Ari Paul

BlockTower Capital and the Cryptocurrency Opportunity

For many years, Bitcoin and cryptocurrencies were regarded as little more than a nerdy curiosity by the financial world. But with the rise of Bitcoin and Ethereum, the process of cryptocurrencies becoming a recognized asset class has begun.

One person at the forefront of this transformation is Ari Paul. Previously a portfolio manager at the University of Chicago’s $8 billion endowment, he recently left to start the cryptocurrency hedge fund BlockTower Capital. He joined us for an insightful conversation about one of the biggest trends in the industry.

Topics we discussed in this episode
  • Ari’s background as a portfolio manager at the University of Chicago
  • The difficulties of investing in cryptocurrency for a large endowment
  • Why he started the cryptocurrency hedge fund BlockTower Capital
  • How to construct a cryptocurrency portfolio
  • The hedge fund vs the VC model in the cryptocurrency space
  • Why cryptocurrencies represent an exceptional investment opportunity
  • The operational complexities of running a crypto hedge fund
  • Why an avalanche of institutional money is entering the blockchain space
Transcript

Meher Roy: Today, we’ll talk to Ari David Paul who is the co-founder BlockTower Capital, a cryptocurrency investment firm. We’ll talk about cryptocurrency investment funds, their incentive structures, specifically, the BTCs that BlockTower Capital has.  Ari, welcome to the show.

Ari Paul: Hi, guys. Thank you so much for having me.

Meher: So before we begin, tell us how you got interested in the cryptocurrency space.

Ari: You know, I’m a slow learner. It took me a while to really appreciate, you know, what I think we all kind of now appreciate. So what happened was after the financial crisis in 2008, the Federal Reserve started printing a ton of money. Their balance sheet went up 4x and I started thinking that while currency depreciation inflation wouldn’t happen right away, because we have these massive deflationary forces, eventually that was going to be a problem. So by the time we got to like 2011, 2012, I was thinking, how do I get out of US dollar? I looked at the euro and the yen and they looked even worse. How do we get out of the UK currency? How do I get out the way of concurrency depreciation? And it took a while, but then kind of Bitcoin was such a clear answer. Here’s money that can’t be debased by a government.

There was one other angle that really made it attractive to me. So when I talk to Americans about the idea of censorship resistance or an unseasonable store value, they often look at me weird and say, oh, so it’s for criminals. But I had relatives who had to flee Nazi Germany with, you know, valuable sewn into their clothes. And when I talked to other people in the crypto community, often, there’s some connection. They had a relative who has a flea Pinochet’s Chile or Mali-China or the Khmer Rouge, they had to flee some country. And so they appreciate that. Sometimes you’re able to escape a country but not with your assets, not with your wealth, not with—and by wealth, I don’t mean a lot of wealth, I mean, enough money so that you don’t starve to death. So I mean, right now, we have some refugee crisis, Syrian refugees, Syrians at flee the country, and many of them were middle class. These were people who had a home, a business, a car, but they weren’t allowed to take it outside the country. So the idea of having a store of value, a way of storing your wealth, you can access from anywhere in the world with just a password capped in your head is very attractive.

Brian: I agree. It’s such a powerful concept. Incredible, right? If you think about, okay, let’s say this had existed during Nazi Germany, it would have been a very different situation, right? Very empowering for those people.

Ari: Definitely. So you know, I came across Bitcoin. It’s funny, I fairly recently I search through my emails, see what was the first reference of cryptocurrency. And I had a friend, a brilliant investor friend named Doran [ph] who worked at Pimco at the time who forwarded me a New York Times article. This was when Bitcoin was $3. And he said this was an interesting, take a look. And I responded definitively saying electronic currency will never have value because value comes from either a long history of value like gold or Fiat backed by guns. And you know, it took me a while and it’s funny. We still see that kind of response from people like Robert Shiller and Howard Marks and Mohamed El-Erian and these are big names in the financial community. And so I’m sympathetic when I see these people saying these kinds of things, it’s like, well, I was saying the exact same thing, you know, five, six years ago. And it took me really two years to wrap my head around, you know, the unique value proposition. And a great line, I think it might’ve been Naval who first said this, that cryptocurrency is kind of a graduate 400 level course with prerequisites in game theory, computer science, economics. There’s a lot of relatively simple questions. So you know, everyone’s like, when you’re introduced here, first you ask, well, why can’t more Bitcoin be created? And the answer to that, we all kind of know that it feels an obvious answer to us at this point, but it took me awhile to understand why more Bitcoin can’t be created. How does the game theory work? What does consensus really need? What does decentralization really need? You know, it took me a while to get it.

And then, you know, what people are worried. There’s the question of is it a bubble? Well, people are asking the same thing when Bitcoin is $100 because it had just rallied from a dollar, right? It up 100x. And so I looked at it in 2013 and I said, man, I don’t know if this started interesting me, but it’s 10x, how do I buy? And then in 2014, Bitcoin crashed 70 percent. Silk Road happened. Gox happened. And in early 2014, it fell from $1,200 to $40. And the trader, the contrarian in me was really intrigued because it’s like, wow, this thing should probably should have died, right? There were these things that should have killed it and it didn’t. It survived. And it sounds 70 percent from its highs. So maybe this is an interesting point to buy. So I started buying just a little bit, started learning about it, started reading, you know, joined some of the subreddits and read the white paper for the first time. And very gradually started learning about it and appreciating. And I think for a lot of people, myself included, Ethereum also helped us understand the broader use cases that are possible. Where you can then start thinking of it beyond just money, but in terms of, you know, an entire ecosystem. Cryptocurrency as rewards points as loyalty a mile—sorry. As airline miles rewards points or as utility tokens, you know, all of that kind of broaden the scope of what this can be.

Meher: Prior to being involved with cryptocurrency, what did you do?

Ari: So I started my career as a trader. So I was a market maker of equity derivatives for Susquehanna International Group. What that means was I was basically like the casino for options on the SMP 500. I was buying and selling all day, bouncing order flow, managing risk. I then traded just about everything. I traded FX currencies. I traded commodities, crude oil, natural gas. I traded treasury bonds. I even traded electricity fords. They are actually financial contracts for electricity. So I was very much a trader as opposed to an investor. A trader, you’re betting on short-term order flow. You’re mostly thinking about what are other people going to do in the next hour or day or week and where’s money going to flow? So I did that for a total of six years and got an MBA in U Chicago. And then I joined the University Chicago endowment, which is a $8 billion endowment, which is totally the other end of finance. You’re thinking very long-term, you’re thinking about how do I construct a portfolio that is humble because you can’t be nimble. So as a trader, you can go in and out of positions in an hour. You can change your mind. As endowment, you really can’t. You can’t move $6 billion. It’s kind of out of local real estate for example. So you have to create a portfolio that has humility kind of built into it where I don’t know what’s going to happen. I don’t know how my views are going to change. Let me create a base portfolio that I think will do really well over 10 years. How do I want to be allocated? Where does return come from, how do I manage risk in a long-term sense? And then within that, construct. How do I find ways to add value? Kind of being a little bit of a shorter, medium term idea.

Brian: When did you choose to leave the University of Chicago endowment and how they come about in your decision then to start a fund specifically focused on the blockchain space?

Ari: So I actually left less than three months ago. We’ve been moving very, very quickly because we appreciated just how fast this industry was growing and professionalizing from many, many angles. What motivated me to leave? It was kind of an interesting path. So I became gradually more knowledgeable and more convinced and more invested in cryptocurrency over kind of a four-year period. By towards the end of last year, I started talking to my endowment colleagues about can we invest in this? Can we, you know, earn a track to the alpha in this? And at the time, all of cryptocurrency, it was only about $13 billion, right? Tiny market cap. From the perspective of an $8 billion endowment, it’s almost uninvestable. It’s so small. It was also so lacking in professional services, right? So if you think about, well, how am I going to buy cryptocurrency? Can I trust an exchange? What if I put my money on MtGox and it vanishes? So I started exploring it. I started producing some educational materials for my colleagues, started to try to familiarize them and myself. And I also talked to all the funds I could find that exist in the space, which at the time, it was like four. There were very, very few funds around a year ago. And one thing that stood out to me was a few of the funds were run by very talented engineers and I’m friends with them. I think they’re going to do very well. I think I would recommend that people invest with them, but it was clear that the endowment, the U Chicago, wouldn’t and couldn’t invest with them. Because frankly, they didn’t know how to pitch. They didn’t know how to frame the investment in the terms that we needed to hear them framed.

