Introduction

Patrick: [00:00:00] In episode one of Hash Power, we explored blockchains as a technology, how they work, why tokens, also known as cryptocurrencies, are an integral part of any blockchain, and how these new networks might change the world. In episode two, we spend time with the leading investors in the field. Like any frenzied asset class, there are countless cryptocurrency hedge funds popping up everywhere. But founders from three of the original firms, Polychain, MetaStable, and BlockTower Capital, are our primary guides this week.

As I speak, the total market cap of all cryptocurrencies is $136 billion. There are hundreds of tokens currently available, but Bitcoin and Ethereum still represent 75% of the total market. $136 billion sounds like a big number, but it's tiny relative to any other asset class. And I use that term with hesitation. To put it in perspective, that's exactly the same size as the market cap of IBM. But IBM has more than $10 billion of earnings. Tokens have none. As you will hear, valuing tokens is a very hard exercise. I said it emphatically during the introduction to episode one, but given that this is the investing episode, let me say it with even more emphasis. None of what you are about to hear is investment advice of any kind. Just as you shouldn't buy Apple stock because you love their products and hope to outperform the broad market, you shouldn't buy any cryptocurrencies without deep, personal research and consideration. A big part of my goal with this episode is to introduce you to the players who are shaping the investment ecosystem and how the investing ecosystem, with exchanges, trading, and weird custody problems, works in action. Collectively, our guests run hundreds of millions of dollars, likely now approaching a billion dollars, in pure-play cryptocurrency investment strategies. While we do explore examples of how to think about individual tokens, these are not investment recommendations. Rather, this is an introduction to the various stages of cryptocurrency investing, from early-stage white papers to full-fledged liquid tokens, and the strategies and skillsets being deployed by the pure-play investors.

Bitcoins, ICOs and Tokens

Before we get into the investment specifics, I find it helpful to start with one example of why investors are interested in this space. Ari Paul, the CIO of BlockTower Capital, was the first person to explain cryptocurrencies to me in-depth over a long lunch in Chicago that ended with my mouth hanging open. I began by asking Ari about his background and the source of his interest in cryptocurrencies.

Ari: [00:02:59] I'll start with the background because it kind of illustrates why I got interested. I was a trader at Susquehanna International Group doing equity derivatives, commodities bonds, 4X, almost anything you can think of, even electricity forwards. Did that for a long time, then I was a portfolio manager and risk manager at the University of Chicago for the $8 billion endowments. I'd like to think of myself as a student of markets, and the most interesting aspect to me has been kind of behavioral finance and the economic side of things. How do we value assets? And not just how should we value them, but how does the market actually value assets? I first heard of Bitcoin in 2011, and like most people, I dismissed it. I didn't see the value right away. What really made me interested was, in 2013, the price ran up to over $1,000, from just $1 not long before. And then the price crashed because there was the Mt. Gox theft, which was the failure of an exchange. And also one of the big use cases at the time was Silk Road, which was an illicit marketplace, and Silk Road got taken down by the FBI.

And a lot of people thought, okay, that's it for Bitcoin. That was its use. That was its purpose. And what was fascinating, was the bitcoin price did fall, but it found a floor that was in many hundreds of millions of dollars of value. And a common idea among kind of students of markets like guys like George Soros are, that when an asset collapses, when the fundamental story seems to be really challenged, when it should die, and it doesn't die, that tells you something. It tells you at least that there's something to look at there. So post the 2013 crash, I became really interested, and I tried to understand, why do people value this thing in hundreds of millions of dollars? Is there real value here? And after kind of understanding a little bit of why this thing might be sound money, then the question becomes, well, what's it going to do to the banking system? How might it change society? What other use cases are there for this?

When an asset collapses, when the fundamental story seems to be really challenged, when it should die, and it doesn't die, that tells you something. It tells you at least that there's something to look at there.

It's really a can of worms where you find all these use cases that are going to challenge the financial sector, but maybe also other sectors. So, really, I'd say, first, kind of intellectual curiosity into just this new market, this new potential asset class. And then more recently, what's been incredible to me is how inefficient it is. So we're looking at these cryptocurrency markets that are producing 10X returns and some that are producing 100X returns that shouldn't be, very clearly, that are clearly kind of inefficiencies that you'd want to short. Why is it so inefficient? And I've worked at some of the biggest trading firms. I'm friends with managers who manage huge amounts of money, who know how to analyze things, and usually are willing to throw a billion dollars at something to arbitrage it away. So why aren't they? What are the obstacles to making this market efficient? What are the operational challenges? What are the regulatory challenges? Why do these opportunities that we think shouldn't exist in markets, why are these persisting in cryptocurrency?

So, when I talk to people in the US about the idea of Bitcoin, I often get the question of basically why do we need it. In other words, I'm fine sitting on cash in a bank account. Why do I need something else? And these are generally people who don't own gold. They're not gold bugs. They're not fearful of the collapse of a government, and I get that, living in the US. But imagine if you're a wealthy person living in India, and you just had a large chunk of your wealth confiscated through demonetization. You had government-issued fiat, and the government just one day said it's no longer valid. Your money's gone. Or imagine you live in a country that has extreme depreciation. So if you're a wealthy person living in China, you're concerned that your currency could devalue by 30% overnight. 30% of your wealth could vanish overnight when you think you're storing it in a secure way. And those are only the cases that are directly monetary. Right?

If you live under a regime that's oppressive, if you have to worry about a government confiscating your money unfairly... I had relatives in the past under oppressive regimes who had to sew valuables into their clothes to escape oppressive regimes and hopefully have a little bit of money, so they wouldn't starve to death in the process. So we take for granted living in the US today that we have a relatively stable currency. We're relatively confident that it won't get confiscated by regime. But a lot of people around the world don't have that luxury. So one interesting, attractive thing about cryptocurrency is, if it's stored properly, it can't be seized. You can store cryptocurrency, for example, basically on cloud services, so it exists everywhere, where it is only secured by a password in your head. You can cross borders with a billion dollars in your head. And no corrupt government official, no thief, no oppressive regime can take that from you, which, to much of the world, is a tremendous value.

Patrick: [00:06:49] We will return to Ari and his investment strategy later. But as you'll hear, it's one of several distinct approaches to investing in cryptocurrencies, one that is more rooted in traditional Wall Street trading. Another style is making investments in early-stage blockchain projects, a style that was pioneered by Polychain Capital and its founder, Olaf Carlson-Wee. Polychain has the backing of well-known venture capital investors like Union Square Ventures and Andreessen Horowitz, and is a fixture of this space. We discuss why token-based blockchain protocols may capture value, and why these tokens may represent investment opportunities in the first place. If you had been in the early 80s and been the genius that picked TCP/IP over X.25, you couldn't have made any money doing that. Right? So you couldn't have invested in that outcome being true. And that seems to be different, which I think sounds like is because of scarcity. Why will, has or will, the value accrue, or someone different or some different profit from innovation this time around?

Olaf: [00:07:45] Yeah, I think that's a great question. So, the way I think about this is, in public markets, most of the value accrues to actually people who are doing what you do, quant trading or really deep analysis, fundamental analysis, like a Warren Buffett style. I don't think that disproportionate value accrues to the sort of average person. Some value might accrue there, but it really goes to the people who know what they're doing. On the flip side in private markets and private equity, venture capital, it all accrues to venture firms. Coordinated groups of capital that are accredited investors and go purchase shares of Uber and Airbnb and all the rest. The interesting thing about cryptocurrency is, if you just look empirically, historically value has not accrued to either of those groups. The people who invested early in Bitcoin and the people who invested early in Ethereum that have made the kind of the best returns you could ever hope to make with an investment, like 1,000X or more in some cases, those people were not in general professional traders or quants. Nor were those people professional private equity investors. Those were geeks. They were computer scientists. They're college students. Just all sorts of... But it's global. Right? And it's just a mishmash of whoever happened to find out about cryptocurrency and get a little bug in their brain that said, "This is actually a really cool technology." So, to me, that value accrual has been to a completely separate, different group of people to date. Now we're seeing, for the first time, I think, what I could call the beginnings of mainstream money try to get into this space. So a lot of... and this relates to what I do, which is running the Polychain fund, which invests exclusively in cryptocurrencies. And so a lot of groups right now are trying to get exposure to this technology. But they aren't this kind of native technologist who just finds it interesting. And they're trying to apply this investing methodology that they have learned in their more traditional investing careers to this space.

