We Study Billionaires - The Investor’s Podcast Network - BTC013: Bitcoin Lending & Borrowing w/ Blockfi's Zac Prince & Mark Yusko (Bitcoin Podcast)

Starting point is 00:00:00 You're listening to TIP. Hey, everyone. Welcome to this Wednesday's release of the show where we're talking about Bitcoin. Today's show is an important one because we're talking about a really interesting and controversial topic, and that's Bitcoin borrowing and lending. To cover this topic, I have two Titans in the space, and that's Zach Prince, who's the CEO at one of the largest borrowing and lending platforms called BlockFi. And we're also joined by Mr. Mark Yusko, who's a major investor in not only BlockFi, but numerous other digital asset companies with Morgan Creek Capital Management. Mark wasn't able to join us until later in the conversation, so it'll just be Zach and myself for the first half of the

Starting point is 00:00:36 conversation. I try to cover all the areas of this topic so the listener can fully understand what risks are being assumed by the potential user of these platforms. At the end of the conversation, I provide my own personal thoughts on the idea of lending and borrowing, and it's kind of a summary of everything I just learned. So with that, here's my conversation with Zach and Mark. You're listening to Bitcoin Fundamentals by the Investors Podcast Network. Now for your host, Preston Pish. All right, so here we are with Zach Prince and Mark Yusco. Zach, Mark, welcome to the show.

Starting point is 00:01:22 Thanks so much for having me, Preston. I was telling you before we started recording, I've been a fan of the show since before you started talking about Bitcoin, almost every episode it feels like. And I like the show even more now, but I'm really happy to be here because I've been a fan for a while. So thanks for having me. I'm humbled and honored that you'd say that, Zach.

Starting point is 00:01:40 This is going to be fun. And I think that when people think of BlockFi and they just think of lending in general for the overall Bitcoin or crypto market, it's concerning for them because they're so used to traditional banking. They're more importantly used to fractional reserve banking. And they're looking at something that's going up like a rocket ship with tons of volatility. And they're used to markets that settle maybe a, like, we just saw with GameStop, they're used to stock certificates that are settling in two-day periods

Starting point is 00:02:11 of time, right? And so if you're accustomed to that environment and you're stepping into something that's very volatile, going up in a major way, you're saying, well, that has to be insanely risky as the mindset. So what I want to do is walk through, because I think once people fully understand what's taking place, it's going to just kind of warp perspective as to how risk is managed and where risk has really kind of migrated from that old system to the new system. So let's walk the dog on a simple scenario. Let's say I have one Bitcoin and I go to BlockFi and I deposit it at BlockFi and I start collecting interest. And for one Bitcoin, I would collect 6% interest. So for people that are not familiar with the space, they're hearing this

Starting point is 00:02:57 right up to this point and they're saying, there is something seriously wrong when the rest of the world is getting 0.01% as interest in their account. So walk us through what's happening when that one Bitcoin is deposited. From the user's perspective, it looks like you're interacting with any other centralized, regulated financial services, kind of company in the crypto space. You go through KYC, you log into your account, you have a wallet address that you can deposit to, you send your Bitcoin to it, it shows up in your account. And The day after your Bitcoin hits BlockFi, we've got this little accrued interest field in your portfolio overview page, and you start to see interest accruing there. And you can hold not only

Starting point is 00:03:44 Bitcoin, but also a couple of other cryptocurrencies, multiple stable coins, which are one-to-one interchangeable with dollars in a bank account, and packs gold on our platform. And for all of it, they work the same way. So Bitcoin is a 6% base rate, stable coins are 8.6%. And the front end of this, It's like the fintech apps that you're used to using. Behind the scenes, there's a lot of stuff that goes on to enable what's happening on the front end. And I want to get, you know, you tweeted about having me on and asking what people want to talk about. And the number one thing was, how does the risk work? How do I know this is safe?

Starting point is 00:04:20 And I want to go really deep on all of those things. I think it would be valuable maybe for some folks who don't know about BlockFi yet, if I give just a few minutes on the history of how we got here. The first product we launched wasn't come earn interest on your Bitcoin, which is now our most popular product by far. So first off, my background, I always wanted to work in the financial services industry, but I graduated in May of 2009. It was a tough time to be looking for jobs and finance.

Starting point is 00:04:47 I ended up working at an advertising technology startup. Throughout my career, I've always worked at venture-back technology companies. And most recently, prior to starting Block 5, I was in the online lending industry. And it was originally referred to as peer-to-peer lending. Now it's called online lending. There are a few parallels to be drawn to the crypto ecosystem from that ecosystem. And a lot of the strategy, the business development strategy that were implementing at BlockFi comes from learnings that I had in that sector, starting with how we saw the opportunity.

Starting point is 00:05:17 So the number one thing that enabled firms like SoFi and Lending Club and others in the online lending world to build businesses was the fact that banks pulled out of a lot of areas of lending coming out of the financial crisis. So while businesses weren't getting access to debt and credit like they used to be able to consumers, et cetera, and now that online lending industry is responsible for a little over a third of the entire unsecured consumer lending that happens in the U.S. So it's material now. When I started working in it, it was pretty new. And I actually started investing in Bitcoin in 2014 because I had been in the online lending industry for a few years. I became kind of like the FinTech guy amongst my friend group. And I started

Starting point is 00:05:59 writing a blog just because I was seeing so much cool stuff. I didn't have anywhere near the audience you have. Maybe 10 people, mainly my friends and family read this thing. But I was writing about FinTech. And I was writing about robo advisors and investing in commercial real estate, all the things you could do, online lending. And I learned about Bitcoin. And what really struck me about it initially was that a lot of what happens in FinTech is just kind of a new wrapper on top of something that's existed for a long time in the traditional financial system, or you know, you have to use a bank to do part of it or you've just put a mobile app on something that used to not have a mobile app. And I learned about Bitcoin and I was like, this is not only a brand new asset, but it's also

