic who is fully informed. So maybe that's an unfair thing to say, but I do believe it to be true in this case. Now, I think there are extremely valid arguments against specific questions. specific schemes and specific blockchains. So there are very good arguments why Bitcoin may not have value, Ethereum may not have any value,

Starting point is 00:21:45 or none of these cryptocurrencies will ever capture values. They may all be bad investments. But to argue that blockchain themselves with tokens underlying are somehow like an invention that's going to go away or not make a difference, that is nonsense. So blockchain plus token governance will be a very important thing. But it is possible that the tokens themselves will never capture enough value to compensate investors and the combination of regulatory risks, scams,

Starting point is 00:22:12 pump and dumps, and just having a very high velocity of the money so they don't actually need to hold on to it will mean that they don't actually capture much value. So you can see the enormous challenge for investors. On the one hand, we may be witnessing the formation of an asset class that has huge value, which would mean this is the opportunity to earn some of the highest returns on invested capital of this generation. On the other hand, these tokens may literally be worthless. The wide dispersion, of potential outcomes is what makes this space so risky and so exciting to investors. Cryptocurrencies aren't currencies or commodities or bonds.

Starting point is 00:22:45 They are different. Olaf Carlson-Wee continues by describing the lifecycle of a token or coin, which has some clear parallels to a traditional company and describes where polychain fits into this lifecycle. From Olaf's description, it's clear we are still in the very early stages of protocol development. Those waiting for killer consumer apps based on cryptocurrencies may have to be very patient. First, before we get into sort of, I'll call it the fundamental analysis part of this, reading the papers, walking the code, whatever that might entail, which we'll get into,

Starting point is 00:23:14 can you first describe the stages? So the stages at which you could earn or get or buy coins, because there seem to be a couple different tiers. Yes. And it depends on if you have a sort of value add mentality or if you're kind of a passive buyer. So there's the first stage that it has been sort of pioneered in part by polychain and in part by other groups in the space is when you have a very early stage blueprint of a protocol that's very promising, but very little actual code written. At that point, people have devised similar to a safe note, which governs a lot of seed deals in venture capital, safe here standing for the simple agreement for future equity. This space, you know, we've helped develop a saft note. And this is a simple agreement for future

Starting point is 00:24:05 tokens. So this is basically pre-purchasing units of a blockchain before that blockchain exists, or units of a token before that token is launched. So I think that's usually like the very, very first stage ever. And that's just a contractual agreement for tokens. So you're not even really holding tokens yet. Then when these things are launched, at that point, the tokens are actually launched on the blockchain and distributed. Usually there are these, you know, these days, there's a sort of crowd sale and participating in that crowd sale by sending a different cryptocurrency, usually Bitcoin or Ethereum, to the creators of the protocol in exchange for protocol tokens. That's kind of the second stage. Then those tokens will get listed on an

Starting point is 00:24:47 exchange. And so there's many pretty traditionally structured exchanges. And by traditional, I just mean there's an order book with asks and bids. And you can go into the order book and say, I want to buy a thousand tokens and purchase a thousand tokens. And you can do that sometimes in an order book that's dollars or fiat currency against that token, so like USD to Bitcoin, or you can more commonly trade in an order book where one half of it is Bitcoin or Ether. So you'll trade Bitcoin for light coin in an order book. And so in general, once it's liquid and in the order books, that's kind of the final stage. And then it will be in those order books forever or until that project falls into total

Starting point is 00:25:29 obscurity and is delisted. If you had to classify polychange potential for value add, we'll call it alpha, relative to say a market cap weighted index of all digital assets. Where's that edge most present? At what stage of what you just described, have you found it easiest to add value, we'll say. Yeah, it's the absolutely earliest stage. We will invest based just on that protocol specification or white paper. Now, these protocol specifications are sort of like blueprints for a protocol. And for the average person, they're relatively hard to understand. There's a lot of technical lingo, and it's hard to parse out what is technically possible or not, unless you understand the technology pretty well. So in general, we will invest at that sort of SAFT stage and help

Starting point is 00:26:20 entrepreneurs get the capital they need to just build the prototype and minimum viable product. you know, or minimum viable protocol in a sense. So I think that's what I would call like our edge. And we're very much fundamental investors in that we're focused on extremely long-term value and real breakthrough technologies. We look at how one protocol will interact with all the other protocols that are out there and be part of what we sometimes call the Web3 stack. And this is basically a stack of blockchain-based technologies that lead to that world we were talking about earlier. That sounds a bit sci-fi, but where Capital Academy coordinated and there are many financial

Starting point is 00:27:00 products native to the blockchain, and there's a whole sort of decentralized internet, in a sense, where server client architecture is distributed, there's distributed browsers, and there's no longer kind of centralized points of failure in the internet. So I think most of the product market fit we think about today is with developers. So most of what's being built today looks more like a developer tool than it looks like an end user application. So the goal, like for example, Ethereum, to me is a developer tool. It's meant to be used by developers to build smart contracts and really other developers, maybe even, to utilize the smart contracts to build applications. You know, a lot of the projects we invest in today, we're thinking of the markets, so to speak, really as developers.

Starting point is 00:27:45 So I mentioned that project, Tezos. hosts, there have a turn-complete scripting language called Mickelson that we think has some interesting properties. It's like a programming language, right? It's really not consumer-oriented in any capacity. But we do think that it has the potential to lead to a rich developer platform so that people can build applications on top. That's mostly what we're interested in today and just where the ecosystem is.