The interesting thing is that this is a totally new asset class, and it's very hard to apply these traditional valuation ideas, or traditional ideas of what makes a good investment, to cryptocurrency protocols. It's very hard to apply those rules. So sometimes people will ask me, "What are the future revenues of Ethereum?" Right? And they're trying to assess... I see you smirk, because you know what I'm talking about. It's like, okay, well, how do we assess the value today? Well, we look at revenues tomorrow. And it's like, okay, well, Ethereum actually has no revenues. That's not how this works. And the analogy of these being currencies, i.e. in the word cryptocurrency, is basically a lazy intellectual comparison. In reality, these really aren't currencies. They're sort of like commodities, in that there are some similarities to something like gold. But ultimately, they're really different from gold too, because they actually do something. Gold's use in jewelry or manufacturing is relatively limited, relative to its market value. Something like Ether in Ethereum can actually be used to execute these smart contracts or pieces of code that live in the blockchain. And so how do you value that, Ether? Well, the reality is you can't use any of these existing methodologies. You kind of have to come at it natively and think about it from first principles as a person who has been natively involved in this, which is how many of the people who value has accrued to in cryptocurrency growth, that's how they think about it. It's really a new arena. The other interesting thing about this value accrual versus value capture is that open-source traditionally has created a lot of wealth for the world. This is the internet. This is also Linux, Wikipedia, all sorts of projects. And it saddens me to see, for example, Wikipedia needs to kind of put banner ads on the page looking for $2, $3 donations.

Patrick: [00:11:42] $3. Yeah.

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

Patrick: [00:12:22] ICOs versus IPOs, tokens versus equity, what are the useful similarities for people to wrap their mind around it, and what are the key differences?

Olaf: [00:12:30] A token is basically a scarce unit. So there'll, say, be an outstanding number of units. Call that one billion tokens. And so if you own 1,000 tokens, you, in a sense, one way, a metaphor, a way to look at it, is that you own one one-millionth equity ownership in a protocol. But, really what you own is the right to interact with that protocol. So think about, if we go back in time, suppose there was an email token, and it might cost one token to send an email. And so then holding 1,000 tokens is really the right to send 1,000 emails. And the value of those tokens is basically a multiplier on how do you value the ability to send an email. And that's sort of how I think about the price of, say, Ether or Ethereum, is when you're holding Ether, you really have the right to execute smart contracts and interact with smart contracts. And so the value of that Ether is based on the expected value of those smart contracts and being able to interact there.

Now, of course, tokens and cryptocurrencies across the board today remain relatively speculative. So the values are even a bit harder to calculate because of that. But I think that it's sort of like equity in that you have ownership in something larger and you own a little piece of this kind of large machine that's out there operating. The difference is that equity is not useful. Equity is just a paper contract that the company will pay you something. In this case, there is no company. It's just an open-source protocol, and the, quote, equity, it's not really equity but in this kind of metaphor, is only valued insofar as it allows you to interact with that protocol. So, that's one way to think of it. Honestly, the analogies though, they run so thin, because the technology is so... it's just so different than really what exists today.

Source: Devish Agrawal

Assessing Crypto Protocols

Patrick: [00:14:26] While valuing a token is a daunting task, one clear path is understanding the token's parent protocol. What does it do? Why might it be useful to customers? How does it scale over time? I asked Naval Ravikant, CEO of AngelList and partner in crypto fund MetaStable about comparing protocols to platform businesses like Uber or Airbnb, because in some ways, protocols feel like these matchmaking businesses that have been so successful by pairing consumers and producers. Naval also provides us with a good perspective, urging all investors to be very cautious when approaching cryptocurrency investing. As I'm sure you've ascertained, this is very hard.

As I've tried to explain this whole idea, or explain it to myself first and foremost, but to others, I kind of keep coming back to the rise of the platform business model, so Uber, Airbnb, AngelList, where you're connecting consumers and producers. And effectively the piece in between, what's now been companies, you could kind of think about like a protocol. So there could be a protocol that sits in between in the future instead of a company. Do you think that that is an appropriate way to describe... I know analogies suffer from leaving a lot out, but do you think that that's an appropriate way to describe how the potential for new protocols, as people design them in the future, like a platform business?

Naval: [00:15:40] Yeah, I thought pretty hard about this. It was like, why can't every intermediary be replaced by a crypto-economic protocol. And at least the criteria that I came up with, which are just my personal criteria... I don't mean this as some sort of industry-wide thing. But when I see a well-designed crypto-economic protocol, I've noticed that there are a couple of things that that protocol has going for it. Firstly, the resources the protocol is allocating and aggregating is provided by the participants in the system. The actual organizer is doing very little other than laying down a few rules and enforcing them, and they've got a very thin platform.

Secondly, the resource that is being provided by all the participants is a fungible resource. In other words, it can be easily compared. This is where Airbnb kind of breaks down, because if you try to build an Airbnb with a crypto-economic protocol at the center, how would you know what the house is actually worth, or if it was actually available? So the houses aren't fungible with each other. And then they're also not verifiable. You can't verify the inventory digitally. You can't say, "Oh, yeah, that house is actually available and not being occupied right now." There's no way to confirm that. People can lie.So the best-designed crypto-economic protocols, you can digitally verify if the capacity's available. That's what I meant, solar power example works, that's for a cell phone grid, built on Wi-Fi would work, because you can verify. Is the bandwidth available? If the resource provider's fungible, the main resource is provided by the distributed participants, not by the central entity.

And then finally, couldn't this be done just more easily by Bitcoin or Ethereum? Does it need its own token? Because a lot of these tend to have their tacked-on tokens, so developers get paid, but the reality of the underlying protocol would be better served by just paying in bitcoin or Ethereum. So, that's kind of my model. It's not super well-baked. I use it to figure out what I think are the good crypto-economic protocols versus the not good ones. So, that's where I think the platform analogy you have to be a little careful with. There are some platforms that I think will be very difficult, if not impossible, at least in the next 20 years to replace with crypto-economic protocols.

Patrick: [00:17:41] I'm curious just how you think about your interest in actually investing in cryptocurrencies? I know you're a partner at a cryptocurrency investment fund. How do you think about that, and how does the pure investing side fit into this equation for you?

Naval: [00:17:55] I mean, it's really scary. These things are incredibly volatile. They're very hard to hold onto. They're very risky. They're very hard to assess. So I actually don't do it myself. My cryptocurrency investing... Yeah, I'm part of a hedge fund. I go through the lead trader in that hedge fund. He makes the decisions in what to buy and what to sell, and we outsource our custody, which is held in vaults by third parties. So, essentially it's still a hairy enough space that the average person can't get into it safely and easily, at least for right now. And, so I try to outsource that as much as possible, so that I can just kind of reflect upon the nature of where this whole thing is headed. I just really don't feel comfortable telling anybody to put their money into it, or how to do it. They got to make their own decision. That's got to come through information.

I mean you got to spend a minimum of two to three months of obsessive reading in this space by everybody who's smart before you buy a single coin. It's a knowledge project. It is a learning exercise. If you're intellectually curious about it, you can dig into it. Eventually, you may learn enough that you also feel confident to risk a very small amount of money. I would just say, to the extent that you can, outsource it to the pros and just understand everything you can on it. It's surprising to me how many people get into Bitcoin, and they've never read Satoshi's paper. Unless you can read that and understand it at a high level, at least understand all the concepts involved, and verify for yourself through your own intellectual logic and reasoning that those are valid, you have no business being in this space.

I mean you got to spend a minimum of two to three months of obsessive reading in this space by everybody who's smart before you buy a single coin. It's a knowledge project. It is a learning exercise...This may be the single most complicated large-scale endeavor yet created by humanity. So, yeah. It's not going to be easy to figure out.

