The Digital Assets Index Revolution: ReSolve Riffs with Matt Hougan and Dave Nadig
- Crypto as a currency looks highly unlikely to succeed, but as a technological advance it is highly unlikely to fail
- One of the most interesting problems in the space: very few people actually understand blockchain technology and its multifaceted capabilities
- The biggest risk in digital assets is behavioral
- Why market-cap weighted may be quasi optimal – size matters in a sector driven by network effects
- The delusional notions of Bitcoin replacing the USD
- The crucial importance of frequently rebalancing a portfolio that holds highly volatile assets
- A shifting zeitgeist and the typical question – from “will it go to zero?” to “what is a reasonable weight range?”
- Why UniSwap may be the greatest entrepreneurial story of the past decade
We also discussed DeFi (Decentralized Finance), technological updates and the excitement around the Ethereum ecosystem, tax implications and much more. A big thanks to Dave Nadig, not only for the introduction to Matt and co-hosting the episode, but for flexing his healthy skeptical muscles and pushing back at times – it made for great entertainment!
Thank you for watching and listening. See you next week.
This is “ReSolve’s Riffs” – live on YouTube every Friday afternoon to debate the most relevant investment topics of the day, hosted by Adam Butler, Mike Philbrick and Rodrigo Gordillo of ReSolve Global* and Richard Laterman of ReSolve Asset Management.
CIO, Bitwise Investments
He was previously CEO of ETF.com, where he helped build the world’s first ETF data and analytics system. Hougan is co-author of the CFA Institute’s Monograph on ETFs. He’s also a crypto columnist for Forbes, and a three-time member of the Barron’s ETF Roundtable.
CIO & Director of Research, ETF Trends
You can follow Dave in his column at ETFTrends.com, his frequent CNBC appearances, or you can read his book, “A Comprehensive Guide To Exchange Traded Funds” which was published by the CFA Institute.
Mike:00:01:01Well, gentlemen, welcome. Another Friday is here.
Mike:00:01:05Cheers to all of you.
Rodrigo:00:01:08Happy Happy Hour.
Dave:00:01:13I’m having local honey and tea. So, not quite there with you.
Rodrigo:00:01:17At least lie about like a shot of alcohol of some sort. No, you can’t do it?
Dave:00:01:22It’s only four o’clock in the afternoon.
Rodrigo:00:01:24Too much integrity for you? Alcohol on a Friday.
Mike:00:01:27He is a very integrous person. And thank you. Welcome Dave Nadig. I’m sure most people who’ve tuned in here know Dave, and thank you for cohosting us and joining us today. And while we interrogate Mr. Hougan on all the various things he’s been up to, I will remind everybody that this is for entertainment purposes, and that you probably shouldn’t be getting investment advice from four hooligans on a Friday afternoon on a YouTube channel. So with that said, let’s dive in.
Dave:00:01:55You sound so legit.
Mike:00:01:56Yeah, we can talk about whatever we want. Matt, welcome.
Matt:00:02:01Thank you for having me, it’s a joy to be here. I’ve been looking forward to this.
Mike:00:02:05Us too. Tell us a little bit about you, your journey, you can go back as far as you want. Just let everybody know where you’re from, how you got where you are. Tell us everything.
Matt:00:02:17Tell you everything. Wow. My journey into the investment space starts with Mr. Dave Nadig, believe it or not. I was working as a minor league baseball mascot in Maine and read an article about a business Dave started, thought it was cool.
Dave:00:02:33You have to use the mascot’s name man, you can’t just leave us hanging out.
Mike:00:02:38Yeah, I know I’ve got another team.
Matt:00:02:42Oh, I thought you meant of your business.
Dave:00:02:45You don’t just get to drop minor league mascot and not finish the story, you schmuck.
Matt:00:02:49I was Slugger the Sea Dog, which is an eight foot seal for the double A affiliate of the Red Sox, now they were the Marlins at the time, in Portland, Maine. My job consisted of dressing in an eight foot seal costume, mostly opening car dealerships. But I did get to play in a celebrity basketball tournament, I will tell you that trying to shoot a basketball with flippers, the size of my chest is quite an experience. So that was my resume. Dave was running the world’s first transparent mutual fund and he looked at that resume and said, yes that is the man I want as my new analyst.
