On The Brink with Castle Island - Travis Scher on the FTX impact on Crypto VC (EP.373)

Episode Date: November 21, 2022

Travis Scher, co-founder of North Island Ventures joins the show. In this episode we discuss: Travis' investing career including his tenure at DCG and his path to founded North Island Ventures. How Travis initially met SBF and his reasons for passing on the deal. Analysis of the bankruptcy process and the likely second order impacts. How this event will change the early crypto VC landscape. To learn more visit northisland.ventures and follow Travis on Twitter.

Today on the podcast, I sat down with Travis Share, the co-founder of North Island Ventures. Travis is a long-tenured crypto investor who previously led VC investments for Digital Currency Group. In this conversation, we spent a lot of time talking about the fallout and the second-order effects of the FTX collapse. I think you'll enjoy this one. So without further ado, here's my conversation with Travis from North Island Ventures. Matt Walsh and Nick Carter are partners at Castle Island Ventures. All of these expressed by them or the guests on this podcast are solely their opinions and do not reflect the opinions of Castle Island Ventures. Guests and host may maintain positions in the assets discussed in this podcast. You should not treat any opinion expressed by anyone on this podcast as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of their personal opinion.

This podcast is for informational purposes only. Brought down by bad mortgage investments, Lehman, which has 25,000 employees, will be liquidated. The federal government loans American International Group, AIG, $85 billion. This is a different kind of market, and the Fed is asleep. The federal government is stepping it to stabilize Fannie Mae and Freddie Mac. the two mortgage giants that have been threatened by the housing crisis. The Bank of England has pumped 75 billion pounds more to Britain's ailing economy with a new round of quantitative easing.

You've printed a couple trillion dollars and all of a sudden people start to worry. So out of this worry, we have something called a Bitcoin. Travis, well, thanks for coming on the podcast. Been wanted to have you on for a while. Interesting time to be doing it. So appreciate you coming on. Indeed. We timed this well. Yeah, to say the least.

So we've known each other for a while. I think probably a lot of people in the industry know you from your DCG day. But why don't we just start with a quick intro and your path in this industry? Sure. So I've been a full-time investor in the crypto blockchain space for about seven years now. I spent four years from 2015 through 2019 leading the venture investments at Digital Currency Group. Amazing experience there. Got to invest in over 100 companies in dozens of countries all around the world and obviously

learned a ton and just had the itch to start my own thing. So left there in 2019 and started a new firm with the name that is shockingly similar to yours called North Island Ventures and started that with two partners. Their father, son, their names are Glenn Hutchins and James Hutchins. So Glenn was one of the founders of Silver Lake, the big technology focus, private equity fund. And his son James, who's my main partner day to day, has been a tech investor's whole career, worked at Co2, and has been a full-time crypto investor since 2018. So we launched in 2020. Here we are about three years after that. And we have three funds, 300 million AUM and have experienced a couple of the craziest years in the history of the financial markets.

And I think by far the craziest couple years in the history of crypto. So it has been a fun and exciting ride thus far. Well, I guess it's probably the busiest week in the history of your investing career. if I had to guess, and certainly not busiest in terms of putting new dollars into the ground, but probably from the perspective of speaking with portfolio companies and LPs, if I had to guess. Yeah, just by virtue of luck, we had our annual LP meeting yesterday. And I do think it was good luck because we had a chance to really tell them what's been happening and what our perspective is on everything.

Fortunately, most of our portfolio companies are fairly insulated from this in the short term. We haven't done a lot in the Solano ecosystem. We haven't really leaned heavily into the trading side of crypto. But nonetheless, it's a scary time for them. And a lot of them are wondering, you know, how and when are they going to be able to raise their next round of capital. So we've been dealing with them too. And what's your take? I mean, you have presumably looked at a lot of the FTX rounds and you're not on the cap table.

It probably looked at the early Alameda pitch deck as well. what's your just general framing for how you describe this to someone who's not in the industry on a day-to-day basis? I met Sam and a couple of his partners. I don't remember precisely whom, but I think Caroline and somebody else back in May of 2019, actually, at Consensus. And I met them with my colleague, Larry Sukharianik, who now runs Reverie, my ex-colle. We sat down with them.