Starting point is 00:28:09 One of the things I'm most interested in is the comparison between utility and speculation and the problem of, let's take Bitcoin, for example, with huge volatility but upside volatility, there's the potential for just hoarding, that people, there's less liquidity because it keeps going up and you don't want to give up a rising asset. You mentioned earlier this idea of, I can't remember what you called a steady state or something that is pegged to, say, a US dollar or something like that. How might that come about? So how could you drop in, say, something that had lower volatility could actually be used,

Starting point is 00:28:41 a blockchain technology or protocol that actually could be used for more everyday functions where clearly, you know, I think that was maybe when I first started reading about Bitcoin, that was sort of the fantasy of microtransactions and all these things, but that clearly hasn't happened at any sort of significant scale anywhere in the world. So maybe use that one as an example for what's missing right now from what we need for that Web 3.0 for that sort of really potentially bright future of technology. Yeah, a lot of it is really basic. Well, I don't want to call it basic. It's very technically complex, but it's like infrastructure or protocol layer components. So for example, with transactional capacity, scalability and transactional

Starting point is 00:29:20 throughput of blockchains is a major bottleneck right now. But there are a lot of promising technical solutions. In Ethereum, this is proof of stake and sharding, which are methods to increase throughput by orders of magnitude, like 100 or 1,000 times. Also, layer two networks like in Bitcoin, this is generally called the Lightning Network, which is a network of what are called state channels, or in Ethereum, the Riden Network, which is similar concept. And it basically allows transactional throughput that's thousands of times greater than what the native blockchain, or the layer one blockchain can support itself. And these technologies simply take a long time to develop.

Starting point is 00:29:59 It's pretty much that simple. But a lot of this kind of, and like I said, with Filecoin, server client architecture is super basic when it comes to traditional internet architecture. But until you have decentralized applications that have high uptime, high resiliency, and work in the browser, you need a server client architecture that works. And so we're just getting the first, what I would call, very solid server client architecture project in the space, which is IPFS powered by Filecoin. And so to me, we're still working on the sort of early building blocks. And before those are done, it's hard to foresee any sort of end consumer application. like a mobile payment app or something, reaching mass adoption.

Starting point is 00:30:44 Both Olaf and Naval give us the sense that there is a lot still to do to make blockchain protocols valuable to the broader world. Olaf's strategy is to foster this early stage environment. Polychain seems to be part underwriter, part venture capital investor, part fundamental analyst. It is clear they play an important role fostering and funding innovation in blockchain. Now early usually also means risky. And because I haven't spent much time sharing more skeptical points of view, I offer two from Jeremiah Lowen and Jordan Cooper.

Starting point is 00:31:10 Jeremiah is a risk and statistics expert who runs risk management for a large family office. He has owned cryptocurrencies in the past, but no longer does. The blockchain technology requires the derivative coin, Bitcoin, Earth, ether, or whatever it is, to have some value. You have to incentivize activity on the blockchain in order to get people to participate in this distributed database. But it's not required to have any great value. It's only required to have value large enough to incent activity. Maybe that means just greater than the electricity costs of running the machine that's doing the calculation. So most of the folks, I think, who believe in these massive multibillion, potentially multi-tillion

Starting point is 00:31:49 dollar valuations are doing so because they think that these digital, these cryptocurrencies will effectively take market share from traditional currency as a store of value. I'm not convinced by those arguments. And I think that even to the extent that they may be correct, the sort of discounted probability of that at this time is so small, it's hard to even give a lot of credence to them because there's a lot of other use cases for these cryptocurrencies that I think are extraordinarily more probable in the short term and don't require it to store value of that magnitude. Look, my personal belief is that anyone who's investing in these things for any reason other

Starting point is 00:32:24 than behavioral beliefs about the other people who are investing in them or who's deluded themselves with charts and technical analysis or things like that is kind of kidding themselves if they think that their belief in the value of this thing should lead to an investment. If that were the case, venture capital would be a very stable, rock-solid investment because some of these things are valuable. Therefore, we should just invest in all of them. It's just not how it works. There's still an aspect of diligence.

Starting point is 00:32:54 These are remarkably young products. And I think that's missed because they are so enormously valuable, right? So it's very hard to square the idea that this thing is, quote, worth. $100 billion, and yet it's extraordinarily young and immature and it has problems and they have to be worked through. And by the way, at any moment, a competitor could pop up and obsolete the whole thing. Yeah, could we make an argument that on a probabilistic basis it could be worth a trillion dollars and we discount that, I guess a 10% full stop? Yeah, sure, someone could, but I think that's just kind of ludicrous. I mean, what kind of valuation would you need given all the threats to this system to justify $100 billion valuation?

Starting point is 00:33:42 If, by the way, what you believe is that it's a store of value because it does need some value to incentivize the miners, but it doesn't require more than that. So you're making two bets. You're betting that people will use it as a store of value, that it will be, well, three bets, that it will be the store of value and accrue a trillion dollars of that value and that it will succeed. and I just don't see how that all works out to, you know, a 10% discount, not even a compounded discount, just 10%, trillion to 100 billion. Jordan Cooper, a venture capital investor who has been exploring blockchains for some time, is optimistic about their long-term prospects, but worried about current prices. So far from what I've seen, 80 to 85% of the projects that I've closely examined and I've

Starting point is 00:34:26 gone nowhere near examining all of them are going to completely disappear. like zeros. And by the way, a lot of those projects are trading at market caps of 20 million to 2 billion. I'm sober in that regard. And like I'm coming at it from this lens, which is I've spent a decade evaluating early stage technology companies and projects and the risk associated with those things coming to fruition. and I'm used to taking this level of risk where most of these projects are pre-launch. They certainly don't have what you would call product market fit.

Starting point is 00:35:09 And I'm used to paying three to $10 million entry prices in order to take that risk. And by the way, if I've done that over, you know, four funds at Lear Ventures and hundreds of companies, we're doing a good job if we're getting three X requirements. turn on those funds. So it's hard to get 3x when you're entering at 3 to 10 million with this risk profile. Now look at this space and you're entering literally at 100x multiple of that for the same level of risk. It's going to be really hard to get 3x on that. That's how I look at the broad landscape, which is only to say, I think a lot of probably your community more than mine, a lot of people are looking at this new asset class and saying, I want to index. I want to index.