So for example, you take a brilliant blockchain engineer who’s very good at reading protocol and finding innovative cryptography and you ask them how much of your return comes from alpha and beta? And they look at you with wide eyes, right? Those are terms they don’t care about, they’re not familiar with. It’s also just an uninteresting question to them. And they don’t, that’s not how they think about investing. And that’s fine. This is not meant as a criticism. I knew that I wanted U Chicago to profit from this opportunity set. I wanted the Red Cross and other endowments and pensions and foundations. And it was clear that most of the existing managers   really weren’t offering that opportunity. And so after spending a few months kind of thinking about this, I actually wrote page-long recommendations to a few of these existing managers as to how they could pitch us. You know, this is what you guys need to say. This is the window dressing you need to add. Here’s a simple example. So having an advisor, for example, with legal expertise. Because the obvious question is how do you deal with the regulatory issues and being able to demonstrate credibility that either you’re an expert or at least you’re in touch with experts, is important to get an endowment to invest. So I tried to help some of the existing managers do that and it was clear that there was this opportunity to create an institutional quality fund, to create a fund that U Chicago could invest in.

The other angle was all the funds I spoke to, actually every single one we’re long-term buy and hold. They were saying we believe cryptocurrency is going to become multi trillion-dollar asset class. We believe in this long-term story and we’re going to buy, you know, 10 or 20 cryptocurrencies and hope that we have one of the winners. And that’s a fine strategy. That’s the venture capital approach. It works well in equity if you know how to do it. But I was trading cryptocurrency myself and, you know, 20 minutes a day, kind of in evening. And it was the most inefficient market that I’d ever seen. All the strategies that I used in trading bonds and commodities, electricity, worked in cryptocurrency because shorter-term, they trade like currencies. So if you can anticipate where money’s going to flow, you can have—here’s an example. If you can anticipate that a cryptocurrency is going to be added to a large exchange that will facilitate retail buying, you can anticipate that the price will go up. And so those strategies worked. And I actually didn’t see anyone doing that. And that’s really, I’m not a venture capitalist, I’m certainly not an engineer, but I am a trader and a portfolio manager. And so I thought that that by building the right team around me that could fill in kind of the gaps in my own expertise, we could offer that, that shorter-term alpha opportunity set to investors.

Brian: And how are you, what kind of funds do you want to build in the longer-term? Do you see this turning, becoming like a very large fund that will run kind of a hedge fund model in this space? Or do you think it will go into some different direction?

Ari: So our long-term goal is to build a firm that supports a series of funds and the intention is to bring in the right people. So for example, our current fund offering does not invest in equity at all. And the reason for that is that neither I nor my co-founder, Matthew Goetz, we’re not venture capitalists, we don’t have experience doing private equity deals. And that really is a separate, unique skill set. And I’m a big believer in this idea of circle of competence. Probably the single most important thing to be in good investor is knowing what you don’t know. You don’t need to be good at everything. You don’t need to know everything. You just need to know what you know. And then you can narrow in on that, invest in that. To be a great investor, you don’t have to know anything about real estate as long as you don’t invest in real estate. So long-term, the plan is to bring on the right partners who have the expertise needed for each investment category and to build out a firm that does eventually cover everything in the cryptocurrency space. And the reason for that is, I think there’s some natural synergies.

So for example, we’re not ICO focused. We have a small portion of the portfolio roughly kind of set aside for ICOs, but it’s a small portion. But I have to spend a lot of time looking at new projects because let’s say I invested in Ether. Well, I need to know about Tezos, so I need to know about EOS. I need to know about Rootstock because all of those could potentially be disruptive. They could potentially kill the incumbent. So I’m already looking at those projects. I’m already talking to those developers. I’m already kind of in that deal flow. I get ten whitepapers a day in my inbox all offering, you know, a 50 percent presale discounts. So they’re kind of these natural synergies where if we have a separate fund, it was more focused on that. I think both of our funds would kind of benefit from that expertise as well as from access to deal flow, access to information. And long-term, this industry will consolidate. So what you’re seeing right now is kind of a million flowers blooming. You’re seeing many, many new funds launching, many new projects launching and that’s great. I’m a big believer in experimentation and entrepreneurship; but over time, this will start looking more like a traditional asset class. You will have a few giant leaders in this space that have advantages that make it hard for others to compete.

So for example, if you’re trying to launch a traditional bond fund, a $2 billion hedge fund, it’s really hard to compete against the giant hedge funds because they have all these, they have the cheapest capital. They have a brand that lets them attract the best employees. They have connections throughout the world for better deal sourcing. They have large organizations that let them have their finger in everything and have their finger on the pulse of everything going around the world. So right now, what we’re seeing is tremendous collaboration. I’m on the phone constantly with other fund managers. We share ideas, we share best practices on security, we share our service providers and we also share our ideas because we’re all small organizations. And at the moment, most of this industry is retail money, so it’s possible for every fund manager in the space to do well because we’re not controlling that much money. But over time, you know, if you have a few funds that have 20 employees, 30 employees, it’s gonna be hard to compete with that. You know, if you’re trying to be a one-man shop or even a five-men shop. So our goal is to build kind of a leading institutional quality firm in the cryptocurrency space.

Meher: Cool. And what kind of opportunities were your first fund pursue?

Ari: So my own skillset is a short and medium-term trading, so not high frequency, algorithmic trading, but kind of everything that’s longer-term than that. That’s also currently pretty low hanging fruit in this market. And the reason for that is through these tremendous barriers to entry. So that kind of a strategy. So if you’re pursuing a venture capital approach, it’s not that part operationally. You sign a SAFT (Simple Agreement for Future Tokens), maybe you receive tokens and you put them in cold storage and then you wait three or six months. It’s quite much harder from a security operational perspective to be actively trading because the market is illiquid. So we constantly have to think about how do we get the best fill. If I want to do a large trade, I need to do that every few days. I spent a lot of time thinking about how do I minimize the slippage or the transaction fees I pay. Security is also harder because I didn’t move cryptocurrency into and out of cold storage.

So those are, I spend a huge amount of time on that. I’m constantly consulting with the best security experts in the industry to make sure that we’re really at the forefront of that. And while it’s a huge pain, frankly, it’s not fun to do. I recognize that it’s a barrier to entry. It keeps a lot of other people out. It keeps a lot of the professional traders out, it keeps a lot of the existing funds away from the space because it’s both a day to day challenge as well as an expertise that they don’t really want to develop. It also has a unique set of risks. So traditionally, most investors like an endowment, they’re not used to taking the risk that money might be lost on and change. They’re not used to taking security risk with assets, right? They’re not thinking about their investment in Microsoft stock being stolen. And so in this space, all of those risks are real.

And you know, I’m kind of grateful for that because of the moment, that’s one of the reasons why I’m mostly competing against the retail investor who really has no idea what they’re doing. The person who, just as an example, people were, as we headed into the Bitcoin hard fork heading into August, people were asking me my thoughts on what would happen. And I said, I really don’t know. I have a guess, I have an opinion, but there’s a small group of Chinese miners who have a lot of control here and I don’t know what they’re discussing in kind of a dark room amongst themselves and I have maybe some contacts, but the reality was, that how many people in the world understood the BIP 148, 91, BIP 141 kind of timeline. Very few, right? But there were very few people on the planet who were actually following blocks as they remind by miners and the signaling. So at the moment, I don’t think of it of us as competing with other funds. It’s more like the small group of funds controlling a small amount of money. We’re all just paying a little more attention than the person who’s buying or selling on Coinbase. And we can all kind of benefit from just bringing a little bit of expertise and even just frankly attention. Literally just watching the blockchain and watching the miner signaling and having spent a few hours to understand what does it mean if miners are signaling BIP 91, what’s the timeline? What’s the deadline?

