David Fauchier - Market Neutral Crypto
David Fauchier stops by The Business Brew to discuss crypto and market neutral strategies in crypto assets. David works at Nickel Digital Asset Management, an investment manager connecting traditional finance with the digital assets market. The firm deploys highly sophisticated low-latency algorithmic trading, pursuing a range of arbitrage strategies in both spot and derivative markets, as well as a range of directional buy-and-hold products. All funds are designed with institutional clients in mind, but we hope the discussion is broadly applicable.
You can reach David at @dfauchier on Twitter.
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+ Transcript
Bill: Ladies and gentlemen, welcome to The Business Brew. I'm your host, Bill Brewster...This episode features David Fauchier. David joined to discuss market neutral strategies in crypto-assets in laypersons terms, that means David trades crypto-assets and quickly sells off the directional risk that he takes in a trade. I find his strategy to be very fascinating and encourage any informed listeners to reach out to discuss the risks that they may see in the strategy because I do find this to be pretty interesting stuff. As part of the sponsorship, we're going to try to drop insights into the shows. David and I discussed Coinbase in this show and Streams library helped me understand that Coinbase is one of the companies that really values doing things by the book. They work with regulators, sometimes to Coinbase's dismay, and they've been described as a bit more cautious, a bit slower in their business dealings, and you can really see that in the crypto-assets they list and so on.
It appears as though they lean on trust to market their offerings to retail traders, who then pay substantially higher fees to trade on Coinbase in exchange for some of that AML KYC security and some security in knowing that the crypto-assets that are listed are high quality. If you're interested in doing more research on Coinbase, please sign up for Stream by Mosaic at streamrg.com. That's S-T-R-E-A-M-R-G dotcom where you can sign up for a 14-day trial and get a more robust understanding of Coinbase or any other company you're interested in. Tell them I sent you. It means a lot to me to drive some traffic to them. So, if you would do me that favor that would be awesome. As always, none of this is financial advice. All of the information contained in this program is for entertainment purposes only. Please consult your financial advisor before making investment decisions and do your own due diligence. Thrilled to be joined by David Fauchier. Is that right?
David: Yeah.
Bill: Is it or is it, Fauchier?
David: It's close enough. Fauchier, Fauchier.
Bill: Okay. Well, It's important, man.
David: Anyway, you like.
Bill: I don't want to be some dumb American like, "Oh, Fauchier." That's not what I'm going for here.
David: I don’t know.
Bill: All right. Anyway, as far as the ad-libbing, yes, I always ad lib. It makes some people nervous. It makes me nervous sometimes but more often than not it works.
David: That seems to be such a mix. Some people will do like to prep calls and send you like a five-page document of like, "This is what we're going to talk through." Sometimes, it's like, "Yeah, just join and treat the shit."
Bill: Yeah, I mean, look, I think that the downside is that, sometimes, the conversation will hit a little bit of a lull and it'll cause like-- I'll have to say, "So what do you want to talk about next?" and then occasionally, I have to edit that portion of the conversation out. But I don't know, man. I just think that, I'm just trying to talk to people and having a detailed, organized plan. I always feel gets in the way of having the conversation that I want to have. Basically, what I'm going to do today is I'm going to ask you some questions and I'm just going to let you talk.
David: Sounds good.
Bill: All right. Well, the first question, sir, is, you want to tell people a little bit about what you do and your strategy?
David: Yeah, sure. I work at a firm called Nickel based in London, and it's a crypto focused asset manager. Everything we do is in the crypto space. I run a fund for them, which is a multi-managers that we allocate-- or I allocate to managers across the crypto space who are doing something market neutral. So, typically, the easy examples of that is like arbitrage, but it's also market making relative value, statistical arb, long, short, all of the different kind of market neutral, beta neutral strategies you can think of from the traditional space, but applied in the crypto space. Previous to that, I run a fund of funds also in the crypto space, also focused on market neutral called Cambrial and before that worked in FinTech with kind of one foot in crypto since 2013 or so.
Bill: I guess, I have a couple questions. One, people that I talk to will say, "Well, you can't even value anything in crypto. So, how can you possibly have a relative value strategy?" Why don't we attack that first thing first?
David: Cool. There are statistical relationships between two different, let's call them coins, which you can look at, and which could be more or less robust over time. That would be kind of one way as just a purely relative-- statistical relative way. That's what we do. Everything we do is pretty much statistically or statistical based, or with a deterministic arbitrage that you can explain. So, like Bitcoin is selling at two different prices on two different exchanges. You buy it cheap, you sell it expensive. We do it with pretty-- I have my own personal views on crypto and everyone kind of does at the firm, but in terms of what we're doing professionally, we don't really have a view. This just happens to be in a liquid market with some very unique microstructures to it, which mean that prices of related assets across the space can move around a lot and dislocate and when they do that's effectively an arbitrage opportunity. That's pretty much where the professional thesis stops in that respect. There is an arb, you can exploit it, the market is liquid, it allows you to do it in size, and so you do do it.
Then how do you value these assets? I would push back. I think that does-- crypto is software and people are experimenting with hundreds and hundreds and hundreds of different models here, and 99% of them are junk, and on the 1% that remains, there are some really interesting ways in which the token can genuinely accrue a value and different valuation models you can apply to that. For some of these like ADCF is absolutely the right way to think about it. That literally kicking off dollar cash flows.
Bill: Do you mind telling me, this is separating your professional view from your personal view, but in your personal view, and the conversation that we had previously, you were telling me about how you got interested in crypto and do you mind going back to 2013, what you saw, and maybe doing a little bit of a timeline of the iterations of technology that you were watching and what got you more and more interested in pursuing the space?
David: Yeah. I came at crypto-- Someone sent me the white paper of Bitcoin in 2012. Bitcoin was pretty much what was around at the time. I thought it was very interesting and I came at it very much from-- I'm a history major. So, it came out from an economic-history background. I think crypto has kicked off this discussion a lot, but a few years ago, people have this sense that monetary regimes are somehow permanent, and history tells us otherwise, like, they tend to last 30 to hundred years, but never more. We can go back to the 70s for the last iteration of what we have today. It always felt to me relatively precarious, monetary regimes do shift and change and there doesn't seem to be any appreciation for that, at least, until in the last couple years and COVID kicked off a lot of those discussions.
I thought Bitcoin was interesting because from a purely monetary perspective, here is an asset which is just as hard or harder than gold in the sense that it's finite, and it's calculatably finite. We don't know how much gold there is on earth or in the universe, but we know that there's 21 million Bitcoin and that can't be changed. It was an interesting thought experiment that to say, "Well, is provable scarcity enough for value." It does not have any value in itself.
Secondly, what was very interesting to me was the concept of money over the internet is a very old problem that people have been trying to solve since the internet began. If you look at the specs for HTTP, what powers webpage delivery, for example. If you hit a link, and the link is broken, you'll get like a 404 or something like those, you get page not found error, and all of these errors have codes, and all of these codes are specified by the World Wide Web foundation, and you can look at the spec and there have been error codes and success codes for payments since the internet began.
An internet native currency has been a really old idea that people tried and failed to do until Bitcoin came out in 2010. So, it just like as an academic exercise, it was already very interesting. Then it's solved some long-standing computer networks problems. One of these is like, how do you have a decentralized database that you can trust and then secure that database, and this is sort of your blockchain, and your mining, and your proof of work, and how do you solve a long-standing networking problem called the Byzantine Generals Problem. If a change is made, how can you gossip that change across the network where everyone can see that the correct change has been made and validate that this was an authentic change? I just thought like from a computer networks perspective it was interesting.
Bill: If you can't validate the change, is what you're running from the idea of like a network becomes like Wikipedia where anyone can go in there and change it? Like you don't know how valid it is and what needed to be changed was like-
David: Wikipedia is a great [crosstalk]
Bill: -making sure that it was a valid change?
