New Economic Systems - Jesse Proudman - Strix Leviathan

What does it mean to be agnostic about blockchain? Jesse Proudman joins the episode to discuss his time at IBM, Tether flows, gap finance and how his hedge fund is navigating the volatility of crypto markets.

About this episode

What does it mean to be agnostic about blockchain? Jesse Proudman joins the episode to discuss his time at IBM, Tether flows, gap finance and how his hedge fund is navigating the volatility of crypto markets.

Jesse is the CEO and Founder of Strix Leviathan and a member of the Strix Leviathan Investment Committee. Jesse has over 20 years of experience as a technical entrepreneur. Prior to Strix Leviathan, Jesse founded Blue Box, a cloud computing startup. Jesse raised $22M in venture capital for Blue Box and subsequently sold the company to IBM where Jesse was named as an IBM Distinguished Engineer. At IBM, Jesse spent time researching blockchain and cryptocurrency. Jesse is an active member of the Seattle startup community. He was awarded the 2014 GeekWire Young Entrepreneur of the Year award, was named to the 2013 PSBJ 40 under 40 class and serves on the board for the Buerk Center for Entrepreneurship at the University of Washington. Jesse holds a bachelor’s degree from the University of Puget Sound.

Jesse's Links

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Strix Leviathan's Website

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What to listen forWhy Jesse’s time at IBM and working in Hyperledger, helped him develop his approach to blockchain investment.How IBM’s marketing machine is doing a great job of getting people talking about blockchain and asking why?Why public blockchains solve three/four problems well and why most business models do not need one.How Jesse’s research demonstrated that prices are entirely driven by behaviour, speculation and liquidity in the crypto space.Why Tether is a privatised Eurodollar network and how this is used to evade capital controls and sanctions.Why the next halving is different than the previous two because of the number of leveraged loans.Why miners are betting on speculation and leveraging their businesses to pay their bills rather than selling their Bitcoin.Why the Stablecoin business model falls apart when you have negative rates, which are coming sooner than you think.Why the painful user experience problem still exists in the crypto/DeFi space and how this needs to be fixed to allow for wider adoption.Why Jesse is a big fan of Silvergate Bank’s exchange transfer network and why infrastructure development still has a long way to go in the space.Why Jesse believes price is a function of the narrative that people choose to believe in: if you think it will happen, it will happen.SUPPORT THE SHOW

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Show Transcription

Jesse Proudman Show Notes

Samuel: Today, I am joined by Jesse, who is the CEO at Strix Leviathan, an algorithmic crypto-focused quantitative hedge fund. Jesse, welcome to the End of the Chain.

Jesse: Thrilled to be here. Thanks for having us.

Samuel: I wanted really to dive into your opinions on some of the things that you were doing in your past. I know that you had started a company called Bluebox, and then they were acquired by IBM back in 2015, and you bounced around between different divisions. Once they determined you can figure out what you want to do with IBM. You came to the VC side of things and their accelerator, specifically at IBM. But one of the things that IBM has done in terms of blockchain since like 2016/17, is developing Hyperledger which is a private blockchain developed for companies and other small enterprises or small/medium enterprises, or even large ones, that would need some sort of private ledger that they could use in relation to what is being done on the public side with say, Ethereum. I’ve never really been a huge proponent of private blockchains. I mean, they’re a read-only database that’s connected between a lot of actors. With the development of the rules and regulations that we have, for data privacy, especially in the EU with GDPR, it takes a lot of the trust factor out of the equation when developing these sorts of databases. I want to start by getting your feeling on since it has been three years almost since you left.  What have you seen at IBM really since then, and how do you think that the Hyperledger system can develop, or is it even necessary with today’s network systems that are being built out for companies?

Jesse: Yeah, it’s a great question. IBM acquired Blueblocks, June of 2015. I spent the first year and a half after the acquisition working with the IBM cloud group to integrate the broader Bluebox products in IBM clouds, their private cloud initiatives, and then began to look for other opportunities there. The blockchain space and the blockchain initiative at IBM, in particular, were really interesting to me. From my side, I’m most interested in blockchain due to the financial aspects of it, and the sort of blockchain as a distributed database is not super interesting to me. When I was making that transition, my pitch was to effectively become the subject matter expert on the cryptocurrency component of blockchain.

At that point in time, IBM didn’t have a focus or an interest on that side. They’d wanted to stay out of sort of the cryptocurrency component, and they wanted to focus on more of the supply chain style implementations. That original sort of pitch that I made was denied. I was offered a role as a product manager working on the Hyperledger project, and I think my challenge or concern is very much like yours. In the midst of the summer of 2017, the word blockchain or distributed ledger was being used really as a marketing initiative to be able to gain sort of excitement from folks, without really thinking through the rationale for why to use these sets of technologies.

I think by far and large, it doesn’t make sense to add the complexity and overhead that private blockchains create for the use cases that they’re being used for or being used for at the time. I think there can be certain use cases where this technology does make sense in a private sense, but for the most part, when you have a bunch of parties that trust each other, which most of the implementations that were being done at the time were for, you don’t need this kind of overhead. That role wasn’t particularly interesting to me, and I ended up settling on the accelerator role, trying to develop a blockchain-focused accelerator for startups and wrote the prospectus for that and then ultimately my job was to continue to research the space over the summer of 2017. At the conclusion of 2017, IBM came back, and it was determined that there wasn’t capital to fund the accelerator.

So I made the decision to leave and to launch strikes. Kind of over the last couple of years I’ve been watching the IBM blockchain group, sort of from my periphery, I think that organization is led by one of IBM’s better managers, Marie Weeks. She ran IBM cloud when we were there for a period of time, so I interacted with her in that domain, and she seems to be sort of in IBM, there are two casts of characters. There’s like the lifelong IBM folks that have kind of moved from role to role and have kind of worked their way up in the company and it in my eyes, IBM has this culture where you don’t really fail out of IBM. You fail up to some extent, so a lot of folks were in positions where they, in my eyes, didn’t necessarily have the technical or leadership capability to effectively run that organization. Then there were other folks in the organization that that really seem to get it. They understood what the technology landscape IBM was operating in looked like. They understood what it took to lead Marie was, was one of those leaders.

I felt like at least that organization had a good head on his shoulders and it seemed to be pulling many of them, brighter folks and the IBM organization into it. I just think that the issue, and this is kind of IBM’s broader issue, has been this focus on immediate revenue growth over-investing in research and development.  In any emerging technology blockchain, in particular, there’s going to be a pretty significant lag between capital you invest now in understanding and developing a sort of a new domain and the revenue that’s going to materialize from that investment down the path and IBM, particularly under the leadership of Ginni Rometty, was so focused on quarterly revenue growth that there wasn’t a lot of tolerance or patience for sort of longer-term investment.

That’s the concern I had at the time, and the concern I’ve continued to have over the last couple of years, there’s not significant, being measured in hundreds of millions or billions of dollars, investment from third party companies into private blockchain space. Yet, like there’s investment/ interest, but this is not the next Watson at this point in time, and it’s going to take time for that to materialize. The question I have is there patience or the ability to sort of wait out that timeframe? I’m not sure. I’m not sure how that’s played out internally, but that’s been my observation and my consideration.

Samuel: Well, I think you called IBM a marketing machine primarily in one of your previous interviews, and you know, they have to keep rolling out technologies to sell to their clients to drive revenues. I think it doesn’t meet the necessity of why you would ever need a blockchain. Right, I’m in the camp of probably 99% of people don’t need a blockchain or companies; it just doesn’t do anything for them. It adds complexity to the typical business operations that they would do and makes it more difficult for them to grow as a company.