Meher: Can you give us an idea of how you would construct a cryptocurrency trading portfolio? So what kind of opportunities would you pursue and how do you balance such a portfolio?

Ari: Sure. I don’t think there’s a right answer to that. A big part of where we hope to add value as investors is in deciding that in an ongoing way. So I don’t know what this industry looks like in five years. I don’t know what this market looks like in five years. We’ve been going through some very short regimes. So I think it’s actually a really important concept in investing. People will often rely on, if you’re an algo trader, you rely on a data set. If you’re a more of a traditional investor, like a value investor, you rely on a set of your risk list, a mental framework. And usually, you’re drawing on what’s worked in the past. So you say, I’m buying low P, low price to earning stocks works well or buying, you know, Warren Buffet made a lot of money buying assets that had hot large cash flows. So you say, well, I’m going to do that. The problem is, in traditional markets, regimes tend to last for a pretty long time, 5 years, 10 years, 20 years, sometimes 50 years. In cryptocurrency, they don’t. And I think that’s for fundamental reasons. This is a constantly transforming both technology and asset class.

And one example on that was a nine months ago, a huge amount of trading volume was in China and cryptocurrency was probably best thought of as mostly a US and Chinese phenomena. And now, it’s trying to something like five to ten percent of trading volume and maybe that’ll be lower tomorrow. And Japan and Korea are huge players. And it’s kind of spread more globally generally. We’re seeing interest in Argentina and Venezuela and Brazil and India starting to come online and the person who’s investing, it’s a different person. So you’re starting to have fund managers like myself who bring more of that Wall Street experience and approach the market differently. You’re starting to have professional arbitragers who trade across exchange. You’re starting to have people who are doing quantitative modeling who were trying to apply fundamental valuation metrics to things like Filecoin. So all of that dramatically changes kind of how this market is likely to work. The patterns of the past will not necessarily repeat.

So all of that is, I guess, a huge asterisk that I don’t believe in there being kind of a set approach to managing a crypto portfolio right now. I think, I can tell you kind of my current mindset, but I’m very humble about it and opportunistic and very, very willing to change this view if the market seems to suggest I should. So from January to May, the theme in the market was Ethereum explosion in value and then a recycling of those profits into everything built on Ethereum. You had a lot of people, you have basically Silicon Valley elites, you have wealthy entrepreneurs, people who had gotten rich, taking a company public or who were early Facebook employees who were buying Ethereum and push the valuation up. And then you had a lot of people who they have put 10 or $20,000 into Ethereum and then suddenly, they had a million dollars. And they were looking for their next 20 ETHs and they were looking, they were excited about Ethereum. Ethereum seemed to be working as an investment idea. What can they invest that’s an extension of that? And so they put money into things like Augur and Gnosis at very, very high valuations.

And then, you know, now we’re in, I think, kind of a different period. So I’m constantly thinking about where is the money coming from, where’s new investment coming? And I think we’re right on the cusp of an explosion in first retail money, which we’re seeing with 35,000 new Coinbase accounts a day and the opening of new exchanges and Korea and Japan that facilitate retail buying. And we’re also on the cusp of institutional buying, so we now have a Bitcoin ETN (Exchange Traded Note). There are a few in multiple currencies. There’s GBTC in the US, there’s a few in Europe. We’re probably going to have an ETF in maybe six months. If not in the US then probably in maybe Macau or Singapore, London. We’re going to have Bitcoin futures within the next few weeks and Bitcoin options. So LedgerX is launching the CBOE, trying to launch Bitcoin futures. There are a bunch of others that have a requesting to the CFTC. So all of that is, I think, dramatically changing kind of the framework.

So, okay, so now let me really answer your question as to at least how I think about it. So I think there’s, you can kind of think about the market or cryptocurrency as an asset class and along a few different lines. You have cryptocurrencies that are competing to be money as store of value. And actually, I should separate money into two things. You have money as a store of value, which is really a separate use case from money for payment. And I think it actually is likely to be separate in cryptocurrency. I might be wrong about this. I say this, you know, kind of humbly, but so you have something like Bitcoin that is pretty good as a store of value because it’s a staple protocol. It’s relatively decentralized, I say, relatively. Where there’s constant debate over mining centralization, but it’s relatively decentralized. It’s relatively distributed in terms of ownership. But a key point, I think, is that stability of protocol. So people forget code is buggy, right? So you have cryptocurrencies that are hard forking every other day. There will be big bugs found. There will be massive problems in the protocol of it that destroyed billions and value. So if I want to know that a Bitcoin today is a Bitcoin in ten years, I can have some confidence in that. There’s probably not going to be that big of a change. Whereas in a lot of other cryptocurrencies, they’re pursuing more of a move fast and break things mentality. They’re competing on features.

So this is how I very broadly bifurcated. For stored value, which I think is the biggest use case, which I think is going to be a $10 trillion use case. Whatever wins is going to look like a Lloyd’s of London. It’s going to look like a giant old insurance company or bank. It won’t necessarily have the lowest fee, won’t necessarily have the fastest confirmation time, won’t necessarily be the cleanest code, the prettiest code, one of the most features, but it will be stable and old and trusted. For most other use cases, you’re competing on features. It’s a bit more like being Netflix or Uber or Facebook where something with better features might come out. So you have to be innovative, you have to be constantly improving the protocol, improving the code. So I think you have the stored value as part of a well-rounded portfolio. And you can either be, there’s kind of two approaches to try to capture that value. You can take the venture capital approach and say, I’m going to buy ten things and hope one of them wins. I’m going to buy Bitcoin and whatever else you think might win that use case. A problem with that though is what if it hasn’t been invented yet? So what if this was 1990 and you’re trying to invest in the winning search engine? Well, Google didn’t exist. What if it’s 1995 and you’re in Ask Jeeves or actually I don’t want to ask you this was created, but you know, what if the winner doesn’t exist yet or what if maybe it exists, but it’s tiny and it’s not on your list. So you can either take the VC approach, and maybe have a good shot of capturing it.

My approach, and this is just because it’s my skill set, is I’m constantly updating with new information. So I’m constantly evaluating every day, every week, what is the most likely things that are going to fulfill that store value? And I probably, if something were to kill Bitcoin and capture that $10 trillion market, I probably wouldn’t be the first one to know it. I wouldn’t necessarily get in at the presale or if it even had an ICO, wouldn’t necessarily get in when it’s $20 million valuation. But I would hope I would realize it when I was at a billion or 5 billion. And if it ends up being that $10 trillion asset, you know, I’m still doing fine. And the benefit of that is I miss a lot of losers, right? I’m not, I’m going to get into the worst valuation, but I’m not going to invest in a lot of things that just die before even getting any network effect.

So there’s that. And then you have this whole area of the market that is, I think of as more like companies. So utility tokens you can generally think of as far as software as a service or as an airline miles or rewards points And I think there’s a lot of those that deserve to be eventually 100 million, 500 million, and a billion. But they’re almost in a totally separate category, for me. The token is almost best viewed as, whether or not it’s legally equity or security, it’s best thought of as really how big is this market, you know? So if you have something that’s like a decentralized casino, well, that can be very lucrative, that can be very profitable. That’s not a trillion-dollar token, probably, or it’s unlikely to be because there are no trillion-dollar casinos. There’s nothing anywhere near even close to that. And so you’d have to, you’d have to make a very strong case that by tokenizing it, there’s much, much greater network effects than anything we’ve ever seen on the planet. Which maybe that’s the case, right? So yeah, I mean, very broadly, it’s things that are more equity like, and then store value. I’m kind of rambling on this point because it touches on so many different things.