He told us about his plans for FTX. At the time, I believe he was raising money by selling. FTT. And I mean, frankly, we were totally creeped out by the guy. His overall demeanor, for one thing, but also his plans to launch in exchange while he also ran this market making fund. And our view was, we never want to do business with this guy. And this is, I'm not just saying this in hindsight, I have old messages, old emails, for anybody who thinks I'm revising history. And it was truly sort of shocking to see him go legitimate in the eyes of the public starting in 2021. We met with one of the investors in the round at that time. James and I didn't ask him,

how the heck did you get comfortable investing in FTX? And to be honest, he shrugged his shoulders and basically implied that all the big guys were doing it. And they just, felt the FOMO and followed along. And so it was a bit of a mystery to us as to how everybody could have gotten comfortable working with them in light of the known conflicts with Alameda and just the general sense that there were, quote, skeletons in the closet. I heard that term many times with respect to the FDX and Alameda backstory and relationship. I nonetheless, less like everybody else and totally shocked at the scale of the fraud that was going on here. But in hindsight, with all the facts on the table, it all makes sense, honestly, you know,

the amount of money that he was throwing around in so many different ways should have been a huge red flag. You know, I think his attempt to whitewash his personality through basically singling that he was this great do-gooder. That was also a red flag to me. I never trust anybody who says that they're trying to save the world. Some of the worst people in history, literally some of the world's worst dictators, this is where they start. They're trying to save the world. So it's been totally shocking to witness this from beginning to end. I want to double-click into a few of the things you said there. So one is on the conflict. So that was the original reason why we were not interested in investing in the business in the first place. And it's just shocking

to me how much capital went into this with no thought around what's the exit strategy. So how do you go public as an exchange if you own a prop trading firm that you admit trades on the venue? What do you think the exit strategy that people had in mind here for this investment? I think that during the tech and crypto bubble, we experienced during 2021 and into early, 2020, people were not thinking about obvious questions such as exit strategy. As shocking as that is, that some of the biggest named venture funds in the world back this company, I think that their diligence and thought process around this was shockingly shallow.

You know, we are primarily seed stage investors, right? So when we write a million dollar check into a company at a 10 or 15 million dollar valuation, we can say, figure out the exit strategy later. And I think that a lot of the growth investing in the venture markets over the last few years has been done like seed stage investing effectively. And it makes no sense, but that's what was happening. I think you're right. I mean, the other thing that's, I guess we'll find out is that he was showing a lot of money

personally. So he had the $500 million investment in Robin Hood, apparently at $500 million as an LP into several funds, including Sequoia and Altimeter, which kind of raises the obvious question of where are you getting the money? And so I guess as an investor, I would want to know, well, was there a secondary transaction here? And if not, where do you get it? And so my guess is that they thought he was getting it from Alameda, which raises the obvious question of, why is that a good thing for your FTX investment if this guy is making billions of dollars a year on something that you're not an investor in? I just can't really wrap my head around it. They must have assumed he was making it at Alameda. That was the only plausible explanation.

But I think that this whole scandal has elements of so many different historical scandals. And one of them is actually the one MBV scandal, the Joe Lowe's, pillaging of this Malaysian sovereign wealth fund. And one of the things that happened there was Jolo was just throwing so much money around in so many different ways and associating himself with various celebrities that people just didn't really ask the hard questions. They didn't really have an incentive to. And I don't, I think this is just human nature. You know, when somebody offers you tens of millions of dollars or hundreds of millions of dollars as an LP and you see he's hanging out with Tom Brady, your mind just goes to great, take it. Yeah, I think that's right. So you're a

lawyer by training and a big part of this is going to be around legal and regulatory. And it looks like he was going down this path of trying to get FTX, the offshore venue, into some sort of a framework that could come back to the United States. I mean, what's your take on how far a long he was in that process. I don't know. And it's one of the most bizarre elements of all this that such a brazen con man who was in the middle of stealing billions and billions of dollars would simultaneously be spending so much time with regulators trying to get regulation passed that he could fit with him. I mean, on the one hand, it's sort of like in the godfather two where the Corleone family tries to go legit, right? And I think maybe that's what was going on. On the other hand,

I think this guy could have just been completely out of his mind. I mean, if you see his tweets recently, there's a huge element of sort of, quote, mistakes were made without taking any personal responsibility. And I think that it's entirely possible that he was out of touch with reality. And hadn't really come to terms with just how outside of the bounds of the law he was operating. I think that's right. I mean, it's almost not even worth trying to get in the mind of a sociopath. That's clearly what we're dealing with here. Yeah. I mean, look, it was either some very well-thought-out strategy to effectively go legit, or he was just completely out of his mind. And I think the latter is more plausible.