Because you’re locking yourself into this one specific network structure that has very conservative growth patterns and is not something that can be adapted to your own personal company’s needs very readily. If you do move on to using a blockchain, going halfway just doesn’t do it. You have to jump all the way into using Ethereum or something else which would then allow you to develop specifically for the traits that are inherent to those blockchains itself. I work for a company that issues securities. I think we’re actually the only company that has a tradable security token on Ethereum right now.

The amount of legal that goes into every decision that we make is the majority of the problems that we have. I can see this exponentially magnified for a company like IBM or any other major corporation, which does not want to get in the sights of the SEC or any other regulatory body when they’re trying to roll out this new technology to their clients because it’s the last thing that they would want to end up on was something like huge liabilities from breaking securities regulations, but there are only a few benefits that are really specific, and if you don’t offer those benefits, then there’s almost no point. But if you can figure them out, which I think we have, then you know there is a benefit to using a public blockchain, but I don’t know about a private one.

Jesse: I think you’re exactly right. You think about, in my eyes, like some of the most clickable use cases outside of financial transactions, like the one that always comes to mind for me is property titles and property deeds, and so here is an existing legacy process and involves a bunch of physical paperwork. It’s shuffled around from signing partner to the escrow agents to being recorded with each individual city. It’s an old bureaucratic, broken process and it’s expensive, and it’s painful. That is a use case where you’ve got a bunch of parties that don’t necessarily trust each other, where you want to a history that is immutable. It’s a perfect use case, but then you think through the regulatory landscape of what it would take to change how that process works, and it’s just immense. The challenge I think that IBM has with going down that private blockchain road is that most of the use cases that really do make sense and where a private blockchain or even a public blockchain would be applicable are touched by so many historical actors and would require so much agreement across so many different parties to make that transition. The bureaucratic headwinds themselves feel almost impossible to overcome. So that’s the challenge. You end up with sort of these pilot projects that are amongst small groups of trusted parties to try to prove that the technology works, and it just doesn’t, the benefits I don’t think, outweigh the effort.

Samuel: Yeah, exactly. I’m excited to see what comes out of IBM because I know there’s a lot of smart people working there, especially in Hyperledger, and it adds back into the system of all the other different networks of what they’re developing. Right? It’s a win-win for everybody else, but at the same time, I don’t see how it directly affects their business bottom line, the business revenues in the short term.  I mean, maybe in the longer term they can figure it out.

Jesse: The powerful pieces that IBM truly is a marketing machine. Like I’ve always been impressed with their marketing organization and for the broader blockchain industry as a whole. IBM has the ability to inform and educate such a broader audience with the marketing budget that they have than any individual company could do on their own. That’s a really powerful benefit to having IBM in this industry. Right? I remember sort of the end of 17/beginning of 18, you would see these IBM ads in the airport talking about blockchain technology, and at least it starts a question for folks. The answer may not be particularly clear, but if IBM can get people interested in the space and can get people starting to do their own research and learning more about what’s involved here, that’s a net win. Whether or not you’re exactly right, whether or not that has a financial benefit for the company as a whole is it’s a different question. But from an industry promotion perspective, I think they’ve done a great service.

Samuel: Well, here’s the thing is that I’m of the opinion that even in 2020, even with the release of CME futures and the development of grayscale trust and all the different products that have been released in the past couple of years, I still see these platforms, these networks as retail predominantly driven networks, right? Where the individual users that makeup of it are the ones who are driving price and who may not have that level of sophistication which would be equivalent to a Goldman or a top-level, top tier hedge fund that’s managing hundreds of billions of dollars where they have specific outcomes they want to affect onto the market by entering it. I think we’re inching closer towards that. There’s a lot of issues, and in getting these types of entities on board, there are regulatory and custodial and all these things which are being solved at the moment, but when you look at the actual users of the products themselves, once you get away from Bitcoin, like Ethereum, primary users of these applications are our retail clients. Even if they have $50 million dollars, you could still probably consider them a retail user just in the way that they’re using it and the way that they are structuring their trade setups or even their general use cases for interacting with these blockchains. If that’s the case, then if you are designing new products, right? At RealT, we’ve designed a product which is geared towards the retail client. The reason we do this is because public blockchains solve three/four things.

The first one is, of course, transparency and accounting, right? So, you know, if you issue a token or anything on a blockchain, you can see it everywhere. It’s completely public and completely transparent. The second thing, which I think a lot of people miss, which is something I feel is really important, and we just haven’t had the explosive growth of any use case for it yet is the micropayments aspect of these public blockchains, especially ones that when they shift to a proof of stake and they can drive transaction costs down to a millionth of a cent or something. What was Google’s microsite they had?

Jesse: I can’t recall that.

Samuel: No, but do you remember? Do you remember what, what I’m talking about? It was something Turk,

Jesse: Oh, mechanical Turk. Amazon has mechanical Turk yet.

Samuel: Right, exactly. So they shut mechanical Turk down, I think because the issue was that they couldn’t make payments to people globally. When people are making like a cent or 2 cents a day, that’s not something that you can easily distribute. But on Ethereum, you can send a tenth of a thousandth of a cent to someone, you know, if there are low gas fees for relatively low cost and these costs should go down in the future.  I think the micropayments aspect, and it’s really overlooked. Also, the interaction with DeFi which we see recently has been huge. We’re still in the test phase of this like billion-dollar rollout of DeFi products. There’s been a lot of hacks and money lost, but somebody has to do it first.

The fourth thing, which I kind of has been my thesis for all of this since the very beginning, is that Cryptocurrencies represent like gap finance.  The reason that that they were created, Bitcoin was created in the first place was an alternative to the dollar, and every single major product which has seen growth on the crypto ecosystem has been a decentralized, either private or semi-private version of the dollar system.

Tether is a prime example, right? Why is there such demand for Tether? It’s because it’s a privatized or semi privatized Eurodollar system and people are hungry for dollars right now. If you can focus on those four things, then I think you can make it work.  But if you’re not focusing on those things, I think it’s an exercise in futility.

Jesse: I think it’s spot on and the broader cryptocurrency industry has been claiming that the institutional capital is coming as long as I can remember, and the reality is, and we learned this the hard way at Strix, the regulatory landscape is so unfriendly for institutional players to enter this space, whether it’s to start new companies dealing with the previous items you’ve discussed, micropayments or cryptocurrency networks themselves or any of the DeFi pieces, or even just entities like ourselves that are trying to launch a fund. The regulatory framework is not designed or is not friendly for the types of custodians you need to use in this space; the way the exchanges are set up, it’s a challenge. This largely keeps the institutional players out, which leaves retail users to be the predominant majority of capital flowing through this space. It’s an interesting result of traditional regulation and how that impacts the space.

Samuel: I mean, my belief was always that the crypto space exists because there’s a gap which traditional finance can’t fill. If a Venezuelan wants to buy dollars in large amounts, they’re heavily restricted and then there’s also OFAC sanctions that restrict their country even further from dealing with the US banking system. Same thing if you’re living in Argentina or somewhere where your currency relative to the dollar has been declining at an ever-growing rate. I don’t see the efficacy of these dollar-based DeFi system competing against countries that are primarily using the dollar as the United States. There’s really no point to move into a DeFi system away from traditional finance because there are such good structures already made.