This may be the single most complicated large-scale endeavor yet created by humanity. So, yeah. It's not going to be easy to figure out. One kind of throwaway line that I use, which I don't mean, this is facetious, but it's slightly true, is that blockchains may be the first indication we have of large-scale AIs, artificial intelligence, bootstrapping itself into existence. In a sense, a market is an AI, because a market makes decisions, allocates resources, and does things that no human can predict or explain, but it does them better than any human can. So, for a certain form of decision-making, a market is always better than any individual participant in the market. And blockchains are a much more extreme version of that. So blockchains will be making decisions and allocating resources and capital in ways that no human can match, so of course, we're never going to figure it out. Even the number one blockchain expert in the world, whoever that is, is just describing on part of the elephant. Nobody knows the whole thing.

Patrick: [00:20:22] What's the counterargument to all this? So, if there are clear and obvious benefits to open protocols and decentralization, which we've covered a lot of them, what do you find the most compelling counterargument?

Naval: [00:20:35] I think most of the arguments that are out there are just from people who are poorly informed. They just don't understand cryptocurrencies. And almost every argument that I've seen, I could sit down, and I could counter given enough time, and if it's a rational person on the other side. They're usually just underinformed because these are very... it's a very complicated topic. And if you don't understand all sides of it, it's sort of like, imagine we're talking about capitalist markets like we're talking about the stock market before any stock market has ever existed. Right?

Patrick: [00:21:04] Right.

Naval: [00:21:04] It would just seem like such a crazy idea. Or we're talking about a bond market, or something of that magnitude, like some organization of human beings in a new, novel way that's never been done before, and we're talking about it in advance. We'd just be shooting holes in it left and right. But the reality is, it's so complicated that I don't think you get the right to criticize it unless you understand it. And I have not yet met a critic who is fully informed. So maybe that's an unfair thing to say, but I do believe it to be true in this case. Now, I think there are extremely valid arguments against specific coins, specific schemes, and specific blockchains. So there are very good arguments why bitcoin may not have value, Ethereum may not have any value, or none of these cryptocurrencies will ever capture value. So they may all be bad investments, but to argue that blockchains themselves, with tokens underlying, are somehow like an invention that's going to go away or not make a difference, that is nonsense. So blockchain plus token governance will be a very important thing. But it is possible that the tokens themselves will never capture enough value to compensate investors, and that the combination of regulatory risks, scams, pump and dumps, and just having a very high velocity of the money, so you don't actually need to hold on to it, will mean that they don't actually capture much value.

The Lifecycle of a Token or Coin

Patrick: [00:22:20] So you can see the enormous challenge for investors. On the one hand, we may be witnessing the formation of an asset class that has huge value, which would mean this is the opportunity to earn some of the highest returns on invested capital of this generation. On the other hand, these tokens may literally be worthless. The wide dispersion of potential outcomes is what makes this space so risky and so exciting to investors. Cryptocurrencies aren't currencies, or commodities, or equities, or bonds. They are different.

Olaf Carlson-Wee continues by describing the lifecycle of a token or coin, which has some clear parallels to a traditional company, and describes where Polychain fits into this lifecycle. From Olaf's description, it's clear we are still in the very early stages of protocol development. Those waiting for killer consumer apps based on cryptocurrencies may have to be very patient. First, before we get into sort of, I'll call it, the fundamental analysis part of this, reading the papers, walking the code, whatever that might entail, which we'll get into, can you first describe the stages? So, the stages at which you could earn or get or buy coins, because there seem to be a couple of different tiers.

Olaf : [00:23:23] Yes. And it depends on if you have a sort of a value-add mentality, or if you're kind of a passive buyer. So, there's the first stage, that it has been sort of pioneered in part by Polychain and in part by other groups in this space, is when you have a very early-stage blueprint of a protocol that's very promising, but very little actual code written. At that point, people have devised, similar to a SAFE note, which governs a lot of seed deals in venture capital. SAFE, here, standing for the simple agreement for future equity. This space, we've helped develop a SAFT note, and this is a simple agreement for future tokens. So this is basically pre-purchasing units of a blockchain before that blockchain exists, or units of a token before that token is launched. So, I think that's usually the very, very first stage ever. And that's just a contractual agreement for tokens. So you're not even really holding tokens yet.

Then, when these things are launched, at that point, the tokens are actually launched on the blockchain and distributed. Usually, these days there's a sort of crowd sale, and participating in that crowdsale by sending a different cryptocurrency, usually bitcoin or Ethereum, to the creators of the protocol in exchange for protocol tokens, that's kind of the second stage. Then those tokens will get listed on an exchange. I mean, so there are many pretty traditionally structured exchanges, and by traditional, I just mean there's an order book with asks and bids, and you can go into the order book and say, "I want to buy 1,000 tokens," and purchase 1,000 tokens. And you can do that, sometimes, in an order book that's dollars or fiat currency against that token, so like USD to bitcoin, or you can more commonly trade in an order book, where one half of it is bitcoin or Ether. So you'll trade bitcoin for Litecoin in an order book. And so, in general, once it's liquid and in the order books, that's kind of the final stage. And then it will be in those order books forever or until that project falls into total obscurity and is delisted.

Patrick: [00:25:31] If you had to classify Polychain's potential for value-add, we'll call it alpha, relative to, say, a market-cap-weighted index of all-digital assets, where's that edge most present? At what stage of what you just described have you found it easiest to add value, we'll say?

Olaf: [00:25:49] Yeah. It's the absolutely earliest stage. We will invest based just on that protocol specification or white paper. Now, these protocol specifications are sort of like blueprints for a protocol. And for the average person, they're relatively hard to understand. There's a lot of technical lingo, and it's hard to parse out what is technically possible or not, unless you understand the technology pretty well. So, in general, we will invest at that sort of SAFT stage and help entrepreneurs get the capital they need to just build the prototype and minimum viable product, or minimum viable protocol in a sense. So I think that's what I would call our edge, and we're very much fundamental investors, in that we're focused on extremely long-term value and real breakthrough technologies. We look at how one protocol will interact with all the other protocols that are out there and be part of what we sometimes call the web3 stack.

And this is basically a stack of blockchain-based technologies that lead to that world we were talking about earlier that sounds a bit sci-fi, but where capital can be coordinated, and there are many financial products native to the blockchain, and there's a whole sort of decentralized internet, in a sense, where server-client architecture is distributed. There are distributed browsers, and there's no longer kind of centralized points of failure in the internet. So, I think most of the product-market fit we think about today is with developers. So most of what's being built today looks more like a developer tool than it looks like an end-user application. So the goal.... For example, Ethereum, to me, is a developer tool. It's meant to be used by developers to build smart contracts and really other developers, maybe, even, to utilize the smart contracts to build applications.

A lot of the projects we invest in today, we're thinking the market, so to speak, really is developers. So I mentioned that project, Tezos. There, you have a Turing-complete scripting language called Michelson that we think has some interesting properties. It's like a programming language. Right? It's really not consumer-oriented in any capacity. But we do think that it has the potential to lead to a rich developer platform, so that people can build applications on top. That's mostly what we're interested in today and just where the ecosystem is.

Patrick: [00:28:09] One of the things I'm most interested in is the comparison between utility and speculation, and the problem of, let's take Bitcoin for example. With huge volatility, but upside volatility, there's the potential for just hoarding, that people... there's less liquidity, because it keeps going up, and you don't want to give up a rising asset. You mentioned earlier this idea of, I can't remember what you called, a steady-state... or something that is pegged to a steady US dollar or something like that. How might that come about? So, how could you drop in, say, something that had lower volatility, could actually be used, a blockchain technology or protocol that actually could be used for more everyday functions, where clearly... I think that was maybe when I first started reading about Bitcoin, that was sort of the fantasy of microtransactions and all these things, but that clearly hasn't happened at any sort of significant scale anywhere in the world. So, maybe use that one as an example for what's missing right now from what we need for that web 3.0, for that sort of really potentially bright future of technology?

Olaf: [00:29:06] Yeah. A lot of it is really basic... Well, I don't want to call it basic. It's very technically complex, but it's infrastructure or protocol-layer components. So, for example, with transactional capacity, scalability, and transactional throughput of blockchains is a major bottleneck right now. But there are a lot of promising technical solutions. In Ethereum, this is proof-of-stake and sharding, which are methods to increase throughput by orders of magnitude, like 100 or 1,000 times. Also layer 2 networks, in Bitcoin this is generally called the Lightning Network, which is a network of what are called state channels. Or, in Ethereum, the Raiden Network, which is a similar concept. And it basically allows transactional throughput that's thousands of times greater than what the native blockchain or the layer 1 blockchain can support itself.