Starting point is 00:35:57 this. And boy, is that a painful strategy because you're indexing at such an inflated entry point where my approach is, I think there will be, they're already in production, single digit, really important things that are being built where like, after all this washes out, I closed my eyes in five years, these things are still going to exist and they're still going to be important and they're probably going to be valuable. But that's single digit. And so I'm trying to do the work to identify those assets, avoid, I don't care at all about trading this stuff. The volatility, the 20% swings. It's like sexy, but it's just not the business I'm in as a venture investor. As a venture investor, it's here's an early technology, here's an early team, here's a possible

Starting point is 00:36:42 outcome. And can I close my eyes in bed on the future? And that's how I'm looking at the entire space. Jordan continued our conversation by exploring how he might try to value a single cryptocurrency, in this case ether. I love this sort of analysis, and I'm sure we'll see a proliferation of it in the near-term future, as pure speculative hype gives way to deep analysis of underlying value. The utility of Ethereum, it's a developer-facing platform. Think of it like blockchain as a service. If you don't want to build your own blockchain and deal with all the security issues

Starting point is 00:37:13 that come with that and getting the early network and all these kind of things, you can borrow theirs. And you can pay a price in their native coin to do that. That's real utility value, right? And one of the most important things that I'm trying to do, especially in the Ethereum world, is say, okay, you have all these downstream applications that are being built on top of Ethereum or plan to be built on top of Ethereum. Well, how deeply integrated are those programs and software into the Ethereum blockchain? How often do you have to call it? How often do you have to run code inside one of their blocks and how much is that going to cost?

Starting point is 00:37:51 And then can we roll that up into some semblance of how much demand will these applications create for the native coin? So you do that bottom up analysis on Ethereum. And you can get to, I would say, current usage, it's probably worth less than a billion dollars in utility value. How many projects are being built? How much do they need to use it? So where is the balance of that market cap coming from?

Starting point is 00:38:18 And in Ethereum's case, I think a big piece. of the balance part of it is just I believe there will be more utility in the future and that's totally justified but part of it I think is that store of value use case again so like if I'm thinking in terms of capital flight or escaping local regulation with my money things like this then Bitcoin is a very attractive place for me to do that because it's not regulated and it's liquid and is Ethereum also that should it also be that a while ago I would have said probably not now like it has a lot of liquidity like it might be a good place to move large sums of money so then the question i've been asking myself and i have more questions than answers is is it a net positive

Starting point is 00:39:01 or net negative for the store value use case for the coin that i'm storing my value in to also have some kind of industrial application and that's where you get to like okay gold can store value but it can also make pretty jewelry eath can store value but it can also run code and do i want that or not. And I don't know the answer to that question. To me, like, from a very theoretical perspective, I like the cleanliness of the pure play. I think something that's likely to happen in the Ethereum ecosystem is the fundamental analysis is going to get more granular. People are going to start to build the tools to monitor the GitHub commits and really analyze what are the contracts that are running on this platform. And I do think people are going to wake up and say,

Starting point is 00:39:48 this is not being used nearly as much as we all think and hope and it's not worth X. It's worth something much less than X. So now my store value is at risk. One of the interesting things about Bitcoin is that because you can't run that fundamental analysis because there is no utility use case attached to it, it's almost insulated from that downside thinking. And I find that attractive as a store of value use case. So in my mind, I think highly likely that Bitcoin will maintain the store values case. Now, if you want to hedge against that, for example, and you see a lot of people doing this,

Starting point is 00:40:24 you might build a basket of light coin and Zcash and Monero. And those things might differentiate on the scalability of those platforms, on the privacy of those platforms. Ultimately, I don't think those features are differentiating enough to compete with the liquidity in the network that Bitcoin has already amassed. And for that reason, it will lose. But maybe you want to bet on Bitcoin stumbling or not working through their governance issues or, you know, things like this. And so you could allocate, I don't know, 5 or 10 percent of your store value bucket to spread

Starting point is 00:41:01 over those other things in the case that maybe one of them, which are also likely pure play, store value plays, will surpass Bitcoin. But I don't think Ethereum is the place to park that. Across my many conversations on blockchain and cryptocurrencies, I heard some version of Naval's idea that blockchain the technology is here to stay, but that evaluating cryptocurrencies as investments is a very tricky exercise. Jordan makes an interesting point. What I find fascinating about Bitcoin is that because its value is literally just a story that a network is agreeing upon, it has the potential to grow massive. Crazy as it sounds, the fact that Bitcoin

Starting point is 00:41:36 isn't tethered to an underlying utility like Ethereum smart contracts may mean it's better investment. Wild. While it's convenient to compare these tokens to equity investments, it may not be appropriate. The network effects associated with the ultimate winners in cryptocurrencies will be enormous, the sort of global reach that only a few technology companies enjoy today. But the way to invest in this world hasn't been in companies, like, say, making a venture investment in Facebook. Instead, it's the coins themselves. You may have heard those in the crypto community referenced Joel Monegro's Fat Protocol thesis. I highly recommend you stop and read

Starting point is 00:42:11 that post before moving on. This is a crucial idea if cryptocurrency investing is going to be successful. The basic thought is that given protocols themselves, that is the different blockchains, are the things that hold value, state, and the identity of owners, most of the potential return will accrue to token holders, not apps or companies built on top of those protocols. This is a huge reversal from the past, where apps and companies, like, say, Google, have taken all the value, and protocols, like TCPIP have taken none. As an example, Coinbase, where you can buy and sell different cryptocurrencies, is one of the largest companies in this entire ecosystem.

Starting point is 00:42:49 It just raised $100 million at a $1.6 billion valuation. But that $1.6 billion is dwarfed by the size of Bitcoin and Ether tokens alone, which are worth almost $100 billion. The fat protocol thesis has proved true thus far. The best returns have gone to token holders, not equity investors. But this also means that prospective cryptocurrency investors face very very important. high entry prices. Like any investment, there's what you pay and what you get. You want the relationship between price and fundamentals to be mispriced by the market. In the case of

Starting point is 00:43:21 cryptocurrencies, that edge may still be largely based on psychology and the speculative value assigned to these currencies. Having discussed the early stage investments with Olaf Carlson Wee, there are now two more primary approaches we can explore, with Josh Seams and Ari Paul. First up is Josh, whose firm Metastable may be the value investor in the space. Hey, it's all relative. Would it be fair to say that the goal of metastable and sort of active management within the space is trying to make effectively a bet on blockchain more than any one individual currency? And then I guess what you tell me is it to properly diversify so that, you know, you don't miss out on the return potential of blockchain technology by just saying being

Starting point is 00:44:15 all in on Bitcoin or all in on Ethereum. Yeah, in a sense. Let me articulate kind of our thesis. That would be great. We're somewhat, I would call us value investors in this space, which is sort of oxymorotic. I want to get into that in some detail, though. Yeah. Right, because these are such ephemeral assets. But the way that we approach it is we think that there is a handful of use cases that are amenable to blockchain solutions and high value use cases, perhaps trillion dollar type blockchains. For example, a store of value.