Jesse: Right. Our systems work. You go to Thanksgiving, and you talk about what you do for work, and people are like, why do we need that? Why do I need some system to send digital dollars and I can just Venmo or PayPal capital here around? It’s because we have the United States, we have these systems, and they work, and they’re easy, and they’re plugged into everything that we do.  We have the benefit and the luxury of that privilege. You think about countries that don’t or that have capital controls or any of these considerations. There’s definitely a need, and that’s, I think you’re spot-on; that’s been fueling much of the growth in this product.

Samuel: If you look at like a product like DAI, which is a synthetic dollar that’s generated from either from an Ethereum basic attention token and some USDC, the reason that it’s so important is that most people have found out by now that, actually making payments with Bitcoin or Ethereum or really any cryptocurrencies is difficult and probably really hard because it can change a couple of per cent in an hour, you know, six-block confirmation times mean that you could lose a per cent or two on the phone call that you’re doing with the OTC desk to actually trade the funds somewhere. But if you have a more stable asset, that’s something that you can actually use for cross-border flows and money, and it provides a much better way of actually being a medium of exchange and people would use that on a day to day basis. I love Bitcoin. I love Ethereum. I love it all because it’s an alternative, but at the same time, I think there’s inherent volatility which doesn’t ever leave any of these cryptocurrencies. I think it is where you stepped in with Strix to take advantage of these huge volatility swings that are seen in crypto on a day to day basis.

Jesse: Yeah, so it’s spot on. So back half of 2017 while I was working on this, this accelerator initiative, my job is effectively to research the space and I started to look at enough of these trading charts and do enough analysis across a number of projects to realize at the end of the day. Almost everything in cryptocurrency, it lacks shared fundamental valuation models. So if you go to a stock market or you go to the bond market, there are market participants with established valuation models that can generally agree on the value that something should be worth and someone’s going to think it’s worth more or less, but broadly speaking, there are models that that market participants can use to come up with some thesis for why an asset should be priced the way it’s priced right.  That doesn’t exist in cryptocurrency. There are some fundamental models based on transaction volumes or address counts, but they’re not widely shared amongst market participants.

As a result of that, effectively prices is driven entirely by behaviour, by speculation; and you combine that with sort of this fractured 24 by 7 liquidity pool. You’ve got exchanges all over the globe that are trading these assets and trading never stops. You’ve got all of these derivative platforms that create sort of immense leverage and pressures as a function of that. And then the last piece that was really interesting to me was with market data. I can’t go to the New York stock exchange as a startup and get access to their entire trade ticker, like every trade that’s being made on the exchange. But every crypto exchange allows you to subscribe to every trade that’s being made on those exchanges, so being able to aggregate that data in real-time and make decisions on it felt like a really unique aspect of this space.

So you take all of those things and then you recognize that there, for the most part in the top 10 coins, there is liquidity to be able to trade in and out. It felt like the perfect recipe to go and be able to build software that would allow an entity to go algorithmically trade in this space and early on, as I was doing this research, I was sort of dabbling in the day trading space and began to realize I was not very good at it.

Quite frankly, there’s a lot of emotion and fear, and sort of human psyche involves in day trading, and if I was struggling with that, I realized so many other market participants were and felt like if I could remove myself from the equation and be reliant solely on algorithms and on computers to drive the decisions that that would help. Often in crypto, people will kind of make this recommendation to dollar cost average into a position and hold it for a long time. I think it’s a good strategy for many people, but it’s also a really also an emotionally difficult strategy in an industry where drawdowns can exceed sort of 80%.

Right? It’s very hard to watch. There’s just always this trading quote, right? It’s more painful to lose money than to gain money. It’s really painful to watch 80% of your capital disappear. I didn’t want to do that anymore. So bringing all of those pieces together, it felt like an opportunity to build software to solve this problem, and that was the thesis to launch Strix in January of 18.

Samuel: So how has liquidity developed since then?

Jesse: Yeah. I’ve learned so much over the last two and a half years. I went into this industry pretty naive about what was available and how everything would work. So when we started this company, and when trading first started, everything was in theory and in code designed to go execute on an exchange, and you think about sort of traditional stocks like if I want to go buy shares of Tesla, I don’t really have to worry about liquidity. You can move capital in and out of these large-cap stocks that have at will without having you think about execution costs. The moment we started, and the moment we tried to begin to move any kind of capital through these exchanges, it was very apparent that on exchange liquidity was not where it needed to be to make any kind of these strategies profitable.

Samuel: I think the main reason is that there are probably one or two exchanges which have most of the liquidity, and these are probably the most used ones that get most of the volume. And then all the other sub exchanges are building out market-making bots that are; they’re arbitraging the spreads between the big exchanges and then their own.

Jesse: Yep, but even the big exchanges, right? We’re now two and a half years later, and we did this analysis the other day to answer a question for a prospect like there is on Coinbase if you are to buy a million dollars of Bitcoin, the complete execution costs, including fees and the slippage you’ll get in the order book; it’s significant. It’s on the order of 40, 50, 60 basis points depending on what’s going on in the book and a million dollars for a retail investor, that’s a significant trade. But for an institutional investor, that’s not that large, and so this was the challenge then, and this kind of continues to be the challenge.

We quickly pivoted early on to work directly with OTC counterparties. An OTC counterparty is, effectively, you can think of them as a market maker. Well, they will block trade a preset price. Say we want to buy 100 Bitcoin, they will give us a preset price for that. That price will always be higher than sort of whatever the spot price is at the time. They will take on the risks to go find that Bitcoin in the market. Instead of the best OTC desks that we work with, they’re often some of the best market makers in the space. They have built the connectivity into broad swaths of exchanges so that they can go source that coin, or they’ll have unique relationships with particular liquidity providers.

So like Miners, for example, in the course of Bitcoin who are looking to offer that coin and on a regular predetermined schedule and they’ll have access to that. They make these OTC desks make their money based on the spread that they charge. From our perspective that became more interesting because the execution costs became predictable. When you’re trading something that’s algorithmically derived or that has been built using models, at the end of the day, you want to ensure that those execution costs can be at or below what you’ve modelled them in the models you developed and that that was our goal that you see. We started at 18. We were working with about four or five different desks, and this was the first big wake-up call and in 2018 working with OTC desk meant you got on Skype and you sat in these Skype chat rooms and when you needed to make a buy or sell. You literally negotiated in a chat room with these four desks and figured out what the best price was, and then everything was done over chat.

It was incredibly inefficient, and it was my first sort of realization about how early this space truly was. The tooling was so premature and so underdeveloped. It was a big shock. Over the next kind of year and a half, we started to see some advancements with a number of the counterparties we worked with many people started, or any of these entities started to create their own APIs that we as an end-user could use to get our own streaming prices. Now in 2020, we’ve built our own complete execution engine that instead of talking to individual exchanges, goes and talks to six or seven of these OTC desks to be their APIs and is able to give us streaming prices and it’s transformed our business pretty immensely.

Samuel: How big were the spreads? I guess the question is how much have spreads collapsed in the OTC market since 2018?

Jesse: It’s obviously a function of markets. It’s a function of what’s happening in the market, and it’s a function of what coin you’re trading. Bitcoin is obviously the most liquid of all of the assets that exist, and I would say spreads when we started in in 18, we’re in the 50 to 100 basis point range depending on trade size and what was happening.

