Odd Lots - Inside The Booming World of Initial Coin Offerings

Episode Date: June 16, 2017

By now everyone's heard of Bitcoin, and probably has an opinion on it. But the world of cryptocurrencies has a new object of fascination: ICOs. Whereas the tech boom in the 90s was characterized by an obsession with IPOs, these ICOs (initial coin offerings) are cryptographic tokens being sold onto the market for hungry investors eager to get in on new ventures. And while some ICOs are connected to companies, others are connected to "protocols" that aren't even recognizably corporations. Confused? You're not alone. On this week's episode, we talk to Chris Burniske of asset management company Ark Invest to talk about this fascinating new world.See omnystudio.com/listener for privacy information.

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slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Put knowledge to work and grow your business. with CIT. From transportation to health care to manufacturing, CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at cIT.com. Put knowledge to work. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthal. I'm sad to say that this week my co-host Tracy Alloway is out. She's currently traveling, so it's just going to be me this week. So this is where normally she would interject something, and then we'd have like some banter, but I'm not really good at solo banter, so I'm not even going to try to say

anything funny or coy. I'm just going to jump right to the topic. Unless you've been living under a rock, you've probably heard about the incredible frenzy that we've seen of late in crypto assets, cryptocurrencies, whether we were talking about Bitcoin or Ethereum or ICOs or all these things, just nonstop, incredible moves these days. So it really is sort of, you know, it's time that we talked about them here. And so today on the podcast, we have a guest who's very well positioned to talk about just what the heck is going on in this area. His name is Chris Berniske.

He's the blockchain products lead at ARCinvest. which is an asset management company that has ETFs, and they actually are one of the few firms that actually has exposure to Bitcoin. So he is going to help us sort out just what's going on right now? Where we are? Is this a bubble? What's going on? Why are people so excited about this area? Chris, thank you very much for joining us.

Thanks for having me. So first of all, before we get into this, what is ArkInvest? ARC Invest is an investment manager. We were started in January of 2014, actually the same month that Ethereum was announced by Vitalik. Right now, we're approaching about a billion in assets, but the key to ARC is taking the open source software development paradigm and applying it to Wall Street investment management and research. So whereas most investment managers keep their trades and their research close to their chest, we actually share all of that because it allows ARCREATM theses to evolve more quickly, and it imbues trust within us. Tell us about your products. You have ETFs. What are they? We primarily have ETFs, and they focus solely on disruptive innovation.

And as a thematic investment manager, they focus on different themes. So for example, we have our next generation internet ETF, which has themes like machine learning, cloud computing, internet of things, and crypto assets. And so for example, in that ETF, because of that. Bitcoin is actually a number one position. And then we've got other ETS like genomics or industrial innovation, so on and so forth. We do have a fintech mutual fund in Japan, and we do some separately managed accounts. So we're a broad purpose investment manager. Now, what's your background? Sorry, I keep forgetting the name of your title, but that's

probably because it's unusual. You know, it's not most people. Blockchain, products lead. You can think of me as the only buy side analyst to focus on crypto assets with a flavor of business development in there. So how did you become the blockchain products lead? What's your background? How did you become the person who would analyze these assets? Well, as with much of life, it was chance. But in college, in 2011, 2012, Bitcoin crossed the radar. I was a student at Stanford at the time, pretty tech-focused environment, and started exploring this brave new world. And that took me down a bit of a rabbit hole. I remember looking with friends at mining equipment on Craigslist and these racks of servers. And we briefly flirted with the

idea of having a mining operation. But at the time, I didn't dig deeply enough to dissociate Bitcoin from what was the major application at the time, which was the Silk Road. And so I interpreted much of what was going on as illegal and didn't necessarily have the courage at the time to leap in, forgot about Bitcoin for a few years, joined ARC in 2014, and at that time, our director of research had invested in Bitcoin early on. It was something that we knew was going to be important, and so picked up the ball and ran with it, and that eventually led me here. You characterize yourself as a byside analyst, and that raises an interesting question, which is that when you hear people talk about any of these crypto assets, like, yeah, but how do you value them? What is the fundamental value? You know, with most things we have, you know, with stocks, obviously, people have developed all kinds of models for valuing of stock based on earnings and cash flow and growth and with commodities, the cost of mining versus the demand, and with currencies, things like purchasing. purchasing power parity. And so all these established models that exist for the asset classes

that we've been familiar with for a long time. And then people look at something like Ethereum or Bitcoin or now there are hundreds of these coins out there and they don't have any idea how to even go about saying, oh, this is a fair price or this is undervalued or this is overvalued. So how do you think about that question? It's a great question. And if we think of this as a new asset class, it follows a that we will have new valuation techniques, and it's a big part of actually what I spend my time focusing on. I think of it as a combination of current utility value plus discounted expected utility value. And to give you an example of what I mean by that, we can take Bitcoin. A lot of people

talk about people using Bitcoin for remittances, and I know of a number of companies using Bitcoin for reminences whose volumes are growing 10 to 20% month over month, which is hypergrowth. If we take the remittances market, it's a roughly $500 billion market, and assume at some future date, Bitcoin will take 10% of that market. Certainly at that point, the market will be a little bigger, but we'll run with this for now. So 10% of a $500 billion market means Bitcoin would have to store $50 billion in value in that year.