Starting point is 00:44:46 That's what Bitcoin is going for. Digital goal. Right. Yeah. like the easiest one to understand, then there's programmable money, you know, smart contracts. And again, that's what Ethereum is going for. And there's several other competitors to Ethereum that are some of them are doing pretty interesting things that Ethereum does have a big head start. There's anonymous transactions. There is a stable coin. One day that people are working towards

Starting point is 00:45:09 a construction where the token will have a stable value, which would be enormously useful. Then you can have credit and debt markets and things like that. Yeah, transactions. You could really use it. Yeah, you don't have currency risk in holding it. And so that would be really useful. Prediction markets are another one in that right now, the state of blockchain technology if you take something like Ethereum, blockchains can only reason about what's on blockchains.

Starting point is 00:45:33 So it's very easy to create a smart contract that expresses something like only allow 10 ether per day to be withdrawn. Okay, that's something like that's kind of, you know, endogenous information on the blockchain. But if you want to create, say, a financial derivative, say, you know, there's a smart contract. that's an option on whether Apple stock exceeds that value in some future date. For that to work, there has to be a process of getting that real world information onto the blockchain. But that brings up tons of issues of, well, how do you trust that information and all

Starting point is 00:46:05 that kind of stuff? And so prediction markets in general is we're going to need them to modulate just how real world information gets put onto blockchain. So blockchain is going to actually reason about real world events. So that's huge, potentially, and actively researched, right? now. And then there's things like storage networks, compute networks, like file coin. Yeah. Storage network. So anyway, so the way that we see this is we believe there's something like five to ten of these like base use cases. And so the way that we approach our portfolio

Starting point is 00:46:38 composition is we want to, well, it's kind of a hybrid between what I'd call a top down and a bottom up approach. Okay. So top down, we look at each of these use cases as buckets. And what we seek to do is place bets on what we think are the protocols that are most likely to emerge as the long-term winner in this space. 10, 15 years from now, what's going to emerge is victorious. Because there's some strong network effects with protocols so that if one really does emerge and locks in, it probably will be the long-term winner. We're agnostic as to whether there's going to be just one in each of these buckets or if there's one coin that will result them all in the future. Because it's a balance between, again, those network effects could lead to one ruling them all. But then there are fundamental engineering tradeoffs in each of these approaches that could lead to separate, a diverse composition of different protocols.

Starting point is 00:47:31 And then the bottom up part where that comes into play is that we have to find credible candidates in each of these buckets. And some of them, there's multiple credible candidates. So we have several bets. And then there are others that have no credible candidates on our opinion. And so we haven't placed bets yet. And kind of how we do that, what I would say is distinct about our fund is the degree of technical understanding. So, and this is really where Lucas comes in.

Starting point is 00:47:56 I mean, Lucas is someone who he reads these source codes for fun. A big part of our thesis is that a major part of what's going to lead to a winner is the strength of the underlying technology itself. And this is where it's a little different, I would say, from traditional companies. And that if you look at, say, I don't know, take Snapchat or Uber, these companies, the technology itself is only a thin part of what led to the success of those companies. There's way more as just how aggressively they executed, how much money they could raise. Just they're hiring. I mean, they're marketing.

Starting point is 00:48:32 They're branding. I mean, all that kind of stuff. In the crypto world, it's the majority as a technology because these are hard problems. Like, nobody has figured out how to create these protocols that have stable concerns. census are scalable to thousands of transactions per second are expressive and secure, all of the qualities. Developers, I mean, we think that these are solvable problems and we're all making progress, but it is, it's like, this is where some of the smartest cryptographers and distributed

Starting point is 00:48:58 systems designers are working. In crypto world, I think, I would say it's like 85% technology and like 15% community management because these are open source projects. So there is a chunk of that's actually community management is important. And so it's really easy. to write a white paper that makes amazing sounding claims. And so a lot of the people I know, they'll just read the white papers and they'll make the decisions based on that. But you get a much deeper insight if you read the source code itself.

Starting point is 00:49:27 And I say, I don't mean just read. I mean, Lucas has made actually quite a bit of money through bug bounty programs. So in other words, he's discovered serious bugs in these protocols that the developers themselves are not aware of and they've paid him for reporting it. So we believe that's valuable insight, and it's also one that it's hard to get. It's not public. You can't just read and digest it from other sources. You have to kind of go to the first party sources yourself. I'm hesitant to oversimplify any of these very nuanced approaches, but there is something

Starting point is 00:49:56 appealing about this simple rip-van winkle test. What sorts of protocols or tokens might still be around and useful in 10 to 15 years? If blockchains are indeed a transformative technology and not some form of 8-track or laser disc, this may be the simplest and most prudent way of investing in them. In this strategy, the balance of power swings away from traditional Wall Street types and towards engineers, developers, and those that can do the equivalent of fundamental analysis on the code itself. Of course, as crypto continues to proliferate, you can bet that some of Wall Street's best

Starting point is 00:50:28 and brightest will move quickly in. In that spirit, we continue with Ari Paul, a block tower capital. Ari has spent hours explaining this stuff to me, but if we're going to call cryptocurrency's NASA class, we also need to understand some basics about the investable universe. Specifically, how many cryptocurrencies can we actually buy and sell? What types of sectors or categories are there? My colleague Manson-Zu suggested categories like privacy coins, decentralized app platforms, store of value coins, payment coins, financial services coins, asset-backed coins,

Starting point is 00:50:57 advertising coins, voting coins, and gaming coins. I'm sorry to use so much hedging language like, if any of this survives, but I feel it's appropriate for anyone listening who is new to the space to be. skeptical. So, if any of this survives, these many categories sure sound like an asset class to me. So what is the equivalent of listed stocks in the world of cryptocurrencies? It's an interesting question, particularly because the universe is changing and growing so rapidly. So if you asked me, how do I invest in cryptocurrency five years ago? I would have said, buy Bitcoin. If you asked me even a year ago, I probably would have said, buy these two or three or