David: I know I'm simplifying here, but anyone could go on Wikipedia and change something. Sure, there are reviewers and stuff, but they don't catch it all the time. So, if you're going to read something on Wikipedia, you don't know it to be true. The neat thing about the Bitcoin blockchain is that changes kind of commit to that because of the cryptography that's used, it's so incredibly hard that it's basically impossible to go back and change what was done. So, you have the sequential statements of facts. In the Bitcoin blockchain, the statements of facts are A sent money to B, B sent some money to C. It's just like a sequence of transactions that are logged and stored and it's really, really, really, really hard to go back and change that history or one of the previous blocks. That allows for a couple of things.
One of them is, decentralized money, because centralized money doesn't work from a network security perspective, and the second was tied to this, which is like suddenly digital scarcity was possible. That as an architectural feature in the digital world rather than the physical world is surely just like an interesting concept to be able to play around with. That was the starting point for me was, Bitcoin is completely crazy. The idea that we can have this global decentralized money that's going to replace the dollar, I never really believed in that, but as an alternative to gold, yeah, that's kind of interesting when you think about it. What are the properties that make gold attractive and could those be replicated or ported over into Bitcoin? There was really small outside chance, I think in 2012, that that might be the case and the price reflected that asymmetry.
Then from a purely computer science perspective, it was just a really interesting new architecture. It felt to me that if you took that architecture and generalized it, you could solve a lot of the problems on the internet that we have today. That general network architecture was a really interesting one because it would allow you to effectively coordinate work at scale in a decentralized way. And that's something that wasn't really possible. I'm 32, I grew up with-- there was Napster, and Kazaa, and BitTorrent, and all of these kinds of decentralized protocols. There was the open-source movement. There's been a lot of different jigsaw pieces coming together I think into what we have today. This really felt like the combination of all of those.
Bill: Something that you said, you said that a centralized-- I think you said a centralized money wouldn't work on the internet. Is that what you actually said or is that what I heard?
David: No. That's what I said. Centralized money means that there's one database somewhere where everyone's balance is being stored.
Bill: Okay. The reason that doesn't work is, it's highly susceptible to something like a hacker or something?
David: Susceptible to a hacker. And by nature, you need to trust the counterparty-
Bill: Okay.
David: -the person who maintains that server. That's why, when it's a government, that's great, because you can trust the government. But creating a private money over the internet had never been possible.
Bill: Okay.
David: Because you always have to trust them. There were attempts at this like DigiCash created by a guy called Adam Back. But it just didn't really work because you had to trust a guy with a server at the end of the day.
Bill: That makes sense to me. Okay, so, you get interested in this in 2013 and what have you seen go on in the crypto market that has gotten you comfortable with really focusing your career there? Because I think a lot of people and I think a fair amount of my listeners would say, "Well, this is a solution looking for a problem to solve as opposed to something that's really necessary," and there's somebody who's in crypto.
David: Yep.
Bill: Yeah.
David: Before crypto, I was a product manager. I built product for a living and the number one thing that gets beaten into you is, don't build something and then go look for a customer. First start with the problem and then solve it using technology. An interesting feature in crypto is, we had no product managers for a really long time in our space. You had hardcore technologists that came up with something really interesting from a technical perspective, which had very little kind of a real-world use case, and no traction, and they've pushed it out to the world, and over time these things basically didn't work out.
What got me comfortable with moving into this space full time, 2013, I feel this a super interesting, but this is an evenings and weekend thing. If I'm wrong, I'm wrong. It's not like I've put my life into those. But if I'm right then this is going to be an entire industry at some point and that will be a time over the next sort of 20- to 30-year horizon, where I'll be able to move into the space full time. I ducked out of the crypto space in 2014 and 2015, because at least at the surface, there was very little going on. People had been experimenting Bitcoin, but really it just seemed like it was digital cash, and because it was so volatile, it's just not a very good cash, and not much was happening from the technology perspective. Then, out of nowhere for me, and it was my fault for missing it, but in 2016, Ethereum came out.
Ethereum, which is today the second largest crypto in the space has really taken the concept of Bitcoin and generalized it and was sort of exactly what I'd been looking for as a trigger. It was a trigger for the entire space to really develop. It basically abstracted away a lot of the complexity around building a new "cryptocurrency" or using cryptocurrencies for real-world purposes. In that, it provided what we call now like a layer one blockchain on which you can build your own protocols, or networks, or products, or everything like that. That's what really fueled the 2017 boom, is that suddenly we went from one narrative and one product, which was basically Bitcoin and cash/gold to Ethereum coming and making it so much easier for people to build on top of it, sort of like an operating system for crypto.
Suddenly, you had thousand new coins, and a thousand new narratives, and a thousand new ideas being tried out. It just attracted a ton of capital to the space, caused this huge bubble, a lot of stuff got funded, the bubble popped, and a lot of that stuff went to zero. But what was left behind was still, if it was 1% of what got funded, it was still 10 or hundred times bigger in terms of product actually being built, brainpower, or raw IQ points in the space and funding. The back end of that bubble. It was a very productive bubble and we ended up with a crypto ecosystem that was one or two orders of magnitude larger than 2016. The story, I think of 2020, 2021, the bubble that we've seen has been all of those projects in 2017 that got funded, 99% of them went away, 1% of them were well funded because there was so much venture capital raised during that time.
That the venture funds had capital to fund all of these projects for the bear market that lasted like three years. And those projects are now coming alive or have been coming live over the past year or so, that are really building like fundamental blocks that you can think of in order to deliver at scale, crypto like products effectively. A lot of the excitement over the past 18 months has been driven by this stuff actually coming alive.
Bill: Yeah. Okay, so, just to take a step back again. You said that Ethereum generalized Bitcoin in a way, right? Isn't that how you term that?
David: Yeah.
Bill: Okay. What you're referring to when you say that is you're referring to the fact that Ethereum provided a common language. I'm probably just repeating what you said. I just want to make sure we're on the same page. It basically gave a base layer that people could build upon using the same ideas that Bitcoin was using from a theoretical perspective of how to approach problems. Is that a fair characterization of what was going on?
David: Yeah. I'll try and make it a little bit more tangible. You can think of Bitcoin as two blocks that were put together. The first is this decentralized secure storage layer, where there's no single person controlling the Bitcoin blockchain, and it can just be updated in a secure fashion over time. The second is like what you can store in that secure database. Bitcoin has the security and decentralization piece down super well. But in terms of what you can actually store in this database, you can only really store Bitcoin transfers. A sent money to B.
Bill: Okay.
David: Okay?
Bill: Okay.
David: For me, the promise with Bitcoin was someone who would take Bitcoin and keep that architecture and that security and decentralization, but make it so that you could store anything you like in the database and when you have a database, AWS is a database, a computer is a database. You can also run programs on a database. So, it's not just storing static information, but it's actually running a program. What Ethereum did is, it copied the Bitcoin architecture and provided that same decentralized secure database, but it allowed you to do more interesting things inside of the database. So, instead of just storing transfers from person A to person B, you can store arbitrary numbers and letters effectively.
If you think about Bitcoin, you're just storing ones and zeros at the end of the day. Here, you're storing ones and zeros, but in a more extensible and generalizable way where you can store balances, but you can also store like a computer program. You can store whatever you want. The technical term for that is something which is Turing complete. The language in which the EVM, the Ethereum Virtual Machine is written and the way in which that database is structured allows you to run computer programs like you would on an operating system. So, Bitcoin is like a paper ledger where you're doing your accounting ledger, money moves from A to B and Ethereum is like a computer operating system that you can run programs on.
The way in which Ethereum solved abstracted problems for one of these other startups and new coins that launched on top of it is that, it said, "We've got the decentralization and the security piece down, you can just write your programs on top of this, and run them on top of Ethereum, and not have to worry about the operating system layer." That made it infinitely easier for someone to just come in and build a product that sat on top of Ethereum, and benefited from the scale and security of the Ethereum lab, and then built something on top sort of like a program runs on Windows.