Yeah, you're really shuddered at thinking how big this could have gotten if he was able to get a CFTC license, if he was actually able to come under a regulatory regime and just get more and more deposits on the platform. It's scary. It would have been an even crazier story than it is, which is hard to imagine. There's also a lot of just disappointing things. If you think about it from the perspective of the tools that blockchains give you and how little we took advantage of those tools. It's unclear to me that there were cold wallets at FTCs, for instance. And so on chain, I think you probably could have seen the story play out a lot earlier. I mean, there was people that were identifying in Q2 FTT transfers between the entities. And so for all the great things that blockchains do, it's very clear that we didn't really use any of the tools. One thing I would say is that the state of investigative journalism in crypto is incredibly weak.

Obviously, this started with that Coin desk article regarding Alameda's balance sheet. And I read that four times after it came out because I was trying to figure out what the heck is going on here. And in the grand scheme of things, good article, glad that it was written. But it was vague, disorganized. Initially, it didn't even say what date the balance sheet was from. It didn't have, it didn't say who the debt was owed to, what it was denominated in. And just very clear that this space could use better investigative journalists or just rogue individuals out there doing the hard work to uncover these frauds.

And I'm surprised that more people didn't figure this out. That said, it's immensely complicated. I've heard through the grapevine that over five companies that do blockchain analytics have already been retained to sort out the state of Alameda's balance sheet and the history of all the transactions here. And I think that process alone, getting the on-chain transactional record in place and figuring out what they own, where it all went is going to take a year. At least, right? I mean, it's going to be crazy. I wonder what's going to happen to just the chart of accounts. I mean, And this hack, is there a world where they just nuke the database on Friday evening?

And how hard is it going to be to recreate customer deposits here? I think this could be a really messy one. In the bankruptcy filing that came out this morning, there's no mention of total customer deposits. Totally. I mean, look, you've had some incredibly complex large bankruptcies, particularly in the aftermath of 2008. You know, the Lehman case went on for over a decade and they had some very complex instruments there. and a ton of counter parties. And you had the Madoff case where there was a lot to untangle.

But there, I think they essentially knew what was within those entities and who they had transacted with and how much, like basically immediately. They had to get it organized. And here it's not even clear who knows what and what records are going to exist when they really get into the bankruptcy case. So it is going to. going to be a complete disaster. I think this guy, Irving Picard, who was in charge of the made-off case. Being a New York Jew, I knew some people who had given Madoff money and just had

a bunch of secondhand connections to it, fortunately no firsthand. And he did this amazing job of clawing back as much money as possible, I believe by going after a lot of the deep, deep-pocketed intermediaries. And so I think everybody following this case should really familiarize themselves with this concept of a fraudulent conveyance. And the essence of a fraudulent conveyance is when an entity pays back some creditor prior to actually going into bankruptcy, whereby under the law, those funds should have been in the total pool available to all creditors. And there's some complex law around it. It really depends on what creditors knew or should have known. It depends if they're related parties. But my hope is that whoever ends up being in charge of this bankruptcy

fights tooth and nail to claw back as much money, particularly from the deep pocketed folks interacting with FTX or anybody who worked there in a senior position who really should have known better. And that process is going to take a long time. But I do think if they get somebody who does that well, they'll get hopefully some material recovery. A lot of people are talking about this, right? So is there a world where that fraudulent conveyance would be brought to bear upon investors that are on the cap table of FTX that had assets that they pulled off the platform, will it apply to the management team? I mean, how will you actually define that fraudulent conveyance, do you think? This is a question for a real lawyer, not an ex-lawyer like me. But it's going to be very

interesting. Yeah, it'll be fascinating to watch. I mean, so what do you think about the second order impacts here from the lending desks and how are you thinking about that? I think that the implications for the industry are broadened. I think we have ongoing contagion risk, although I think most of the leverage has now been flushed out of the system. That's the good news. But I think it's very possible there are other hidden bombs here. You know, whether it's just industry players that interacted with FDX that did something wrong along the way and are going to face some sort of regulatory backlash or whether it's other exchanges that were doing the same thing. And whether there have been a bunch of funds who have gone on Twitter and said, hey, we lost a bunch of our

assets that on the one hand, you want to get ahead of the news. On the The other hand, for some of them, I think it takes some courage to do that. So I think there's a lot of folks who've lost a lot of money who are going to be out of the game for a while, who it hasn't been made public yet. So there's going to be more money just lost and sucked out of this industry and more losses that come to light for sure. I think that there's absolutely the potential for a broad regulatory backlash here. Our hope is that this actually spurs smart regulation.