Starting point is 00:51:31 maybe four cryptocurrencies. Today, there have been more than a thousand created, and there's more than a hundred that are actively traded with meaningful liquidity on multiple exchanges. And of those hundred, I would say that probably 25 represent real meaningful projects with real economic prospects that have market caps and liquidity that are interesting to investors. So our universe, for us specifically, is frankly anything that we can make money trading and investing in. And that universe is changing week by week. So the term in the cryptocurrency world is ICO, initial coin offering. That term is a little bit misleading because it also can sometimes refer to secondary offerings, and it may be, that term may be replaced, but it basically refers to the launch of a new

Starting point is 00:52:09 coin, very broadly, and there's now an ICO basically every other day. And some of these projects are real projects that are launching with $100 million in funding and that are immediately listed on exchanges with real liquidity. So our universe is anything that's investable and tradable in the cryptocurrency space. So to find some of this a little bit more deeply, so we mentioned there are 21 million Bitcoin. So what is a coin? What does it represent? Is it effectively a different version of Bitcoin. What relevant features or variables are there with new coins that are being offered to the public? And how are they buying them? Are they buying them with fiat US dollars or euros or whatever? Or are they exchanging other cryptocurrencies, tokens, coins for the new ones?

Starting point is 00:52:51 Kind of all of the above. So you have blockchains that are entirely separate databases that are really kind of non-overlapping. So for example, Bitcoin and Ethereum are two separate blockchains that each have their own native currency. Bitcoin's on the Bitcoin network, Ether, which is the Ethereum token exists on the Ethereum network. But a lot of people launching new tokens don't want to recreate the entire architecture of a network. They say, okay, Ethereum already has all of the security. They have all this development. Why don't I piggyback on that? So a lot of the tokens that are being issued now, especially the ones on the Ethereum network, they're new cryptocurrencies that exist on the Ethereum network. And there's more than, I believe, more than 100 already,

Starting point is 00:53:27 and that number will probably continue to grow. And it makes a lot of sense because there's no reason to recreate the entire architecture, everything that goes into creating a successful secure network. So in terms of actually converting fiat, that's kind of the hard part right now. So banks are somewhat reluctant to work with cryptocurrency because we're in a regulatory gray area. There's nothing specifically illegal about it, quite to the contrary. There are a lot of very regulated, well-regarded businesses, including here in New York State that meet the highest regulatory standards. But there's a concern that we just kind of don't know what the SEC is going to do going forward. Even the IRS has been reluctant to give clear guidance. So banks have been

Starting point is 00:54:01 somewhat reluctant to deal with customers, with exchanges, with cryptocurrency businesses. But there are a few two located in New York, for example, that are very well regulated, they're insured, and you can connect them to your bank account. You can wire money to them. And then through them, they act as a portal, and they'll convert your fiat into cryptocurrency. Some act as brokers, but ultimately there's an exchange behind them. So you're trading your U.S. dollars for someone else's Bitcoin, or your U.S. dollars for someone else's Ethereum. Because of these regulatory issues, there are a lot of exchanges that prefer to just not deal with fiat at all. So some of the biggest exchange, is you have to deposit cryptocurrency like Bitcoin or Ethereum, and then you can convert it to any of 100 other cryptocurrencies.

Starting point is 00:54:37 You can then pull that cryptocurrency off the exchange. You can send it back to a broker and convert it back to dollars. People sometimes say, is this real money? So they see that Bitcoin is a market cap of $45 billion today, which is likely to change rapidly as it has been. Is that $45 billion real? And the answer is yeah. Yeah, if you wanted to sell $15 million worth of Bitcoin and convert it to U.S. dollars, you could do it in a day without moving the market that much. and you would have $50 million in U.S. dollars in your bank account that day. So the analogy that I've heard a couple times is to envision like a big fairgrounds where you go in and you use fiat currency to buy little gold tokens, and then those gold tokens can be used within the fairgrounds to do all sorts of stuff. You could go on a ride, you could buy some elephineers, you can play games.

Starting point is 00:55:23 So within that network, the coins have some value outside of the network. they don't have value. So is it clean to think of the fairgrounds as a sort of like protocol system and the coins or tokens that are issued in an ICO? Maybe like something like Filecoin would be a good example here where owning the token actually does have. So Bitcoin is all about transactions, you know, currency transactions. But other things are about computing power or storage or, you know, other things

Starting point is 00:55:53 beyond transactions. Is that the idea that by creating tokens, you have. effectively can do something within these protocols, so build a better fairground that can do more stuff, things that people actually want to do, and then hope that if you buy in today, right? So when you buy an IPO, you do so because you think Facebook's going to go 3x or 5x and that what they've built will grow and you'll participate in that. So is it the same idea here that you buy a coin or a token in an initial coin offering because you think the value of that kind of fairgrounds or protocol will grow and that what you can do with one token today will grow, you know, three or five

Starting point is 00:56:32 years from now and that the developers are incentivized because they own those tokens. Am I getting that kind of all right? So you nailed it for one set of tokens. So a real challenge of talking about this is Matt and I throw around the term asset class for cryptocurrency, but it's a little bit misleading. Tokens really play many different roles. So as we talked about Bitcoin, I mostly think of it as digital gold as a store of value. Although you also have to pay Bitcoin. to transact on the network. So it is also a little bit of a token on a fairground where that that fairground is the ability to move money. So you literally, you're charged a little bit of a Bitcoin anytime you want to move Bitcoin. So you can think of it as kind of a monetary transmission

Starting point is 00:57:08 network and you're paying for that service. Other tokens, though, were much more exclusively tokens in an amusement park, like Filecoin was a great example where it enables you to both price a scarce asset, which is file storage, which currently, if you have excess filespace on your computer, there isn't really a marketplace for it. So Filecoin, among other things it does, is it facilitates a marketplace for a scarce resource. Take a slight step back. When you think about the value of capitalism very broadly, one of the real values is just having a marketplace that lets participants price resources means we're going to allocate those resources more efficiently. And it provides an incentive for people to trade. Comparative advantage only arises if there's a marketplace.