Starting point is 00:06:39 built on top of a brand new network that enables you to move something that call it an asset or value or money, whatever you want to call it around the world with no intermediary, 24-7, completely digital, completely global by design. And I thought that was awesome. I just started buying some and slowly and steadily went down the rabbit hole. And in early 2017, I had started going to meetups in New York City because my wife got tired of me talking about cryptocurrency with world. She didn't want me to talk about it with her. And she gave me like Tuesday nights every week or something. And I started going to these meetups. And the meetups started with just like a couple folks in a random hole in the wall bar in Union Square. And they shifted and they,

Starting point is 00:07:25 you know, started happening at big law firm offices in Midtown. And it went from 10 people at the meetup to 400 people at the meetup. And it felt like things were really starting to happen. And I knew that banks weren't going to be active in this space anytime soon. Because I'd seen, you know, I had a lot of experience working with banks in the online lending sector. And they weren't going to be around anytime soon. So I thought, okay, I have to get involved in this full time. There's nothing I believe in more than what's starting to happen in this ecosystem. And the original idea for BlockFi was to build debt and credit markets for the crypto asset class. From that starting point, we always knew that we wanted to build not just a monoline lending business. So,

Starting point is 00:08:08 one of the learnings from the online lending industry is that if you can pick what company you want to emulate, you would much rather emulate someone like SOFI versus someone like Lending Club. And why is that? Well, Lending Club, really was just a one-trick pony, unsecured consumer loans. SoFi, on the other hand, started with student loans to Ivy League graduates. And they said, we're going to refy the student loans of everyone that graduated from an Ivy League school because right now they're all priced the same by the federal government. And Ivy League school graduates should get cheaper loans because they're a better risk. But then they expanded and offer their student loans more broadly.

Starting point is 00:08:43 And then they moved into other products to add more value for their clients, mortgages, wealth management. Now they do quite a few things, and they're going public with the Chimot's back. So the first product that we started with in 2018 was U.S. dollar loans for folks that held Bitcoin and other cryptocurrencies, but didn't want to sell it. We were the first company to get lending licenses across the U.S. from states to make loans to individuals secured by their Bitcoin. And we were the first company to raise institutional capital to support that type of lending. And from that starting point, we just listened to the, the market, knowing that our priority was to diversify our products suite in a way that adds more

Starting point is 00:09:23 value for our clients, and we got to where we are today. So a lot of these things kind of happen incrementally over time. And I think that's important to understand in terms of how our risk management system works. With that backdrop, if you don't have any questions, I can start talking about how does this risk management system work and what are the things that we're doing to generate the attractive yields that folks who hold assets of BlockFi are receiving. I love the background. And I think that it adds to the overall story of, especially when you start talking about how the legacy system really wasn't going to change unless it had to change. We're about to describe people's eyeballs are going to be pop open as they hear this.

Starting point is 00:10:06 So let's describe the one BTC that was deposited on BlockFi. What happens after it gets there? So after that, Bitcoin gets deposited at BlockFi, it is co-mingled with other assets at BlockFi with one of our custodians. Today, BlockFi works with three custodians. Jim and I is our primary custody platform, but we also custody with Fidelity and BitGo. The reason for that is that we decided early on that we wanted to build a debt and credit business, financial services business, not a new custodian that was going to safely hold private keys. So we just decided to work with the best folks in the market. And we picked them based on their operating history, whether they've been through audits or not, how much insurance they

Starting point is 00:10:56 have. So that's the starting point. From that point, these assets are available to be utilized in different types of lending activities. And these different types of lending activities are what generate the yield that we're offering to our clients at BlockFi. Fundamentally, there are two different types of loans that BlockFi makes. There are loans where collateral is posted back to BlockFi, and there are loans, well, over-collateralized, and there are loans which are smaller as a percentage than the over-collateralized loans, but there are loans where they are under-collateralized. Also, we have two different types of borrowers who are borrowing from BlockFi.

Starting point is 00:11:38 We have our retail clients who are borrowing directly in our mobile app or our web app. They're always borrowing dollars secured by the value of their cryptocurrency holdings on our platform. And then we have institutional borrowers who, depending on who they are, may be borrowing in a similar construct as our retail borrowers where they're always minimum 2x over collateralized, or they may be borrowing where they are one-to-one collateralized or under-collateralized. And importantly, on the institutional side, the loans could be denominated in dollars or cryptocurrencies. They're denominated in Bitcoin.

Starting point is 00:12:18 So now let's talk about the risk management. The over-collateralized part is pretty easy. And that's where we started. So what do you need to effectively manage risk when you have over-collateralized loans? You need a system that is monitoring prices that is connected to liquidity and that is available to take actions in the event of price volatility. where you would need to based on the loan to value ratios of the different loans. Let's just make it really simple with numbers. So when we're talking about an over collateralized loan, the one Bitcoin that I deposited at BlockFi

Starting point is 00:12:52 is then Len out to a person who is in order to receive that loan, they're posting collateral that is above the amount that they're borrowing. So let's say another person on the other end is borrowing that one Bitcoin that I deposited. in order for them to do that, but they might have to deposit 1.5 or two Bitcoin's worth of value, either in USD or Bitcoin or whatever, in order to borrow that amount. So if the price of that collateral starts moving down, they get a margin call, I'm still protected because it's an over-collateralized loan. And if it gets down to the price that it was at parity with my original deposit of one, they haven't stepped back into the market to replenish their escrow.