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

Skeptical View on Investing in Crypto

Patrick: [00:30:44] Both Olaf and Naval give us the sense that there's a lot still to do to make blockchain protocols valuable to the broader world. Olaf's strategy is to foster this early-stage environment. Polychain seems to be a part underwriter, part venture capital investor, part fundamental analyst. It is clear they play an important role fostering and funding innovation in blockchain. Now early usually also means risky. And because I haven't spent much time sharing more skeptical points of view, I offer two, from Jeremiah Lowin and Jordan Cooper. Jeremiah is a risk and statistics expert who runs risk management for a large family office. He has owned cryptocurrencies in the past, but no longer does.

Jeremiah: [00:31:18] The blockchain technology requires the derivative coin, bitcoin or Ether or whatever it is, to have some value. You have to incentivize activity on the blockchain in order to get people to participate in this distributed database. But it's not required to have any great value. It's only required to have value large enough to incent activity. Maybe that means just greater than the electricity costs of running the machine that's doing the calculations. So most of the folks, I think, who believe in these massive multi-billion, potentially multi-trillion-dollar valuations, are doing so because they think that these digital... these cryptocurrencies will effectively take market share from traditional currency, as a store of value.

I'm not convinced by those arguments, and I think that even to the extent that they may be correct, the sort of discounted probability of that at this time is so small it's hard to even give a lot of credence to them because there's a lot of other use cases for these cryptocurrencies that I think are extraordinarily more probable in the short term and don't require it to store value of that magnitude. Look, my personal belief is that anyone who's investing in these things for any reason other than behavioral beliefs about the other people who are investing in them or who's deluded themselves with charts and technical analysis or things like that is kind of kidding themselves if they think that their belief in the value of this thing should lead to an investment.

If that were the case, venture capital would be a very stable, rock-solid investment, because some of these things are valuable. Therefore we should just invest in all of them. It's just now how it works. There's still an aspect of diligence. These are remarkably young products, and I think that's missed because they are so enormously valuable. Right? So, it's very hard to square the idea that this thing is, quote, worth $100 billion, and yet it's extraordinarily young and immature, and it has problems, and they have to be worked through. And, by the way, at any moment a competitor could pop up and obsolete the whole thing.

Yeah. Could we make an argument that, on a probabilistic basis, it could be worth a trillion dollars, and we discount that? I don't... I guess a 10% full stop? Yeah, sure, someone could, but I think that's just kind of ludicrous. I mean, what kind of valuation would you need, given all the threats to this system, to justify a $100 billion valuation? If, by the way, what you believe is that it's a store of value, because it does need some value to incentivize the miners. But it doesn't require more than that. So you're making two bets. You're betting that people will use it as a store of value... Well, three bets. That it will be the store of value and accrue a trillion dollars of that value, and that it will succeed. And I just don't see how that all works out to a 10% discount, not even a compounded discount, just 10%, trillion to 100 billion.

Patrick: [00:34:11] Jordan Cooper, a venture capital investor who has been exploring blockchains for some time, is optimistic about their long-term prospects, but worried about current prices.

Jordan: [00:34:19] So far, from what I've seen, 80-85% of the projects that I've closely examined, and I've gone nowhere near examining all of them, are going to completely disappear, like zeroes. And, by the way, a lot of those projects are trading at market caps of 20 million to two billion.

Patrick: [00:34:41] That's amazing.

Jordan: [00:34:41] I'm sober in that regard, and I'm coming at it from this lens which is, I've spent a decade evaluating early-stage technology companies and projects, and the risk associated with those things coming to fruition, and I'm used to taking this level of risk where most of these projects are pre-launch. They certainly don't have what you would call product-market fit. And I'm used to paying $3-10 million entry prices in order to take that risk. And, by the way, if I've done that over four funds at Lerer Ventures and hundreds of companies, we're doing a good job if we're getting 3X return on those funds. So it's hard to get 3X when you're entering at three to 10 million with this risk profile. Now, look at this space, and you're entering literally at a 100X multiple of that, for the same level of risk. It's going to be really hard to get 3X on that. That's how I look at the broad landscape, which is only to say, I think a lot of, probably your community more than mine, a lot of people are looking at this new asset class and saying, "I want to index this." And, boy, is that a painful strategy, because you're indexing at such an inflated entry point, where my approach is, I think there will be... they're already in production. Single-digit really important things are being built, where after all this washes out, I close my eyes, in five years these things are still going to exist, and they're still going to be important, and they probably could be valuable. But that's single-digit, and so I'm trying to do the work to identify those assets, avoid... I don't care at all about trading this stuff, the volatility, the 20% swings. It's sexy, but it's just not the business I'm in as a venture investor. As a venture investor, it's here's an early technology. Here's an early team. Here's a possible outcome, and can I close my eyes and bet on the future? And that's how I'm looking at the entire space.

Patrick: [00:36:48] Jordan continued our conversation by exploring how he might try to value a single cryptocurrency, in this case, Ether. I love this sort of analysis, and I'm sure we'll see a proliferation of it in the near-term future as pure speculative hype gives way to deep analysis of underlying value.

Jordan: [00:37:01] The utility of Ethereum, it's a developer-facing platform. Think of it like blockchain as a service. If you don't want to build your own blockchain and deal with all the security issues that come with that and getting the early network and all these kind of things, you can borrow theirs. And you can pay a price in their native coin to do that. That's real utility value. Right? And one of the most important things that I'm trying to do, especially in the Ethereum world, is say, okay, you have all these downstream applications that are being built on top of Ethereum or plan to be built on top of Ethereum. Well, how deeply integrated are those programs and software into the Ethereum blockchain? How often do you have to call it? How often do you have to run code inside one of their blocks, and how much is that going to cost? And then can we roll that up into some semblance of how much demand will these applications created for the native coin?

So, you do that bottom-up analysis on Ethereum, and you can get to... I would say current usage. It's probably worth less than a billion dollars in utility value. How many projects are being built? How much do they need to use it? So, where is the balance of that market cap coming from? And in Ethereum's case, I think a big piece of the balance... part of it is just, I believe there will be more utility in the future, and that's totally justified. But part of it I think is that store-of-value use case again. So, if I'm thinking in terms of capital flight or escaping local regulation with my money, things like this, then Bitcoin is a very attractive place for me to do that, because it's not regulated, and it's liquid. And is Ethereum also that? Should it also be that?

A while ago, I would have said probably not. Now, it has a lot of liquidity. It might be a good place to move large sums of money. So, then the question that I've been asking myself, and I have more questions than answers, is, is it a net positive or a net negative for the store-of-value use case for the coin that I'm storing my value in to also have some kind of industrial application? And that's where you get to, okay, gold can store value, but it can also make pretty jewelry. ETH can store value, but it can also run code. And, do I want that or not? And I don't know the answer to that question. To me, from a very theoretical perspective, I like the cleanliness of the pure-play. I think something that's likely to happen in the Ethereum ecosystem is, the fundamental analysis is going to get more granular. People are going to start to build the tools to monitor the GitHub commits and really analyze, what are the contracts that are running on this platform?

And I do think people are going to wake up and say, "This is not being used nearly as much as we all think and hope, and it's not worth X. It's worth something much less than X, so now my store of value is at risk." One of the interesting things about Bitcoin is that, because you can't run that fundamental analysis because there is no utility use case attached to it, it's almost insulated from that downside thinking. And I find that attractive, as a store-of-value use case. So, in my mind, I think highly likely that Bitcoin will maintain the store-of-value use case.

Now if you want to hedge against that, for example, and you see a lot of people doing this, you might build a basket of Litecoin and Zcash and Monero, and those things might differentiate on the scalability of those platforms, on the privacy of those platforms. Ultimately I don't think those futures are differentiating enough to compete with the liquidity and the network that Bitcoin has already amassed. And, for that reason, it will lose, but maybe you want to bet on Bitcoin stumbling or not working through their governance issues or things like this. And so you could allocate, I don't know, 5% or 10% of your store-of-value bucket to spread over those other things in the case that maybe one of them, which are also likely pure-play store-of-value plays will surpass Bitcoin, but I don't think Ethereum is the place to park that.