Starting point is 00:57:45 So one of these things the cryptocurrencies do is just by having, by tokenizing a resource, you create a marketplace, you allow people to buy and sell, and you also incentivize people to produce more of that resource. So there's no real index for this yet. I'm sure people are building one that's just a simple market cap weighted index so you could buy in an ETF. But obviously, the goal is both absolute and relative return, like in any active management scenario. So how do you start to approach this? And very specifically, how, for example, does your background at Susquehanna trading options at Chicago, how do lessons that you've learned in more traditional avenues apply to arbitrage both short term and long term.

Starting point is 00:58:26 Traditional markets are hard. It's hard to find alpha. It's very competitive. A line that I like is to describe kind of markets in general, at least the way I think about them, is markets are mostly efficient most of the time. And the reason for that is the people you have on your podcast, you're brilliant managers who have a lot of capital behind them and some of the best minds to basically arbitrage away attractive opportunities.

Starting point is 00:58:47 And they don't arbitrage them away fully. They're able to capture little pieces. but they have to compete fiercely to capture small edges. Because if there's a really attractive edge, everyone jumps on it and it goes away. Working in Susquehanna, it was always emphasized to us basically that there's kind of no free lunch, that we were always taught that there are other people in the market who have better information than us. If something looks too good to be true, it probably is. Someone probably knows something that we don't.

Starting point is 00:59:08 And so the emphasis was always on how do you build structural, sustainable advantages? How do you build? And by advantage, I don't even mean over competition. I mean, how do you build a structure that is going to consistently monetize whatever edges are in the market. And traditional markets, that requires massive investment. So there was a point, for example, where I was investing in microwave towers to have a slightly faster connection between Chicago and New York exchanges. A 20 microsecond advantage was necessary to be earning good profits in the treasury market at that time. In other markets, you need the very best quantitative

Starting point is 00:59:37 analysis. You need the best machine learning. You need the best, sometimes its structural advantages, like the cheapest cost of capital to compete. Here we have a space where the alpha opportunities, at least at first glance, look enormous. It looks like a wildly inefficient market where a talented security selector or a talented trader can add tremendous value. I've been really interested to explore why is that? Why is this so uncompetitive? And the answer is, as you would kind of expect, there's always a reason for it. There's always a reason why these opportunities exist. And in this case, it's really hard to get access to these opportunities. So you have a huge range of challenges. You have regulatory challenges. It's not easy for an existing hedge fund to take

Starting point is 01:00:15 advantage of these opportunities. It's costly to get set up in the way you need to. They're operational challenges. So transferring and securing cryptocurrency is operationally difficult. It's scary to a lot of people. It's scary to existing hedge funds. We spend probably half of our time focusing on security because it's such a critical issue in the space. And while it's a headache for us, we also recognize that it's part of our moat, that there's a lot of managers out there with a lot of capital who just aren't willing to deal with the headaches. If you had to disentangle the opportunity, again, into kind of beta and alpha, beta being, you know, you buy a cap-weighted index today, which I guess would be mostly Bitcoin and Ethereum, maybe some ripple and light coin. What gets you more excited right now

Starting point is 01:00:54 as an active manager entering into the space? The problem is that buying, so there may be, for example, a Bitcoin ETF that exists in six or 12 or 18 months, and that may be a great purchase for retail investors. The problem, though, is that's not a bet on cryptocurrency, any more than buying Yahoo in the mid-90s was a bet on the internet. So, Investors may be, and I think should be, very confident in cryptocurrency as a technology is creating value. But the problem is most of the tech giants of the 90s died. They got replaced by better innovators. And cryptocurrency is the same. I think one of the areas where the alpha comes in, aside from just being alpha and adding return, is by having strategies that are kind of basically a whole portfolio of strategies. We have a playbook, a playbook from kind of every asset class, commodities and treasuries and equities of the last hundred years.

Starting point is 01:01:38 And many of those plays work well in a neutral market, and they work well in a bear market. And so by being able to generate value in alpha, even when cryptocurrency is selling off, even when it's in the midst of a six-month or 12-month bear market, which will happen, by the way. Part of what's so attractive about the space is the asymmetric risk reward. So if I create a portfolio and I make five bets, and this is actually true, by the way, in my own portfolio. If my portfolio is more like 10 to 12 bets at the time, usually. But if I make a bad bet, it very quickly, and it's, say, 5% in my portfolio, it very quickly often becomes 2% of my portfolio. because the good bets that achieve a two or three or four or five X very rapidly, those are growing the portfolio as a whole. And the bad bets, of course, are shrinking naturally. Right. So it's just the fundamental nature of longs for shorts, right? Shorts are dangerous because your risk increases as they move against you. But in a normal market, that risk is usually not that pronounced. Usually you're not, there isn't much of your portfolio that you're hoping for a 2x gain over a six month period. But in cryptocurrency, the extreme volatility means that owning a security itself is almost like owning a call. So if I, if I buy a cryptocurrency that I believe has promised, and is 100 million market cap, simply owning it is almost like owning a call because the most I

Starting point is 01:02:41 can lose is that 100 million market cap. But if I'm right, it may give me a 10x over six months. And I have that 10x, right? So basically, my portfolio is a portfolio of calls. And that naturally kind of limits the risk to some degree as long as you use proper diversification and as long as you properly identified the regime. Talk about kind of your impressions from talking to family offices, talking to institutions. What are they thinking? What might they do? What's stopping them from investing. So, you know, I've heard things like counterparty risk and where will the stuff be custodied, volatility, all these things are reasons. But talk about the, the burgeoning ownership base and who you think is kind of going to be the next people in the door as investors,

Starting point is 01:03:20 as big investors. Sure, absolutely. So part of what's so exciting about the space is people sometimes say, oh, is it a bubble, right? The market cap was a billion dollars a few years ago. Now it's 100 billion. Right. As investors, buying into something that's up 100x is really hard. I look at that And I say, I can't, I can't do that. It's just, if you're a contrarian by nature, if you think you're a value investor, how do you, how do you buy into that? Which I totally commiserate with because that was kind of part of why I dismissed it back in 2011, because it was $3 up from $0.10. And I think the answer is, you know, you look at the total market cap right now, which I'm sure will be, will be totally wrong very soon. But right now, it's about $110 billion.