So the one other thing I’ll add to kind of how do you construct a portfolio in this is, for me at least, I think about themes in an ongoing way I think about where things are in the stage of development or like the Gartner Hype Cycle. So there are a lot of projects today that are ICOing, that are probably five years away or longer from being usable. The things like where it’s the equivalent of a Pets.com. So Pets.com kind of things example from 1999. I was just a horrible idea that people evaluate too much. The reality is Pets.com wasn’t a bad idea. We now have PetSmart, we now have pet food over the internet. It was just way too early. You couldn’t have had Facebook in 1990. So I think you had some projects like the Oracle projects that were just too early. They were good ideas, they were good teams, they just didn’t have the stack built and they didn’t yet have the demand. So there’s some projects that I’ve been evaluating recently that are decentralized cloud computing or decentralized databases and things like that that you have to think about very much as a VC, meaning this is not going to be usable in the next year or two. By usable, I don’t mean that the code won’t work. I mean, there’s no real fundamental demand for it. Because first, you need decentralized applications to become prolific and consumers to be using those and then those will demand these services. And so, you know, usually they kind of keep in mind where we really in the cycle and to something that is brand new with no network effects in a very early stage software and technology. Am I confident, can I be confident that that’s going to be an ultimate winner to value it so highly today?

Brian: Fantastic. Well, that was that long thorough, but very, very interesting, good answer. Now one thing I would like to talk about a little bit. So you wrote this, you started this series of blog posts, which is something about these kind of principles or your thoughts in general about this investment landscape. And the first post is very interesting, right? Because you essentially ask the question like why have such good returns had been made in this space, because obviously, anybody who has been investing in this industry, it looks like a genius, if you could probably compare it to traditional money manager, right? So people have made insane returns. So, you know, why do you think that is? And do you think that’s going to continue? Or with your fund with BlockTower today, what kind of returns are you expecting, aiming for, hoping for?

Ari: So I think the blog post that you’re referencing, I’m just trying to develop this idea of that, as investors, we get returns, in traditional finance, the idea is you get return for only a very small number of things. You don’t get returns in traditional finance for taking what’s called idiosyncratic risk. So for example, if I buy it, let’s say there’s a Biotech stock and it’s going to either get an FDA approval and go up hugely in value or it’s not, will go to zero. That’s very risky. But finance theory says I don’t get rewarded for taking that risk. Because everyone in the world, if it’s a good bet, should make it just one percent of the portfolio or 0.5 percent of the portfolio. So that risk, because it’s idiosyncratic, because it’s uncorrelated, because it has nothing to do with anything else in your portfolio, it’s not really a risk. But if I have it, we can take it further. If it was 0.1 percent of my portfolio is being bet on this coin flip, it’s not really a risk because if the FDA doesn’t approve it, I lose 0.1 percent. It has nothing to do with anything else.

So the risks that investors care about are correlated risks. The risks that basically the entire portfolio goes down and that’s called a systematic or structural risk. And the traditional finance idea is that you get rewarded only for those. And those are beta, which is kind of exposure to the market, duration exposure to credit and interest rates, and maybe illiquidity. So if you’re willing to lock your money up, you should get real return reward. It’s that mindset that is leading a lot of people to call cryptocurrency a bubble in traditional finance world. Because they say there’s no reason for cryptocurrency to be doing as well as it is. And my counterargument is, there actually is. Those people who were early investing in crypto are earning a return for good reason. They’re earning a return for taking a different set of risks, for taking operational risk, for taking complexity risks, right? These are new and hard to understand. They take time. And frankly, for taking career risks. So if you’re an endowment investor right now, so like if an endowment had put five percent of their portfolio or one percent of the portfolio into cryptocurrency two years ago, it would have been the top performing endowment in the country. Well, why? I would argue, because that investor was willing to take career risk. That if this idea doesn’t work out, even if it just loses one percent of the portfolio, they look like an idiot. They look like the investment Bernie Madoff to their peers. So maybe they lose their job or their target better than the industry.

So I think that that pattern of a kind of the operational complexity, all those risks, we’ve got another few years, right? It’s still scary. It’s still hard. When it becomes easy, here’s kind of something I said as a joke, but I actually kind of believe. We’re probably not at peak ICO until someone can buy it on an iOS store app. So you, Floyd Mayweather and Paris Hilton hocking these ICOs. How many of their Instagram followers can buy any of their ICOs, right? Like of Floyd Mayweather’s Instagram followers who wanted to buy the ICO that he was pitching, how many were able to? You know, probably one percent or less because it’s hard, right? It’s hard to participate in an ICO if you’re brand new to the space. So I think we have a few years left where it’s going to become easier to invest and that means more money will flow in and as investors, we’ll be rewarded for having taken the time and effort to do this early.

Meher: Do think you’re taking career risk when switching to cryptocurrency?

Ari: Definitely. I mean, definitely. So if I was investing in equities and equities fell 50 percent or 90 percent, no one thinks worst of me for it, right? And what you’re supposed to invest in equities. Everyone invests in equities. Everyone lost, right? By doing this, if cryptocurrency were to collapse and go to zero, right? Which I don’t think anyone here would, probably no one listening thinks is possible. But you know, if that were to happen, I would look like a pretty big idiot to my colleagues back in the endowment world. It’s like, you know, you left, and you lost investor money on buying tulips? No, but part of it is, I’ve left the endowment, right? But I had to take a lot of risk to launch a firm. I put a lot of my own money in. I’m not taking a salary for years, you know. There’s a lot of risk inherent in that. If I had stayed at the endowment and somehow convinced my colleagues to invest very aggressively, to be the first endowment in and really push that hard and put my name on it and said, you know, this is my bet and it had gone poorly. It would have been career risk. It would have reflected poorly on me. I don’t know if I would have been fired for it, but it definitely would have been, you know. That, yeah. [Laughs] The answer is yes.

Brian: Now with BlockTower, right? So in endowment, I guess this is kind of special investment institution. Now, BlockTower is basically like a hedge fund, right? So do you think this is the appropriate structure to invest in this industry or do you think we will have to have some new kind of fund, then investment structures that are maybe new fee structures, new type of agreements with their own investors? What’s the best way to invest in this space from an institutional perspective?

Ari: I think that the traditional bifurcation into VC and hedge funds still makes sense. I haven’t heard a better idea yet. So the basic idea here is, if you’re trading something that’s liquid, that is daily valuation, a hedge fund structure works well. And the main difference here is a hedge fund structure is evergreen. What that means is there’s generally one fund that has a perpetual life and it can take in new money anytime it wants. So at the end of any month or any quarter, new investors can come in. And that’s not a problem because what you’re investing in is entirely or mostly things where you know the fair price because the fair price is whatever it’s trading on an exchange. If you’re investing in things that are illiquid, they’re not exchange listed. You can’t really do that because you don’t know what the thing’s worth. So imagine if I, let’s say I invested in all of my money in something like a Cosmos network, ICO. Well, today that investment is probably worth more than when I first put it in and if I accepted new investors into the fund, they would effectively be buying at the price from five months ago. And it would be diluting the initial investors, which is not fair to the initial investors, but there’s no fair way to do it because we don’t know what it’s worth today. There is no exchange price. We would just have to guess.

And so if you’re investing in illiquid things of use of venture capital structure. And the way venture capital structure works, the other term is a drawdown structure is, you have a fund, you accept money, you close the funds, you’re not accepting any new money, you make your investments. And then over time, you liquidate the investments and you get money back to investors. And if you want to raise more money, you do a new fund. So a firm like Sequoia has Sequoia 1, 2, Sequoia 3. I think, throughout Sequoia 18. Because every time they want to raise new money, they launched a new fund. So I think in crypto, it really depends on what you’re doing. Because we’re more actively trading because we hold basically nothing in illiquid assets, it makes sense for us to be structured as a hedge fund. But if you’re investing mostly in pre ICO or ICOs, I think you really have to do the VC structure.