Patrick: [00:41:12] Across my many conversations on blockchain and cryptocurrencies, I heard some version of Naval's idea that blockchain, the technology, is here to stay, but that evaluating cryptocurrencies as investments is a very tricky exercise. Jordan makes an interesting point. What I find fascinating about Bitcoin is that, because its value is literally just a story that a network is agreeing upon, it has the potential to grow massive. Crazy as it sounds, the fact that Bitcoin isn't tethered to an underlying utility like Ethereum smart contracts may mean it's a better investment. Wild. While it's convenient to compare these tokens to equity investments, it may not be appropriate. The network effects associated with the ultimate winners in cryptocurrencies will be enormous, the sort of global reach that only a few technology companies enjoy today.

But the way to invest in this world hasn't been in companies, say, making a venture investment in Facebook. Instead, it's the coins themselves. You may have heard those in the crypto community reference Joel Monegro's fat protocol thesis. I highly recommend you stop and read that post before moving on. This is a crucial idea if cryptocurrency investing is going to be successful. The basic thought is that, given protocols themselves, that is the different blockchains, are the things that hold value state and the identity of owners, most of the potential return will accrue to token-holders, not apps or companies built on top of those protocols. This is a huge reversal from the past, where apps and companies like, say, Google have taken all the value, and protocols like TCP/IP have taken none.

As an example, Coinbase, where you can buy and sell different cryptocurrencies, is one of the largest companies in this entire ecosystem. It just raised $100 million at $1.6 billion-dollar valuation. But that $1.6 billion is dwarfed by the size of Bitcoin and Ether tokens alone, which are worth almost $100 billion. The fat protocol thesis has proved true thus far. The best returns have gone to token-holders, not equity investors. But this also means that prospective cryptocurrency investors face very high entry prices. Like any investment, there's what you pay and what you get. You want the relationship between price and fundamentals to be mispriced by the market. In the case of cryptocurrencies, that edge may still be largely based on psychology and the speculative value assigned to these currencies.

Source: Fat Protocols

Investors in Crypto

Patrick: [00:43:29] Having discussed the early-stage investments with Olaf Carlson-Wee, there are now two more primary approaches we can explore with Josh Seims and Ari Paul. First up is Josh, who's firm MetaStable may be the value investor in this space. Hey, it's all relative. Would it be fair to say that the goal of MetaStable and sort of active management within this space is trying to make effectively a bet on blockchain more than any one individual currency? And then, I guess... well, you tell me. Is it to properly diversify, so that you don't miss out on the return potential of blockchain technology by just, say, being all in on Bitcoin, or all in on Ethereum?

Josh: [00:44:17] Yeah, in a sense. Let me articulate kind of our thesis.

Patrick: [00:44:19] Yeah, that'd be great.

Josh: [00:44:20] We're somewhat, I would call us, value investors in this space, which is sort of-

Patrick: [00:44:24] That's funny. Yeah.

Josh: [00:44:24] It's kind of oxymoronic. Yeah.

Patrick: [00:44:26] I want to get into that in some detail though. So...

Josh: [00:44:27] Yeah, sounds good. Right, because these are such ephemeral assets. But the way that we approach it is, we think that there's a handful of use cases that are amenable to blockchain solutions and high-value use cases, perhaps trillion-dollar-type blockchains.

For example, a store of value. All right? That's what Bitcoin is going for, digital gold.

Patrick: [00:44:48] Digital gold, yeah.

Josh: [00:44:48] Right? Yeah. That's the easiest one to understand. Then there's programmable money, smart contracts, and that's what Ethereum is going for. And there's several other competitors to Ethereum that are... some of them are doing pretty interesting things, but Ethereum does have a big head start. There are anonymous transactions. There's a stablecoin. One day, the people are working towards a construction where the token will have a stable value, which would be enormously useful. Then you could have credit and debt markets and things like that.

Patrick: [00:45:17] Yeah, transactions. You could really use it. Yeah.

Josh: [00:45:20] Yeah. You don't have currency risk in holding it, and so that would be really useful. Prediction markets are another one in that, right now, the state of blockchain technology... I mean, you take something like Ethereum. Blockchains can only reason about what's on blockchains. So it's very easy to create a smart contract that expresses something like only allow 10 Ether per day to be withdrawn. Okay, that's something that's kind of endogenous information on the blockchain. But if you want to create, say, a financial derivative. Say, there's a smart contract that's an option on whether Apple stock cedes that value in some future date. For that to work, there has to be a process of getting that real-world information onto the blockchain. But that brings up tons of issues of, well, how do you trust that information and all that kind of stuff. And, so prediction markets are in general are... we're going to need them to modulate just how real-world information gets put onto blockchains, so blockchains can actually reason about real-world events. That's huge, potentially, and actively researched right now. And then there are things like storage networks, compute networks, like Filecoin-

Patrick: [00:46:25] Yeah, Filecoin. Yeah.

Josh: [00:46:25] Yeah, storage networks. So, anyway, so the way that we see this, is we believe there's something like five to 10 of these base use cases. And, so the way that we approach our portfolio composition is we want to... Well, it's this kind of a hybrid between what I call a top-down and a bottom-up approach. Okay? So top-down, we look at each of these use cases as buckets, and what we seek to do is place bets on what we think are the protocols that are most likely to emerge as the long-term winner in this space. 10, 15 years from now, what's going to emerge as victorious? Because there are some strong network effects with protocols so that if one really does emerge and locks in, it probably will be the long-term winner. We're agnostic as to whether there's going to be just one in each of these buckets, or if there's one coin that rules out them all in the future. Because it's a balance between, again, those network effects could lead to one ruling them all, but then there are fundamental engineering trade-offs in each of these approaches that could lead to separate, diverse composition of different protocols. And then the bottom-up part, where that comes into play is that we have to find credible candidates in each of these buckets. And some of them, there are multiple credible candidates, so we have several bets. And then there are others that have no credible candidates, in our opinion, and so we haven't placed bets yet.

And kind of how we do that... What I would say is distinct about our fund is the degree of technical understanding. So, and this is really where Lucas comes in. I mean, Lucas is someone who... he reads these source codes for fun. A big part of our thesis is that a major part of what's going to lead to a winner is the strength of the underlying technology itself. And this is where it's a little different, I would say, from traditional companies in that, if you look at, say, I don't know, take Snapchat or Uber, these companies, the technology itself is only a thin part of what led to the success of those companies. Right? Way more is just how aggressively they executed, how much money they could raise, just their hiring, and their marketing, their branding. I mean, all that kind of stuff.

In the crypto world, the majority is the technology, because these are hard problems. Nobody has figured out how to create these protocols that have stable consensus, they're scalable to thousands of transactions per second, they're expressive and secure, all of the qualities. Developers, I mean, we think these are solvable problems, and we're all making progress, but this is where some of the smartest cryptographers and distributed system designers are working. In the crypto world, I would say it's 85% technology and 15% community management, because these are open-source projects. So there is a chunk that's actually... community management is important. And, so it's really easy to write a white paper that makes amazing-sounding claims. And, so a lot of the people I know, they'll just read the white papers, and they'll make the decisions based on that. But you get a much deeper insight if you read the source code itself. And when I say read, I don't mean just read. I mean, Lucas has made actually quite a bit of money through bug bounty programs. So in other words, he's discovered serious bugs in these protocols that the developers themselves are not aware of, and they've paid him for reporting it. Right? So we believe that it's valuable insight, and it's also one that it's hard to get. It's not public. You can't just read and digest it from other sources. You have to kind of go to the first-party sources yourself.

Patrick: [00:49:52] I'm hesitant to oversimplify any of these very nuanced approaches, but there's something appealing about this simple Rip Van Winkle test. What sorts of protocols or tokens might still be around and useful in 10 to 15 years? If blockchains are indeed a transformative technology, and not some form of 8-track of LaserDisc, this may be the simplest and most prudent way of investing in them. In this strategy, the balance of power swings away from traditional Wall Street types and towards engineers, developers, and those that can do the equivalent of fundamental analysis on the code itself. Of course, as crypto continues to proliferate, you can bet that some of Wall Street's best and brightest will move quickly in. In that spirit, we continue with Ari Paul of BlockTower Capital. Ari has spent hours explaining this stuff to me, but if we're going to call cryptocurrencies an asset class we also need to understand some basics about the investible universe. Specifically, how many cryptocurrencies can we actually buy and sell? What types of sectors or categories are there? My colleague, Manson Zhu, suggested categories like privacy coins, decentralized app platforms, store-of-value coins, payment coins, financial services coins, asset-backed coins, advertising coins, voting coins, and gaming coins. I'm sorry to use so much hedging language like "if any of this survives," but I feel it's appropriate for anyone listening who is new to this space to be skeptical. So, if any of this survives, these many categories sure sound like an asset class to me. So what is the equivalent of listed stocks in the world of cryptocurrencies?