Rodrigo:00:03:27To be clear this is the …Matt:00:03:30Exactly. That was my start. Then, I bounced around a little bit. I spent a long time in the ETF industry. So my big claim to fame at first was in the ETF industry. I worked with Dave on a company called ETF.com, built the first ETF rating system in the world, the largest ETF conference, largest ETF media space. We eventually sold that business.
Matt:00:03:57ETF ego. Did I mention I won the Lifetime Achievement Award in ETFs?
Dave:00:04:01No. That was like four minutes. Congratulations.
Matt:00:04:07One thing you might know about that award actually is that Dave hasn’t won it. One of the characteristics of that award.
Dave:00:04:15Due to years, a decade of ineligibility.
Matt:00:04:20I’m just joking, Dave. Most of my career has been letting Dave do work and trying to take credit for it. After my ETF journey, after I sold that business and didn’t earn out with the conference company, we sold our conference unit separately. That was our biggest unit. I did two years for a FTSE 100 company running conferences. I made a switch into the next big multi trillion-dollar market that’s growing quickly that no one understood, that people thought was toxic, that people described as weapons of mass destruction or rat poison squared, which of course is crypto. And so now I’m the CIO of Bitwise Asset Management, which manages somewhere north of a billion dollars in crypto assets for mostly financial advisors, some hedge funds, some institutions, some retail investors. And we’re best known for creating the world’s first crypto index fund. So we’re kind of like the world’s most conservative, boring crypto asset manager if you can catenate those phrases into one, that’s us.
Mike:00:05:22I love it.
Rodrigo:00:05:23The lower bound of boring is still very exciting.
Dave:00:05:27I will say Matt, leave it to you to find the way to make crypto boring.
Matt:00:05:33Yeah. We all have our skill days.
Dave:00:05:34But like, interestingly it kind of was needed. I mean, you guys have been pretty successful at being the boring guys in the crypto space.
Matt:00:05:42Yeah, well, you’re taking enough risk on an asset class that’s new, nascent, emerging into the regulatory space, has a lot of security risk. It’s not clear to me why you would layer on active risks or other trading risks on top of that, particularly for a beta that even though it’s down 50% from its highs, is up 250% over the last year and up to 3000 plus percent over the last three years. So I do think it makes sense as a strategy, we’ve been doing well. Just raised our Series B, we’re about 40 people and growing. And we think financial advisors are the next major market in the crypto space. And we’re surprised that there’s basically no one else focused on that market.
Rodrigo:00:06:21Matt, before we get into the crypto and the use cases and all the things that are happening in that space. I actually want to go back to something that you said when you decided to move forward to the most toxic, least loved etc. market. There’s some experience I think that you bring to the table, and maybe one of your personality traits that have led you to be in there one after the other. Was the ETF space considered the same thing back in the day Dave, Matt? Was it toxic persona non grata, the end of capitalism and the like?
The End of Capitalism?
Matt:00:06:53That, 100% true. Yeah, Financial Times called it weapons of mass destruction. They talked about liquidity doom loops. Almost everyone’s forgotten, but the US Congress pulled ETF executives in front of it and had a whole interrogative session about whether ETFs were destroying American entrepreneurialism, which is a pretty big claim for a product that really just lets people get exposure to the market for a few basis points less than index mutual funds.
Dave:00:07:20Point of order, it didn’t destroy American capitalism.
Matt:00:07:25Not yet, they’re still making those claims.
Dave:00:07:27There’s still time, there’s still time.
Matt:00:07:28There’s still time.
Mike:00:07:29It could happen.
Matt:00:07:31It is true that no one understood them. They called them EFT’s. If you talk to someone about the creation, redemption mechanisms, their eyes rolled back in their heads. It was all jargon and people were very skeptical, and for good reason. Another analogy that’s similar between ETFs and crypto is that in the early days ETFs were kind of terrible. The spreads were huge, they weren’t liquid, they really weren’t the lowest cost way to get exposure over the full term of an investment. But they had one or two really sort of unassailable advantages. They had unassailable advantages on intraday liquidity, on taxation, on fidelity to what they’re getting exposure to. And those were enough to eventually overcome the limitations. Same thing is true on crypto. If you look at Bitcoin, it’s a pretty janky currency. It’s volatile, you can’t spend it anywhere. Retailers don’t accept it. But there are a few things in crypto, that are sort of undeniably true about the efficiency of the technology and the new mindscapes that it opens up.