Starting point is 01:03:54 That's smaller than McDonald's. So we're at a state now where all cryptocurrency ownership is basically trivial. So, yeah, your Uber driver might own it. But by definition, the world. basically owns zero. It's a rounding error on the world's balance sheet. To put a couple specific numbers to it, a back of the envelope guess is that less than 0.3% of all the people in the world own it, less than 3% of Americans own it. Talking anecdotally with people in finance, it's under 5% of people that I can, I mean, I ask every trader, every manager, every analyst,

Starting point is 01:04:23 everyone I talk to, I ask about it and it's less than 5% who own it. And these are people who generally have some money are a little bit more, maybe risk tolerant, who probably are good enough with technology to make a secure purchase through an easy-to-use broker. So we're really at the very, very tip of the iceberg. I think this is how this unfolds. Over the next six to 12 months, that number of particularly Wall Street types, people in the investment community who own it, is going to skyrocket. At the same time, we'll start seeing increasing general ownership as well. Part of that will be, it'll become much easier to buy. So three years ago, it was pretty darn hard to buy and store Bitcoin. Today, you can buy Bitcoin fairly easily and store it securely,

Starting point is 01:04:58 but if you want to buy something like Minero, it's still difficult. Even installing a Minero client is still prohibitive for many. As we add things like insured, structured notes, it becomes much easier for institutions to buy. As we have more over-the-counter products, eventually when we have an ETF that really opens the floodgates. What we're seeing right now, though, is massive family office interest. So a lot of the, of the 10 biggest family offices in the country, at least three of them, probably more like five or six, have actually made investments in cryptocurrency. small investments, but they're looking to add a second and a third. They dip their toes in. They saw what they liked, and they want a bit bigger. The next step, I think endowment investors will eventually come

Starting point is 01:05:38 along, but it'll take a little while, partly for good reason. So as a fiduciary, you have a lot of boxes to check. You have to do due diligence. You're responsible for that investment. And the infrastructure around the space is currently being built. So things like having custody of the assets, having auditing, having prime brokerage. All of that is going to be here and it's going to be here in a mature, sophisticated way that endowments can trust. But it's not here yet. It's as we speak, being built and being tested and confidence is still being developed. Ari's overview is comprehensive. If you asked how a huge hedge fund like Millennium or Citadel was run, it'd be appropriate to start at a very high level with types of strategies, structure, sources of edge, market making

Starting point is 01:06:18 activities, and so on. But if you kept digging to the bottom, you'd find specific investigations of securities or algorithmic trading strategies. At the bottom, there are always the things themselves that you buy and sell. I say things instead of securities because in the case of cryptocurrencies, we don't really know what they are. They are a new thing entirely. There are too many to explore in detail on hash power. We've discussed Bitcoin and Ethereum in episode one, so I asked Ari to describe a few of these currencies and what they do, starting with Ripple, the third largest cryptocurrency with a current market cap of roughly $7.6 billion. One that currently has a pretty High Market Cap, right now it's the third biggest, is Ripple. So the symbol's XRP. They're aiming to

Starting point is 01:06:58 replace the SWIFT network to facilitate interbank transfers, as well as theoretically to be used for anything and anyone to transfer economic value. Very broadly, the way it works is their premise is you're going to have a token, which is the XRP token, the ripple token, and they kind of need it to have tremendous economic value for this to work. And the idea is they'll be market makers in different countries, and I'll be able to transfer huge amounts of wealth via just moving ripple that can then be converted into whatever I want locally. So their premise, is they're giving lots of ripple to banks for free, saying we want to bootstrap this to having very high economic value. You'll then have a market maker who will make this very, very tight

Starting point is 01:07:30 market. Let's say you're a bank and you want to move a ton of U.S. dollars from U.S. to China, but you have all sorts of regulatory issues with capital controls and you're subject to the central bank oversight, to the SWIFT network, to all these kind of agreements. Instead, you view it as a market transaction. So you say, I'm going to send a billion dollars. And let's say ripple is a trillion dollar value at that point, which I'm not predicting, by the way, but this is how that could work. I send a billion dollars of ripple. It just instantly converted in China at basically a local exchange, but it's run by a bank to a local currency rate. And it'd be easy you could put that in a contract, of course, to lock in a price. So it's a little bit of a

Starting point is 01:08:00 regulatory arbitrage as well as potentially a true technological innovation, because right now there is no great system. When you send that U.S. dollar transfer from the U.S. to China, not only is it unwieldy from a regulatory perspective, it's unwieldy from a technology perspective. There isn't even a good database system to even record that. Errors are somewhat frequent. So one that's totally different that I'll highlight that's a much smaller cap one, currently about $60 million is called a fun fair. So the symbol's fun, F-U-N. It's a decentralized casino platform. So a really clear use case. There are a lot of use case that are coming up in crypto where we're a little unclear. Does this need to be decentralized? Should it be on blockchain.

Starting point is 01:08:33 So the basic pitch for a decentralized casino is, one, it's open source, so provably fair. So as a poker player myself, I played on poker sites that were later turned out to have been cheating players. So literally some people on the inside were allowed to see your cards. And there are casinos where you think you're betting on a fair craps table, but you're not. The odds are tilted against you even more than they normally are. So here it's open source. You can actually audit the code. You can prove that it's fair.

Starting point is 01:08:56 It's decentralized, which means that if the U.S. tells banks you're not allowed to fund a poker site, that it doesn't matter. So it's kind of not immune, but at least resistant to local regulation. So those are the two main pitches. I think there's a real use case there. As with any small cap coin, so to kind of give you a little color on it, it's interesting. There's something like 15 people who own half of the market cap. We're just believers in it who are supporters. so it's publicly traded, but in many ways, I think of it as a C-stage VC project.