Brian: Cool. Interesting. But actually, it’s interesting that the way you phrased it. Because you say, okay, in a hedge fund, it’s no problem if new people come in because you know the fair value. But how do you think about the liquidity risk here? Because if you are in some of these tokens, okay, Bitcoin, Ether, you know, liquid enough. So, you know you can sell your position, probably. But if you’re talking about other assets, do you price that in?

Ari: It’s interesting question. So with things that are, I had a conversation actually with our fund administrator about this, about hypothetically, if we had a position that rocketed up, but we couldn’t, but that I felt was almost mispriced by the market, and we were taking a new money, what’s the right thing to do there? So the answer is, the default is to treat the exchange price as the real price. You need to make a pretty, you need to be really competent to do anything otherwise because that is the price the market is giving you. Cryptocurrency is unusual in this regard because you have a few individuals, sometimes you have a fund that buys up a huge percentage of all the tokens, right? They may buy up 10 percent, 20 percent of all the tokens that exist pre ICO or ICO. So then you have a price on the exchange that really doesn’t reflect that. It doesn’t reflect this mass or actually sometimes as much worse. I mean, you have some tokens were single individual owns 40 percent of all the tokens. And so the price that you see on the exchange, it’s not real if that individual was trying to liquidate almost anything. So there’s no great answer to this. So legally, what, as a fund manager, I’m allowed to do is basically apply liquidity discount. So if we had, if there’s something like 50 percent of the fund was in some very, very liquid asset that we were very gradually selling out, but we thought that it was really fair price was something like lower than the market, we can talk to our administrator, it would be a conversation. So that’s kind of the legal answer from a liquidity perspective.

It’s part of trading and you know, it’s a huge part of trading. We’re constantly evaluating the liquidity and what that means and is this price real and it works in both ways. So sometimes the liquidity is really great for us. Because if an asset is really, really liquid, it means that it can overshoot or undershoot a reasonable fair value very sharply. And we even see this and things like Ether where with the flash crash, for example. So Ether flash crashed on GDAX which is Coinbase as exchange and actually fell to something like 11 cents. Well, that’s great if you’re a trader, right? You know, you love buying for 11 cents or a dollar or $50, $100. And then immediately, the price was back to where it had been before because it was just a result of very temporary liquidity.

Meher: When you have traditional money managers, you generally have benchmarks to competitive performance against, right? So inequities they would compare it against maybe the SMB and so on. In the crypto space, what do you compare a hedge funds against? What is, how do you measure your performance?

Ari: So there’s no objective right way to do it. Part of the answer is, I think as a fund manager you are giving a particular product to investors. So there’s some investors who want a beta 1 product. They want 100 percent exposure to cryptocurrency. And then you’re hoping to add alpha beyond that by selecting the best cryptocurrencies. And in that case, your benchmark probably should be you maybe total market cap of cryptocurrency. There are other investors who say, I mostly want to be invested in the biggest and what they think of as “best”. So I want to be invested in Bitcoin and Ether and, but I’m willing to let you invest a little bit around that. So that may be the benchmark is 50/50 Bitcoin and Ether, or maybe it’s top five. And then there are people who say they’re market neutral, they’re high frequency trading and then the benchmark is probably a zero percent return or some kind of almost risk-free rate. You’re competing with hedge funds doing high frequency trading in equities and bonds. So I don’t know. So first, there’s no right answer in terms of I think it’s what you picked your investors, what product you’re offering. And different investors want different things.

Beyond that, it’s really hard because we’re going to face hindsight bias. So for example, let’s say Ether does phenomenally well. Let’s take Bitcoin and Ether are the ultimate winners. Let’s say in five years, Bitcoin and Ether are both multi trillion-dollar assets and nothing else really is anywhere close. Investors are gonna ask me, how did you compare it to a 50/50 portfolio of Bitcoin and Ether? And almost certainly, all have underperformed. Because if those two were the winners, you couldn’t have done better than just buying, button hold those two. And the act of trading that we do to try that alpha, it’s going to be hard to surmount two assets that are just going up a thousand percent. It’s gonna be hard for us to add enough alpha to compensate for basically the risk management. But you don’t know ahead of time that that’s going to be the case. It’s a little bit like asking them Warren Buffet, how did you do against just buying and holding Amazon? Well, he did pretty badly compare to that, but you didn’t know that Amazon was going to, you couldn’t have known that Amazon was going to be Amazon 30 years ago. You could’ve said it had a shot at it. Maybe you had a premonition, maybe you thought it was a good theme or something.

So cryptocurrency is kind of the same where I fully expect people to benchmark be against whatever it does best. But the reality, a priority looking forward, the way I think about it is, I kind of have three benchmarks that are incompatible with one another. So one, I have to be Bitcoin long-term. Two, I have to be total crypto market cap long-term because if Bitcoin fails, let’s say Bitcoin goes to zero and something else takes place, no one’s going to be happy that I was down 90 percent and Bitcoin’s down to 100. No one’s going to say good job already, right? So another is I kind of need to capture the crypto upside. But the third is absolute return. I have all my own money invested in our funds and I don’t want to lose my money. And investors don’t know, investors may say they buy and hold and they believe in the long-term. But we just saw cryptocurrency, it’s fallen 70 percent numerous times. You know, we just saw Bitcoin just fell 40 percent peak to trial. Most investors are not really comfortable with the idea of losing 70 percent of their money in a month. And so the third is don’t lose money. So of course, those are challenging to reconcile because how do I capture the full upside while reducing risk and making sure I don’t capture the full downside. So we’re constantly trying to balance those three objectives

Brian: And how do you deal with as a fund if you feel like, okay, the market is turning, right? This is no longer a good environment. Are you prepared to take large short positions as well or would you potentially just kind of liquidate positions and stay in cash or how would you handle that?

Ari: Yeah, right now, the answer is that we liquidate positions and will hold more cash. So we’re generally trading into an out of cash. You can’t use shorts for risk management right now because you can collateralize a short. I have to leave a short on an exchange, which means a counterparty risk and the exchanges go down quite frequently, right. Even the better, even GDAX goes down for eight hours at a time, which means I can’t trust stop limit orders. So if I put in a short position, I may not be able to cover it. I may not be able to close the position when I went to. So an idea in shorting that’s a little bit unfamiliar to people outside of finance is, you can short using a derivative like a future, but if you short the underlying, the actual asset, in this case, if you want to short Bitcoin itself, that means you’re borrowing it from someone. For me to sell a Bitcoin, I need someone to give me their coin to sell. So the way that works is if I’m on an exchange, someone who has Bitcoin on the exchange is lending me their Bitcoin, I pay them some kind of margin and I’m able to short it. There isn’t that much liquidity. The exchange, it’s individuals who are doing the shorting. If I want a short $20 million worth of really anything, it’s going to be hard for me to get that liquidity on an exchange. So at the moment, shorting is not really a viable risk management approach, but that will change.

So Bitcoin futures may be a way for us to quickly hedge exposure. So for example, if let’s say a headline came out that said, you know, all governments in the world all ban all cryptocurrency and I’m like, oh man, I need to reduce exposure right away. Selling Bitcoin futures will be a good fast way to do that. And then kind of think about how do I reposition the portfolio as a whole. Also, cash lending. So you’re going to have professional, basically, prime brokerage where I’ll be able to actually source and borrow tens of millions of dollars of cryptocurrencies to then sell. All of that is probably, some of the features are coming within the next probably month or two. The cash lending, my guess was probably something like four months away.

Brian: I guess that kind of leads into one of the next question. So we’ve talked about this in quite a few ways already. You know, the situation with institutional money and just new sources of money slowly coming in and trying to get in. What timeline do you see happening here? When do you think different sources of money will come in and in which ways?