One question people ask me is, why do some people like me, who look like me, end up in the crypto industry and an equal number end up hating it? And I think it comes down to that. Whether you approach it as a currency, in which case it looks highly unlikely to succeed, or if you approach it as this technological advance, in which case it seems highly unlikely for it to fail. And I think that that sort of fork in the woods explains a lot of the extremism in crypto.
Rodrigo:00:08:57And is that the difference when you’re thinking about moving on to the next business? When I think about, you went from ETFs to crypto, some people might look at that and say, well, you could have gone to, I don’t know, marijuana or psychedelics, or who was the guest that we had on Monday Mike? Uranium. These are just as volatile, just as crazy. But somehow crypto seems to be seen as that plus something very different. What made you not go into the theme based stuff and be as toxic as you can be, and rather choose this other space?
Matt:00:09:41It’s a great question. I think there are two things. One is that I really love the efficiency. This sounds like a dorky thing to say, but one of the things I loved about ETFs is that they were just efficient and true and right. And that aligns with crypto, it’s not the same with cannabis or other thematics. Look, I’m not a crypto hyperbolist. Crypto tends to be the land of hyperbole. I think the answer is in the messy middle. But I will say in terms of the market that it’s addressing, not the market it will capture but the market, it’s addressing, it’s by far the largest addressable market I’ve ever seen a new technology attack. It’s attacking finance and money. Like if you want to abstract back to what crypto is at the core, it’s a way to move money and property rights over the internet. It’s the biggest market the internet’s ever gone after. And so, one thing I learned from the ETF industry is, it’s great to be in a career with a strong beta to a very large size. You make all sorts of dumb mistakes and still turn out okay. Crypto is going after a very large market.
Now we can discuss will it get there? What parts of the market it can really capture. But unlike marijuana or psychedelics, it’s really big. It’s really big. And there are very few other industries at least in the finance space, maybe arguably AI, but there are very few that are going after a market that’s nearly as big as what crypto and blockchain are going after.
Dave:00:11:05So knowing you forever, you love solving problems. That’s sort of why I associate with you. When I call you at two o’clock in the morning on a Friday, it’s because I have a problem, and you’re really good at that stuff. So what are the problems that you saw in crypto that you’re trying to solve versus like, Rod, you’re talking about things like cannabis? A lot of those problems are regulatory, cultural as much as anything. What are the problems you’re trying to solve in crypto that you think are really interesting and that you thought were interesting back then because I think a lot changed just in the last couple of years?
Matt:00:11:38A lot has changed. In terms of what I personally was trying to solve.
Dave:00:11:42Yeah, like what was getting out of bed?
Getting You Out of Bed
Matt:00:11:44Two. They are really only two. One was no one understood it. It like occupies this giant mind space in society. 95% of people talk about it, and they have hard and concrete opinions about it. But if you actually tried to get them to explain what a blockchain is and what space it opens up, zero people, not zero, very few people could actually explain that. And I thought I could help in that. One of the things you know Dave, one of the things I did do in the ETF space, was giving ETF 101 presentations about 15,000 times. And I think anchoring people on first principles of what crypto really is, what space it’s attacking and what it’s not. I thought I could add value there.
And then the other piece is sort of the why Bitwise piece. The biggest risk in crypto is behavioral risk with investors chasing high returns, dumping at the wrong time. Investors have never had access to a liquid intraday priced investment that’s as early as crypto. So they’re not used to this volatility. And I thought Bitwise is product solutions of a, like an S&P 500 of crypto, was the answer to that. So educating people about what it is and then getting a product that helps them not run into the shoals, was what drew me to the space.
Mike:00:13:00Yeah, it seems like a pretty good thesis from the get go, in an environment where the information that you might be garnering is relatively low in the vast potentiality. As you said, the addressable market is huge, the number of coins is huge. What the coins may do, from Bitcoin all the way right down the chain, so I’m taking that mindset of let’s let the market sort it out, and use traditional finance methodologies, is to me probably one of the most sound ways, certainly a first way that you would probably tackle that problem. Is that the way you saw it as well?