Bill: Makes sense and then Ethereum in order-- So, let's say, hypothetically, I own, what is it? Is it an ether or a coin of Ethereum or an Ethereum coin? How am I supposed to tip it like actually refer to this?
David: Some Ether or--
Bill: Okay. So, I own some Ether, and then my Ether, that accumulates value by charging [unintelligible [00:21:49], right or am I wrong? Is that totally wrong? Sorry, if I'm an idiot here. I'm just trying to get the basics.
David: I'm trying get people to-- No, you are totally right, but I try to flip it around a little bit. People always focus on the token first, and I try and get people to flip it, and think of like, what's interesting and important is the service that's being delivered by this product, and then, you are trying to figure out like-- [crosstalk]
Bill: Yeah. Well, it's a theoretically an operating system, right?
David: Yeah.
Bill: Right.
David: Product, it's an equivalent to AWS or cloud computer. AWS, or Google Cloud, they buy servers, they put them in server farms, they run the server farms, and you can go and run your programs on their cloud. The Ethereum is basically the same thing, except that instead of that being one company like the Ethereum Corporation, that goes out and buys servers, and installs them, and lets you run their programs on them. It's going to the rest of the world in saying, "Hey, you've got a really fast M1 chip on your iPhone 13, and right now that phone is not being used, and you have latent capacity on that chip.
People want to run computations, and they don't care where those computations run. So, why don't you rent your computation power on your phone to some other guy? Ethereum is like a marketplace for computation. It sits in the middle and it connects the demand for computation with the supply for computation. So, I can run an Ethereum miner off my phone, and what that means is random people are going to send me computations to run and I'm going to run those computations and send the result back to them and I'll get paid. That's the Ethereum product and what it does.
Now as part of that, as part of the security for it, there is a token, which is Ether. The value I would say of Ether with the way in which you value it, it is pretty unclear because Ethereum, everything except for Bitcoin is like a car that's driving down the motorway and is being upgraded or fixed as it goes. It's sort of like a startup. It starts with a product, the product is imperfect, but they keep tweaking it and making it better. The piece around what is this token actually going to look like and how does it accrue value, if any, is sort of still up in the out. So, there are certain-- I think, like Bitcoin, and maybe we can talk about Filecoin, there are certain coins where there's a very clear valuation bond that you can point to. With Ether, it's not clear. The bet that you're making is, it's going to be the dominant next computation platform or next big cloud in the world and it's massively scalable, and that's probably worth a lot and who knows how much.
That's very much sort of like a venture type valuation, pretty much. So, it's incredibly nonspecific, but it's very directional. When something is worth a few $100 million bucks, and you think it could be worth a trillion, it doesn't matter if you're off by an order of magnitude. I'd say when the price is where it is today, it becomes a lot more relevant and I don’t have a really good answer for you.
Bill: Yeah.
David: The way in which a Ethereum is used is, if you want to run a computation in the Ethereum ecosystem, you need to pay for it using Ether, the token. That's like a fairground ride. If you want to go on that particular ride, you got to buy the token for the ride, you go on the ride, you pay with the token, and then you walk out, and you buy McDonald's in normal cash. So, we call that a utility token. [crosstalk]
Bill: What if I don't want to go on the ride? No, I'm kidding. You just don't buy it.
David: Yes-- [crosstalk]
Bill: I think, it's interesting, right? Because-- [crosstalk] Yeah. When I pick up the Twitter machine or whatever, and I see Dogecoin, and SHIB, and all this stuff, is this on top of Ethereum or is this other project going on a different code base for lack of a better term?
David: Different blockchain. I know that Dogecoin is. I've never looked at Shiba, I don't know. But I would say 90% of the coins out there are sitting on top of Ethereum as a guess.
Bill: Yeah. So, I think this is probably true in the 90s. I think it's true of any probably a new trend that gets a lot of hot money and like you referred to it as a bubble earlier. So, I don't think I'm going out on a limb and saying that there's a lot of shoddy stuff going on within the space. What do you tell people that have like a highly skeptical--? You mentioned Filecoin for instance, so what about Filecoin makes that project unique versus something like DOGE or Shiba or whatever else? You know that's the question. How do you decipher real from garbage?
David: I think crypto gets a little bit of an unfair beating on this because people have crappy ideas with startups all the time. This is like in the tech space, people set up crappy funds all the time, people set up crappy restaurants, a lot of businesses start and fail. I don't know that the failure rate in crypto is any higher than the rest of the world but it's a lot more public and it gets a lot more press attention. So yeah, just like everything else 99% of stuff in the crypto space is garbage. How do you differentiate a good project from a bad project? There's a lot of low hanging fruit here. The lowest hanging fruit is, when someone copy pastes something else, and puts a picture of a dog on it, and says that this is explicitly a joke, and then walks away from the project, and does nothing for years with it, that's probably not going to be worth much. And DOGE is sort of-- [crosstalk]
Bill: It turns out that you should probably buy it.
David: [laughs] Totally wrong. But in terms of fundamental value, I don't know what-- DOGE is a meme. It's fun and playful and everything else you could say about it. It's completely useless effectively. It's never going to do nothing except just go up and down in price. That's the really low hanging fruit and that's gone up for reasons I don't know I don't understand. The other extreme is you have incredibly smart technologists who are trying to build solutions in a way which makes sense. They have a clear problem that they're attacking and they're using crypto in logical ways as a reason why they should use a blockchain to solve this problem. Typically, a well-funded by crypto venture funds who really know what they're doing, these are like ticks that can give you an indication that this is probably not like an outright fraud. You can go and look because a lot of the work happens open source, you can see the stuff being built publicly in real time. You can just go to the website, and go to their GitHub repositories and you can see the code base.
If you're technical in any way, you can see for yourself, what's crap and what's not and what might be interesting. You can read the research papers that are publishing, etc., etc. So, it's very technical, it's a very deep dive, but no more so than biotech. There're tons of crap in the biotech space as well.
Bill: Yeah.
David: What's unfortunate about crypto is that everybody in finance feels entitled to a view here. I've never seen such strong, entrenched, and emotional responses to something where the proponent of those views has spent so little time actually trying to understand what it is. It's a very funny thing. I don't understand it, but people have very strong opinions about crypto even if they've never actually tried to understand what it is. It's pretty complicated technology. If you don't know how a computer works or how the internet works, how can you possibly-- if you don't know what a protocol is, how can you possibly have a view on a cryptocurrency, which is by definition a protocol but people do. So, there's also a lot of really interesting good stuff out there, but you need a modicum of qualification to try and pick out the good from the bad. That gets you in, let's say the 1% of crypto projects, and then you're like in a Bonafede venture landscape. But venture like it used to be. Venture wasn't always about underwriting like Series B SaaS companies who have like a capital LTV ratio of higher than four.
At some 20, 30 years ago, it was actually venture capital underwrote technical risk, which is like, "If this guy can pull off this piece of technology, this could change the world or be very, very valuable in many obvious ways." If you can build a safe fusion reactor in nuclear, that's obviously valuable. If you can build a rocket that can launch in open space and land itself, that's obviously useful and same with crypto. If you can build a decentralized identity protocol, that's mathematically and provably true, that's useful. If you can-- I don't want to get into the weeds, but there're a few different things, which are clear problems with the internet today, which if you could solve it clearly be of some value.
Bill: I kind of do want to get into the weeds. What's one of these things that you're thinking about?