I think there's a few ways you could look at this. And one is that it was a failure of the regulatory system. And the fact that crypto's been operating in such a gray zone for such a long time is what led to people wanting to go offshore to trade. And so hopefully we actually do get smart regulation out of this. And the last piece is just reputational for the industry. I think for those of us who have been in the industry for a long time, who are in the industry not only for its commercial potential, but because we are aligned with the positive ideals in the industry,

we're going to stick with it. But for anybody who dip their toes, whether those are institutional investors who had started to do more here, year, web to entrepreneurs who were interested in starting businesses in crypto or big companies that had started to experiment with the technology. I think the reputational stain of this is likely to keep them away for a while. So I think 2023 is likely to be a pretty dark period for the industry, but we're psychologically and strategically prepared for it.

And my hope is that over the long term, there are actually some good that comes out of this. Yeah, I think that's exactly right. I mean, how does it make you feel as an investor? How are you preparing to be on the offense or the defense for that matter in this new paradigm? I don't think it changes much from a venture investing perspective. I think for us, we invest with a three to five to 10 year time horizon. And we haven't been super excited about sort of the trading side of crypto for a while. We're really interested in backing entrepreneurs who have great ideas for new use cases that we

believe can succeed and change the world over a longer period of time. So on the one hand, it doesn't change much about our sort of venture lens. On the other hand, I do think that for many, we also just happen to close. is our second fund in September, it's $125 million. And the plan there is to deploy it over three years. But we had many peers in the industry who raised funds that were much larger than anything they've ever managed and were deploying with, you know, a 12 or 18 month time horizon, meaning that they plan to make new investments over a year, a year and a half and then go

out and raise their next fund. them, I don't think anybody can feel comfortable assuming that they're going to raise a penny in 2023. So a lot of investors are going to have to slow down. Yeah, I think that's exactly right. And obviously, the ripple through will be to the actual startups themselves. It's just don't expect the generalist funds to be there because a lot of them got burned on FTX with their very first crypto deal. And, you know, the size of the total allocator base is probably going to shrink in 2023. Totally.

And look, we were already on pace for this. I think that, you know, if you look at the size of the crypto venture markets, it was basically low single digit billions from 2016 through 2020. And then in 2021, almost 30 billion was invested in crypto startups. And in the first half of 2022, it was over 20 billion. And these charts look a lot like the amount of money invested in the late 90s. 90s in internet companies. And so I think we were already experiencing the popping of this tech bubble. And so entrepreneurs should have known there was going to be a lot less capital available

for follow-ons or the bar was going to be much higher if they were starting something new. But I think with the reputational damage done here, the drop-off in total venture invested in crypto is going to be even more extreme. One of the things I really struggle with through this whole cycle is, similar to you, I had really uneasy feelings about FtX and Sam and Alameda from the start, but I never said anything publicly other than, hey, there's some big conflicts here. There are other things in this industry right now that really worry me, you know, crypto.com, gate I.O. Coin. I mean, a bunch of these venues where on chain, you can see really troubling things, you know, I hope as a byproduct of this fallout that people

just get more comfortable calling out what, you know, it looks like pretty sketchy behavior. I don't think we've done enough of that as an industry. Totally agree. And huge props to the people who did call out, you know, some of the stuff around FTX publicly. You know, I saw there's dance from framework was very public and criticizing Sam for, you know, what he was doing in Washington as were a few other folks. And, you know, I give them massive. I also think, you know, the way that you have held three arrows to account in the aftermath,

I have a lot of respect for that. Personally, I'm not, I'm not huge on sort of stirring the pop in public on Twitter. I don't have how many followers in any case. But, you know, behind closed doors, I think I don't hold much back. So one of my personal lessons out of this is to really trust your intuition. You know, when I look back and see some of my messages around FTX, one of our investors emailed us about them in 2021 because they were looking at the round. And what I basically said in response is I met the guy once. I have some questions around his ethics, but I don't really know him well and some people seem to like him. So maybe my instincts are wrong. But I think those of us who have a moral compass in this industry should trust our instincts on that front because there are

so many bad actors in this space, unfortunately. And where there's smoke, there's fire in crypto. And the good news is I think a lot of the bad actors are being flushed out, but it is our responsibility to sort of push that process further alone. I think that's right. I mean, it gives me a lot of respect, even more respect than I already had for the entrepreneurs that have built these financial services business in the crypto space in a compliant way in the U.S. You know, think about Brian Armstrong and Jesse Powell and Eris X guys, the Fidelity team, Boney. I mean, you're playing with one hand tied behind your back when there's an offshore venue that has infinite leverage and all sorts of products that you can't offer in the United

States and all the retail attention and Super Bowl ads. It's just, it's an unfair playing field. Totally. In the early days at DCG, one of the things we did was try to find the top Bitcoin exchange in every meaningful geography in the world. And we invested in 20 of these exchanges, companies like BITZO in Mexico and BitPesa and Africa and Bid Oasis in the Middle East and Ripio and Argentina and many others.