Matt:00:13:42I completely agree, I think that’s exactly right. And a market cap weighted index that’s unconstrained and uncapped does that really nicely. It also means that investors for whom this is often a 1% allocation or a 2% allocation, don’t have to panic every time Elon Musk tweets something. The index reacts to that, it adjusts to that. And the other thing about crypto which is maybe people don’t think about enough, is network effects are central to the value of crypto assets. And so market cap weighting I think is closer to an optimal strategy in crypto, even excluding costs than it is in equities where it’s an average strategy excluding costs and only beneficial after costs are added in. In crypto because it’s all a network effects business, because size really matters, I’ve seen lots of active managers run afoul of getting obsessed with technology, this blockchain is slightly more efficient than that one, doesn’t matter. This one is in a regulated space and has liquidity up the wazoo. So I think that’s the added benefit of a market cap weighted strategy is it captures a network effect.
Mike:00:14:52The age old VHS versus Beta, or the fact that we still use a QWERTY keyboard today. The most inefficient keyboard that you could have, it’s not efficient, it’s not the best keyboard, it 100% dominates all keyboards. Because the network adoption was, hey, we’re going to learn this keyboard because we have typewriters that get caught up together. I don’t know if people remember what a typewriter is. You had to slow people down in the way they typed. And that’s why that is the dominant force. It is not the best keyboard. So just like you’re saying, if you get fundamentally based in this, is Cardano, no it’s better than Ethereum, whatever, but if nobody cares then nobody cares. And market cap is the way to express. Go ahead.
Dave:00:15:39Well, let me pull on a thread here. I agree with you Mike. Yes, I get the logical chain. This is also one of the biggest problems I have with the current defy crypto industry, which is everybody knows this, everybody understands that all that matters is how much you get in circulation and how much you get it being used in mined. And so consequently, we’ve ended up with this sort of massive degeneracy in what are otherwise really interesting technologies, because everybody realized we got to get the coins out, we got to get the coins out. So, you end up with the whole liquidity pool insanity that’s taken over crypto for the last three to six months really, because all that matters is getting the coins out. And so you end up with things like what happened with MATIC, where you end up with poorly designed products, poorly designed liquidity pools that have fatal flaws, but you’re rushing to get out there because you know the network effect is all that matters.
How do you balance that out because it doesn’t seem out of the question to me Matt that the thing that’s going to boot whatever the 10th thing is in your top 10 out, when it shows up it could show up simply because they were better marketers at getting people to use it, but it could be toxic technology.
Matt:00:16:49Yeah, it’s so true Dave. First of all, I completely agree with you. And second, the index tries to screen those… Our index methodology tries to screen that out, and I think it does a pretty good job but it’s not going to be perfect. So what are the screens we look at, we have seasoning rules, it’s not like an asset that emerges today can enter. It has to be on the market for a certain period of time. We have liquidity in terms of percentage of market cap rules. We have regulatory screens related to security status. On the DeFi fund we have an Advisory Council of five of the leading VCs in the DeFi space who opine on new projects, investigate if they have real developers behind them. We look to see if there’s been a technology audit of the new asset. And all of those screens are binary, if they fail they’re not in. Even if you look at our Bitwise 10 which is the largest crypto index fund in the world, holds the 10 largest assets. If you go to coin market cap, our 10th asset is number 24.
So there are a lot of these assets that you screen out because of those risks, but it’s not perfect. It’s not perfect at all. It’s impossible to be perfect and there’s going to be risk and there’s going to be blow ups. We saw one yesterday. Thorchain got hacked, which is like I don’t know, it’s top 50 assets, not in our funds. That’s going to happen. It’s interesting that we’ve kind of solved how to jumpstart network effects. That’s a big sort of interesting business breakthrough. But it comes … with all these risks. We try to create…
Dave:00:18:25The liquidity pool model.
Rodrigo:00:18:29Well, why don’t we discuss the liquidity pool model Dave? Why don’t you give everybody here an idea what the issues have been and why it’s been useful in this space?
Dave:00:18:38Do you want me to go first then Matt can laugh at how wrong I am?