Starting point is 00:13:37 So the account would just be liquidated in my one Bitcoin as protected. Did I describe that accurately for the overcollarization process? That's perfectly accurate. One thing that I would mention is that in terms of how our system works, we're doing this in both directions, meaning there are certain loans that we're making where someone has held Bitcoin on our platform and they're borrowing dollars at a 50% LTB secured by the Bitcoin. There are other loans that we're making, your example, where someone's borrowing Bitcoin

Starting point is 00:14:06 and they're holding dollars as collateral. And in the scenario where the price of Bitcoin moves down, the borrower of dollars secured by Bitcoin is getting warnings and then a margin call and then a liquidation. And in a scenario where the price of Bitcoin moves up, the borrower of Bitcoin who posted dollars is getting warnings and then a margin call and then a liquidation. So in terms that most people are just comfortable with,

Starting point is 00:14:31 it'd be like your house is paid off and you want to go out and take a loan out against the house that's completely paid off, but you can only borrow one third of the value. It's maxed out in order for it to be over collateralized. That's what's effectively happening on both sides of this trade that you're talking about, whether you're borrowing or lending it. That overcollateralization is protecting it. Now, what I think is really interesting about this particular market that for me reduces a lot of risk is when we're talking about a house, how hard is it to step into the market and sell that if the price starts moving away from. So let's just take the example. So let's just take the example.

Starting point is 00:15:06 example where you took out one-third of the value of the house in a loan, and it's collateralized because the house is paid off, over-collateralized. And let's just say there's a meltdown in the real estate market and the price collapses 67%. And it's approaching down to the parity of the amount that was borrowed. You can't step into the market in one minute from now and sell that and liquidate it in order to protect the underlying value of the loan. But in this space, It's traded 365 days a year, 24 hours a day, all over the world. And so you can step in and if the price moves in a dramatic way like that and the loan is becoming at parity or under collateralized, you can sell it immediately.

Starting point is 00:15:49 So this is just so different than how anything works in traditional finance because you might have to wait, I don't know, two days to clear. If you're talking stock certificates, that's a huge risk. even if you are over collateralized. That's a risk if you can't step into the market and settle immediately. Absolutely right. The liquidity profile of the assets that are supported to be used as collateral at BlockFi is dramatically better than a house. I would argue that it's even dramatically better than securities because of exactly what you described. Preston, these things trade 24-7, 365 globally across both bot exchanges, derivative exchanges,

Starting point is 00:16:31 changes and with real over-the-counter institution to institutional volume. And BlockFi is connected to all of those venues where liquidity is available. Okay. So now here's where I would be concerned. If I deposit my Bitcoin and it's then either turned into USDC into a cash stable coin and Lenout or it's lent out as Bitcoin, I don't really necessarily care about that. The thing I really care about is the person who would be making that deposit is that the escrow that's being held on my behalf is being held in the token that I deposited. Let me give you an example. Let's say I really dislike Ethereum and I don't trust it. I deposit Bitcoin. I'm going to take so much crap for that on Twitter, but it's okay. I deposit Bitcoin and let's say BlockFi is holding

Starting point is 00:17:24 Ethereum in escrow for me. And then let's just say that there's a major issue with that with that escrow or with that protocol that moves in a very dramatic way that we haven't maybe seen or we might not expect. I would be very upset as a person who's deposited Bitcoin that my escrow is not being held in the thing that I deposited. So how do you guys think through that particular? Because it's almost like a CDO. Like your black box that I can't see into and how you guys are managing this could be viewed as a CDO like risk to a person like me who's looking at that and trying to account for that risk. So how do you guys think through that problem? First off, one thing that we're that we're not doing in any scenario is taking a

Starting point is 00:18:09 Bitcoin denominated liability, which is what that deposit from you, Preston, or any other client into a BlockFi interest account is on our balance sheet and saying, let's convert this Bitcoin denominated liability into another asset. And hopefully something we do with that other asset is going to generate a return that'll keep up with Bitcoin and then we'll convert it back into Bitcoin and everything will work out just fine. So the assets and the liabilities match in terms of the currency that's being placed into the BlockFi accounts. So when Bitcoin's coming in, we're making a Bitcoin denominated loan to a borrower. As a general rule, we don't accept cryptocurrency as collateral for a Bitcoin denominated loan. We accept things. We accept things.

Starting point is 00:18:55 things like dollars, which could be either dollars in a bank account or stable coins. We also accept euros. We accept things like shares of the gray scale Bitcoin trust as collateral. We accept things like equity value in a Fidelity digital assets account. There was an announcement that at the end of last year, we were the first lender that was integrated into the FDAS environment as a third party providing financing to folks who are buying and selling the assets that are supported on that platform. But we're not taking Dogecoin or even Ethereum as collateral for a Bitcoin-denominated loan today. And those assets and liabilities are always 100% matched throughout all of our activities. Hey, so on the GBTC comment, I know when people heard you say

Starting point is 00:19:47 that. They're thinking, my immediate thought was, well, how about the GBTC premium? How does that impact the way you guys are looking at how the value is managed? Because I mean, right now, we saw the premium on GBT almost go to zero. And then you get a big bull run. It's a 1.2 on the premium for that. So how are you guys accounting for that in the way you're managing risk? And then talk to us a little bit about your relationship with Grayscale. We don't prescribe any value to the premium in terms of financing that we're providing to folks that want to use either liquid or shares that still need to be seasoned of the various gray scale trusts. In terms of our relationship with gray scale, we filed what's called a Form 13G towards the end of last year in the fourth quarter,

Starting point is 00:20:32 which disclosed that we are a greater than 5% holder of the total number of shares of the gray scale Bitcoin trust. The reason for that is that we, you can think of us as a market market maker of sorts for that product. So we're very active in facilitating the new creation of shares by subscribing at NAV with Bitcoin. We're very active in the securities lending market for gray-scale Bitcoin shares. And we're very active in capturing the premium that exists in the market on shares of GBTC. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo, the height of the summer. You've got long days of daylight, incredible food, floating saunas on the

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Starting point is 00:25:12 dot com slash WSB. All right. Back to the show. So for a person who would go to your platform and they'd say, all right, I'm going to borrow some Bitcoin. Who is this person that is putting up double the collateral of what they're borrowing and paying 9% interest for it? Who is this person and what are their interests in order to take that on?