Ari: So right now, we’re seeing retail. Japan and Korea exchanges, Coinbase accounts, I think that’s gonna continue aggressively. There’s a lot of people who are still learning and getting interested, looking for dips to buy, looking to onboard to Coinbase, for example, where you have to go through a fairly long AML process and get your account approved. As well as the other service providers like that. We’re seeing a lot of interest from venture capital firms and family offices. So family offices are kind of the private, it’s almost like a private hedge fund or an endowment for wealthy families and wealthy individuals. Most of the large family offices in the US have invested in cryptocurrency in the last year, but small amounts. Many of them are looking to invest much larger. And we’re also seeing high net worth individuals. So, you know, the average American millionaire currently owns zero cryptocurrency. That’s going to change, I think. Or maybe not even the average, but a meaningful percentage of wealthy people in America and around the world will want to have some percentage of their net worth in cryptocurrency. So I think we’re going to see large inflows there.

On the institutional side, endowments, I think we’re getting at the first damage check into cryptocurrency in the next three months, probably a small check. And then I think really over the next nine months after that, it will become a story. It will become big meaningful checks. Pensions are still 18 months away. The main obstacle is custodial services. So right now, managers have to sell custody assets. That means that managers have access or storing the assets and can basically steal them. Venture capitalists are used to trusting entrepreneurs with money. They’re used to writing a check of a million dollars for an entrepreneur and know they can run away with it. But endowments and pensions aren’t used to that and that they’re very uncomfortable with that. And so there’s a huge push right now in the industry as some managers like myself say, hey, we desperately need, we want custodial services, we want third party custody so that we can go to endowments and pensions and other institutional investors and give them access to this opportunity. I don’t know how far away that is. It’s complex both from a regulatory perspective as well as a technological perspective. But you have a lot of companies like Ledger that is doing kind of early stage on that. So I’m optimistic that maybe in six to nine months, we’ll have it.

Brian: Yeah. Thanks so much for this answer. Now, there was another article I wanted to talk with you about that that you wrote. So this is this question of table selections. You used to be a poker player, right? And you said, okay, what you’re good at is just understanding what’s the right game to play, where do you need to be? And of course, it’s interesting to carry over this idea to the cryptocurrency space. And in particular, there’s one aspect in which I’m wondering how you think about this. So you’ve had a bunch of early funds that started, you know, professionally investing in blockchain space, you know, one of the earliest ones was Polychain because we’ve talked with Olaf before, I think when we had them on the podcast. You know, they were just managing 10 million or something and then soon later, he was on the Forbes cover and 200 million. And so it’s blown up, right? But still, I mean, he and the people in the fund, for the most part at least, are your blockchain people, right? And so I think a lot of blockchain people to date are investing, they’ve set up their own funds or they’re investing money they’ve made from Bitcoin or from Ether. And then there are people like you coming in right through our professional money managers and who have the experience on the financial side. So how do you think this is going to play out? Do you think there is a substantial benefit or advantage for one party versus the other?

Ari: So I think what we’re seeing already is people are finding ways to build the teams they need to fill in their weaknesses. So it isn’t necessarily happening with hires, it often happens through just communication. So for me, I’m not an engineer and I don’t pretend to be one and while my trading focus is shorter-term, I never want to be on the wrong side of fundamentals. So how do I fix that? Well, I’m not reading the protocol myself, but I’m talking literally every day with a blockchain engineer or developer. And I’ve worked hard to establish good relationships with the industry leaders, the very, very smartest people in the space who do read the protocols, who are developing the protocols. So I’ve developed a very strong expert network where, you know, it’s almost like having a much, much bigger team. Similarly, the people who are the engineers, the blockchain engineers, the smart ones are either partnering with someone with some traditional financial experience or similarly, they’re taught like one of the reason those developers talk to me and there’s some other fund managers who were engineers and they give me their insight and expertise and then they asked me questions and I talked to them about risk management, portfolio management, derivatives, you know, money flows, all of that stuff.

So at the moment, I think the people who are approaching intelligently. They’re bringing their skill sets to the table and they’re talking to the best in every other skill set and trying to create synthesis. Bigger picture than that, I think it really depends on where you think your edge is coming from. So I don’t want to be on the wrong side of fundamentals, but I’m never claiming that the alpha we’re trying to generate comes from me being better at judging the consensus mechanism than another fund manager. That’s never, that’s not the claim. That’s not what we’re trying to do well. What we’re saying is, well, we don’t wanna make any dumb mistakes in that regard. We want to kind of know what the consensus is among the engineers, but where we hope to add values with the shorter-term understanding of market psychology and money flows as well as gaining access to information. On the other hand, there are people who are VC focused, who are trying to pick the best pre ICO an ICOs, and they kind of think they need to make sure that they might not be a legal expert, but they need to make sure they’re not on the wrong side of the law. And they might not be an expert on derivatives or exchange flows, they want to make sure they’re not getting into something that they can never get out of. But where their value add comes from is that deep, deep expertise in the protocols, the business strategy or thinking about the ecosystem. And so, that’s their focus.

So in traditional asset classes, you don’t need to be good at everything. There are a lot of ways to profit from—so here’s an example. One of the most successful firms of all time is Rentech. Rentech is a high frequency trading firms. It’s mostly computer programmers. They trade equities, they trade commodities, they trade bonds. But when they’re trading Microsoft stock, they don’t necessarily know that much about Microsoft. They probably have someone on the team who follows the news, who reads the financials, but that’s not where they’re adding value. That’s not where they’re making money. What they’re doing is they’re treating Microsoft every second. They’re buying and selling and buying and selling and they’re using quantitative signals and all that. And alternatively, Warren buffet doesn’t look at quantitative signaling and Warren Buffet doesn’t look at algorithmic trading and he doesn’t look at all these other things, right? So I think there isn’t a single right answer, and how to profit from this. You, you mostly need to make sure that you’re bringing something exceptional to the table and you’re not doing anything really dumb in the areas in which you’re not an expert. And you can do that by coordinating with other people.

Brian: Now on the table selection, we can of course look at the cryptocurrency space and the blockchain space, so overall as a table, right? And you can say, okay, as an investor there, all these different tables you can, you know, you do equity investing or this cryptocurrency table. But do you see within the blockchain space also what are the kinds of the different tables you think about there and where you see interesting opportunities?

Ari: Yeah. So first of all, I’ll tie the broader crypto idea just in a sentence or two and then kind of get specific. So I did view cryptocurrency generally as a very attractive table because of these barrier to entries, because it’s so hard for other traditional financial people to get in the space. There’s a big learning curve in many, many ways, both about cryptocurrency itself as well as the operational security areas. So you know, I think cryptocurrency as a whole, there’s a tremendous opportunity set, because there aren’t that many people involved yet for these kinds of clear reasons. Within cryptocurrency, tables selection is subjective. It really depends on your skill set. So for me to compete, so one of the things that I saw a year ago was that most of the funds in the space where venture capital focused, if I had a VC background, I might still have gone into that game. I might still have tried to compete with them, but it wouldn’t have looked quite as nice of a table to me. Because I’d say, okay, well, I’m competing against. I mean, I have a lot of friends who are launching crypto funds already have, who were really, really sharp engineers and/or VCs or putting together a team of a VC plus an engineer. And I kind of don’t want to compete against them like that. Yeah, I think they’re going to do a great job. What I see as a great table to be at right now is this kind of a little bit more shorter-term focused because they’re just literally aren’t that many people doing it. And the opportunities are pretty broad and deep. It is subjective to your skillset.