Rodrigo:00:18:44You brought it up and maybe Matt…
The Liquidity Pool Model
Dave:00:18:48No. If I’m trying to start the excellent Davecoin and all I care about is getting Davecoin out in circulation, well, what I do is I set up a liquidity pool where people can stake in something I want to trade Davecoin against, and in order to do that you have to have some reward, and you pay those rewards out in more Davecoin which nobody wants to really hold. So they trade it back for something they do want to hold like Ethereum or cash or a Stablecoin or Bitcoin or whatever. But those coins go away in that process. So the coins start generating circulation but their value is really only associated with how much they’re willing to turn the knob on how much extra Davecoin you’re going to get. And this is where our friend Corey Hoffstein went down this rabbit hole on MATIC, where the three tiered … something or other and there was a multiple coin system with a governance coin and a non-governance coin. And you end up with these sort of loops that if you’re in there in exactly at the right time, yes, you can generate an enormous amount of real money, but every step along the way there’s the risk that you’re the greater fool right before the bottom falls out, which is you know what happened.
Rodrigo:00:19:56And the way they presented to is interesting and they talked about this is how much yield you can get, at 23% yield.
Dave:00:20:03If it all worked perfectly.
Rodrigo:00:20:0523% yield on Davecoin, what’s that worth in real life? And then no, it’s back to Bitcoin, Bitcoin versus, it just becomes those big percentage numbers, seem to attract that network effect. You’re just pulling in the same, all that behavioral economics, all that work Amos Tversky and Danny Kahneman, those economists have done, they have really harnessed that for both good and bad in the crypto space, which I find fascinating. Anything to add to that Matt?
Matt:00:20:35Just that I agree with you, it is fascinating. I think it’s important. There’s positives to it, but it’s a huge risk. for what it’s worth I’m structurally short Davecoin. Have been for a number of years. No, I agree it’s a real concern and it says something about the crypto space. There is a degree, particularly in the DeFi space which I’m very excited about, talking about why. But there’s a degree of circularity and recursiveness in there. It can make it appear larger than it in fact is, that doesn’t take away from some of the really exciting technological breakthroughs and things that they can do in Defi protocols. Those are still very real. But you do have this element of fluff and nonsense around it. For what it’s worth it’s been in crypto for a long time, used to be large problems with wash trading and issues like that. Yeah, this is part of the anarchic mass that is the broader crypto landscape and it’s very real.
Rodrigo:00:21:35And I will add, I’ve said this before on this podcast, but there are also some very important use cases of understanding behavioral economics, and your business model. So what I brought up before are companies like Helium or Akash which require for the business to make any money in the real world, it requires some sort of network effects. So Helium is just peer to peer networks where you place a little modem on the top of your second floor of your house to connect to another peer to peer network. Somebody else is incentivized to put that little modem there. How do you incentivize people to create these networks, this technology that has been around for 30 years that would benefit the world if everybody did a little bit of it for a $300 piece of equipment. You’re going to incentivize them by giving them some Helium coin. That incentive then leads to more peer to peer networks, the growth of actual real business, and the incentive for those who mined the Helium coins to keep them, which I do find in that community.
So there are cases like that, and Akash is the same idea but with cloud computing, and that creates a more secure network where a single big organization does not hold all of your data and you can kind of separate it as more like a Torrent style approach to cloud computing. So within all that chaos and madness, you see these gems where you’re like aha, this is a fantastic use case to me for behavioral finance, the coin and the crypto industry, and in real world economics. So it’s just a matter of finding them.
Matt:00:23:07I love that so much. Yeah, you found way to economically incentivize a decentralized network, which has been a challenge for a long time. And I think that’s completely true. Just need to separate the gems from some of the other projects.
Mike:00:23:22And so as you’re going on this journey in crypto land, have you noticed any corollaries that remind you of your journey in ETF land? I mean, I think we’ve covered one or two of them, but are there any others that stand out as, hey, I know I’m on the right track because of XYZ, that you feel are similar or not? Has this been a really kind of unique journey?
Give Me Five Minutes
Matt:00:23:52Let me think about that for a minute. There are certainly a few. One, I really do think I got to this point with ETFs where I felt like if someone gave me four minutes, I could explain to them why ETFs had a manifest destiny that would eventually take over the mutual fund space. It took me a couple years to get to that point, but I felt like I got to that point eventually. I think the same thing is true in crypto and blockchain. I think if I have five minutes, I can get almost everyone on board from this is an interesting thing that will have a major view in the future. And I think that’s important because if you can boil something down to a pretty simple level and people sort of understand and get it, I think that gives me confidence that there’s something real there. So that’s one that I think a lot about. And we see similar things that we’ve seen before. I mean, ETFs went through waves of adoption by different groups of people. Crypto is going through waves of adoption by different groups of people. You see people who are very skeptical come into the light, and you also see persistent skepticism throughout. There’s still plenty of people who hate ETFs, And think they’re going to destroy the world. And I think that will be true in crypto.