Ari: [00:51:18] It's an interesting question, particularly because the universe is changing and growing so rapidly. So, if you ask me, how do I invest in cryptocurrency five years ago, I would have said "buy bitcoin." If you asked me even a year ago, I probably would have said "buy these two or three or maybe four cryptocurrencies." Today, there have been more than 1,000 created, and there are more than 100 that are actively traded with meaningful liquidity on multiple exchanges. And, of those 100, I would say that probably 25 represent real meaningful projects with real economic prospects that have market caps and liquidity that are interesting to investors. So, our universe, for us specifically, is frankly anything that we can make money trading and investing in, and that universe is changing week by week. So the term in the cryptocurrency world is ICO, initial coin offering. That term is a little bit misleading, because it also can sometimes refer to secondary offerings, and it may be that term may be replaced. But it basically refers to the launch of a new coin, very broadly, and there's now an ICO basically every other day. And some of these projects are real projects that are launching with $100 million in funding and that are immediately listed on exchanges with real liquidity. So, our universe is anything that's investible and tradable in the cryptocurrency space.

Money Flow Chart in an ICO

Source: Alte Capital via Hacker Noon

Patrick: [00:52:25] So define some of this a little bit more deeply. So, we mentioned there are 21 million bitcoin. So what is a coin? What does it represent? Is it effectively a different version of Bitcoin? What relevant features or variables are there with new coins that are being offered to the public, and how are they buying them? Are they buying them with fiat US dollars, or Euros, or whatever, or are they exchanging other cryptocurrencies, tokens, coins, for the new ones?

Ari: [00:52:51] Kind of all of the above. So you have blockchains that are entirely separate databases that are really kind of non-overlapping. So, for example, Bitcoin and Ethereum are two separate blockchains that each have their own native currency. Bitcoin's on the Bitcoin network. Ether, which is the Ethereum token, exists on the Ethereum network. But a lot of people launching new tokens don't want to have to recreate the entire architecture of a network. They say, "Okay, Ethereum already has all of the security. They have all this development. Why don't I piggyback on that?" So, a lot of the tokens that are being issued now, especially the ones on the Ethereum network, they're new cryptocurrencies that exist on the Ethereum network. And there's more than, I believe, more than 100 already, and that number will probably continue to grow. And it makes a lot of sense, because there's no reason to recreate the entire architecture, everything that goes into creating a successful secure network. In terms of actually converting fiat, that's kind of the hard part right now. So, banks are somewhat reluctant to work with cryptocurrency, because we're in a regulatory gray area. There's nothing specifically illegal about it. Quite to the contrary, there are a lot of very regulated well-regarded businesses, including here in New York state, that meet the highest regulatory standards. But there's a concern that we just kind of don't know what the SEC is going to do going forward. Even the IRS has been reluctant to give clear guidance. So banks have been somewhat reluctant to deal with customers, with exchanges, with cryptocurrency businesses.

But there are a few, two located in New York, for example, that are very well-regulated. They're insured. And you can connect them to your bank account. You can wire money to them, and then, through them, they act as a portal, and they'll convert your fiat into cryptocurrency. Some act as brokers. But ultimately there's an exchange behind them. So you're trading your US dollars for someone else's bitcoin, or your US dollars for someone else's Ethereum. Because of these regulatory issues, there are a lot of exchanges that prefer to just not deal with fiat at all. So some of the biggest exchanges, you have to deposit cryptocurrency, like bitcoin or Ethereum, and then you can convert it to any of 100 other cryptocurrencies. You can then pull that cryptocurrency off the exchange. You can send it back to a broker or convert it back to dollars. People sometimes say, "Is this real money?" So they see that Bitcoin is a market cap of $45 billion today, which is likely to change rapidly as it has been. Is that $45 billion real? And the answer is yeah. Yeah, if you wanted to sell $50 million worth of bitcoin and convert it to US dollars, you could do it in a day without moving the market that much. And you would have $50 million in US dollars in your bank account that day.

Patrick: [00:55:05] So, the analogy that I've heard a couple of times is to envision a big fairgrounds where you go in, and you use fiat currency to buy little gold tokens, and then those gold tokens can be used within the fairgrounds to do all sorts of stuff. You could go on a ride. You could buy some elephant ears. You can play games. So, within that network, the coins have some value. Outside of the network, they don't have value. So is it clean to think of the fairgrounds as a sort of protocol system, and the coins, or tokens that are issued in an ICO, maybe something like Filecoin would be a good example here, where owning the token actually does have... So Bitcoin is all about transactions, currency transactions. But other things are about competing power or storage or other things beyond transactions. Is that the idea that, by creating tokens, you effectively can do something within these protocols, so build a better fairground that can do more stuff, things that people actually want to do, and then hope that if you buy in today... Right? So when you buy an IPO, you do so because you think Facebook's going to go 3X or 5X, and that what they've built will grow, and you'll participate in that. So is it the same idea here, that you buy a coin or a token in an initial coin offering, because you think the value of that kind of fairgrounds or protocol will grow, and that what you can do with one token today will grow three or five years from now, and that the developers are incentivized because they own those tokens? Am I getting that kind of all right?

Ari: [00:56:40] So you nailed it for one set of tokens. A real challenge of talking about this is... Matt and I throw around the term asset class for cryptocurrency, but it's a little bit misleading. Tokens really play many different roles. So, as we talked about Bitcoin, I mostly think of it as digital gold, as a store of value. Although, you also have to pay bitcoin to transact on the network. So it is also a little bit of a token on a fairground, where that fairground is the ability to move money. So you, literally, you're charged a little bit of a Bitcoin any time you want to move bitcoin. So you can think of it as kind of a monetary transmission network, and you're paying for that service

Other tokens, though, are much more exclusively... tokens in an amusement park. Filecoin was a great example, where it enables you to both price a scarce asset, which is file storage, which currently, if you have access to file space on your computer, there isn't really a marketplace for it. So, Filecoin, among other things it does is it facilitates a marketplace for a scarce resource. Take a slight step back, when you think about the value of capitalism very broadly, one of the real values is just having a marketplace that lets participants price resources means we're going to allocate those resources more efficiently, and it provides an incentive for people to trade. Right? Comparative advantage only arises if there's a marketplace. So one of these things that cryptocurrencies do is, just by having, by tokenizing a resource, you create a marketplace, you allow people to buy and sell, and you also incentivize people to produce more of that resource.

Patrick: [00:57:56] So there's no real index for this yet. I'm sure people are building one that's just a simple market-cap-weighted index, so you can buy in an ETF. But obviously, the goal is both absolute and relative return, like in any active management scenario. So, how do you start to approach this? And, very specifically, how, for example, does your background at Susquehanna, trading options, at Chicago, how do lessons that you've learned in more traditional avenues apply to arbitrage, both short term and long term?

Ari: [00:58:26] Traditional markets are hard. It's hard to find alpha. It's very competitive. A line that I like is, to describe kind of markets in general, at least the way I think about them, is, "Markets are mostly efficient most of the time." And the reason for that is the people that you have on your podcast. You're brilliant managers who have a lot of capital behind them and some of the best minds to basically arbitrage away attractive opportunities. And they don't arbitrage them away fully. They're able to capture little pieces. But they have to compete fiercely to capture small edges. Because if there's a really attractive edge, everyone jumps on it. It goes away. Working at Susquehanna, it was always emphasized to us basically that there's no free lunch. We were always taught that there are other people in the market who have better information than us. If something looks too good to be true, it probably is. Someone probably knows something that we don't.