David: One area of intense research over the past few years is narrow called zero-knowledge proofs, and this is like PhD math stuff. So, I can give you some examples, but I can't go all the way down. Concept of zero-knowledge proof has been around for a very long time. But it's been devilishly hard to do at scale because it was very computationally intensive to run, running one of these proofs, which I'll explain in a second would take a hundred hours and 50 computers or something. So, they were never very useful. But the concept is, how can I prove something to you without ever showing you the proof? So, for example, if you're a bank or a lender, how can I prove to you that I'm solvent without ever showing you my bank accounts or my balance sheet or how can I prove to you that I'm David without you physically inspecting my passport, for example? That would be an example of a zero-knowledge proof.
Bill: Yeah.
David: People have come up with some interesting ways of doing this with providing a cryptographic proof that something is true without ever showing the working behind it. So, one interesting example of a zero-knowledge proof conceptually would be, we're both standing on a beach and I tell you, "Hey, Bill, I know how many grains of sand are on this entire beach" and there are billions of grains of sand and you said, "Well, that's preposterous." I'd say, okay, and I'm going to turn around, and I'm going to tell you to scoop up a handful of sand and count how many grains you have in your hand. When you've done that, I'll turn around and I will recount grains of sand on the beach. I'll tell you the difference between the two. You say, "Well, Jesus, how the hell did he guess that I had 752 grains of sand in my hand?" So, you do it again and you say, okay, turn around again and you pick up another handful of sand, you count the grains, you get me to recount how many grains of sand are on the beach, and I'll tell you the difference between the two values again. This time, it was 1,272 grains. If you do that five times or 10 times or 1000 times, you know with basic statistical certainty that somehow I know how many grains of sand are on this beach and I can recount that. If we do that exercise, if you can-- [crosstalk]
Bill: Because if you can tell the difference.
David: Exactly.
Bill: Yes, consistently, then there's a reasonable argument to be made that you know the total amount anyway.
David: Exactly and so that's an example of zero-knowledge proof. I have proven to you that I know how many grains of sand are on the beach without ever telling you how many grains of sand were on the beach.
Bill: Okay.
David: If you take that sort of concept and now you apply it to underwriting, or banks, or identity, or anything like this, suddenly you can prove stuff to people without them needing to verify that proof. They can just accept this little piece of cryptography, which is like a string of numbers and letters, which looks completely meaningless, and that proves beyond reasonable doubt that what you're saying is true. That as a mathematical problem is decades old and was really kick started in the past couple of years by crypto and cryptocurrency. It attracted all of this compliment of the space and suddenly that was 100 or 1000 times the amount of dollars available from research into zero-knowledge proofs because suddenly, zero-knowledge proofs are a really important piece of making crypto better.
One of these is scaling and so people always look at Bitcoin and Ethereum and say, "Well, it's completely ridiculous, like you could only do seven transactions per second. This thing is completely useless." Well, there's a lot of smart people in the space and presumably [unintelligible [00:35:00] that they've also come across this problem and thought about it. If they're still hanging around, it's probably because they think that there's a reasonable solution to this. One of the scaling solutions involves zero-knowledge proofs. When I was talking about stuff that was funded in 2016-2017 that's going live today, specifically, what's known as layer 2s will use often be using zero-knowledge proofs in order to scale Ethereum, for example. So, instead of the way-- if you're in [unintelligible [00:35:29] is you submit a "transaction," what that transaction is, is basically a piece of code that you're asking someone to write and that's a computation.
A computation has an input and an output. You send it to the Ethereum network, everybody has to run the same computation, and then if all of the outputs match, then it's like, "Okay, this is definitely the correct output, the computation has been run, and everyone gets paid." It's just really inefficient because suddenly a 1000 people have to run the same computation and this is why Ethereum is slow. Instead of that, I could say, "Hey, everyone, submit your transactions to me. I'm going to run them on my machine and I'm going to post the output of those computations and my zero-knowledge proof, which states with certainty that I did in fact run those computations, and that the output that I'm sending you is correct," and that's it and so, you can look up if anyone's interesting like optimism, and roll ups, and zero-knowledge proofs, and scaling, just Google that basically companies have come up or cryptocurrencies have come said, "You can just submit the transactions to me or run a zero-knowledge proof on them, and then I'll post them to Ethereum." Suddenly, you can run an arbitrary number of transactions, because I can take you a million transactions, roll them all up into one bundle, provide one output and one proof and submit that to Ethereum.
Bill: Hmm, interesting.
David: That's super interesting. That's one of many different ways that people are trying to scale these crypto networks.
Bill: Huh? So, with the zero-knowledge proofs it seems to me that one use case at least could be that rather than having the entire network run one proof, now you can outsource it maybe to a lot of different nodes who can run zero-knowledge proofs, and it can speed up the amount of transactions that can occur per second or to your point, maybe there's a couple big bundlers that can do it really fast. But basically, a potential outcome is that you speed up the amount of proofs that you can run, right, which is a key hiccup as of today to the technology.
David: Yeah, the network can run more computation. It's the equivalent of scaling up the size of AWS. But computing platform just gets bigger and more powerful and in doing so a computation is cheaper to run.
Bill: Okay and something that you had also talked to me about in the past was that the concept of trying to build an internet like Web 3.0 in a manner that almost circumvents these big monopolistic type trends that are inherent to the current Internet maybe, and one thing that I was unable to contemplate is won't you always need AWS as servers, but it sounds as though what you're describing to me is each node creates the compute and the aggregate amount of cell phones and computers out there in a potentially ideal world can circumvent the big server farms that we need. Is that fair or no? Do they probably need to be connected to the servers somehow?
David: Yeah. Ethereum and Filecoin is sort of Ethereum for file storage. So, you can think of Dropbox and AWS as the equivalents here. We think of the cloud as being like all of our data and requests for stuff go up into the Ether, and just get processed and come back down to us. But in reality, you're just communicating with the nearest AWS on the phone, which is a couple of miles down the road. Ethereum is trying to bring it back to what the cloud was originally envisaged as being, which is literally in the Ether spread across billions of devices across the world. All of this latent computing power and storage power on everybody's phones, and PCs, and fridges, and cars, whatever you want, all of those should be operating at full capacity, and today they're not. If we could access all of that and we could have a neutral middleman, which is not a company or a government, but is basically like a protocol which is effectively like math and software that's open source is completely neutral and verifiable in the same way as the internet is, it's also permissionless like the internet, you don't need to ask for anyone's permission to go on the internet or to send an email, you just can. That's something that all computer protocols generally are or at least open ones are.
Ethereum is an open computing platform for the world that runs on every-- or could if this works, will be running just on everyone's devices everywhere. That's the grand vision of Ethereum. When we think of Web 3.0, which is like the next evolution of the Internet, we basically went from whatever we call Web 1.0, which was a very static internet, you had files that were stored somewhere and you could go and retrieve those files, you could go and retrieve a webpage from-- a static webpage from a server. The equivalent today would be loading up a Wikipedia page. The page basically never changes, and you go and you retrieve it, and that was the early internet or like I send a file to you, Bill.
Then the second stage was more interactive. So, this is like Twitter. I can go and I can not only consume a Twitter feed, but I can like something or retweet something, and I can hail in Uber, and I can see the Uber driver moving on the map in real time. This is a much more kind of interactive, streaming Netflix or recording and streaming this podcast, what's kind of Web 2.0. What happened in the history of the internet is that it started out extremely idealistic people who wanted to free information and make information free to everyone, etc., etc. What happened is that information got centralized into a few key players basically Fang today, and it turns out that owning the data layer, owning the data is really valuable, and you can monetize on top of it, and you can build network effects around it that solidify your position and aggregate the data to yourself. The data layer was the major kind of choke point in the internet that allowed companies to go and centralize it and then monetize it.
What's interesting in crypto is, if you remember to how I was talking about Bitcoin and then Ethereum, that all of the data is stored in the blockchain, and the blockchain is public, and it's decentralized and freely available and not owned by anyone, and the paradigm shift if it happens like I think it'll happen with Web 3.0 is that people's data will be owned on a blockchain communally and using things like zero-knowledge proofs it will also be private, and then the apps that we think of today, the Facebook's of the world will sit on top of the data and only be able to interact with the data because I give them permission to interact with my data. That say, individual first, privacy first vision of the internet, which is only possible today with blockchains. There is no other way that we know of to enable that. So, that's one of the big promises of Web 3.0 is giving people ownership of that data again.