Dave:00:25:04Can I answer the question better? Because I think you missed the key one which is, if what we care about here is people who are marketing and selling products and stuff which presumably you are, what you care about is where’s that money coming from? Where’s the people who are going to invest in this, it’s following exactly the same arc that ETFs started with, which is, you start really as an institutional experiment. Then you have this sort of rampant rabid early adoption by weirdos and freaks which is totally what happened in ETF market until about 2004 2005, at which point financial advisors got the message.
And along with the financial advisors getting the message, the rest of the institutions realized they no longer had cover to put money in places that didn’t belong, ie: hedge funds that were charging two and 20 etc. And all along the way they were yelled at by regulators and skeptics who said this is destroying the world, it’s never going to go anywhere, it’s a regulatory nightmare. But then this sort of, this three part system of retail advised and institutional all ends up coming together at which point it becomes unstoppable, which I would argue is the global financial crisis for ETFs. The survival of ETFs and the thriving of them in 2009 and 10, is the reason that it is now an unstoppable force.
I don’t think crypto’s quite had that moment yet. But I just look at my own websites and I see the amount of traffic we get to anything related to the crypto channel we run. It’s crazy. So it’s clear that advisors are now very focused on this space. So it just feels like we’re following the exact same mark.
Mike:00:26:40So is that is that the reason why you’ve followed the same tactics Matt? Going after like the advisor space as the next targeted space? It seems to fit into Dave’s narrative almost perfectly if you think about the narrative of adoption that Dave laid out with ETFs, and the way you have looked at Bitwise investments and the partnership with LPL and some of the things you’re doing to really nurture the advisor awareness and understanding, so that in turn they can pass that on to the client assets. Is that the same thing? And then, not supposed to ask two questions but I’ll put one on the end of that, are you going to bring your conference expertise to bear at some point and start to do some sort of advisor crypto conference like you did with ETF so successfully?
Matt:00:27:29Yeah, I love it. Yes, it’s part of the reason. I mean, a lot of us at Bitwise come from the ETF industry. I would say probably 70% of the people at Bitwise come from the ETF industry. And there’s been a lot of crossover. And that is one of the reasons. The other reason was, and I still don’t understand. It’s under penetrated. You have a huge number of crypto companies focused on self-directed investors, Coinbase, Kraken and etc. Self-directed investors don’t have any money. So it’s curious that there’s this giant ecosystem focused on them. You also have VCs focused on true institutions, pensions, endowments, etc. a lot of crypto VCs. No one was talking to financial advisors, who control as much money as those largest institutions. They just need different service. They need a distribution team, they need research, they need webinars, it’s a different market. I think part of it is venture capitalists haven’t discovered the advisor market. They don’t know how large it is. And so we were uniquely positioned to move into that market.
Mike:00:28:29One thing you missed that advisors need is, they need access, they need access that’s on their platform. You got to navigate all of the platform access points. So you get to the advisor and the advisor says, yeah, I want to do that. And then you’re like, okay, so what firm you with? Then let me start on that process. And maybe you can buy it in a year.
Matt:00:28:47It’s so huge and you need people who are focused exclusively on that. I agree. We’ve been working, get on the Orion platform for years. And you make progress. We just got on to the LPL platform. Venture capitalists never probably heard of LPL. That’s 18,000 advisors and a trillion dollars of assets. But I agree, you need all of those steps. And I think it’s pretty unique. On the events stuff, of course, I love events. We’re doing some around it now. I’m doing an event with Dave called Exchange, focused on the ETF space. I’m also an advisor to a company called Blockworks, which is probably the leading provider of financial professional conferences. They just launched a big DeFi conference for next year, they do a number of events. So I keep my nose in that game.
Mike:00:29:37 I love it. So on your site, just since we’re on the advisor angle, what are some of the top pieces that people should read? Because you’ve got a bunch of resources on the site, but if someone’s looking at this and saying, yeah, okay, fine I’ve been beaten over the head. Where should I start? In Bitwise, because it’s substantial, the amount of information that you provide and the assistance that you’re nurturing for advisors to educate themselves on this very frontier asset class. So where should they start? What’s the best place to go?