Here’s an example. So there is massive arbitrage is between us exchanges and China and Korea. China is, of course, a bit more dangerous now as exchanges are about to maybe that’s shut down. And I say may, some definitely are. Maybe all of them. We don’t know. But that was true three months ago. You had large arbitrages. In Korea, you have large arbitrage opportunities. And those are because of capital control rules. By large, I don’t mean two percent, I mean, a 30 percent discount to buy Bitcoin or premium to sell Bitcoin and Korea to the US. That exists because it’s not easy to move money. So it’s not easy to, you can’t just trade on exchanges because you can’t actually get one out of the country of Korea. And I say you can’t, because realistically, probably you, Brian, can’t. And it’s not an I can’t right now. But there are people who can. So there are firms that are, for example, global trading firms that have subsidiaries in Korea and they have local relationships in there, they have connections in the government and they’re potentially well suited to actually take advantage of that arbitrage. So I have friends, for example, who are Korean, who were doing that arbitrage at small scale with, you know, they have a million dollars themselves and maybe they’re making $100 thousand a month doing it. And they’re doing that, that opportunity is available to them because they have friends in Korea and they know business people in Korea. So if someone was listening to this and they are well connected in Korea, and they have a little bit of their own personal money, that’s a week. That’s a great table for you. That is a great opportunity set for you to take advantage of. And the reason why it exists and why it’s so lucrative for you right now, is because it’s hard for me to do, because I don’t speak Korean. I don’t know about that many people in Korea. And for me to overcome that barrier to entry will take a major investment.

Yeah. So I think it really depends if someone’s looking to get involved in cryptocurrency generally. Again, I think it really depends on kind of your skillset. You don’t have to launch a fund there. I just had to call it with a friend who was kind of asking for, you know, insight or connections in terms of what he wants to do next in the crypto world. And I was saying, you know, I think working on something like a cash lending facility. Because this guy, this gentleman has both operational experience, financial experience and crypto experience, which is a very unique set, a unique combination of skills in this industry. And one way to take advantage of that kind of, that point of synthesis, is to launch a fund. But another is you’re going to have a lot of businesses that are created that are $100 million businesses, $500 million businesses that do traditional finance things in the crypto world. Things like prime brokerage, things like being a sell side analyst at a Wall Street bank. It’s about to become a real thing. Here’s an example. Things like auditing of exchanges or doing third party custody. Those businesses are going to be very lucrative opportunities that most people in the cryptography world can’t do because they don’t have the operational background, they don’t have the financial background. So yeah, long story short. I think it really depends on what you bring to the table.

Meher: Cool. So one of the interesting themes that Brian and I sometimes discuss about and we’d like your opinion on is, if you look at the markets today, equities are actually quite pricey, right? So there was recently this article from Robert Shiller, the economist. So Robert Shiller has this measure called CAPE (Cyclically Adjusted Price Earnings) ratio, and the equity markets on that particular metric, they are higher than they’ve ever been with the exception of 1999 and 1929. So the markets are quite, quite pricey. We haven’t had a huge recession, let’s say, at least in the United States for the past eight or nine years. And there’s this many people suppose that there could be a broad market recession coming someday. So if a situation like that does materialize, how do you think cryptocurrency will behave?

Ari: I think it really depends on the source of the downturn. So if we have a deflationary recession, most recessions are deflationary. And what that means is the velocity of money falls. Money is circulating more slowly. People are not making loans or accepting loans. Businesses are not expanding. Businesses aren’t hiring. In that scenario, I think cryptocurrency probably falls. It gets hurt. It’s hurt because everything gets hurt. Everything from, not only do equities fall, art falls, the price of wine falls, the price of expensive cars falls. And the reason for that is everything is competing in the individual’s portfolio. So if I’ve just lost a huge amount of my net worth, if my wealth has evaporated because I had a lot of equities. Well, I’m going to look to see where I can get money that I could spend day to day. And a lot of us in the crypto community, we like to talk about Bitcoin as money, for example, but it’s not yet, right? And it’s not, things are not yet priced in Bitcoin. So what ends up happening is you liquidate anything and everything, even things that shouldn’t. So maybe the price of real estate shouldn’t fall, but it does, because it’s just another asset that people hold that they then used as a piggyback. Cryptocurrency will be the same. And I actually think that effect will grow worse over time as more institutional investors enter the space. Because when Bitcoin fell 85 percent in 2013 to 2015, it was a hobby for most people. There were very few people who had their livelihoods connected to cryptocurrency. If you had half of your net worth in Bitcoin, you probably had a day job. You were probably a programmer at Facebook and yeah, maybe you just lost 100 grand and Bitcoin, maybe more. But it was kind of this thing at the back of your mind. If you’re managing a portfolio and cryptocurrency as part of that or if you’re a wealthy individual where cryptocurrency is 25 percent net worth or more, suddenly, that starts being part of your portfolio as you think about your portfolio.

I think, for example, if an endowment has five percent of their money in cryptocurrency in ten years and everything sells off, they’ll use it like a piggy bank. They’ll sell their cryptocurrency so that they have more cash, or they could buy more equity and so they can rebalance. That’s a deflation and recession. Where cryptocurrencies maybe a very good hedge and very attractive as an investment portfolio, it’s in an inflationary crisis or an inflationary recession, which I actually think is more likely. And that’s content, so a caveat here is basically, no one is good at predicting either inflation or recession, like no one. And I don’t claim really to be different, but my guess is that the next serious problem we faced economically is inflationary driven, or at least currency depreciation driven. So the US dollar made may lose global reserve currency status over the next five years. There’s some major data points. China and Russia are both trying to push that to happen very aggressively. And if that happens, what you’ll see is not necessarily wage inflation. We’ll not necessarily see wages skyrocket, but you may see the price of things increase. And in that scenario, cryptocurrency probably acts like gold. It probably acts as a hedge against the value of your US dollars or euros or your francs depreciated. So I think in an economic downturn, that is inflationary, or currency depreciation driven, crypto does well. Maybe very well, actually. So a hedge fund manager, Kyle Bass, suggested that he thinks that the likely scenario is the US dollar loses global reserve currency status and cryptocurrency goes up 10x in a very, and within an 18-month period. He thinks it’s almost like a step function. It’s going to happen fast and it’s going to be a sudden realization around people all over the world that there is no longer a single currency that you can trust as a store value.

Brian: Recently, there were these news in China, right? That China is, well, they moved against ICO and they move against some exchanges, right? It looks like they’re going to shut down some exchanges, maybe many exchanges. You wrote some interesting posts on that. What are your thoughts about the China thing? Both maybe the particular and about what it illustrates about some of the larger trends we are seeing.

Ari: So China is fascinating, and I think this is very, very—first, it’s important to recognize that there is no China, there’s no Chinese government, there is no monolithic body. The Chinese government is composed of competing interests, some of whom own cryptocurrency, some of whom are invested in Bitmain. Others who don’t. So I think even the Chinese government doesn’t know what they’re going to do because there’s power struggles behind the scenes. There’s kind of conflicting interests. With that caveat out of the way, I think this is mercantilism I think what’s happening is China is saying, not that they don’t want Bitcoin, but that they don’t want Bitcoin leaving the country. So if you look at what they’re doing, they’ve temporarily banned ICOs, and what they’ve said is, they’re going to put a regulatory scheme in place. Basically, so there aren’t scams so people don’t just, their monies aren’t thrown away. They’re closing most exchanges, but they’re going to have a licensing scheme for exchanges. We don’t know how many the license. Maybe only one. But I bet that in six months, there’s at least one giant Chinese exchange that basically, you have a liquid exchange in China. Whether it’s one or three, I don’t know. And they’re saying that it seems like there’s conflicting information about mining, but I’ve seen no evidence that they’re gonna shut down all mining. So it seems either they’re going to, again, have a licensing scheme where they licensed only one or two or three or four miners, that’s the most draconian they’re going to go. So it maybe they say Bitmain is the Chinese miner or there’s a Chinese state miner. But I think they want to do as much money as they can.