Now, you have to also slap a velocity on it. of money for how often the asset's going to turn over. So, velocity of the U.S. dollar is roughly five. What does that mean? What is the five? What's being measured here? For the velocity, it is the number of times that currency is turning over per year to facilitate the transaction of goods and services. So if we say Bitcoin's going to be roughly five as well, we take that $50 billion in value transfer that Bitcoin will facilitate, divide it by $5 to get $10 billion in stored value that year that Bitcoin will need to have in order to facilitate that use case. So just to back up, if you wanted to do $50 billion worth of remittances, based on the sort of

some expectation of how many times a typical Bitcoin would move in a year, you would need, Bitcoin would need to be worth $10 billion. Would need to facilitate that much of a market. Yes, and only for the remittances use case. Right, right. Right. And then what we can do is we can start to stack different use cases, right? We look at the global financial gold market, roughly $2.5 trillion. If Bitcoin were to take 1% of that, that means it would have to store $25 billion in value for that use case.

And so you can see how we can start to stack these different requirements for stored value to get an idea of what I call the network value of Bitcoin, which is analogous to market cap for stocks. the reason I say current utility value versus discounted expected utility value is the market price of this asset is comprised of what people are currently using it for plus the expectations for its use. And so for any expectations of its use, we have to discount that back to the present. So combining these two values, we can get the current market price of these assets. Interesting. Real quickly, your publicly traded ETFs. do have exposure to Bitcoin. How do you get that? We get it through Grayscale's Bitcoin Investment Trust,

which is a trust that tracks to roughly one-tenth the value of Bitcoin. Now, with the way that the trust is set up, at least the publicly traded part, which is ticker GBT, Trades OTC QX over-the-counter markets, it doesn't have a functionality to meet supply and demand, and so it tends to trade at a significant premium, which is something investors should be aware of. So that has grown to be a number one position in two of our ETFs are Internet ETF, ARKW, and our overall innovation ETF.

Put knowledge to work and grow your business with CIT. From transportation to health care to manufacturing, CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at CIT.com. Put knowledge to work. All right. Let's switch gears for a second because, you know, people are maybe heard of Bitcoin for a while,

and there's obviously been tons said about it. It's the old man in the room. Yeah, exactly. The thing that everyone is talking about and curious about and asking questions about these days are these things called ICOs, and that's really what I want to talk about. Initial coin offerings, sounds like IPOs, but it's one letter different. Regrettably. What are they?

You can think of them as the combination of crowd funding, which we all learned about through Kickstarter, plus blockchain technology. So Kickstarter coincidentally started the same year that Bitcoin launched 2009, and that taught us about how we can use capital from the crowds to fund projects. And then blockchain technology basically allows the decentralized storing. and transfer of value. And what we've been having at the intersection of these two is assets that are similar to Bitcoin

but perform different use cases. So Ethereum is something that we will end up talking about, I'm sure. So that's a decentralized world computer. And it uses a blockchain in order to facilitate value transfer in order to pay for that computer. And in order to get that project off

the ground, there was a crowd sale. So because blockchains are really good at storing and transferring this value, people are natively using that functionality to bootstrap capital for their projects. So let's walk through what kind of project it would be and how you would raise, one would go about raising money through an ICO. Let's create a fictitious example or a real example. We can use a real example. Yeah, let's do that. A few weeks back I participated in a crowd sale known as Eric. And what Aragon does, we'll walk through sort of my process, right?

When I'm figuring, okay, am I going to participate in this? First thing I do is, okay, what is the use case? Is this a viable use case? What Aragon does, you're going to have to hang with me here. No judgment. I'm just going to listen. Aragon is a platform on top of Ethereum, uses Ethereum's decentralized world computer. and it basically provides an out-of-the-box system in order for corporations to run on top of Ethereum.

So it provides cap table, accounting, payroll management, things like that. And so what it's going to be used for long term is facilitating decentralized autonomous organizations. So Ethereum is a basically is a crypto. It's a cryptocurrency, but it has all the crypto commodity. Crypto commodity that has all this, you called it a decentralized world computer, upon which you can run new applications and companies and stuff. And you participated in the initial coin offering of a company that runs on top of Ethereum whose business is going to be facilitating other companies to run on top of Ethereum. Yes. the only thing I would change in what you said, you got to exactly correct, is replacing

company with protocol. Okay. These aren't, they're not companies in that they're not generating cash flows necessarily. They're facilitating through software, distributed software. And so Aragon is not a company, it's a protocol. It's a protocol. Does that mean that there's not like a corporate entity associated with it? Now, this is something of experimentation.