Bill: So, in that world would Facebook then have to pay the blockchain like a tax in order to use that data and is that where the coin gets its inherent value from?
David: Facebook would have to pay the blockchain for access sort of, but most importantly it might have to pay you for the access.
Bill: Yeah.
David: Right?
Bill: Yeah.
David: In terms of the coin, you can sort of think of-- [crosstalk]
Bill: With the collective view right, and then you got to break it out because my data-
David: Well, like literally.
Bill: -won't probably isn't worth much. But yeah, I'm saying, in order for the data to have any value, you have to be part of a group that opts in giving the data or something like that.
David: But you could tie the monetization of your data back to a price potentially. I don't think the price would be very high but you can think of a firm- [crosstalk]
Bill: This might be depressing. People find out how little they're worth.
David: Well, exactly. You're worth like-
Bill: [laughs]
David: -and if you are in the US maybe you're worth 50 bucks, but people are worth three to 10 bucks a year kind of thing.
Bill: Yeah.
David: I think is ex-US kind of the going rate for someone's data. If you look at how much Facebook is basically able to monetize data--
Bill: Yeah.
David: The concept that I find interesting that I feel is useful for people is, if you think of your phone, you've got a really good processor in there, and you could rent that processor out to people whenever your phone is plugged in and not being used. So, screen is locked, phones plugged in, switch on the renting of my processing power, okay? I have 60 or hundred either-- I've got 128 or 256 gigabytes on my phone, I probably use 50 of them. So, I've got call it 100 gigabytes of free space on my phone, why don't I rent that out as well.
I've got a 40-gigabyte bandwidth with my phone provider that I may or may not use this month. I could rent some of that bandwidth out as well. You start to piece all of these different revenue streams together and maybe rent my data to Facebook or whatever, so they can target ads better. But if you start to piece all of those things together, maybe you have a phone that pays for itself. If you have a phone that pays for itself, maybe you can give high-quality phones with high-speed broadband to the developing world. What use cases does that open up? So, I think with crypto, what's super interesting, I think the first order effects are really interesting, but it's the second order effects that really blow your mind. When that becomes possible-- [crosstalk]
Bill: All right, so blow my mind with some. Let's go down this path. What's one of the real mind shattering conclusions that you came to have where you think the world is almost certainly going to go?
David: One of them is basically, if resource utilization gets better, everyone is going to have high-speed phone with data on it, and it's going to be unlimited, and that probably enables a bunch of things, because there's still actually a lot of people in the world that don't have smartphones. The other one is around debt. If we can make the issuance of debt fully programmatic, and reduce the costs of fraud and administration basically down to zero, what does that open up if you can make micro loans lending 10 bucks profitably? If you can lend 10,000 bucks with cost of administration and underwriting which is near zero, what does that unlock? Inventing new types of, if we look at-- One of the big things that has been built on Ethereum is something called DeFi or Decentralized Finance, where people have been rebuilding financial products in crypto land. That's what is really interesting. That's kind of starting to look like everything you could want from a bank.
But all in crypto, where you basically own all of it. What does that unlock? I don't know. It's all very wishy washy but as we saw with the internet, if you have a paradigm shift in the architecture that can fuel decades of innovation. I think that there has been for years a critical mass of smart people and money in the space such that world-changing stuff is going to come out of this, and if I could bet my [unintelligible [00:47:41] from that, I would. The question is what is going to be life changing out of the thousands of experiments that are basically being run right now and where the value going to accrue in this new stack? In the previous stack, the stack we're in today, the value very obviously accrues at the data layer. If you own the data, you can monetize the hell out of that. It makes for a better user experience, which means users come to you, which means they give you more data, more data makes a better user experience, you have a flywheel, and now you have Google with a 90% market share and such. It's just amazing.
But if the data layer gets made public, the corporate in today's world just gets reduced to an interface. Now, they're just competing on who has the better interface that sits on top of your data. But the experiences that they could give you as a user are equivalent. It's just like, who can build a better UI or user interface on top of the shared data layer? So, that's really interesting. But the question, I'm a big believer in swings and roundabouts and pendulum swinging, both in markets, but also in tech. We go from systems that are open to closed as people figure out the new choke points in an industry. There will be new choke points in crypto, and I think we are going towards like this pendulum has swung from like an extreme of centralization to swinging back towards decentralization, things are going to be very open over the next decades, and direction of travel will be towards openness and decentralization, and then just as quickly as that's happening, suddenly, people will find new choke points. I don't really know what those choke points are going to be. But I'm sure that that's the rough outline of what happens.
Bill: Hmm. Dude, I don't know. I'm obsessed with these silly bored apes that people have on the internet and--
David: [laughs] I don't know. I don’t understand it.
Bill: Well, so, here's a version of the world that I think is honestly more likely to occur than not at this point. Like Zuckerberg's big metaverse announcement or whatever, I've put it on the map, but I really think that there's going to be a part of our lives and probably an increasing part of our lives. That is some blend of virtual reality, augmented reality, and reality as we currently understand it, like in the physical world, and I view it as almost inevitable. I said-- recently, I said, "I'm either going to pay a lot of money for these apes one day or nothing. I don't know what it is. But I'm going to own one of these damn things" like I do baseball cards now. But the reason that I think that it could be a lot is, I think that there's a world where this digital ownership and digital scarcity actually is able to be shown to your eyes as if current scarcity is.
There is a world where there's a virtual Louvre that you can go into, maybe these apes are actually one of these projects that is seminal in the internet becoming ownable or digital scarcity actually being able to be to tangible, I guess, it's not tangible per se, but it's the first manifestation of this idea, or at least a community that I've seen that way. Maybe over time, the person that owns the ape has the right to extract rent from some digital museum that people pay to go into. I think a lot of people right now say, "Well, that's stupid." I'm almost convinced that's where the world is going. I think it's the concept of being able to create digital scarcity is super, super interesting. I think people that are really not thinking about this stuff, because they associate it with Visa and MasterCard already have this solution. So, this is redundant or this is a solution looking for a problem. Therefore, it's got no value. My mind just says yet, right? I think someday there will be value. I just don't know how to articulate what it is and what it will look like. Does that make any sense?
David: I agree with everything you've said. I don't know how much I can add to that.
Bill: I mean, maybe not the apes, right? Maybe that's the wrong example. But I'm saying the movement represents something that is big to me.
David: Yeah. Apes [crosstalk] kitties whatever it is.
Bill: Yeah.
David: One of the things I've learned through painful experiences, when you think something is like stupid and crazy, and then it gets 10 times more stupid and crazy, it's generally not actually stupid and crazy. Beyond a certain point, you're probably missing something and I thought it was-- So, CryptoKitties is at least the first NFT project that I know of. They released a bunch of kitties and they look a lot like bored apes.
Bill: Yeah. I actually remember when those came out.
David: Yeah. I was like, "Well, that's fucking stupid" and that was it. Then CryptoPunks came out and I was like-- "Early 2021, this stuff is really blowing up and by March it had gotten so big that I was like, okay, I've definitely missed something here." This is too big and there's too much money flowing in for something interesting not to come out the backend. I'm going to wait for this to blow up, which will happen in the next couple of months, and then I'll circle back with all of the founders of all of the best projects, and their tokens will be in the dumpster, and no one will want to talk to them anymore. The bear markets are just the perfect time to go and learn about the crypto space, because you have access to everyone. They will talk to you because suddenly no one is talking to them or interested in them.
Bill: No one else will.