Starting point is 00:25:37 Let's go back to the segmentation of the groups that we lend to. So the person who's putting up Bitcoin to borrow dollars could be an institution or an individual just using the publicly available BlockFi platform. It's someone like me who is likely to have held Bitcoin for a while, is still very bullish on the future trajectory of the price of Bitcoin, and who has a liquidity need or something that they want to do in their life. It could be making another investment or a down payment on a house or taxes, and they don't want to sell their Bitcoin.

Starting point is 00:26:14 They don't want the tax burden. They want to be able to continue to hold it without the tax burden and just pull their timeline a little bit to the left. They'll quickly pay it off. It's like working capital. Absolutely. If your cost basis on Bitcoin is really low, and let's say half of the position is a gain,

Starting point is 00:26:31 or more than half of the position is a gain, paying 25 to 50% in taxes on a large part of your Bitcoin holding is a very expensive way to finance something. A 9% annual interest rate on a loan that you may only even use short term for a month or two or three or six pales in comparison to that tax cost, not to mention the fact that you've sold some of your Bitcoin, whereas when you get a loan, you're not selling that Bitcoin, you still have that long Bitcoin position and you benefit from any price appreciation that may occur. And then lastly, note that if you are using the proceeds of the loan to make

Starting point is 00:27:14 another investment, our tax code is very favorable to debt financing. And generally, depending on your personal tax situation, not tax advice, of course, but generally, you're able to deduct the cost of that interest under what's called the investment interest expense deduction. We never lend Bitcoin to individual or retail borrowers. It's not something you can do on our platform where you're also earning interest on your Bitcoin and also able to buy and sell. Institutions are the only folks who can borrow Bitcoin from us. And what types of institutions are doing this? It's primarily market-making firms, trading firms, hedge funds, and other types of institutions who are active in the cryptocurrency market. But importantly, they cannot finance

Starting point is 00:28:03 that activity with their traditional prime brokers. So the same problem that we set out to solve for retail folks, we pretty quickly, after we got into the market realized that institutions had the exact same challenge. Banks weren't actively helping them participate in the cryptocurrency market either. So let's talk about some of these use cases that the institutions have. Anyone who's active in the cryptocurrency market knows that there are lots of different venues where cryptocurrency trades, spot, futures, OTC, U.S.-based exchanges, exchanges based in Asia, in Europe, in Africa, and Latam. The number one use case that we see for borrowing Bitcoin is inventory to conduct market making. So Susquehanna, who's also an equity investor in BlockFi,

Starting point is 00:28:52 is a very well-known market-making firm, and they fit the profile of a very common type of Bitcoin borrower from BlockFi. Traditional financial institution, cryptocurrency is less than 5% of their business, and they have a very long track record of operating incredibly profitably through lots of market cycles, lots of volatility, lots of major market events, way better than banks, by the way, from a credit risk perspective. Actually, they make more money when things get volatile and markets are moving around, not less. So what do they do? It's really simple. They buy Bitcoin over here for 99.95 cents, and they sell it over here for 1.002. And they just do that all day. It's a service that they're providing to the market at the end of the day. The services,

Starting point is 00:29:43 they're providing liquidity into the market, and they get paid by capturing those small spreads. They're doing this simultaneously. So from their vantage point, it's practically risk-free minus their ability to control the technical aspects of it. Since they're going long and going short and capturing that spread by being a market maker, it's very risk-free for them to be participating in this. Now, the spread that you just said sounds to me like it was that the margin there is actually way bigger than what you just said.

Starting point is 00:30:14 Are they capturing pretty fat margin? Because every time I talk to Plan B or I look at his post that he's doing, he's saying that these margins, the spread between going long and going short are massive relative to anything else in financial markets right now. They absolutely are massive. And the level of sophistication that's needed from these firms to capture these spreads in the cryptocurrency market is dramatically lower than in traditional markets because it's still nascent.

Starting point is 00:30:42 We're not using the same technology in the cryptocurrency trading ecosystem. that exists in the U.S. public equities markets where folks are co-locating servers in the data center and you've had regulation, kind of put in a bunch of rules around best execution and you're selling order flow. We're not even close to that point in this market's evolution yet. The market is sufficiently liquid, but the market is fragmented and the market lacks access to traditional financing. And so as a result, whether you're talking about someone who's borrowing dollars secured by their Bitcoin or someone who's borrowing Bitcoin finance their market-making activities. The cost of borrowing is higher than in the equities market

Starting point is 00:31:23 as an example. And this doesn't just show up in market making for the Bitcoin spot price. It also shows up in the futures curve where the implied basis, which is if you take the futures price compared to the spot price, and then you annualize that, oftentimes has a yield, which is basically risk-free. You're taking risk to the CME of north of 20%. What happens if you're a portfolio manager at Susquehanna or another firm like them? Well, what happens is you go to your bosses one day and you say, I think that the trading strategies that I've implemented in traditional markets could work great in crypto. In fact, they could deliver way better returns than what I'm delivering in traditional markets. Then your bosses say, that's great.

Starting point is 00:32:10 go do it. Here's 10 million bucks. And you start doing it with 10 million bucks and it works great. Well, then what do you want to do? You want to start doing it with 100 million or 200 million. And normally in traditional markets, when you want to scale something like that up, you call your prime broker, you tell them what you're doing. They already have a relationship with you. And they have no problem giving you financing for it. Well, in cryptocurrency, they had literally no one to call. So BlockFi's phone started ringing towards the end of 2018 when at the time we had really only brought this retail loan product to market. And it was folks like Susquehanna and others saying, we have an idea we want to run by you. Have you ever thought about providing financing to the

Starting point is 00:32:52 institutional side of this marketplace? And we said, yeah, we thought we would get to that at some point. We'd love to do it. And we were one of the first companies providing financing into that part of the market as well. And we really quickly learned that the amount of Bitcoin that we had, which at the time was just the Bitcoin that was being posted for U.S. dollar loans, we didn't have the interest account yet, was not going to be nearly enough to meet the demand from the institutional side of the equation. But now you have institutions and you have companies that are now putting this on their balance sheet. So are they coming into the lending side or deposit side for you? They are. The total size of assets on BlockFi's platform today is over $10 billion.