Different projects are experimenting. with having foundations or different entities that won't necessarily classify as a cash-generating company in order to support the development of the protocol. But there's not going to be quarterly earnings calls on revenue and earnings and eBidda and all these things. That was step one. So that's evaluating long-term, do I think this is going to be a viable project, then look into the team.

great pair of developers behind this project. And then we get more into logistics. And in order to participate in a lot of these sales, you have to send either Bitcoin or Ether to an address. And let's say we're using Ether in this example. So what I'm doing there is I am sending Ether that I have, which stores value, right? I'm sending it to an address that lives on Ethereum's blockchain.

And in depositing that ether in that address, basically that address records, okay, this other address, which represents Chris, is entitled to a certain number of these units of Aragon, which is the ticker A&T. And so in that process, they're able to accept in mass capital from the outside world that is then programmatically exchanged into shares of their new protocol. These, okay, so now you have these coins in Aragon. What are they, what do you do with them? What are they for? How do they create value for you? Well, there are those two aspects of value, right? The current utility value versus the discounted and expected utility value.

The reason for Aragon, one of the main reasons for Aragon to have a native token is actually to facilitate a decentralized court. So if you have these organizations running on top of Aragon, let's say there's disputes. Since they're decentralized organizations, they won't necessarily go to the courts as we think of them. They will actually go to the masses and let the masses decide upon what is the truth or not the truth, what is right or wrong, and pay out using the native Aragon token to the people that perform that service. So we've gotten very abstract here. Yeah, no, I know, but that's right. Because, you know, I think it's 2017 and everyone's got an open mind and people realize,

so it's okay. We can keep going down this. But it is pretty abstract. It is abstract. Now, these courts, are they like, and you say the people are going to decide, are there going to be literal votes? Is there people on a jury and who will participate? Or is it like something like the algorithm decide?

So decentralized votes, right? A broad set of actors that anyone can participate in. If you have the token. Yes, if you're involved within the network, you will get paid out in the token. Okay. For voting correctly. Okay. And so what happens over time is as more organizations build on top of Aragon,

there will be more demand for that token for these conflict resolution. use cases. But there's also, because this is open source software, it can evolve over time. There can be further use cases that are built in that require the token. And you need, so let's say I'm a business. And so, you know, let's think go to the very end consumer, some business and like, oh, this seems, because right there, you said that Aragon is positioning itself as a service to businesses, right? What's a kind of business that might benefit from this? Well, this idea of a decentralized autonomous organization. Oh, so it's not like a typical entity as we get it now.

It would be a sort of new kind of organization. Well, it is taking your typical organization. Let's take an insurance company. Yeah. Right. So an insurance company is really a number of policies and procedures. Right. A number of if this, then that statements.

That's what claims management is. And what's happening is, we are having these processes be written in software. So you can actually have a waterfall of decisions, right? If, let's say, if Chris misses his flight, pay him $30. If he doesn't miss his flight, he doesn't get paid anything. But it can become more complex than that, more conditional. And so these organizations, these processes are being written in code.

And the reason it's called the decentralized autonomous organization, It's just as we have autonomous vehicles, these organizations are expected to, in part, run themselves. And so in running themselves, they need to be on top of a platform that helps facilitate that and interfaces beneath that with Ethereum, which is providing the compute power to process all of these decisions. Here's a question I have. That all sounds pretty cool. right now there's clearly a lot of, I think when I look at it, a lot of speculative fast money coming into the space, people who are looking for to make a get rich fast, which is not necessarily an indictment because that's always part of any industry. So it doesn't necessarily mean bubble.

I don't know. But there's clearly just a lot of people looking for flips, looking for trades. Two questions. A, is anyone actually using these tokens yet in a. Or do any of these entities actually exist where there's a real ecosystem for these tokens, or is it still all basically in the trading realm? Actually, that's my first question. You know, are there anything, oh, this is really, here's an organization or here's a protocol,

and people are really using it? A lot of these teams have what are called test nets, where they have what you could think of as a minimum viable protocol that's in development, just as, for example, with a genome, economics company, right? Something that's gone public. They're running it through the process, getting it to the end market, the end consumer. And for Ethereum and the apps, decentralized apps that are being built on top of it or protocols, a lot of those do not have mainstream use as of yet. As you said, there's a lot of discounted, expected utility value or speculative value to these assets. But what's key right now for me,

when I look at something like Ethereum, the users are the developers. It's not a mainstream application. My mom or grandma is not going to be using it. It's the developers, and the developers, because this space is so young, are the ones that are building it out. You have a lot of people starting to talk about this as Internet 3.0. It took a while. I mean, the Internet had its origins in 1960 with packet switching. So it takes a while to build these things out.