Now we’ll often see them in the four to 12 basis point range, so pretty dramatic compression. The interesting thing to me though is as you moved down the list of assets on from a market cap perspective, how dramatic the execution costs increase.  If you think sort of top five coins, so that’s Bitcoin, LightCoin, Ethereum, XRP, Bitcoin cash, like those all generally have pretty good liquidity.  A number of those assets will at certain times, be more expensive to trade. As soon as you get out from those top five, and you go five to 10, the story changes pretty dramatically. And then below 10, it’s shocking. We’ve seen quotes for assets below the top 10 that are in the 300 400 500 basis point range, and these are large trade sizes. You’re looking at maybe a hundred or $200,000 purchases of some of these assets, and it just gets ridiculous. It’s a testament to how much true liquidity actually exists in the space. Like you can go on coin market cap, and you can see these volumes presented that give it the impression that there’s a lot of dollars sloshing back and forth in this space, but you quickly realize that so much of that is fabricated.

Samuel: What about Tether?

Jesse: Tether is a tough one. We have made a decision not to trade actively in Tether. I think Tether has done the industry a great service over the years. I think you’re exactly right. I think it is used by an entire cohort of traders around the world who don’t have access to traditional dollars. It’s given them a medium to store capital that that removes the volatility to exist in Bitcoin. So big benefits there. I think there’s also this big issue I have around transparency right. The entire premise of Tether is that there are US dollars backing the complete reserves of all tethers issued on-chain sitting in bank accounts.

Samuel: It’s not true.

Jesse: Well, it was the original premise.

Samuel: Right. Original premise. Yeah.

Jesse: We now know that’s not actually accurate, right? We know that there was a 25% deficit at one point in time. We know that they have at other points of time elected to use other assets to kind of back those reserves. We know that that was done.  Without being particularly transparent until the New York attorney general case sort of forced them to update the website. If I am using something that is purported to be stable, and supported to be stable because there are assets in reserves, I want to know what those assets are and I want to know that I can trust the issuer. I don’t.

Samuel: Here’s the thing, right? Like my explanation of it, to me, and this is what makes it makes a lot more sense now. Let’s say I’m a Russian billionaire, and I have a lot of money in Russia. And maybe some offshore venues, but I don’t have any money in the United States, and I want to get $50 million so that I can go, you know, maybe buy some Bitcoin, or maybe I can pay my operations for my company, or, you know, just do different things with it.

Because of my status, because of who I am, and because I know the Tether people, I can just pick up the phone call Tether whoever it is, and say, Hey, give me 50 million together, send it today. They’re like, sure. You know, you’re a billionaire. We know where to come and find you. You signed some documents just saying that you’re good for it and we’ll send it to you today.

I’m pretty sure that’s how the majority of all of this money, or at least all the Tether is created, right? There is probably some dollars in an account somewhere, but I think the majority of it is loans that the company is issuing to very wealthy people so that they can go out and use it for whatever purpose they have.  They come to them and say, you know, like, lend me tether at whatever the going rate is 3 or 4 percent right? I’ll borrow this, and then I will pay you back. Then they can go off, and they can lose all their money in whatever kind of crypto they want. They come back, and they have to pony up the 50 million-plus interest.

Jesse: Yeah. That’s interesting. I haven’t heard that there before, but that would make a lot of sense. Particularly if you look at the piece that’s always been confusing to me is to look at the issue schedule. If you go look at other traditional stable coins, like USDC for example, and you look at the way the market cap of USDC has grown, it is not in these giant lumpy blocks. If you look at how Tether’s market cap has grown to $125 million chunks at a time, it doesn’t make any sense. One of the other big gripes that I have is that particularly as a fonder, as a market maker in the space. I can go mint and redeem USDC.

I can go mint and redeem Paxos like other stable coins have a process where I can take that coin and get true dollars back. Tethers process is not transparent. It’s not easy. There are very few people that I have met in this space who have actually successfully redeemed. Like it is possible. I know people who have redeemed tethers, but it is not a common practice.

Samuel: Let’s say I have a company, and I’m in China, right? I need to send $50 million into India or Russia or somewhere. Normally this would be a very difficult process. I’d have to go to my bank. The bank would have to approve the transfer. Then I’d have to send the money, and then the other bank would have to approve the transfer. This is going to take like a week or two weeks, and it’s very slow. By knowing the tether guys, I can just make an OTC trade where I call them up and say, Hey, you know, I need $50 million today. I need it for my company. Here’s how I’m good for it like issued to me now, and you know, we can settle it later. They issue $50 million. I go on my way, and I pay for all my operations, you know, it’s a stable coin. There’s instantaneous settlement when I pay with things. I can do all the business operations that I want to. Then at some later date when I can, or, you know, maybe not even when I can, I either sell this loan on to somebody else who then takes the Tether from me, or it just gets passed on, or I just keep the tab open while I use the money for different purposes.

Jesse: Yeah. That makes sense. I think that the issue then is if you and I are doing business together and I am receiving your tethers. What do I do with them? I can’t get them back into dollars. The only really generally liquid market for Tether to US dollars on cracking and the spreads there are pretty large, and there’s not a ton of liquidity. Now I’ve got all these, these digital dollars that I’m holding.

Samuel: You’re thinking about it in the wrong way. I think if you take a look at it from an OTC perspective, it makes a lot more sense. It doesn’t have to be the exchange that you could sign up for and try to find liquidity on there that you’re trying to exchange your tethers… there’s an article that was published by Coin Telegraph, and I think like two years ago in 2018 or something. It detailed how these Chinese were bringing their goods into Russia and then selling them on the outskirts for rubles. They would collect their rubles all day, and then at the end of the day, they would take all their cash to a trading desk in OTC desk where they would exchange their cash. Originally it was for Bitcoin, right when the price of Bitcoin was going up every single like 10%.  You know, week on week a week, they were just buying Bitcoin and then using Bitcoin to pay off their debts back in China. But once the price started going the other way, then they switched to Tether. Tether was the main way that they would transact a cross border and be able to sell all their goods in different countries and then instantaneously be able to send all of those revenues back to China to the company themselves.

Jesse: That makes sense. It’s fascinating. Looking at this world of sort of central bank digital currencies and thinking about the privacy implications of this, if you think about the model you just described at the end of the day, since Tether rides on top of Bitcoin or Ethereum or predominantly Ethereum, now all of those transactions are now publicly traceable.  It sort of creates this surveillance effect. It’s an interesting question around how long can they continue to do knowing that they’re sort of evading capital controls or evading sanctions before government sort of wise up and the chain analysis companies, they get a bunch of these contracts to identify those capital flows.

Samuel: [00:41:24] I spoke with a chief economist at Chainalysis, he told me that what happens on-chain is pretty much outside. They can’t do anything. The only thing that they can control is when money comes into these exchanges or endpoints that they can control.

Where you have an account that can be locked, and that’s the only place that they can actually make a dent. But if you’re making OTC trades, if you send money and you’re dealing with an OTC broker back in China or Russia, or somewhere, that’s fully on-chain. You’re exchanging cash like a bank account. You can do this all offshore as well too. I mean, one of the things that happen, I know this would happen a lot back in Russia many years ago, I think it probably still exists, is that it’s really difficult to move money offshore because of legislation that was put in place nearly a decade ago.

If you’re a company, you used to be able to move billions of rubles offshore in whatever manner that you wanted to, but they instituted this D offshore station. Now it’s extremely hard as a business to do these sorts of schemes. The typical way that things were done would be that you would have a bank account or cash inside the country, and then someone else would have an offshore account where they would have money just in an offshore account.