Starting point is 01:09:20 It's almost like there's a few VC supporting this, and it has promise. But because it's publicly traded, it has this tremendous volatility, which you wouldn't normally have with a project that's so early in its stage. Another interesting thing that it highlights for me about the crypto market is very few people who are cryptocurrency. So most of your listeners have certainly not heard of it. Most people invest in cryptocurrency have not heard of it. And by most, I mean, probably 98% haven't heard of it.

Starting point is 01:09:41 And those who have heard of it probably know one sentence about it. So the number of people in the world, so it's made. I actually don't know at the moment. I think it's something like, say, the 25th or 30th biggest cryptocurrency. The number of people in the world who know more than one sentence about it is probably something like a few hundred people. You have this kind of market that is inefficient is not the right word. It's just information is so fragmented. Because if you want to learn about it, there's no single great source. We're at the stage where you have to be talking to the founder, Jess Sam, and he'll take your calls because, well, I apologize to jazz if he gets inundated, but it's at a point where he's not

Starting point is 01:10:10 getting that many calls. The last segment I want to talk about a bit is we'll call it like hedge fund like investors in the cryptocurrency space and the mission that you guys are on. And the tendency for, again, power or returns or edge or alpha, however you want to think about it, to concentrate in a small list of players. Talk about how you see that playing out. What sorts of things would allow you to create, whether it's first mover advantage or you tell me, that sort of edge that can then be sustained over the longer term. And do you think that's right, that just like we see in other asset classes, there are often a fairly small number of firms or individual traders that tend to eke out most of the excess profits.

Starting point is 01:10:51 There's a lot around this that is a huge barrier to entry for someone like Citadel, for example, who might be very confident they can get into the game from a trading perspective, but they don't want to jeopardize their whole bit. If they lose a dollar because of a, let's say, a lost private key or something that could be viewed as a lack of fiduciary responsibility, why would they jeopardize their whole business over that? So you have these kind of barriers to entry that will be fading over time. So third party custodial services that are insured opens the door to a lot more people like us.

Starting point is 01:11:16 It frees up a lot of that effort and time and risk and kind of things that keep us up at night, making sure that we are super focused on that. You know, so it's going to take a little bit of time for those barriers to entry to fall. As they do, the space will become much, much more competitive, which means, like, what really creates that concentration is not just one group being better at it than everyone else. It's that if you're not one of those groups, you just can't compete. You can't be in the game. So you're forced out. So that won't happen until things are much more efficient.

Starting point is 01:11:40 And right now, this is a market where if you're reasonably intelligent and you're a skilled engineer with maybe a little bit of trading skill or you're a good trader and you have a little bit of engineering skill, right now those people are making money. In a few years, they won't because they'll be competing against professionals with all the advantages. So we're very, very focused on converting what is a little bit of kind of an early mover advantage into something that is, I like to use the term unfair advantage. So when I was working at Susquehanna or as a prop trader, you'd say, I can't compete at this because Rentech does it. And how can I compete? They have, you know, half a billion dollars. Hardware costs are probably more where they've optimized. their chips for co-location, for microsecond latency.

Starting point is 01:12:13 You know, we just can't compete with that, right? And so we have to do this. We're forced out of that area. We don't want to do anything where a Rentec can get in the game the next day and potentially be better than us. We want to build a firm where if Rentec gets in the game, they're like, wow, it's going to take a six months or a year to start replicating what these guys have built.

Starting point is 01:12:25 So for us, that area is more focused on medium-term trading at the intersection of relationships where we can access information and deep, deep understanding, as well as kind of the market psychology, having a really good understanding of who the players are in the crypto space, the term that's used as often, you know, who the whales are, who the players are, who the corporate interests are, having both relationships with them and just kind of an understanding that there is no Bloomberg that'll tell you that, right?

Starting point is 01:12:47 It takes time to kind of build that understanding. So having some element of scale where if I want information from a Korean exchange operator, why are they going to take my call? A little bit of maybe I've invested time in building a personal relationship, but part of it is also that, well, if I'm CIO of Block Tower and we're a force in the industry, they take the call. Whereas if you're just entering the space, it might be really hard to get that person on the phone. So trying to build that.

Starting point is 01:13:07 Another side is attracting top talent, right? So being positioned as if you're a small firm, you kind of have to compete on pay or promises. If you're a Citadel, you don't. People want to work for you, right? So being able to attract world class talent, building a world class team. So that's our focus. We're very focused on being the firm that people don't want to have to compete against. If we look back in 2025 and 2017 was the dawn of the crypto asset class, we now have on record some of the major investors who kick things off.

Starting point is 01:13:34 As I was talking to Naval, Ari, Olaf, Josh, Jeremiah, and Jordan. The combination of uncertainty, excitement, and rapid pace of change was palpable. As I said last week, a missing piece to my puzzle so far is deeper conversations with some leading skeptics. I'll make that happen in the coming months. But for now, I'll summarize what I've heard. First, the legal and regulatory side of crypto is a huge question mark. We are seeing a wave of governments shut down exchanges, ban ICOs, and take action that was inevitable as total market cap of these coins continued to grow. I'm sure there will be a lot more where that came from in the near.

Starting point is 01:14:09 future. There's also the question of price that Jordan Cooper explored with us. Many of these protocols are filled with promise like any good speculative investment, but they have little actual traction in the real world. The valuations you have to pay seem preposterous. Then again, preposterous valuations have been a common feature of our generation's best investment stories, from Amazon to Netflix to Bitcoin itself. I've joked often that this show should be called This is Who You're Up Against. If you're a crypto investor or if you're a curious bystander, now you know. Already, we have early stage investors, buy and hold investors, and traders. We may be on the cusp of qualified custodians, institutional investor interest,

Starting point is 01:14:49 and deeper, more standardized fundamental analysis. What will be the PE ratio for cryptocurrencies? How long will alpha last? How many firms will deliver competitive returns against a cap-witted index of the top tokens? When will volatility die down? All fascinating questions. We shall soon find out. next week in the final episode of Hashpower, we spent time with some of the creators in the space who are building protocols like Filecoin and Blockstack, and we look to the future. Where might all this be heading and what should you do next? See you next week.

Invest Like the Best with Patrick O'Shaughnessy - Hash Power – Ep. 2 - Investing in Cryptocurrencies

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