And so the emphasis was always on, how do you build structural sustainable advantages? How do you build... And by advantage, I don't even mean over competition. I mean, how do you build a structure that is going to consistently monetize whatever edges are in the market? And traditional markets, that require massive investment. So there was a point, for example, where I was investing in microwave towers, have a slightly faster connection between Chicago and New York exchanges. A 20-microsecond advantage was necessary to be earning good profits in the treasury market at that time. In other markets, you need the very best quantitative analysis. You need the best machine learning. You need the best... sometimes, it's structural advantages, like the cheapest costs of capital to compete. Here we have a space where the alpha opportunities, at least first glance, look enormous. It looks like a wildly inefficient market where a talented security selector or a talented trader can add tremendous value. I've been really interested to explore, why is that? Why is this so uncompetitive?

And the answer is, as you would kind of expect, there's always a reason for it. There's always a reason why these opportunities exist. And in this case, it's really hard to get access to these opportunities. So, you have a huge range of challenges. You have regulatory challenges. It's not easy for an existing hedge fund to take advantage of these opportunities. It's costly to get set up in the way you need to. There are operational challenges. So transferring and securing cryptocurrency is operationally difficult. It's scary to a lot of people. It's scary to existing hedge funds. We spend probably half of our time focusing on security because it's such a critical issue in this space. And while it's a headache for us, we also recognize that it's part of our moat, that there's a lot of managers out there with a lot of capital who just aren't willing to deal with the headaches.

Patrick: [01:00:40] If you had to disentangle the opportunity, again, into kind of beta and alpha, beta being you buy a cap-weighted index today, which, I guess, would be mostly Bitcoin and Ethereum, maybe some Ripple and litecoin, what gets you more excited right now as an active manager entering into the space?

Ari: [01:00:56] The problem is that buying... so there may be, for example, a Bitcoin ETF that exists in six or 12 or 18 months. And that may be a great purchase for retail investors. The problem though is that's not a bet on cryptocurrency anymore than buying Yahoo in the mid-90s was a bet on the internet. So investors may be, and I think should be, very confident in cryptocurrency as a technology that's creating value. But the problem is most of the tech giants of the 90s died. They got replaced by better innovators, and cryptocurrency's the same.

I think one of the areas where the alpha comes in, aside from just being alpha and adding return, is, by having strategies that are... kind of basically a whole portfolio of strategies. We have a playbook, a playbook from kind of every asset class, commodities and treasuries and equities over the last 100 years, and many of those plays work well in a neutral market, and they work well in a bear market. And, so by being able to generate a value and alpha, even when cryptocurrency is selling off, even when it's in the midst of a six-month or 12-month bear market, which will happen by the way... Part of what's so attractive about this space is the asymmetric risk-reward.

So if I create a portfolio, and I make five bets... and this is actually true by the way in my own portfolio. My portfolio's more like 10-12 bets at a time, usually, but if I make a bad bet, it very quickly... and it's, say, 5% of my portfolio, it very quickly often becomes 2% of my portfolio. Because the good bets that achieve a 2X or 3X or 4X or 5X very rapidly, those are growing the portfolio as a whole, and the bad bets of course are shrinking naturally. Right? So, it's just the fundamental nature of longs versus shorts. Right? Shorts are dangerous, because your risk increases as they move against you. But in a normal market, that risk is usually not that pronounced. Usually, you're not... there isn't much of your portfolio that you're hoping for a 2X gain over a six-month period. But in cryptocurrency, the extreme volatility means that owning a security itself is almost like owning a call. So, if I buy a cryptocurrency that I believe has promise and has a 100 million market cap, simply owning it is almost like owning a call. Because the most I can lose is that 100 million market cap. But if I'm right, it may give me a 10X over six months, and I have that 10X. Right? So, basically my portfolio is a portfolio of calls, and that naturally kind of limits the risk to some degree as long as you use proper diversification and as long as you properly identify the regime.

Patrick: [01:02:56] Talk about kind of your impressions from talking to family offices, talking to institutions. What are they thinking? What might they do? What's stopping them from investing? So, I've heard things like counterparty risk, and where will all this stuff be custodied, volatility. All of these things are reasons, but talk about the burgeoning ownership base and who you think is kind of going to be the next people in the door as investors, as big investors?

Ari Paul: [01:03:21] Sure. Absolutely. So, part of what's so exciting about this space is people sometimes say, "Oh, is it a bubble?" Right? That the market cap is a billion dollars a few years ago. Now it's 100 billion. Right? As investors, buying into something that's 100X is really hard. I look at that, and I say "I can't do that." If you're a contrarian by nature, if you think you're a value investor, how do you buy into that? Which I totally commiserate with, because that was kind of part of why I dismissed it back in 2011. Because it was at $3, up from 10 cents. And I think the answer is you look at the total market cap right now, which I'm sure will be totally wrong very soon. But right now it's about $110 billion. That's smaller than MacDonald's. So we're at a state now where all cryptocurrency ownership is basically trivial. So yeah, your Uber driver might own it. But, by definition, the world basically owns zero. It's a rounding error on the world's balance sheet. To put a couple of specific numbers to it, a back-of-the-envelope guess is that less than 0.3% of all the people in the world own it. Less than 3% of Americans own it. Talking anecdotally with people in finance, it's under 5% of people that I can... I mean, I ask every trader, every manager, every analyst. Everyone I talk to, I ask about it, and it's less than 5% who own it. And these are people who generally have some money, are a little bit more, maybe, risk-tolerant who probably are good enough with technology to make a secure purchase through an easy-to-use broker. So we're really at the very, very tip of the iceberg.

I think this is how this unfolds. Over the next six to 12 months, that number of particularly Wall Street types, people in the investment community, who own it is going to skyrocket. At the same time, we'll start seeing increasing general ownership as well. Part of that will be it'll become much easier to buy. So three years ago, it was pretty darn hard to buy and store bitcoin. Today, you can buy bitcoin fairly easily and store it securely. But if you want to buy something like Monero, it's still difficult. Even installing a Monero client is still prohibitive for many. As we add things like insured structured notes, it becomes much easier for institutions to buy. As we have more over-the-counter products, eventually when we have an ETF, that really opens the floodgates. What we're seeing right now though is massive family office interest. So of the 10 biggest family offices in the country, at least three of them, probably more like five or six, have actually made investments in cryptocurrency. Small investments, but they're looking to add a second and a third. They dipped their toes in, they saw what they liked, and they want to bet bigger. The next step, I think endowment investors will eventually come along, but it will take a little while, partly for good reasons. So, as a fiduciary, you have a lot of boxes to check. You have to do due diligence. You're responsible for that investment. And the infrastructure around the space is currently being built. So things like having custody of the assets, having auditing, having prime brokerage, all of that is going to be here, and it's going to be here in a mature sophisticated way that endowments can trust. But it's not here yet. It's, as we speak, being built and being tested, and confidence is still being developed.

So of the 10 biggest family offices in the country, at least three of them, probably more like five or six, have actually made investments in cryptocurrency. Small investments, but they're looking to add a second and a third. They dipped their toes in, they saw what they liked, and they want to bet bigger. The next step, I think endowment investors will eventually come along, but it will take a little while, partly for good reasons.

Interesting Alternative Cryptocurrencies

Patrick: [01:06:06] Ari's overview is comprehensive. If you asked how a huge hedge fund like Millennium or Citadel was run, it'd be appropriate to start at a very high level with types of strategies, structure, sources of edge, marketing-making activities, and so on. But if you kept digging to the bottom, you'd find specific investigations of securities or algorithmic trading strategies. At the bottom, there are always the things themselves that you buy and sell. I say "things" instead of securities, because in the case of cryptocurrencies, we don't really know what they are. They are a new thing entirely. There are too many to explore in detail on Hash Power. We've discussed Bitcoin and Ethereum in episode one, so I asked Ari to describe a few of these currencies and what they do, starting with Ripple, the third-largest cryptocurrency with a current market cap of roughly $7.6 billion.

Ari Paul: [01:06:51] One that currently has a pretty high market cap, right now it's the third biggest, is Ripple. So the symbol's RXP. They're aiming to replace the SWIFT network to facilitate inner bank transfers, as well as theoretically to be used for anything and anyone to transfer economic value. Very broadly, the way it works is, their premise is you're going to have a token, which is the RXP token, the Ripple token, and they kind of need it to have tremendous economic value for this to work. And the idea is there will be market makers in different countries, and I'll be able to transfer huge amounts of wealth via just moving Ripple that can then be converted into whatever I want locally.