David: I said like, "I'll let this blow up and then I'll do my work." I wish I'd done it before. This NFT space just continues to explode in a good way. So, at this point, I'm sitting back and saying, "Something is going to happen here and I don't really get it now, but I'm sure it's how we're going to be doing the research when the whole thing calms down." On a long-time horizon, completely agree with you, and I disagree that we can't call these things tangible. So much of our social and economic lives is already on the internet, not to mention political lives. Is already on the internet and already intangible in a physical or nonphysical way. You can have something that's digitally tangible, I think. More and more of our lives is going to move on to the internet. That's just going to happen. The question is what pace and what is the value accrue? And on the pace, I think, it's a long way off. I actually just ordered an Oculus again, because I bought one a couple of years ago and it was just crap and there was nothing to do on it, and I was super underwhelmed, and so I've bought one again and I'll just like have a play kind of for a weekend and see what can you actually do on this stuff and how good is it.
Bill: You got to get Superhot, the game Superhot is incredible. You got to get the boxing game, Thrill of the Fight, Superhot, and then I haven't watched Oculus TV in a long, long time. I've been on YouTube TV, the VR, but the Oculus TV wasn't set up for a while, and I just never went back. But dude, that thing changed my entire perception of how inevitable this-- what I think is going to happen.
David: That what I've been hoping for. Cool.
Bill: Yeah. Now, you know, is-
David: So, is this bad like you can-- [crosstalk]
Bill: -Zuckerberg the one that wins? I don't know.
David: Yeah. But can you see that this product has so much promise when you're using it and you can actually be like, "Wow, we're actually getting that where this is not crappy."
Bill: I think, it's inevitable. I don't even think it's debatable that we're going to this. Now, what-
David: I'll tell you in brief but is it up now or in 20 years [crosstalk]
Bill: -does it need how many hours do we spend? I don't know. A five, 10?
David: How long does it take for the tech to be mature enough for this actually to be usable is my question?
Bill: Dude, for what?
David: And maybe if already is.
Bill: Well, I think the questions for what. So, I think that we are there where you can already make business presentations over an Oculus and have somebody experience many if not all of the experience. I think you need a very, very competent content team. I know of a company that's trying to do it and I think that they're doing it reasonably well. I think they have a long, long way to go. But this is what I think Zuckerberg is pouring billions of dollars into you talk about the creator economy, why can't you and I be basically looking in a screen right now and it feels like we're in the same room. I don't think we're very far from that. I just don't know that the tools are distributed enough to get there tomorrow. But in the next five years, 100%.
Now is that going to be every business meeting? No. I don't think it will be. But could it be introductory meetings, could it be follow-up meetings, could it be all that stuff? Yeah. I think it's certainty. I don't even know how somebody would take the other side of the argument and also be paying attention to what's going on. I accept that. My confidence interval may be too high.
David: My big question on it is the timing piece. If you're actually going to go and invest, because if you're off by a few years that's [crosstalk] probably.
Bill: Yeah. Well, this is not an investment discussion. This is more of like I truly think the world is going here discussion.
David: Totally, I agree on it. Yeah, I think it's interesting. Looking at like my how-- I've got a 10-year-old godson, and games are social to him. He goes and plays Roblox with his friends and they build games, and him and his friends go and watch other gamers gaming on Twitch. This is something I didn't do as a kid. That's insane.
Bill: To my kids, I was reading. They're into Minecraft and I kind of like it more than Roblox because I think it's a little bit more contained. I also like to kid my buddy, Francisco. He's long Roblox. I like to tell him that he's long child pedophiles, but I digress.
David: [laughs]
Bill: [chuckles] It could be the same on Minecraft for all I know. But I'm reading this children's book to my kids, and the book is about four kids who go to a beach and it's a Minecraft beach, and they're attacked by a monster, and how they feel when it's all going on, and then, they get through this battle on Minecraft, and then the next chapter, that's Chapter 2 or whatever. Chapter 3, they're back at school talking about putting on their VR headset again and going back into Minecraft. It's like once it's in children's books and my-
David: Wow.
Bill: -perception of what Oculus already is, it's going to happen. [crosstalk] It's like, Ready Player One only not that-- Yeah, it's just not dystopian, right? It's not the dystopian world that exists in Ready Player One. Maybe people do their stuff on their Peloton treadmill. Maybe, it's really high class and I think the hardware has to get lighter weight. I already do this shit on Twitter. Spaces is a version of it. It's just there's no vision in the version. It's a group meeting place where people are coming together and speaking. You're just going to layer on visuals to it.
David: Yeah, I guess, bring it back to NFTs, just look at any luxury company and tell me that social proof isn't a real thing. If you're going to spend time in a digital world, you're going to pay for stuff. As crazy as that sounds.
Bill: Mm-hmm. Now, are the current prices inflated-- Are the current prices inflated by people trading their own stuff? Yes. I admit there's a lot of stuff going on and there's probably a lot of fraud and whatever. But fundamentally, the concept makes sense to me.
David: It's not even fraud. It's like someone is releasing a bunch of JPEGs and being like, "Go for it" and then it just gets straight up to the moon.
Bill: [laughs]
David: They are not like fraudulently misrepresenting what this is. That was a big NFT project that, it was like two lines. It was 10 random words. White on a black screen and they just minted these NFTs and you could trade them, and the idea was that like people would take these 10 random words and build a story around them or something. Someone just hit a word generator and make 10 words per black like 100x100 pixel image and just solve them, and they're worth tons of money or they were. It's not fraud. It's just a terrible purchase. [laughs] It's not fraud.
Bill: Yeah. All right. So, let's go back to what you do. Would you trade something like that or would you outsource capital to people that do trade something like that? If so, how do you make sure that you're not getting caught with vaporware at the end of all of it or just sort of worthless [crosstalk] trading sardines?
David: I do a thing that I do professionally as market neutral non-directional. So, we don’t have-- In the types of trading that we do, we don't need to have an underlying view about whether the assets are fundamentally going to change the world or trading sardines. The only thing we really care about is the underlying liquidity. Then it's as simple as when the prices diverge, you can buy it at one price, sell it another, and pocket a spread. So, we trade top 50 assets, and among those are some things that I considered to be completely worthless like Ripple and Dogecoin. But there is a demand for liquidity, for example in Dogecoin. There has been enormous demand for liquidity in Dogecoin in the past few months. They're all swaps and futures linked to Dogecoin. The price of that swap can get way out of whack with the spot price. So, you can buy the spot and sell the future, which is selling at a premium, and then you can just wait for that future to expire and collect the roll on them.
That's a super simple fixed income arbitrate but the spread can be crazy, because suddenly everyone wants to buy Dogecoin with average and the future just goes nuts. You can do the same on Bitcoin and Ethereum and whatever you want. The underlying value of Dogecoin is never a factor in a trading decision like that. It's just, can you get in, and can you get out, and can you not blow up on the way? So, it's very much kind of high frequency trading type of mentality.
Bill: So, one, I think the answer is you close-- I think, high frequency is the answer to some of this but how do you mitigate counterparty risk?
David: You diversify and you try and stay on top of what's happening and come to a reasonable assessment of the risk that you're underwriting and make sure that if you're trading on exchange X, there is a reasonable expectation of profit that's commensurate with the counterparty risk you're taking on.
Bill: Yeah. In your Doge example, for instance, to just make this simple, because I don't know that these conversations get into some places that people need some explaining. So, Doge, you said in one sentence, it could be worth zero, and you also said, you would be willing to be long in some sort of arbitrate. So, what I'm hearing you say is, I go along Doge, I am short the future immediately.
David: Yes.
Bill: So, you're basically lock in your spread. It's the time you're getting paid for the time value of money, right, when the future contract is at expiration, you can exit a position to the buyer of the future, even if the underlying is worth zero, you are owed money on your contract.
David: That's correct. Yeah.
Bill: Or, have I fucked that up? Yeah, okay.