So you go to them, you say, okay, you know, I’m going to give you my cash. I’ll pay like 4% or 6% or something like that. And then, you know, you give me your money offshore. And then you make the exchange. Everybody’s happy. And, you know, life just goes on. So I think a lot of this happens. Tether made it a lot easier for these transactions to take place because now the cost of moving into an offshore dollar, and one that is essentially like having an offshore bank account is much easier or maybe not easier, but it’s another option for people who like to have a private offshore dollar that they can access.

Jesse: I believe an interesting component of that if you look at USDC or these other coins that are sort of onshore based, they all have mechanisms to sort of freeze funds. They had to build those in as a function of regulatory oversight. As far as I’m aware, Tether does not have that built into its ERC 20 contract.

Certainly, I don’t think the Omni layer supports that so that would explain why there’s such a significant volume there and why the market cap Tether grows so much or has been growing so much faster, particularly this year than any of these traditional stable coins. It’s a fascinating theory.

Samuel: Exactly. It’s a privatized Eurodollar system which was a direct response to the collapse, or at least the problems that existed with the Eurodollar back in 2008.

Jesse: In this model you’re proposing, because my theory has always been that if it is truly backed by dollars and those dollars are sitting in bank accounts, then as soon as the US government or some other entity is tired of that coin being used for whatever elicit purposes or they don’t like it anymore.  They go seize those dollars and in a way you go. If your model where these are actually fundamentally just backed by loans held where they bunch of different counterparties are in the club like that’s a much harder network of capital to go seize, which to some extent actually makes it a better digital dollar than some of these traditional, like USDC.

Samuel: Exactly. The traditional Eurodollar system is based on a series of credit issued between banks interbank lending, so this is just a privatized version of that.

Jesse: This is what makes our industry so fun. It’s incredible what private individuals have been able to build over the midst of the last decade.

Samuel: This is my fourth point, which I brought up earlier, is that all of these cryptocurrencies were created for gap finance. That there is a place where traditional financial systems cannot go because of regulatory reasons. There’s a huge demand for dollars mainly since it’s global reserve currency offshore and the integration and creation of crypto into this new economy allows for all these new systems to be built where people who weren’t able to access dollars before now can get a digital dollar that is outside the purview or control of any regulatory body.

Jesse: It’s interesting if you think about all of this was created because of Bitcoin because there was an asset creator that wanted to be sort of removed from the world of dollars and now the end result is creating this mechanism that’s just digitized dollars.

Samuel: Exactly. What’s kind of the end goal that everybody’s pushing for right now with defies to be able to take your Bitcoin and create a credit-based synthetic dollar from it.

Jesse: Absolutely. Yep.

Samuel: I don’t think anybody in the Bitcoin community expects that they will. Maybe, except for like diehard maximalist think that at some point you’ll be able to use your Bitcoin to pay for things that kind of died at this point, so the only other option that exists for the maximalist, this is price appreciation, or it’s the ability to generate a synthetic dollar or like a credit-based synthetic dollar.

Jesse: Yep. Whether it’s DeFi or decentralized finance, you look at the rise of block fee or the rise of Genesis capital’s blending book, that is proof in point. Like Genesis issued something like $2 billion of loans in Q1 for exactly what you’re talking about, that those holding Bitcoin and wanting to continue to hold Bitcoin for the long term, but also need access to use that capital to not have it just locked up on their balance sheet and they need options.

Samuel: Exactly. I think a lot of that the mining community, which is strangely prescient of what’s going to happen and maybe like the next week or two with the having. The big difference between this halving and the last one is that there are a lot more leveraged loans that are issued.  This leverage is created because I don’t think the miners sell their Bitcoin. You don’t mine Bitcoin to just sell it and collect a profit margin. Most of these people are speculating on a 5x increase so they can dump their coins in and make a bunch of money.

Jesse: This has been such a fascinating topic for the broader crypto community and for us. I think there’s a gross misunderstanding of how the mining industry works. You see all of these models that go back, and they look at this data set of the two prior halvings and the price appreciation that occurred following both of those.

At the end of the day, the mining industry is so dramatically different today than it was in the last two prior halvings. We have this industrialized process now, whereas the first halving you had individual recreational miners securing the network. In the second halving certainly, it became a little bit more sophisticated, but the amount of capital that has gone into these industrialized scale mining operations now, it’s so far above and beyond. I think people understand, and you’re exactly right, like people say, Oh, well the block reward is being halved, so the sell-side pressure on coming into this space is going to halve,  but that’s making the assumption that these miners take all the coin that gets submitted every day and they go immediately to sell it to pay for their operations.

We don’t think that’s true at all. We very much agree with you that miners are in this space because it’s a speculatory vehicle. They believe in price appreciation. They’re holding those assets and using leverage to go create the capital, to pay their electricity bills, to buy new mining infrastructure, to do additional development and build-out.  We saw sort of the first hints of that on our black Thursday in March as miners were getting called, left and right on their loans, from a bunch of the lending desks. Fortunately, I think that was a great stress test for the lending desks. All of the ones that we’re aware of passed it with flying colours, and the system didn’t collapse. Miners had some good control over their balance sheets and were able to kind of repay those loans.  This fallacy that all of the block reward is sold every day. I think it couldn’t be farther from the truth.

Samuel: You don’t mine just to sell it off. You’re hoping for a like a 2x or even 10x or up to a million dollars for Bitcoin price appreciation. I’m pretty sure that every single miner that is running right now are speculators and they’re not just speculating with a bit of money. They’re over-leveraged. There are even companies like BlockFi and maybe Genesis, which were taking collateral as the mining machines from the miners themselves to be able to issue more loans which is incredible.

Jesse: We worked pretty closely with the BlockFi guys. I don’t think that they have done that. I’m not sure about Genesis, but that would be an incredibly rapidly depreciating asset that has one use case as collateral as a risk officer, it would give me shivers down my spine.

Samuel: I’m pretty sure I saw this somewhere.

Jesse: I wouldn’t doubt it happened like this. That feels like something that absolutely would happen in this space.

Samuel: It really makes sense in that you’re a loan officer and you’re trying to drive more loans from your business because things have been difficult over the past couple of years. And you eventually find a large scale miner, maybe even one that has like 40 or 50 megawatts. You start taking collateral from them as their equipment, but you’re playing with a nice edge right there.

Jesse: It’s a house of cards.

Samuel: Exactly. I have no opinions coming into the next two weeks. My kind of long-term thoughts on where Bitcoin is, I already think it’s succeeded.  I think that it does what it’s designed to do already and the same thing for Ethereum. Ethereum is just getting golden with its DeFi systems. And the next step is that you have a layer one, right? You have like a base token, but then everything on top of it, the integration of all these off-chain assets like securities and digital dollars as well too.

That’s there now, or at least the securities are slowly coming, but that’s a different story. Digital dollars are here and also base layer currency to secure the network is also here . Next, are these just on-chain? Financial applications, you know, whether they’re centralized or decentralized, doesn’t really matter, but the ability for people to do all the traditional leveraging and borrowing and lending that they normally would do with a bank. We saw that in 2018 with the growth of DeFi and the growth of the stable coin industry, but again it seems that it’s built on another house of cards, right?

I’m 99.9% that we’re heading towards negative rates in the next five years. Let’s just say that we’ve already seen some negative rates on the front end of the curve, but really it’s the 10-year and the 30-year, that’s one of the long-term bets that I have is that rates go negative on the long end of the curve. At that point, the stable coin market really has a reckoning, how do they make money? By holding money because their business right now is just to collect billions of dollars and then make money on the carry. But how do they do that when you have a negative carry?