And the vision there was let's help create the on-ramps and off-ramps so that people can own Bitcoin anywhere in the world and also use Bitcoin for international payments, which I still think is a great use case for crypto networks in general, although more likely stable coins than a volatile asset like Bitcoin at this point. And then in 2016, we really started to see the rise of what I would call shitcoin casinos. Companies like Poloniacs and BitTreeks, and I was never interested in those. And we never invested in any of those during my tenure.

But those companies got so big. And it was a little bit hard to see, you know, when you're working with some of these incredibly high integrity, mission-driven entrepreneurs, starting these sorts of companies in places that are hard to start any sort of company. And I think that crypto lost the plot a little bit. You know, the point here was that these exchanges would create an on-ramp to a better decentralized system that would enhance individual autonomy and freedom. And instead, what we built up was this giant interconnected shadow banking system for

compulsive gamblers. And my hope is that we give more attention to and celebrate, you know, entrepreneurs like Brian and Jesse and others going forward because I just think that'll be a much more sustainable direction for the industry. I couldn't agree more. I mean, it will also be interesting to see some of these ecosystems that Sam was so closely affiliated with. I mean, on one hand, they're very vibrant ecosystems.

On the other hand, you have this huge overhang where FTX owns like 10% of the supply or even more. So what do you think happens to some of these Samcoin ecosystems? We've looked at Solana a bunch of times from an investment perspective. and my perspective has typically been like we should maybe short the hell out of this thing. And now I think it actually could be a more interesting place to make some investments and play a little bit now that he's exited because my feeling is Solana has outgrown him. I think that it does have a bunch of other big firms that are integral to its success.

So I wouldn't describe it as the most decentralized ecosystem in crypto. But nonetheless, I have been impressed by the quality of entrepreneurs I've seen building in Solana over the last years. And there's a lot of overhang there. They're going to have to pick up the pieces. I think Defi and Solana is a complete mess at the moment. And there's definitely some outstanding questions on the long-term viability of the tech, which I'm not really qualified to opine on person. But I do think it actually, this whole collapse of FPX could be a positive for Solana in the long term.

I think that's probably right. I mean, getting out of that overhang, I guess it'll just be interesting to see what the cell pressure is on that network from the liquidator. There'll be block by block cell pressure. It's not like the liquidator wants to hold any exposure to crypto assets. Yeah, it'll take some time, obviously. So what's most exciting to you right now from an investment perspective? what type of category is you guys looking at? I think the most important thing in crypto over the next year to cleanse itself of this disaster is real use cases. And if we look at defy, I'm very excited about how can we use defy to solve problems in the real world. I think if you look at something like Maple Finance, which I think you guys are also investors in,

it's a great example of a design that I believe can utilize crypto rails to create better lending and borrowing products in the real world. So stuff like that in Defi. And we've also invested in other companies that I think are leaning into using stable coins as payments for international payments and using them for basically give people access to a semi-inflation protected asset. I think if we look at NFTs, the first wave of NFTs was highly speculative. It was people buying and selling 2D static images that really didn't do much, but we're excited about how people can create NFTs that have more utility that actually

forge communities of people that stick around and are not just in it to flip them, but also, you know, the NFT can convey some sort of wrong. right so that there's more fundamental value there. And I think we have seen very little development on the Dow front thus far, but I remain very excited about the potential for Dallas long term. That to me has always been the biggest, most exciting idea in crypto, that we can create these new digitally native, on-chain, flexible organizations that can rapidly assemble and solve problems that are limited,

but also create vibrant, sustainable, long-term organizations. So those are kind of the three big categories, and that's how I'm thinking about them. There's also a lot on the infrastructure side that needs to get built to enable all of this. So we're very excited about interoperability and invested in a bunch of the interop protocols and are doing more in Cosmos, made a bunch of investments related to cybersecurity and crypto. I think things related to identity are super interesting. So that's been our focus. That's awesome.

Well, Travis, it's been a pleasure to have you on the podcast. Where can we send people to learn more about North Island ventures? Sure. They can follow me on Twitter at Travis Share. Awesome. Well, thanks so much for coming on. Thank you, Matt. Thanks for listening to another episode of On the Brink with Castle Island.

To find out more about Castle Island, visit castle island. To listen to all of our podcast episodes, please go to On the Brink, dashpodcast.com or just click on the tab in our website. Thanks for listening.