Starting point is 00:33:33 And it's growing by every week so far this year north of a quarter billion. So when I think of a stress test for BlockFi, I would think that the March liquidity crunch where the market had an immediate reaction to COVID, the whole derivatives market was getting repriced. You had this massive run on baseline dollars. What was that experience like for customers at BlockFi as far as depositors? and margin calls and that kind of stuff. Yeah, so a few things that are worth noting here. So first off, we made our first loan in January of 2018,

Starting point is 00:34:12 and we've had perfect performance with no losses in our lending activities in terms of our client accounts with BlockFi throughout not only the event in March, but also the kind of final capitulation coming off the 20K high in October of 2018 when we went down from 6K to 3K. in multiple times where we've had greater than 20% upside volatility in a single day, including at least one day where we went up 40% in a single day, and most notably and most recently in March when we went down 50% in a single day. So one of the things that I think is indicative of the strength and robustness of our risk

Starting point is 00:34:55 management system is that on March 12th, the day after Bitcoin went down 50%, we were operating across our entire platform completely normally. We were processing withdrawals. Still over collateralized on it. Still over collateralized, still making loans for our retail and institutional clients. And that was not true for everyone. If you look up other folks, you know, at least cosmetically report to do the same things that we do in this market, a lot of them publicly stated.

Starting point is 00:35:24 We are not actively lending right now. We are waiting for the dust to settle or we're evaluating the condition of our books, not blockfying. We were open the whole time, we were available to our clients and our risk system performed perfectly. What you realize when you're in the business that we're in, providing the products that we are to our clients, is that oftentimes the hard part isn't just like, does your risk system work well? Can it make the margin calls and get the liquidity? It's how do you, in the context of market volatility, still deliver a positive experience for your clients. We don't want to liquidate someone's Bitcoin who's borrowed dollars from us because the

Starting point is 00:36:04 price of Bitcoin goes down 50%. That's a horrible experience. We don't want to do that to anyone. And one of the things that we did, two things actually that are, I think fundamentally different than how a lot of folks and certainly defy approach things is we're capable of using our own equity capital to hedge extreme volatility when risk systems are kind of flashing yellow or red lights on our side. And we did that in March. So you're saying the retained earnings that you as a company have were put at risk in order to allow your customers more time to react to their margin calls. Is that what you're saying with that? That's exactly right. Additionally, what happens in these stress scenarios is the blockchain gets very active. Sending Bitcoin

Starting point is 00:36:53 gets very expensive. And we have clients every time there's been extreme volatility who with the best intentions are trying to send us collateral, but whatever wallet infrastructure they're using or whatever traditional bank payment rail they're using isn't set up, make it move quickly. And as a result, despite the best intentions of our clients and their ability to post more collateral, the timing gets off a little bit. And it's not that we turn our risk system. them off and say, oh my gosh, we're going to just take all the risk and trust that everyone's going to send us the money. We obviously don't do that. But we absolutely do on days like March 12th, listen to our clients. And if, you know, they've sent us collateral that arrived 12 hours

Starting point is 00:37:40 after we liquidated, you know, parterall of their position, we do the right thing to the best of our abilities. While still having an interest for the depositor and not putting them in a predicament or risking the depositors capital, right? The starting point, the baseline is preservation of capital and never incurring a hedging cost or a client service expense that would put client capital at risk. So that's the baseline. We're now in extra credit land. So in extra credit land, you can make a decision like, okay, the market has moved in the 12

Starting point is 00:38:18 hours that it took my clients collateral to arrive. And the cost of that in terms of us just reinstating their position versus what actually happened, which is we liquidated part of it, in accordance with the loan agreement and how our risk management system works, is let's say 50 grand. And we can say things like, we'll split it with you. I'm just giving an example, but that's the type of thing that our client service team was doing with our customers, not only on March 11th, but also on March 12th and 13th. And I think that is truly, unique. And I don't know of any other platform that was not only operating, but also operating in a way where we have a long-term client relationship at the front of mind. Because, you know,

Starting point is 00:39:00 we're not here to make a loan to someone and then blow them out and great, the risk system works. So, you know, have a nice day. Like, we believe that our platform is going to keep growing. We're going to keep adding more products that should add more value for our clients, and we want them to be our clients for life. And so it's more important than a single trade or a single day of volatility. So we had a lot of questions in reference to insurance. Lots of people wanted to know, let's say there is a mistake or the risk management is somehow goes wrong for one particular token. Is that somehow insured or is that part of the expense that is being taken out of my yield that BlockFi has?

Starting point is 00:39:43 Yeah, so there is insurance available from our custodians for the assets that are held with them, which is at all times a minimum of, you know, a minimum of 20% of the client assets on BlockFi are just literally sitting in a custody account, not being utilized for loans. And oftentimes it's a much higher number than that. So there's insurance there that would protect against things like employee theft or cybersecurity issues with the custodian. There is not insurance today for losses that may be incurred from the lending activities that BlockFi does.

Starting point is 00:40:18 We are always thinking about ways that we can bring insurance to the table. To date, it's been cost prohibitive. The cost of insurance would effectively completely eliminate all the yield that we're offering to our clients. But I believe that that will change. The question is just how long will it take? And the things that help it change are operating history, capitalization of blockfize business, data that you can share about what happens to our risk management system and periods of volatility.

Starting point is 00:40:52 And I also think that over time we'll have probably different flavors or different kind of levels of risk accounts and associated yields that you can have on our platform. So on one end, it'll be the highest yielding option. And on the other end, there'll be a very low or zero yielding option where literally your assets are just held with one of the top custodians that we work with. So, Zach, you and I have had a lot of back and forth here. And Mark has been insanely patient. He's listening and smiling.