David: No, that's totally correct. You're long with one hand, and you're short with the other. So, you have long one Dogecoin, short one Dogecoin, but the short that you sold is selling at a premium and so at expiry, you're always neutral on Doge, it can go to the moon or it can go to zero, you don't lose anything to the beta of where Doge goes. The one thing you do-do, the only exposure you have at that point is to that spread and to the counterparty risk.
Bill: And the counterparty in that instance is the-
Bill and David: Exchange.
David: Yeah. Exchange counterparty risk is like the largest risk exposure, I think, that you have when you're trading market neutral in crypto.
Bill: Yeah.
David: But I think counterparty risk is generally overpriced from a risk perspective. When you really sit down and think of these exchanges and the contracts that you're trading and stuff, your risk of total capital loss, I think, is much smaller than somebody who doesn't know the space might assume, because you have multiple layers of waterfall between you getting wiped out and something bad happening. So is that interesting for you guys? You can go for like-- [crosstalk]
Bill: Yeah, for me, it is.
David: Yeah, okay.
Bill: Yeah. Let's do it.
David: Take an exchange, it's offshore, it's regulated in the safe shells or some jurisdiction like this. So, basically unregulated. It's not audited. You don't really know much about it, you don't really know who you're facing, and you sort of do, but it's not like facing the CME. So, you say, "Well, Jesus, it's a coin flip." Make or just run away with all of the money. So, you kind of look at that and one of the things you can say as, "Well, what's the trading volume on this exchange?" The exchange tells you what the trading volume is, but of course, you can't trust the exchange. So, you need to come up with your own assessment. If you're trading in size on that exchange, it's very helpful to you because that volume can't really be faked. So, if you can see with your own eyes that the liquidity is really there, you can come up with a reasonable haircut to apply, if you think the exchange is lying to you in terms of volumes. Then you can add up all of that volume and you can look at the trading fees that exchange-- [crosstalk]
Bill: And that's because just real quick. Wait, just real quick, just so that I fully understand what you're saying. If you can get in and out on an exchange in size, you prove out like without really moving the bid ask or whatever.
David: Pretty much. Yeah.
Bill: You prove out that there must be some depth.
David: Exactly.
Bill: It's almost like the negative proof that we were talking about earlier, except that's your own money.
David: There are actual buyers and sellers of this coin that you're trading.
Bill: All right. I'm sorry to interrupt you on a thought process.
David: You can turn to [crosstalk] disciplines and stuff like that. Yeah, if you're trading full time, you're talking to a lot of people, and they're also trading, and you try and triangulate from everybody's perspective, is there real liquidity here? If there's real liquidity that there are fees associated with the trading, and so you can sort of spit out like a rough estimate of how much free cash flow this exchange is printing each quarter. Then you can triangulate that number with what you're seeing, if you have access to it in terms of the private market valuations of companies like Kraken, and then the public market valuation of companies like Coinbase. You can come up with a number that's fairly reasonable and well triangulated from different angles, and you start to look at an exchange that's unregulated offshore of the stuff. You know what, Jesus, these guys are printing $200 million in free cash per quarter. This is a real business. If so, my first kind of conclusion there is that there is a basic incentive for them to keep this going. This is a real gravy train. So, yeah, sure, they could shut the exchange and run away with all the crypto. But they could also just run a legitimate business and get very, very, very, very rich very quickly.
Bill: [laughs] There's also that option.
David: Everyone who founded an exchange is a billionaire at this point. Why would you go through the trouble of stealing another few billion of assets off the exchange and being like hunted for the rest of your life? So, there's a reasonable kind of supposition that these guys are not just going to run away with the assets. The next thing is, if they did, the cash is easily trackable. The crypto is yeah, like they could run away with the keys, but how are they going to liquidate the crypto? Because if the founders of exchange X like run away with the crypto, remember, all of this is like an open public ledger. Everyone knows what the addresses are. Those addresses will get blacklisted. It's not like they can take 10,000 Bitcoin and just cash out for $6 billion if I've got my math's right on Coinbase or something. Because Coinbase is going to say, "This Bitcoin in this address is red flagged as having been stolen from the users of exchange X."
Suddenly, it just becomes really difficult and tiresome for a billionaire to try and liquidate that additional few billion. Even if he did run away with the money, it's hard to actually move that into cash that you can use. So, that's the next point. Then after that, you start thinking about hacks, and one thing is the track record of the exchange. So, BitMEX for example is a much-maligned exchange, the three cofounders have been sued by some branch, some organ of the US government, and I think two of them are in custody, and one of them is on house arrest. But the exchange itself has been running for four or five years at scale, and it has never been hacked. It also doesn't touch the currency. It's like okay, that's a pretty good track record. It's always worked. It's always on its debts or whatever. It's never run away with the money and it's never been hacked. So, that's one small indication that maybe it's a reasonable bet, if I can make 20%, 30%, 40%, 50% on this exchange for year.
The next is, the bigger the exchange, the more of its assets it can hold in a cold wallet versus a hot wallet. These are two different types of crypto wallets. But basically, a hot wallet is quite easy to hack and a cold wallet is basically impossible to hack. The bigger the exchange, the more the inflows and outflows can be nutted. So, if you're a big top five, top seven exchange, I would guess that 1%, 2%, 3% of your assets are stored in hot wallets at any time and most of it is cold wallets and those cold wallets are very secure. So, if they do get hacked, which is the next attack vector, yeah, sure, maybe the hacker is going to run away with one of these hot wallets and the assets are split across a bunch. So, if they hack one, we're talking about basis point type loss to the exchange, and the exchange is making $200 million, so that probably just going to make you hold.
Now, if they hack all of the wallets, still we're talking about a couple of percentage points. There are examples of exchanges that have had enormous, multi $100 million hacks, who basically went out to the market and issued a token that was basically debt with interest, and people bought that debt. BitFenix did this in 2019, I think. They issued $200 million worth of debt, basically to the market, and said, "We're going to pay you 50% of our revenue for three years and make you whole and this might return your principal and more basically." They raised that money in like, I think, it was less than a week from the hack and they made everybody hold. So, they have big balance sheets. They have the ability to raise large amounts of capital and exchange called Deribit did this during March, they nearly went broke, because there was a ton of liquidations, and they just raised the money, but this time from venture. So, if that's like a couple percentage points of loss here, you're probably going to be made whole. Now, if you're not, these exchanges have insurance funds.
Basically, a portion of every transaction to simplify things goes into this insurance pot. If something blows up or there's an issue, you pull assets out of the insurance fund to make the other side of the trade whole, oversimplifying a little. So, you can see the size of these insurance pots. In some cases, they're really, really, really big. So, that gives you more comfort that there's some kind of cushion before you, the user where the client is actually getting hit. And then if you blow through all of these layers, the loss is probably going to get socialized. So, we're talking about, I don't know 1%, 5%, 10%, 20% loss on the capital that you have with that exchange on which you're hopefully making more than double digit returns and your counterparty risk is split across five or 10, or 15 different exchanges. So, when you start adding all of these things up, I think your counterparty credit risk should be, maybe, in the 5% to 10% range for the major unregulated offshore exchanges.
What's interesting is that we now have prime brokers in the space that are starting to come out who are lending you assets that you're going to go and trade on the exchange. And as part of that, it's their ass on the line if the exchange goes up. So, these guys are giving you a little bit of signaling power as well, because you can see in that price, the cost of dollars to them, but then the exchange counterparty credit risk that they are explicitly having to price. And it's low single digit percentage points. The returns available in the crypto space are higher than that, and they're this, I think, imbalance and this is why I say, I think, counterparty credit risk is overpriced in our space. But you really have to know what you're doing.
Bill: Yeah. No, this is not for amateurs. When you say the returns are double digit, you mean they're arb returns?
David: Yeah, like market neutral arbitrage type of times that you can extract from the market.