Jesse: Yeah. How do you penalize the users of the stable coin appropriately if given that situation?

Samuel: Exactly. What do you see for the development of this stable coin market?

Jesse: In my eyes, we’ve had this really painful user experience problem that has existed in this space since inception. I had some belief that sort of 2017 would create enough of a focus on that user experience issue to kind of change it. I’ve not necessarily seen that these are hard technologies to use. They’re not user friendly, they’re error-prone, and the risk of losses is immense. Whether it’s just Bitcoin or stable coins, all of these technologies and coins and networks kind of suffer from the same challenge. That continues to be a concern of mine. Widespread adoption in my eyes is not going to happen until we can solve a bunch of this user experience problem.

I don’t know who’s focusing on it and I don’t know how that ultimately gets fixed, so that’s a concern. We’ve been at this for years and still every time we send capital across one of these networks, your heart skips a beat, making sure the address is correct, and the funds are going to the right place.  The stable coin industry more broadly I’ve been really impressed with the development of Paxos USDC over the last couple years. As someone who has to deal with both the traditional wire system and the stable coin system, it’s just such a better experience being able to demonstrate sort of capital flows and being able to send transactions.

Everything about it is better than the traditional wire system. We’ve got something that’s really interesting, but, but I absolutely agree in this world of negative rates, the long-term sustainability of this business, these business models comes into question.

I think there are solutions. There can be creative ways to somehow tap sort of the transaction flows of the network as a way to drive, revenue, but I don’t know what those look like. I’m glad that’s not my business to solve, that’s for sure.

Samuel: One thing that you can do is that you can build in the negative rate into the token itself. So the token can lose value over time if you hold it just by readjusting the supply every single day. If you had a thousand USDC after a whole year of negative 2% rates, they could automatically adjust your coin balance down to what 980 algorithmically.

Jesse: It’ll make for an interesting world. Like you look at some of the business models referenced BlockFi earlier, right? They lend 8.6% in your bar on your USDC holdings because there’s the demand for them to be able to go out and lend that USDC to other folks as that asset becomes potentially punitive to hold. It’ll be interesting to see how those business models play out.

Samuel: I found that article that I was talking about. It just came out at the beginning of April. Zach Prince said that we’re starting to establish relationships with miners for the first time now. And then he says, two months ago, lots of lenders were accepting mining equipment as collateral, and this isn’t happening anymore.

Now the risk tolerance has declined. It seems as if they, or maybe not them, but there are other lenders who were taking this mining equipment as collateral, and then the sell-off just completely wrecked their balance sheets.

Jesse: Yeah, that is a great article. That is exactly why anybody participating in DeFi or centralized finance in this space needs to do an immense amount of due diligence on the counterparty and what they do with their balance sheet and how they hold collateral like that. That’s terrifying, and I’m glad it was the competitive landscape.

Samuel: There’s a lot more risk in doing in investing in these companies. It’s like doing startup investing, right? There’s been a whole host of companies which have come out of your area in Seattle which really has not succeeded. I mean, you had dragon chain which came out of Seattle, right? They lost 99% of their market cap, and I don’t know if they’re still working, but it seems that they’re not where they were and that they hadn’t been able to grow where they wanted to grow. I think there’s been a lot of internal struggles there, but there has been a whole host of other companies like them, which have just come and gone and just have quickly faded it into the token bubble that was. You’re left with a few core providers that are dominating the space now. I mean, you look at USDC and its growth and Paxos. How would you take a look at these companies balance sheets and how do you take a look at the companies themselves and make sure if it’s somebody that you’d want to work with.

Jesse: Yeah, it’s an interesting question. I think 2017 created so many perverse incentives for market participants in the space because things were just so out of control, that there’s a lot of sort of consequences that we’re still seeing from that today. It’s interesting Seattle actually has had far fewer companies emerged in the cryptocurrency space than I would have imagined.  When I started looking into this in 2017, Dragonchain is still chugging along as far as I’m aware, but certainly, they’re not as successful as I think the holders of the token would hope.

We’ve got kind of a handful of companies, and there’ve been a couple of others that have been acquired, and there was another one that was acquired by a healthcare company, but it’s not in my eyes the community that I thought we would see, and that’s interesting.

I’ve thought about it over the last couple of years, at the end of the day, this is all about liquid angel investing. You are making speculative bats into a handful of assets with the high probability that the majority of them are going to die and your investment will go to zero. To some extent that requires that you think about it like a venture portfolio that you need to spread your bets around as far and wide as you can. This has been why, as some of the maximalist that have belief in any single asset that it’s always been confusing for me. Like you wouldn’t in 2000 make the argument that Yahoo was the only tech stock you should buy because Yahoo will win all tech stocks. You wouldn’t say today that Amazon is the only cloud computing company that you should buy because they’re going to win all of cloud computing. It’s a silly argument to me. So to say that Bitcoin is the only thing that matters and the only thing that will survive, it doesn’t feel appropriate given what we know about the space and given all the uncertainty in the industry going forward.

I think about it like liquid angel investing. I’m going to place a bunch of bets. I’m going to be smart about those bets, and so that’s kind of step one. Then step two is really thinking about. What is the business model? What is the token appreciation model? How am I going to get my money back from these assets?

In terms of the centralized finance lenders, if that means I’m personally lending capital to BlockFi, I want to make sure I understand what BlockFi’s business model is, what they do with my capital, how they make their money? I want to have a lot of confidence and faith in that business as much as I can—the same thing on the DeFi side. I’ve personally made the decision not to participate in a bunch of the DeFi projects cause I think it’s a big state of experimentation right now. You have to be willing to lose everything to participate in that. I think I’m happy that people are right. I think that’s it’s part of the evolution of the network.

Samuel: Does that include holding DAI as well?

Jesse: Yeah. I won’t touch DAI. It’s not that I don’t think they’re interesting projects. I think it’s a fascinating project. I think what they’re trying to achieve is really interesting, but at the end of the day, part of it is able to have a complete understanding, right?  I went to college with Eric Vorhees who went on to found Shapeshift and Nick Kerry. I’ve been friends with those guys for years, and I’ve been watching over their shoulders for years as they’ve built their businesses. I didn’t have the intellectual barrier to understand Bitcoin until the beginning of 2017, and I’m not super comfortable investing in things that I don’t understand.

I missed out early on, but I’m okay with that because I want to make sure that I understand the ramifications of what I’m participating in, to spend that time and that energy to understand the nuances and the mechanics and the whole situation with the Oracle pricing, the auctions with DAI in March. There are so many edge cases to all of these protocols that are going to be discovered over the next couple of years. I just don’t have the bandwidth right now to try to understand and think through the ramifications of those.

Samuel: I think that there’s been a lot of good investigatory work done into what the different outcomes can be. I’m not sold on the eternal hopium that a lot of maximalists have. I don’t think that you would ever see a cryptocurrency like Bitcoin or anything else replace a Fiat issued US Dollar. It’s not even because the design of the cryptocurrency or anything is better. It removes the democratic process from the issuance of the currency itself. We lose the fact that it was our own governments that created the federal reserve, and it also created the banking system, it was legislated, right? People may think that it was some grand conspiracy to establish some sort of strange, control over people in the United States and to take away all their gold, but we’ve created a really stable, dominant currency that has been able to become the global reserve currency of the world, right?