Starting point is 00:41:23 And I can see his reaction on the various questions. So Mark, I want to throw it over to you. This is a tricky question. When you look at this, this marketplace, it's getting competitive by the day. everyone who's probably listening to this is thinking defy and how what's defy's impact to block phi as far as the competition for for yield moving forward. How do you think through that? And after you respond, Mark, I'm kind of curious how Zach sees it as well. I'm mostly just smiling because, you know, we've been partners with Zach for a long time. And every time I hang out with him,

Starting point is 00:41:58 I just get more excited about being partners because he's, he's just, like I said, so clearly visionary and that client focus is so unique in this business. Great business person and he and Flore have built an amazing team. But more importantly, they built an amazing customer-centric business. And the way I see it is the ecosystem is going to evolve. And there'll be lots of other systems that pop up. But in the same manner as how the traditional financial services ecosystem evolved, and at the core of that are the banks. And I say it all the time. I probably say it five, six times a day. I say it's called BlockFi for a reason. And what they do is essentially banking services for digital assets don't calm a bank. They're blockchain financial or

Starting point is 00:42:50 financial services company, utilizing this wave of technology around blockchain and Bitcoin and crypto to provide essential services as we all transition from the analog to the electronic to ultimate the digital financial ecosystem that's ahead. And at the root of it, no matter what other systems come up, I mean, take FinTech and what it does relative to the banking system. In the old days you had a banker. And the banker knew your name and you knew where you lived and you knew your family. And if you wanted a loan, he would facilitate, he or she would facilitate that loan. Today, it's nameless, faceless organizations. And if you want a loan, you can go online with one of these and you can get a loan through a peer to peer exchange a lot faster than the bank and not

Starting point is 00:43:40 have the experience. My first time I tried to do it. And they said, well, you deposit 100,000 will lend you 50,000 to buy that house you want to buy. I had 100,000. I wouldn't need to borrow the money for the house. But I think that importantly, there'll be some number of institutions, and I think BlockFi is one of them, that will be the core of the digital financial system and the other systems, including DFI, will evolve around that. But I don't see them as negative at all. I see them as complementary to one another with the core and then these satellite services, same way that investment banks built up around commercial banks. And then you've got financial services. And then you've got financial services firms, and then you've got the whole fintech industry around that.

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Starting point is 00:48:17 I could hold my Bitcoin, but there are personal security risks, there's implementation risks, there are all kinds of risks. And so having a service, a business where I can deposit those assets and have somebody take care of custody and safekeeping could make sense to me, and I'm willing to pay for that. So I do think C-Fi and just the automation of functions that have historically been people-centric, legacy system-centric. Why does it take three days or two days to settle a common stock transaction when I can settle it at BlockFi instantaneously? Zach, would you characterize the risk of a person putting their money in BlockFi to being akin or

Starting point is 00:49:01 being almost the same level of risk of a person just having their money on an exchange? because it's a key management risk, or is there more risk that doesn't meet the eye with BlockFi? I think it depends on the exchange. I think it's certainly in the same ballpark, and there are probably quite a few exchanges where I would categorize it as more risky to hold your assets there versus BlockFi. And there are exchanges where I would categorize it as less risky because they're not offering the same service that we are where there is, even though it's very small, but there is an incremental layer of risk. because of the lending that we're doing to generate the yield. So I would say it's both, but from a user experience perspective, the same kind of value that Mark was alluding to around just making

Starting point is 00:49:49 it super easy or enabling me to send money to and from this account and my bank or get paid for referring a friend to it, like know who I am and if I lose my password, help me recover it safely. Like, there's a lot of things that a centralized financial services company can do that add a lot of value for people like me. I tried the hardware wallet thing and I didn't sleep well at night, not because I don't love the idea of it, not because I don't believe that it's one of the unique and incredible characteristics of Bitcoin that gives it value, but just because I lose my car keys once a quarter. It's not my style or personality to want to, keep track of a large amount of money.

Starting point is 00:50:38 You had mentioned early on when we were talking about that there's a portion of the funds that you manage that are under collateralized. I'm curious what that would be kind of as a percentage of the overall funds, and then why are some of them under collateralized? As a percentage of the overall funds, I don't know the exact number today. it's well south of 50%, maybe even south of 20%. Why is that? Well, certain institutions who borrow from BlockFi are getting, go back to that example with

Starting point is 00:51:13 Ciscoana. I started trading with 10 million. It worked out great. Now I want to do it with 100. Their return improves if part of that 100 million that they're making markets with is debt not equity. Their equity has a pretty high hurdle rate in terms of the return that they want to generate on And so for the same reason, folks finance all types of investments, whether it's real estate

Starting point is 00:51:38 or other investments, marketmaking firms like to finance their activities. And Block 5, in our institutional services team, which primarily comes from prime brokerage backgrounds, are familiar with and comfortable underwriting the credit risk of these firms. And as a result, it's more valuable for them if we can get comfortable taking some amount of credit risk and not always requiring over-collateralization, and we're capable of assessing that risk. Not for everyone. Not a lot of people pass the credit risk assessment threshold. Less than 50 firms ever have passed it. That's how it works. As a person on the retail side that's thinking about my deposit, my immediate thought went to

Starting point is 00:52:23 that could be managed by a corporate governance structure at BlockFi in order to separate institutional under collateralization from retail over collateralization and then have a parent company above that that would separate from a legal structure, it would remove that risk from your retail depositors and borrowers. Is that something that you have in place from a corporate governance standpoint or is that something that you were thinking about doing in the future? What we have right now, I think, is better than that, which is every penny of BlockFi equity sits junior to our client's assets in our capital stack, meaning, like, structurally, we wouldn't be passing through a dollar of loss to our clients unless our equity was wiped

Starting point is 00:53:10 out, and our equity is north of half a billion dollars a day. And one of the big constraints that goes into what portion of the lending that takes place is allowed to be credit, or how much credit exposure could we take to any one counterparty are based on things like the size of BlockVise equity that stands behind it. This is my last question for both of you guys. When I think about the price action that I kind of expect in the coming six months to year, and I think about everything that we just discussed, it makes me think that interest rates are going to go higher for people that are depositing their funds. What are your thoughts on that?