I think they want control over Bitcoin and they just don’t want those Bitcoins to get mine to leave the country. Because this is all part of the broader play of destabilizing US dollar and replacing it as the global reserve currency. I don’t think the people, there’s some people who have this view who think this is the grand play. China is obsessed with Bitcoin and hoarding it all. And I think that’s probably unlikely. I think this was probably one of a dozen plays for them. Bitcoin is tiny to China, right? It’s a $70 billion asset. But I do think they see, I think what’s going on is they say, this could be a real issue. This could become a trillion-dollar currency. And if it is, we sure as heck want to control it and we sure as heck want as much of it within our borders as we can have.

Meher: Cool. So if you look at this year, like as you mentioned, things happen, the main theme this year is the rise of Ethereum and then the investments into the further ICOs. Well, the crypto space has gone up a lot. What do you think the next few months look like? What’s going to be the major theme there?

Ari: You know, it’s tough. Things change so quickly in a space that both from a market psychology perspective as well as just new information and new news. That’s part of why I like being an active trader because I can adjust the new information very quickly and the fact that I’m likely to make a wrong prediction right now won’t necessarily hurt our investors because I can hopefully be a step ahead of the market whenever new information comes out. With that said, I think I’m actually more comfortable making a one-year prediction than a two months prediction. I think there’s a massive force of money moving into the space that is extraordinary in its size. So total market cap this morning is $130 million dollars. I think there’s more than $100 billion that’s going to be flowing into the cryptocurrency over the next year. And that’s an extraordinary statement. Like you think about what that means for valuation, right? But the counter, so that, this is how I think about this market. Every day, you have new marginal buying, you have a new buy and hold retail investor, not a new trader, but a new Coinbase account who just buys one Bitcoin and holds it or buys a tenth of a Bitcoin. Or buys some Ethereum or some Ether or some Litecoin or Coinbase or on a Korean exchange, buys one of the five Cs they can access. So cryptocurrency goes up every day. Then you have speculators who see it’s going up every day and they say, this is free money. Why don’t I just leverage this? Why don’t I max out my credit cards? Why don’t I go long on exchanges with margin? That’s when you get a parabolic rise. Well, then it starts turning down, all of those speculators run for the exits and you get a short-term crash, but you still have this upward trend line. You still have a fairly steady rally, you know, with maybe a lot of volatility around that.

So what causes the more major crashes? What causes a bear market like we had in 2013 to 2015 or even what’s happening right now? Also, you could also point to maybe what happened heading into the hard fork in July. So what happens is some exoticness to that, some shock that is external to the system. And I say external, I mean, a hard fork is not really external, but you know, a regulatory fear. China closing exchanges, maybe a major SEC division that forks people. Maybe a huge, you know, when people are constantly asked by investors what are the risks, what could, what are the existential risks? What could really destroy this? What could kill Ether, what could kill Bitcoin? And there’s a long list. So for example, you know, these are tail risks, these are small probabilities. I don’t mean to say that anyone is likely at all, I’m not predicting any of this, but they’re non-zero risks. Those are a lot of them. So Ethereum is going to have a hard fork, right? What if there’s a major bug in that protocol? Bitcoin may have a hard fork in November that may lead to replay attacks and rollback attacks between the chains. What happens there? What happens if another major base protocol, I guess, there aren’t that many others. I’m thinking of some crypto node for example, had a major bug found that the Monero team discovered and they handled it very, very well. But the point is, bugs can be found in protocols. A state actor could attack a network.

Let’s say I’m totally wrong in my read on China, and China actually decides they want to kill Bitcoin and they start doing DDoS attacks in every note they can find and they start double spending with mining and they start doing all of these things. I don’t know if they can kill Bitcoin, but they could certainly attack the price quite a bit. Heck, if they just confiscated, it means Bitcoin and market sold them, the coin with fall 95 percent and they could hold it there for at least a few days. So there are all these exotic events that can happen that make it, you know, short-term, create this massive volatility that is very, very hard to predict. So in a year, I think everything is higher. I’m not sure which protocols win, but base case is that almost everything is higher in a year because money flows with everything that’s not an outright scam or totally buggy protocol or garbage. Everything is hired as money flows in and list all of tides. Over two months, I’m less certain, I think things are higher. I think that story’s still plays out over the next two months. But there’s genuine uncertainty. I don’t know about the Byzantium fork of Ethereum. I don’t know how November plays out. I can only guess. I think November won’t be catastrophic, but you know, I’m really speaking out of ignorance on that

Meher: With many crypto people, when I talked to many early crypto people, when market events happen, it creates some kind of learning in the people that were in those market events, right? So when you talk to early crypto people, they’re kind of psychology is colored by what happened in 2013, 14, 15 and 16. So like a massive rally followed by this two-year winter where money left, things left. Things were super bleak. This was going to die. And for them, this situation feels eerily similar. This year is really good and then you start to think maybe the next two or three years are gonna to be very bearish and there’s going to be another winter. Because you tend to think it’s going to repeat in some way. But from your conversation, it looks like there is genuine money coming in and we don’t have as high a probability of suffering through another long winter.

Ari: It’s very hard for me to see at this point in time another long recession in crypto because there’s so many people waiting to buy the dip and getting in. So like for our firm, I was worried that this Bitcoin fell 40 percent over a week, basically. 5,000 to 3,000. That’s a huge move in traditional markets. That’s insane. And I thought that was Bitcoin, other things fell more. I thought that might really freeze investing. I thought the investors we were talking to, we were pitching, might say, this is too crazy. I’m going to wait this out. But it actually had the opposite effect.

It’s the two things. One, there were a lot of people who are worried about buying the peak. They were thinking, man, this thing’s gone up and up and up. I’m worried about buying Bitcoin at 5,000 because maybe a correction’s overdue. This pullback feels healthy to them. This feels like, okay, look, I might not be, I don’t know what the fair price is. I don’t know what a great price is. Maybe we’re on a 50 number, but at least I’m not an idiot who’s buying the top. At least I’m not the guy buying the high mark, right? So there’s that. And then the other thing that I’ve been kind of pleasantly surprised at is, when things are going vertical, as a fund manager, it’s very, very hard to make a case. Like people are like, why don’t I just buy Ethereum and hold it? It went from 10 to 400. Why don’t I, why do I need you for it? Well, why don’t I just buy Ethereum and hold it? It’s a lot easier for me to then say to that person, well, yeah, but if Ethereum just felt $135 from $400. It just lost more than 65 percent of its value. This is not a one-way street. This is not easy free money. If you bought Ethereum at 400, today, you’re still massively underwater, right? So and it’s not a foregone conclusion that Ethereum will end up at a thousand dollars. You might like it as a bet. You might think it’s going to be Google or Facebook, but maybe it’s a site, maybe it’s, you know, geocities.

So you know, it’s a little bit, it helps us make the case a kind of, as for active management, but you do have all of this interest that is slowly moving in space. Every, at most of the large endowments in the country are actively diligencing funds to put money into and they will put money in. Retail investors are still getting on boarded onto Coinbase. People who bought one Bitcoin when at a thousand and we’re kicking themselves for not buying more, they buy more now, and they’ll buy more in 2,000 and they’ll buy more 1,500 because they’ll see it as a second opportunity to get into this kind of trend that they missed and that they’re now starting to understand.

Brian: Cool. Well, all right. Thanks so much for joining us today. It was super fascinating talking with you. Super interesting to get your perspective. And hopefully we can do this again at some point because I’m sure lots more will change, and this will be a never-ending conversation with a lot of interesting developments.

Ari: That was really my pleasure. Thank you so much for having me on.

Brian: And of course, we’re going to put in the show notes link to Ari’s blog. He’s written some nice posts and his Twitter. He is extremely prolific on Twitter, so that’s probably for people who want to follow up with him and he does just really a wonderful job at describing a lot of the events in the market and the developments in the cryptocurrency space. I recommend checking out his Twitter. And yeah, thanks so much for listeners. For once again, tuning in. So we are a part of the Let’s Talk Bitcoin Network in the show and other shows on letstalkbitcoin.com. And yeah, if you want to support the show, you can leave us an iTunes review. And we look forward to being back next week.