By having the federal reserve, you were able to become the most dominant currency in the entire world. When you take away these controls, and you take away the ability of our lawmakers to influence and then also people to have a representative and a position in determining their money structure.  I think it’s a net negative. Even if the structure of the crypto or whatever it may be, the coin, it doesn’t matter, even if it’s been hardcoded in and nobody can change it, I think that having a voice and being able to change the monetary structure as you go forward is a really important factor in our economy and also our monetary and fiscal systems at large.

Jesse: Yeah, absolutely. All of these technologies are incredible. They’re fascinating. I mean, people are pushing the envelope in what was thought to be possible. You look at even some of the DeFi attacks that have happened over the last couple of months. When you actually analyze them, and you think about how they occurred, it gets pretty amazing how interwoven and interlinked so many of these different contracts and protocols have become like that.

Samuel: The bZx flash loans hack was…

Jesse: Absolutely. You’ve got people out there that understand this well enough to pull something like that off. I guess it’s a testament to both the complexity of what’s being built into the creativity of those out there and kind of evaluating it all.

Samuel: Right for people listening, right? The bZx hack you had; Stu Stein came on the podcast a while back and talked about flash loans, and this is before the actual hack. It wasn’t really a hack. It’s an exploit, right? Because they were able to borrow, I think 10000 ETH for a block, and during that block, they executed a bunch of on-chain transactions.

Jesse: Yeah. Everything changes together.

Samuel: A bunch of interactions between all these different contracts and we’re able to steal, I think the first hack was what, a couple of million dollars, and then the second one was, like $700,000.

Jesse: Yeah. That sounds right.

Samuel: This was like a brand new offering, and within like a month, you had someone use it for a system breaking exploit with one of these projects.

Jesse: Yeah. Same thing with the D-Force attack or the last couple of weeks. Yeah. It’s amazing how fast these things move, and then how quickly they can be tested, validated that things are secure.

Samuel: Well, what would you want to see before interacting with any of these contracts?

Jesse: That’s a really interesting question, and I haven’t been able to put the intellectual throughput to figure that out. I think that the challenge that I have is that because contracts are world-readable. It’s like the worst thing about open source software, right? Everybody can read the code, which means anybody with time can go look for exploits, except now there is financial reward for individuals that have identified those exploits. That’s the ultimate challenge. It’s like how do you know that these contracts are secure, that they aren’t going to suffer from some edge case scenario that that’s not thought about because some additional set of contracts was brought online down the road.

I just haven’t thought through the ramifications of that yet, and there are much smarter people with much more time are spending their energy focusing there. I do think like regardless of that, I think it’s really neat. It’s showing the power that these platforms like Ethereum have created. It’s showing the power of being in weave all of these different applications together. That’s an incredibly interesting demonstration of what the next decade of development on these platforms will look like.

Samuel: I’m interested personally just to see if there is any other competitor that can grow to the size of Ethereum. There’s a bunch of other protocols, which telegram eventually once they kick all the U S investors out. There are all these other different protocols that are launching, but none of them starts on the back foot, and you have to spend billions of dollars to catch up to where the room is

Jesse: This is the Ethereum version. Wander theory in version two transition will be a fascinating case study for protocols as they think creative ways to upgrade, sort of the base layer technology and I think Bitcoin gets a lot of grief for being sort of slow and it’s innovation, but I think there’s been a lot of benefit to that for the industry. It’s stable, and it’s been a consistent operating entity with incredible uptime and reliability. There’s a lot of benefit to that. This one to two transitions will be the first time a multi-billion-dollar protocol. It was undergoing such a major transformation is sort of how that goes economically. How that goes technologically will be fascinating, and we’ll set the direction, I think, for a lot of these projects going forward.

Samuel: Will you take a step away from trading during that period?

Jesse: We’ll definitely look at it. We have a policy around assets like the Bitcoin Cash hard fork in November of 18. if we think there will be network instability, we will suspend active trading of an asset. A big part of our business requires being able to actively send these, these assets on-chain. And if the chains are broken or if counterparties have suspended their activities, then then it’s not an appropriate asset for us. So yeah, we definitely do a bunch of diligence around what we’re trading and what market events within that basket that we’re trading may impact.

Samuel: Are you also working with any banks like Silvergate or anything?

Jesse: Yeah, we work with multiple banks in the space. Silvergate has been our longest partner, and we’re big fans of theirs.

Samuel: Can you walk me through their dollar transfer system that they have between the different exchanges?

Jesse: Yeah, absolutely. Silvergate has a network they call the Silvergate exchange network, and effectively it is an internal bank to bank transfer mechanism that has an API. Think about your own bank, if you have a checking account and a savings account, you can go onto your online banking, and you can move money from your checking account to your savings account any point in time, regardless of the bank holiday, regardless of what needs to happen.

Because all that’s happening on the bank side is they’re just upgrading, updating their internal ledger. Silvergate exchange network is exactly like that. It creates a mechanism that allows an entity like us to transfer US dollars to enter any counterparty that’s active on the system 24 hours a day and then they’ve overlayed an API on top of that. Programmatically, within our platform, we can initiate these Silvergate exchange network transfers. Then they also have webhooks, so when a transfer is completed, we can be notified. The transfer is complete and we can take actions. If you send it over to the subrogated exchange network, it shows up in their account with an identifier. They get a notification on their side that new capital’s arrived and they’re able to respond instantly. It’s really for folks that are moving capital around frequently in this space, and it has been pretty much a game-changer. You’re not reliant on wire systems. You’re not reliant on the traditional banking system operating with the speed in which it operates. You can move capital in and in an out of counterparties in a matter of minutes.

Samuel: And has it changed your business structure? A lot.

[01:14:59] Jesse: [01:14:59] Okay. There were counterparties that we started with that did not accept Silvergate or that were not on this super good exchange network. To some extent, we ended up choosing our counterparties based on who was a participant there. That’s the biggest change. I think because they were sort of first with that system, they have gained critical mass. So now everybody sort of has to be there to some extent. Other banks, like they have something called Cigna that is similar or prime trust, has something called Primex, which is similar, but because those offerings launched after Silvergate, that they’re good offerings, but they just don’t have that critical mass that Silvergate has been able to establish.

Samuel: I purchased some silver get stock at IPO. Sold it a little while later, but I know it’s come down a bit. I’ll probably look at purchasing more at some point. I think they have a strong business model and a particularly good use case for what they’re doing. It’s probably good to look at them. They’re not going to have their public disclosures in their 10 K’s that get published every quarter. But it’s very cool to see that sort of counterparty transfer development happen within the space.

Jesse: Oh, it’s been a blessing. I mean, you think about 2017 2018 there weren’t banks available for most of the companies in crypto. To see an entity like Silvergate kind of make a bet on this industry and then kind of go full force after that has been absolutely wonderful to see and the leadership team over there the product’s been great. We have a lot of respect for that.

Samuel: What other parts of your business do you have? Would you need another service provider or two to come in and be able to provide a counterparty solution or custodial solution? What’s missing at the moment? What are the biggest gaps?

Jesse: Yeah, the infrastructure continues to be very weak for crypto funds, and we ended up as a result of that building an entire operating and platform to solve most of those problems for ourselves. Things like portfolio management, order execution, reconciliation, settlements, LP, accounting, all of these pieces, they exist in piecemeal solutions, but there’s not been a provider out there that’s been able to aggregate all of those into one end to end offering. That’s something that we ended up building from the ground up. We thought about possibly selling that as a standalone product, but at the end of the day, there’s just not enough market participants out there with enough assets under management to make that an interesting, standalone viable business. That’s a big challenge. And the second big issue is regulatory compliance; it’s very difficult. In this space, particularly for an entity like ourselves that we’re trying to be sort of transparent and compliant. That’s our mandate. We want to do this the right way, and it’s very difficult in this space to even know what the right way is. We have spent 10 times more in legal costs to set up and operate our entity than if we had just launched a venture fund, right? Because a venture fund, everybody understands what the structure looks like and what the documents need to look like, but in this world, you are constantly interfacing with lawyers, trying to figure out, as the world evolves, how to stay compliant and be doing things correctly and it’s a waste of money because we’re doing that, other funds are doing that, all the centralized lending platforms doing that, the OTC counterparties are doing that.