Starting point is 00:53:50 And what do you see as the primary driver for those interest rates or the amount that you're paying out to depositors? I think it'll be interesting to see. I could argue both scenarios. I could argue a scenario where rates go up and a scenario where rates go down. Ultimately, the drivers are adoption, liquidity, volatility, and sentiment, you know, market sentiment. And the more volatility there is, the more demand there is to borrow, the more liquidity there is, the more demand there is to borrow to more different types of institutions there are, the more demand there is to borrow. And on the market sentiment piece, directionally, there's less demand to borrow Bitcoin in times where the market is bullish and more demand to borrow Bitcoin in times where market sentiment

Starting point is 00:54:37 is bearish. I think rates will stay, the way I think about it is relative to traditional financial rates How long of a runway do we have where, for market constituents who are capturing these yields, how long of a runway do we have where they're staying incredibly attractive relative to what you can get in the traditional market? And from that perspective, I think we have a long way to get. Long. I think we have super long.

Starting point is 00:55:07 Which is crazy because the spreads are so massive and the margins are so fat. You would think everyone in their kid's sister would be trying to cap. capture that. They are, Preston. I think that's the key, right? And again, Zach can't say this, but I will. It's because it's hard to build what Zach and Florey and the team at BlockFi have built. It's hard to have the quality and the trustworthiness. I refer to this whole thing as the trust net for a reason. It is literally all about trust and eliminating that lack of trust that we have in institutions today that's been on a downward trajectory, like interest rates for the last couple of decades. And by focusing on a high standard of quality and a high standard of risk

Starting point is 00:55:54 management and asset management and building out infrastructure and capabilities well ahead of the asset growth, Blockvites put themselves in a position where they are the gold standard in this nascent industry. And so, yes, there will be competitors. you're right, Preston. Everybody would love to do this. But if I'm a borrower, I don't want to borrow from Joe's crypto shop. I want to borrow from somebody that I really trust, that I know has the systems in place where there's not going to be a question of whose assets or whose and how the transactions are occurring. So I think it's, it's Paul Romer won the Nobel Prize for this, right? It's called the law of increasing returns. It's not necessarily the best technology that wins. It's the technology

Starting point is 00:56:47 that gets critical mass and the network effect first. And the network effect of BlockFi in the most important circles of financial services users is there. And it's kind of like when when people say, oh, you know, something better is going to come along and displace Bitcoin. No, it's not. One, because open source, but two, because network effect wins. And you can just look around the world, right? The top five of the top 10 largest, most valuable entities in the world, they're not companies, their networks. Amazon, what is that? Amazon doesn't make anything. They're a network of users. They're basically a search engine that matches buyers and sellers, and they take a cut. It's a brilliant business model, incredible. But the scale, as you get more users, when there was one of these,

Starting point is 00:57:34 not valuable at all. Now, if there's 10 billion of them connected around the world, pretty valuable. One thing I want to mention, if I can, Preston, is a year from now, if we do check in again, I believe that you will be talking as much about some of the other things that we're doing at BlockFi as you are about the lending side of it. The thing that I'm most excited about personally is the Bitcoin Rewards Credit Card, which we're launching in the second quarter of this year, which will be the first ever Bitcoin Rewards Credit Card will launch cards outside the U.S. market

Starting point is 00:58:08 and make it available in places where credit cards are available like Canada, UK, Australia, other European markets. And that's just going to be our first product in the payments category. I mean, there's so much that we anticipate building over the next few years. And against the backdrop of what's happening in the Bitcoin ecosystem, We think that people think of us as a crypto lender today or maybe crypto financial services, like five or ten years from now, it's just going to be financial services. And we're going to be doing all of the things that the big banks do or traditional fintech companies.

Starting point is 00:58:45 We're just going to be doing them better, faster, cheaper for consumers than they're able to. So on that note, do you see, because we've got these stable coins, you have a gold token that's backed by physical gold in a vault. I'm curious, when are we going to start to see the major ETFs or major stocks, call it Apple, Amazon, that's tokenized, that's held in some central entities, treasury, and things like that start to become available on the platform as well? That one's probably going to take some time. You know, the regulatory regime that is the toughest to crack in a lot of ways is the SEC. And, you know, folks have tried. in different ways to, you know, make U.S. equities available in markets that aren't as under the

Starting point is 00:59:36 purview of U.S. regulators. And it's really, really challenging. Even though you're a custodian of the underlying. It's not like you're, I'm not talking about launching a new token like sushi or something like that that doesn't have any backing to. I'm talking about something that a person would be taking stock certificates and they would be holding it almost like a U.S.D.C. or your your Gemini coin, the U.S. dollar Gemini coin. Why isn't that happening with stock certificates? Because I don't see it as an equity issuance. I see it as

Starting point is 01:00:06 somebody just managing collateral for something. That's a good question. We have not started working on that yet, so I don't know the specifics of why it hasn't happened. I would guess that there's some nuance in the regulation that makes it really, really harder. I don't know if it would be here.

Starting point is 01:00:22 But I would also guess that someone's working on it. And here's the reason why So I look at it as like, my hurdle rate these days is the NASDAQ. If I can outperform the NASDA, I'm not looking at like measuring my unit of account is not the dollar anymore. My unit of account is the NASDAQ. Can I beat that? If I was going to have that as one of my tokens that I could convert into as almost like my form of a dollar, I mean, with the printing that's happening, it's just going to keep nominally. It's just going to keep driving everything up, right? If we're just going to print $5 trillion here and $5 trillion there, It's going to make equities keep going up. I couldn't agree more with you. I think about my personal investment is the exact same way. And the question for me is whether tokenizing the equities will happen

Starting point is 01:01:07 or if we'll just have to become a traditional broker dealer and enable folks like yourself to also buy QQQQ in your BlockFi account. The question is, which way does that end up happening, not whether it happens in my mind? I just don't want it to have to clear two days to clear the certificate. It's coming. It will come. But, you know, the cool thing, you're not to put too much pressure on you, Zach, but most people don't know that, you know, Visa was started by Bank of America. And they had basically the majority of customers in Sacramento, California. And they had this idea, followed Diners Club. And so that, you know, I think is the analogy works with LockFi at the center of this digital financial services. Revolution and Zach's point, really expanding all the tools for us as users of financial services. So pretty exciting.