Bill: That's wild, man. You ever worry that people are going to jump in there as pros and suck all the arb out?
David: Yeah. I've been worried about it for four years.
Bill: [laughs] Well, maybe you should do a podcast.
David: So, of course, I did.
[laughter]
Bill: I like how you think about that. Somebody that I respect a lot has just released a Coinbase right up, and I haven't gotten through it but I will. One of the things that I wonder about is, will the volumes on all these exchanges explode? When I say explode, I don't mean to the upside. I mean, yeah, collapse, right? I guess that I had a discussion with somebody who has me convinced that crypto-assets are the new asset to trade, which is not how I like to look at the world necessarily, right? Because I prefer to own interest in businesses, but I think that my fear of the idea of the trading on these exchanges going away is maybe misplaced a little bit. Potentially not, right? I think it's still early, but--
David: I ascribe to the Matt Levine's boredom market hypothesis. People want to trade when they're bored.
Bill: What's that?
David: Ah, basically, there's a link between boredom in trading. If we look at what's going on in the stock market and crypto market, generally, most markets that retail have access to, a lot of it can be explained by the fact that people just bought a home. He has this wonderful writer in one of his daily ladders, which is just a hilarious explanation of the boredom market hypothesis. But unambiguously people like to trade and they don't seem to really care what it is that they trade. And crypto is global. It's unregulated in a bunch of places, regulated in some, it's tradable 24/7, all of those, it's volatile. It has these extraordinary narratives around it, boom-bust cycles, lots of excitement. All of that makes for a wonderful substrate for entertainment trading without passing any judgment on that. I think your friend has a point, though.
I hope that the crypto space is going to be more than trading sardines. I think, it will. But undeniably a lot of volume today is, people punting on stuff. I think the same way as they do on stocks and options and everything else, CFDs, whatever.
Bill: Yeah.
David: With that said, we have very, very, very, very clearly seen that crypto market volumes go up and down with the price. In the bear market in 2018, 2019 volumes were down like 90%. I am sure that we are going to shoot way above to the upside. This is going to be my fourth bull cycle. I don't see why that one's going to be any different. There are people saying that this time, the institutions are here, so there's going to be no bear market. I just don't think that's true. I think institutions can be [crosstalk] as retail and they can-- [crosstalk]
Bill: Yeah. They haven't exactly-- They haven't stopped bear markets and things like stocks in the past. So, I don't think that they're going to be able to stop it in crypto-assets. That seems flawed.
David: But a lot of people ascribe to this. I don't agree. I think, we're going to have a crazy, crazy write up, it's going to go way too far. Maybe it's already way too far, who knows. We're going to have an equally-- equal and opposite collapse. The volumes on Coinbase, I think, will track that. The revenue is going to be very volatile on the trading fees side of things. That being said, on a normalized through the cycle basis, it's just an incredible business. Coinbase is an extraordinary business like they have got a chokehold on US retail trading and they can charge them enormous trading fees. If you sign up for Coinbase account and buy some Bitcoin, I don't think it's changed and a year or two or five ago, they were charging like 2.5% on the way in and 2.5% on the way out. It's just insane. That's a wonderful business to be in. All of your costs are fixed. It's an interesting company.
I think, exchanges, there was one venture fund out there that was betting on exchanges in 2014, 2015, 2016 called Pantera. They did incredibly well on exchange bets, but today, I think everyone's realized that exchanges aren't actually terrible businesses. They're actually pretty fantastic businesses. And they're probably getting priced appropriately. But the variability in that revenue might be-- [crosstalk]
Bill: This is going to sound really stupid, but who does Robinhood route Bitcoin trades through or Doge?
David: I don’t know. It felt great. Yeah.
Bill: I guess, Doge is the primary driver of revenue. If not primary, doing your own [crosstalk] work crack open 10K in--
David: There might be [crosswalk] like ventures into crypto now. They'll go and buy spot for Robinhood. Maybe, it's about-- I don't know. But I'm sure that's public. So, you could find that.
Bill: Yeah, I am, too. I just haven't.
David: Yeah. I don't know who it is.
Bill: I can only do so much research on Robinhood before I get too upset and I put it down. But that I digress on. So, what keeps you up at night about your business and about what you're seeing in the world and whatnot?
David: I think what kind of pause the-- I worried for a long time that the space would go away. I think the last bull run and bear-- the last bear market that we had the 2019 bear--, I thought at the time was the last time that we would debate whether crypto was even a thing. The debate was, is it worth nothing or is it worth something? I think we're kind of past that at this point, we've definitely hit that tipping point, and the debate for the next bear market is going to be how much is it really worth? That's a very different place to be in when it's your career and you work in the industry. So, I don't really worry about crypto disappear. I think that every venture fund I know is two or three times oversubscribed and they've all closed funds that were upped, upped, and upped in size. There is more than enough capital locked up in venture funds today to see us through the next four-year bear market if we have one.
Any high-quality project in the crypto space in the next four years is going to get funded. So, that's from an ecosystem and industry perspective, that's great news. My mind is at rest from that perspective. In terms of the things that I do worry about counterparty risk is one, everyday trading risk is obviously another, and I worry that volumes will dry out. In what we do, we really benefit from large amounts of volumes and volatility, and as with any market neutral strategy, if markets are doing nothing, if the term structure is doing nothing, if nobody is crossing the spread, if there are no volumes, then it's just really hard to put large amounts of capital at work profitably, you just sit there, maybe, eking out an adequate return, which on a net basis would already be an achievement. We do get these periods. We had one, the last six months of 2019, we had one May through August, there was very little to be done in market neutral world of this year. Now, markets have really picked up. But if I'm correct and that we're going to have this huge blow off top that the backside of that, once everything is settled down, we might just be sitting on our hands trying to stay out of trouble for quite a while. Those periods tend not to last much more than six months but trying to stay disciplined during that period is something that's on my mind. How am I going to keep myself out of trouble when that's just nothing to do in the market? So, much like, you got to do a copy and just take a holiday.
Bill: Dude, you have good company, because Buffett says the same thing, right? When he has a lot of cash and valuations are a little bit high, that's when he gets worried about making a mistake. So, you're not alone on that. So, I think a logical question to ask you is, who are you looking for and who can you help sort of allocate? Because I haven't come across many people that do what you do. Market neutral in crypto is a pretty seems like an-
David: It's a niche [crosstalk] niche.
Bill: -uncorrelated asset to me. Yes, that's right. So, how do you find investors and who are you looking for, who should be looking for you?
David: I guess, the main reason I do these pods apart from getting to hang out with you is just as a PSA, if you're a trader in the crypto space and you're doing something interesting, we would love to talk to you and maybe we can allocate some capital. But yeah, we're always on the lookout for people doing interesting stuff in this space, especially, when it's market neutral, high frequency, high Sharpe, these kinds of strategies. In terms of our investor base, I'm lucky to be at-- for the crypto space relatively big and well-established firm, FCA regulated, we tick a lot of the institutional boxes that people might have and we've got a wonderful fundraising team who speak to family offices and institutions more and more around the world and I'll leave it there for regulatory reasons.
Bill: It sounds good. So, if anybody wants to follow up, how can they contact you and where should they find you?
David: I'm on Twitter, @dfauchier, D-F-A-U-C-H-I-E-R, and you can always email us at david.fauchier@nickel.digital or look at our website, which is nickel.digital as well.
Bill: All right, man. Well, I think we've given people a lot to chew on in the conversation one. I hope that you will come back. If you are correct that there's a blow off top and then there's some sort of like lull, perhaps you'll spend some of your time talking to me and giving people an update on the markets, and that may preclude you from doing something silly.
David: [laughs] Perfect. Let's do that.
Bill: All right, man. Well, it was great talking to you.
David: Thanks so much.
Bill: David Fauchier, thank you very much for stopping by, man. I appreciate it.
David: Thank you.
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