We’re all spending money on the same set of lawyers trying to answer the same questions, as as a function of the opaque regulatory environment. It’s a shame. One thing that would be nice to have is a centralized, regulatory agency that was able to answer a lot of these questions, and it’s becoming better. It’s definitely better than it was in 2018, but there’s still a lot of challenges.

Samuel: Is this a problem that’s specific to operating within the United States, or would you be having these issues if you had set up offshore?

Jesse: Both. I mean, we have some unique issues because we’re in Washington state. There is the DFI, the regulatory agency that oversees investor protection. If we had set up our investment management company offshore, the DFI still has jurisdiction because we’re physically here.  We were working very hard with the DFI to do this all correctly, so that’s a challenge. If we had been offshore entirely, I think that that may have made it an easier issue, but it’s still like they’re still questioning. It’s regulatory endeavours like there, it’s not particularly clear how they’re set up, where you look at what, what a BitMex has been doing. There’s no simple answer to all of this, right? Everybody is kind of trying to write the book as they build their business. It’s a waste of time. It’s a waste of capital in my eyes. By far and large, most of the market participants in this space have the desire to do this correctly. There’s not a clear, correct way to do most of this, so you have to figure it out as you go.

Samuel: I think you’re probably right on the infrastructure and then also the liquidity aspects that kind of prevent a lot of larger institutional clients from coming in as well too. I know that the recent events of March, was it already March when the dip occurred?  In March, right when we went to almost zero because of one exchange, that is a scary thought process, right? That one single derivative exchange could potentially drive the price of BTC to, you know, double figures if they had been able to if they haven’t if they didn’t kill the exchange like they literally had to shut the exchange off to stop the price from falling.

Jesse: It’s the pros and cons of this giant distributed liquidity pools, right? I talked about at the beginning, one of the things that really was fascinating and curious to me about this space, despite all of those different liquidity pools, sort of March 12th really called out the reality that there are subsets of those pools or subsets of those providers that really have an oversized impact on everything that we all do.

Samuel: I was always of the belief that the CME futures with somehow settle things down. But after the events of March, I’m really not even sure that they matter. You now have a few derivatives exchanges where the outside leverage allows people to push price the way that they want to farther than they normally would on a traditional stock exchange or anywhere else.

Jesse: Right, and you hear a lot of calls for things like circuit breakers in the aftermath of that event. When you think about the reality of having these distributed exchanges, like circuit breakers arguably work to some extent because they’re on a single exchange, you’re able to stop those assets sitting in that exchange.

When you have Bitcoin trading across hundreds of exchanges globally, circuit breaking on one doesn’t necessarily stop a cascading effect. March 12th, I think it was largely driven by liquidations being pushed on Bitmex so being able to pause those, which is exactly what they did by turning the exchange off, obviously helps the situation pretty dramatically. But if that’s sort of the solution going forward for this type of situation, I think it’s to be determined.

Samuel: It may not even be the best solution, right? Because you could just move from one during this exchange to another and you know, take advantage of that because there are no centralized liquidity pools. It means that the liquidity is fractured and you’re able to push the price around in these, either with spot or with the derivatives, exchange a lot easier than you normally would be if there was some sort of central liquidity pool.

Jesse: I think it’s the broader interesting question to me is, is it fiscally responsible or appropriate for these exchanges to be offering 50x to 100x leverage for traders? And what ramifications does that have on the industry more broadly going forward? Would it make more sense to have, some of that, reigned in? But other people would argue that it’s that kind of leverage that makes the industry so interesting. The powerful piece here is that nobody can set these roles across the entire industry.

Samuel: I mean, look at the FX markets, right? That’s the closest analogy to what’s going on in the crypto markets. With FX, you can get up to what, like 2000% on your collateral. Yeah and it’s not really a problem, but then again the FX markets are like a $6 trillion a day market.

Jesse: There is liquidity.

Samuel: In the BTC markets, if you have 5,000 BTC, you can move the price a lot. That’s a small amount. I think that what did they say March 12th collapse was caused by someone who had like a hundred thousand BTC, I think it was. It was, or maybe 80,000,

Jesse: It sounds definitely like a number that it could be used to move these markets around.

Samuel: They took it, what, 80% down or 70% down in a couple of days. It’s ridiculous. I think it highlights the lack of liquidity and for as many exchanges have come online, and for all the different products that you have across all the different markets, there still is not the liquidity there that would allow for this type of product to grow into the global instrument that people use with a high degree of trust.

Jesse: Right.

Samuel: Yeah. So, but again, these are just my opinions.

Jesse: Yeah. I think you’re spot on. I mean, it’s an interesting question. There’s always liquidity. It is how deep is it? You’re highlighting that exactly in the way that is materially important that the equity that exists in these markets is predominantly provided by market makers in this space and not necessarily by sort of new market participants. You go back to this is halving talk like much of the industry believes that halving is going to have a significant impact on price and the reality is it that we need new market participants putting new capital to work in the space to have a significant impact on price.

Whether or not the halving helps create that as a function of a narrative that people can believe in, I think is to be determined. It’s not sort of this magical event that changes the existing market dynamics and the existing participation by new capital.

Samuel: Yeah. The longer that I am in the industry, the more that I see that people don’t really have a good understanding of how their economic and monetary system works, especially the monetary system when you’re talking about different lending between banks and how the Eurodollar system works and how it applies to crypto especially, is something that I think is really lacking.

And that kind of gets lost when, when you have all these monetary actions by the Fed, people look at theirs $6 trillion of increase in their balance sheet, and they just think that that somehow is going to get directly transferred into PTC somehow when really the Fed is using that, they’re that balance sheet transfer to be able to affect the yield curve and not, and they’re not distributing money to people.

They’re affecting the yield curve and also lending to tier-one banks as well. The tier one banks can go out and learn, but it’s just mind-boggling to me about some of the two in points people come to.

Jesse: Narratives are powerful, particularly in an industry where everything is speculative and if you can get enough people bought into your narrative that it can manifest itself into reality. That’s the fascinating part for us and a big thesis in how we’ve approached these markets.

Samuel: That’s a really good thesis actually. That if you think it’ll happen, it’ll happen.

Jesse: Right? Yeah. If enough people think it will happen, it can happen, and it’s an interesting observation.

Samuel: That’s probably a great point to probably wrap upon. Is there anything else that we missed or that you want to talk about Strix?

Jesse: Absolutely. I may briefly go over it. We’re quantitative. A hedge fund trades cryptocurrencies algorithmically. Yeah. You can find more about [email protected]. Our big belief is that there is a better way to invest in this space than buying holds, and that being the leading transparent, compliant provider approaching it that way has been an important differentiator for us.

We’ve recently launched an investor portal that allows our investors to gain access and visibility into performance and documents and market news. I think that sets us apart. We are a hedge fund, so applicable to qualified purchasers, so always happy to speak with qualified purchasers who would be interested in learning more.