Starting point is 01:02:05 This is some exciting stuff. So I want to thank both you, Zach, Mark, for taking time to chat. Can you guys give everyone a handoff? I think they all know your location to find you, Zach. But go ahead and give people a handoff where they can do some more research and learn more about you. Yeah, happy to. So the company's website is blockfi.com, B-L-O-C-K-F-I-I-com. I think we're one of the only companies in crypto that has a phone number that you can call during normal business hours and talk to someone in the U.S.

Starting point is 01:02:35 Who loves BlockFi and understands how everything works on our platform and also loves crypto. So click on the contact us and give us a ring or an email if you want. I'm very active on Twitter. My DMs are open. My handle is BlockFi Zach, Z-A-C. I love hearing from folks. Don't hesitate to get in touch. for this. Preston, thanks for letting me be the fly on the wall with this just unbelievable

Starting point is 01:02:57 conversation doing you guys and I really appreciate it. So Morgan Creek cap cap cap cap.com where you find everything about Morgan Creek. And then I also am active on Twitter. My wife I'd say too active at Mark Yusco. And my DMs are open as well, although I hazard a guess that I'm probably less good at answering than the two of you. But I'm trying to, I aspire to get better. gentlemen, thank you for your time. This was really fun. Thanks, Preston. Preston. All right. So what did you guys think? So I've been getting asked a ton of questions online about Bitcoin borrowing and lending. So here are my thoughts. And first things first, these platforms, as I suspect, everyone already knows, are not FDIC insured. So if something happens to the way the

Starting point is 01:03:48 platform owner is managing risk or the private keys, you name it, there isn't. anyone that's going to come and bail you out. Now, what's the likelihood of something like that happening? Well, I just don't have any idea how I would assign a probability to something like that. If anything, this space is like the Wild Wild West is probably the only way I can describe it. There's enormous yields relative to traditional finance, but like anything, it's just because there's risks associated with where we're at in the maturation of this entire process. when I think about the way I distribute risk and invest, I view it kind of as an expected value problem. So let's say you own one Bitcoin and your expectation for the rest of 2021 is that the

Starting point is 01:04:34 price will double from here. And let's just say that you're expecting Bitcoin to go to $100,000. Or your second option is you could take that one Bitcoin and put it on a platform, the borrowing lending platform. And let's say you could get a 6% return on top of that 100% that you're expecting they get from here. But that investment of putting it on a lending platform comes with higher risk than just taking the self-custody of the coins. So you're comparing a choice of 100% or 106% with higher risk. And that's also assuming that you're really good at self-custody, which might be an if for some folks. Well, when you do that problem from an expected value mindset, the answer isn't binary. It isn't you should do one at 100% and you should do the other one at zero.

Starting point is 01:05:21 The answer is some percentage of the one strategy and then the other percentage for the other strategy. So maybe 10% of your portfolio position of Bitcoin should be in lending and 90% should be in self-custody. I'm not sure what that number is. That's totally up to you. It really becomes a personal preference. How you can view the risks of not holding your own private keys. And it also depends on your personal net worth and your lifestyle expenses. There's no way to perform a Kelly criterion because that's what we're ultimately talking about here to put quantitative values necessarily to some of these factors.

Starting point is 01:06:00 It's your personal preference. It's your personal expertise and some things that you have to work out in your own head. I strongly encourage people to do their own homework and to make your own decisions. If there's one thing we've learned about Bitcoin from the beginning, it's truly making personal responsibility a real thing again. Now, one of the reasons I'm so excited about this space is because I think it's going to change a whole lot in the near future. In the past, you would always hear that Bitcoin has no intrinsic value because it doesn't produce any free cash flows. Well, that's just not the case anymore. In fact, when you look at companies like micro strategy have more than a billion dollars

Starting point is 01:06:40 of Bitcoin on their balance sheet, that Bitcoin now has the earnings capacity through lending to actually generate more free cash flows than all the workers currently employed by that company. It's kind of a mind-blowing fact if the management actually start to put the Bitcoin into the lending market. In fact, since this lending is over collateralized and it's operating in a 24-7 liquid market, I could see these kinds of rates in the future whenever these lending platforms really kind of have established themselves as being to have your private keys with them. that it could maybe even be considered a risk-free rate in the future.

Starting point is 01:07:20 It's hard stuff for us to kind of wrap our head around, and I suspect its impact is going to start intertwining itself into the valuations of every other asset on the planet. At a time where central banks keep the basing fiat currency and stock and traditional bond markets appear to just keep on getting bid into the stratosphere, what if this really high interest rate that we're seeing in these markets start to demonstrate to the traditional markets that these are what free and open interest rates actually are and actually look like. What would that do to equity valuations? What would it do to

Starting point is 01:07:54 fiat denominated fixed income prices? As you can see, this particular part of the digital asset space has really caught my attention and I don't suspect these yields are going down anytime soon. With that, I hope you guys have enjoyed the discussion and please do your own homework. Thank you for listening to TIP. To access our show notes, courses or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decisions, consult a professional. This show is copyrighted by the Investors Podcast Network.

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We Study Billionaires - The Investor’s Podcast Network - BTC013: Bitcoin Lending & Borrowing w/ Blockfi's Zac Prince & Mark Yusko (Bitcoin Podcast)

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