So their premise is they're giving lots of Ripple to banks for free, saying, "We want to bootstrap this to having very high economic value. You'll then have a market maker who will make this very, very tight market." Let's say you're a bank, and you want to move a ton of US dollars from the US to China, but you have all sorts of regulatory issues with capital controls, and you're subject to the central bank oversight, to the SWIFT network, to all these kind of agreements. Instead, you view it as a market transaction. So you say, "I'm going to send a billion dollars," and let's say Ripple is a trillion-dollar value at that point, which I'm not predicting by the way, but this is how that could work. I send a billion dollars of Ripple. It just instantly converted in China at basically a local exchange, but that's run by a bank, to a local currency rate. And, to be easy, you could put that in a contract of course to lock in a price. So it's a little bit of a regulatory arbitrage, as well as potentially a true technological innovation. Because right now, there is no great system. When you send that US dollar transfer from the US to China, not only is it unwieldy from a regulatory perspective, it's unwieldy from a technology perspective. There isn't even a good database system to even record that. Errors are somewhat frequent.

So one that's totally different that I'll highlight that's a much smaller cap, one currently about $60 million, is called FunFair. So the symbol's FUN, F-U-N. It's a decentralized casino platform, so a really clear use case. There are a lot of use cases that are coming up in crypto where we're a little unclear. Does this need to be decentralized? Should it be on a blockchain? So the basic pitch for a decentralized casino is, one, it's open-source, so provably fair. So, as a poker player myself, I've played on poker sites that were later turned out to have been cheating players. So literally some people on the inside were allowed to see your cards, and there are casinos where you think you're betting on a fair craps table, but you're not. The odds are tilted against you even more than they normally are. So here it's open-source. You can actually audit the code. You can prove that it's fair. It's decentralized, which means that if the US tells banks "you're not allowed to fund a poker site," that it doesn't matter. So it's kind of... not immune, but at least resistant to local regulation. So those are the two main pitches. I think there's a real use case there. As with any small-cap coin... So to kind of give you a little color on it, it's interesting. There's something like 15 people who own half of the market cap. We're just believers in it who are supporters.

So, it's publicly traded, but in many ways, I think of it as a C-stage VC project. It's almost like there are a few VCs supporting this, and it has promise. But because it's publicly traded, it has this tremendous volatility, which you wouldn't normally have with a project that's so early in its stage. Another interesting thing that it highlights for me about the crypto market is very few people who are cryptocurrency... so most of your listeners have certainly not heard of it. Most people who invest in cryptocurrency have not heard of it, and, by most, I mean probably 98% haven't heard of it. And those who have heard of it probably know one sentence about it. So the number of people in the world... I actually don't know at the moment. I think it's something like, say, the 25th or 30th biggest cryptocurrency. The number of people in the world who know more than one sentence about it is probably something like a few hundred people. You have this kind of market that is... inefficient is not the right word. It's just, information is so fragmented. Because if you want to learn about it, there's no single great source. We're at the stage where you have to be talking to the founder, Jez San, and he'll take your calls, because... Well, I apologize to Jez. He gets inundated. But it's at a point where he's not getting that many calls.

Patrick: [01:10:11] The last segment I want to talk about a bit is, we'll call it to hedge fund-like investors in the cryptocurrency space, and the mission that you guys are on, and the tendency for, again, power or returns or edge or alpha, however you want to think about it, to concentrate in a small list of players. Talk about how you see that playing out. What sorts of things would allow you to create, whether it's the first-mover advantage or you tell me, that sort of edge that can then be sustained over the longer term. And do you think that's right, that just like we see in other asset classes, there are often a fairly small number of firms or individual traders that tend to eke out most of the excess profits?

Ari Paul: [01:10:51] There's a lot around this that is a huge barrier to entry for someone like Citadel, for example, who might be very confident they can get into the game from a trading perspective, but they don't want to jeopardize their whole... If they lose a dollar because of a, let's say, a lost private key, or something that could be viewed as a lack of fiduciary responsibility, why would they jeopardize their whole business over that? So, you have these kinds of barriers to entry that will be fading over time. So, third-party custodial services that are ensured opens the door to a lot more people like us. It frees up a lot of that effort and time and risk and the kind of things that keep us up at night, making sure that we are super focused on that. So it's going to take a little bit of time for those barriers to entry to fall. As they do, the space will become much, much more competitive, which means... What really creates that concentration is not just one group being better at it than everyone else. It's that, if you're not one of those groups, you just can't compete. You can't be in the game. So you're forced out. So, that won't happen until things are much more efficient. And right now, this is a market where, if you're reasonably intelligent and you're a skilled engineer with maybe a little bit of trading skill, or you're a good trader and you have a little bit of engineering skill, right now those people are making money. In a few years, they won't, because they'll be competing against professionals with all the advantages. So we're very, very focused on converting what is a little bit of kind of an early-mover advantage into something that is, I like to use the term, unfair advantage.

So, when I was working at Susquehanna, or as a prop trader, you'd say, "I can't compete at this, because Rentech does it. And how can I compete? They have half a billion dollars of hardware costs or probably more where they've optimized their chips for colocation, for microsecond latency. We just can't compete with that. Right? And so we have to do this. We're forced out of that area." We don't want to do anything where a Rentech can get in the game the next day and potentially be better than us. We want to build the firm where, if Rentech gets in the game, they're like, "Wow, it's going to take us six months or a year to start replicating what these guys have built." So, for us, that area is more focused on medium-term trading. At the intersection of relationships, where we can access information and deep, deep understanding, as well as kind of the market psychology, having a really good understanding of who the players are in the crypto space, the term that's used is often "who the whales are," who the players are, who the corporate interests are, having both relationships with them and just kind of an understanding that there is no Bloomberg that'll tell you that. Right? It takes time to kind of build that understanding. So, having some element of scale where, if I want information from a Korean exchange operator, why are they going to take my call? A little bit is maybe I've invested time in building a personal relationship. But part of it is also that, well, if I'm CIO of BlockTower, and we're a force in the industry, they take the call. Whereas, if you're just entering the space, it might be really hard to get that person on the phone. So trying to build that. Another side is attracting top talent. Right? So being positioned as, if you're a small firm, you kind of have to compete on payor promises. If you're a Citadel, you don't. People want to work for you. Right? So, being able to attract world-class talent, building a world-class team. So that's our focus. We're very focused on being the firm that people don't want to have to compete against.

Patrick: [01:13:26] If we look back in 2025, and 2017 was the dawn of the crypto-asset class, we now have on record some of the major investors who kicked things off. As I was talking to Naval, Ari, Olaf, Josh, Jeremiah, and Jordan, the combination of uncertainty, excitement, and rapid pace of change was palpable. As I said last week, a missing piece to my puzzle so far is deeper conversations with some leading skeptics. I'll make that happen in the coming months. But for now, I'll summarize what I've heard.

First, the legal and regulatory side of crypto is a huge question mark. We are seeing a wave of governments shut down exchanges, ban ICOs, and take action that was inevitable as total-market-cap of these coins continued to grow. I'm sure there will be a lot more where that came from in the near future. There's also the question of price that Jordan Cooper explored with us. Many of these protocols are filled with promise, like any good speculative investment. But they have little actual traction in the real world. The valuations you have to pay seem preposterous. Then again, preposterous valuations have been a common feature of our generation's best investment stories, from Amazon to Netflix to Bitcoin itself.

I've joked often that this show should be called This Is Who You're Up Against. If you're a crypto investor, or if you're a curious bystander, now you know. Already, we have early-stage investors, buy-and-hold investors, and traders. We may be on the cusp of qualified custodians, institutional investor interest, and deeper, more standardized fundamental analysis. What will be the P/E ratio for cryptocurrencies? How long will alpha last? How many firms will deliver competitive returns against a cap-weighted index of the top tokens? When will volatility die down? All fascinating questions. We shall soon find out. Next week in the final episode of Hash Power, we spend time with some of the creators in the space who are building protocols like Filecoin and Blockstack, and we look to the future. Where might all this be heading, and what should you do next? See you next week.

Created by @ekmokaya