Right now, we have mostly developers using Ethereum. We've got a lot of mainstream use cases for Bitcoin, I would say, increasingly so. And over time, there will be more mainstream users, but right now there are definitely mainstream speculators. I think that's very well put. So there are mainstream speculators, sort of everyday people, or even not many everyday people, but certainly people savvy enough to like figure out how to get in. The geeks. The geeks, speculating, but nothing really, you know, basically all of these projects are still in

the infancy in terms of actual uses? Everything is largely in its infancy. I mean, if we go back in time, Satoshi Nakamoto released the Bitcoin white paper in late 2008. So the whole movement's not even a decade old. Right. And you raised a good point where speculation lays the foundation for innovation. When we look at the railroad boom or when we look at the tech and telecom boom,

we had a fiber glut. People built things out way too much. They got ahead of themselves. And that's okay. It's a predictable pattern we've seen over time. Another question I have is, could you get into a situation in which the speculators discourage actual usage? In other words, it's perceived as being expensive.

Let's say, you know, I'm trying to, let's say there was something more. I know that there are some of these, like these ones that are trying to build prediction markets based on top of Ethereum, which is something. You've been looking into things. I'm trying to do my research, but I'm interested. I've always been interested in prediction markets, and I think, you know, it's an interesting idea, and I miss, you know, I wish in trade were still around and some of these sites. But on the other hand, like, do I really want to be, let's say I wanted to get involved in that, do I really want to pay up to get involved in this prediction market or put my tokens at risk if the tokens keep soaring in price and I'd be better off just holding them? Mm-hmm. So really quick, the prediction market thing, that's partially what underlies Aragon, prediction market to resolve disputes for companies.

Now, in terms of the value of these tokens actually being debilitating to the underlying utility of the protocol, it's something I've been talking about with Joel Monegro a lot. Who's that? Joel Monegro. So he was the blockchain lead at Union Square Ventures. clearly reputable firm. And one of our concerns is exactly, as you said, when you look at Ethereum right now, for example, the native token for Ethereum, Ether, the more that goes up in price, the more expensive it is in some ways to use the network. And so there needs to be a way, and Ethereum has tried to solve this with a dynamic exchange rate for the units that you pay to use its world computer called Gas. So people are working on ways to dissociate the rise and value of the token from actually using the underlying network. So, in other words, you don't want to have a situation where, let's say, you know, going back to, what's the dispute, what's the ICO you participate?

Arragon. Arragon. So let's say it costs X amount of, what's the unit called? Is it just called an Arrigon? A&T. All right. Let's say it costs X amount of A&T for this dispute resolution mechanism. You don't want a situation in which suddenly the value goes up 5x and it's suddenly 5x more expensive.

Exactly. So you want to be able to create a protocol so that the price drops accordingly with the increase in value. Exactly. Now, what's nice about these things is as they accrue value, they do bring new people on board, right? And there's more capital in order to fund the protocol development. So it is a balance. But you struck at the heart of something that does concern me. And when we think of how the VC world exists, right, VCs allocate capital for the long term in order to help these teams build out.

If we have too much capital sloshing back and forth between these different protocols, that may actually hurt the value of what's being built here. So this is something that's under development, and I think teams are really focused on given the recent rise in speculation. All right. Well, Chris Berniske of Arc Invest, thank you so much. This is a fascinating. sort of a sci-fi world and I think it's certainly very eye-opening to me. I've done a little bit of research into this, but hearing you describe the layers upon layers and new kinds of entities, new kinds of mechanisms is fascinating. And regardless of whether we're in a bubble or whatever, and I hate using that word because when media people use the word bubble, they're always wrong. But it's still very intriguing to watch. So thank you very much for coming on.

world. Yeah, exactly. That'll do it for this episode of the Odd Lots podcast because Tracy isn't here. There's no point for us to have any banter at the end. So thanks for listening. I'm Jill Wisenthall. You can follow me on Twitter at the stalwart. You can find Tracy on Twitter at Tracy Allaway. Our wonderful producer, Sarah Patterson, on Twitter at Sarah Pat with two T's. And Chris, are you on Twitter? I'm on Twitter as well. What's your handle? ARK blockchain. A.RK blockchain, check them out. He tweets a bunch of fascinating stuff about this space and you'll probably learn a lot. Thanks for listening. Put knowledge to work and grow your business with CIT. From transportation to health care to manufacturing, CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at CIT.com. Put knowledge to work. The news doesn't stop on the weekends. Context changes constantly. Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra.

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