Matt:00:30:15Great question. The first one’s not even on our site, I was fortunate to write the CFA Institute’s Guide to Bitcoin, Blockchain and Crypto which published in January. So if you Google CFA crypto you can find that piece. It’s about a 64-page introduction to this space. I think it’s one of the better ones. Dave and I wrote The Guide to ETFs in 2015. So I was glad to publish that. The other, on the resources page, you can sign up and you’ll get a monthly note from me, that’s email only which I think is pretty helpful. We also have a paper on Crypto’s Roll in a Portfolio, which I think is pretty good and emphasizes something that is dramatically overlooked in crypto which is the importance of rebalancing. Rebalancing in crypto can transform from a volatile asset to a big portfolio contributor.
Mike:00:31:06Say more, you want to just give them the highlights on that because I think people do misunderstand adding a highly volatile asset to a portfolio that’s non correlated will improve the risk adjusted returns of the portfolio. So can you say a bit more about that?
Harvesting Volatility by Rebalancing
Matt:00:31:22That’s exactly right. The really unique thing about crypto as an asset, if you abstract away all the noise, is it adds high potential returns, low correlation, and daily liquidity which is not something that you typically get, typically high returns/low correlation. You’re locked up for seven years in an early stage VC fund. Once you get liquidity, you can rebalance. And if you rebalance a highly volatile non correlated asset, as long as you assume it’s not going to go to zero, which a bunch of people in crypto won’t make that assumption. But if you assume that, yeah, it has a dramatic impact. You’re harvesting that volatility. And the history of it is, if you add two and a half percent Bitcoin to a 60/40 portfolio, there’s never been a three-year period where it didn’t add to the cumulative and risk adjusted returns. On average over that three-year period, it boosts the Sharpe ratio by about 50% which is incredible, and it contributes about maybe 33% of the portfolio’s returns on average from a two and a half percent allocation.
But the rebalancing tolerance is critical. Without a rebalancing tolerance it leads to dramatic increases in max drawdown, the Sharpe ratio doesn’t even budge and it makes the portfolio much more volatile.
Dave:00:32:41Let me push back on that a little bit. Because to me, that is one of the critical problems with advisor adoption right now, is that most advisors are used to maybe doing a quarterly rebalance, which is really pretty insufficient based on your own math, which you were not nice enough to share with me when you were doing it. Quarterly rebalance doesn’t cut it in crypto. You got to, you either have to be triggered or it has to be a lot more frequent than that. But that puts the adviser in this terrible box because like Mike was saying, you don’t get to just make that as a bucket trade for 400 of your clients. If you were going to actually do that with your fund or with the direct crypto allocation, like that’s an operational nightmare. I know there’s some folks out there like Onramp they’re trying to solve some problems. But is this actually viable as a portfolio asset for most folks, absent some sort of bridging mechanism like an ETF, like direct custody, something like that?
Matt:00:33:36Well, an ETF will be a great thing. In the interim you have these OTC traded trusts which can trade at premiums and discounts, which are sort of like wrinkly ETFs. The short answer Dave, quarterly actually does at least on a historical basis, quarterly is sufficient. It’s annual or semiannual rebalancing that’s maybe not rapid enough. But I agree that that rebalancing piece is a challenge for advisors if you’re dealing with private investments and you have to send 400 wires every quarter, like no one’s going to do that. It’s part of the reasons we need better access vehicles. For what it’s worth, it’s part of the reasons people buy funds like GBTC or BITW, despite and understanding the premium and discount issue, because the rebalancing capability can overwhelm that risk. And so a lot of people think people buy those naively. Most advisors fully understand the premium discount risks that attend those products. But the ease of use, the ease of reporting, the ease of charging fees, the ease of rebalancing, more than compensates for the necessary hair on those. So I think it’s positive. The other thing I’d say for advisors, if you ask your clients, most of them are buying crypto anyway.
Rodrigo:00:34:51My biggest point is, you have a fiduciary responsibility not just on the assets that you hold for your clients, but you also have to know what they’re holding elsewhere and advise them on that. And if you’re, the advisors that I’ve heard say, oh, it’s going to go to zero, it’s garbage, is not worth it. Those guys talk to me and say, well, how do I buy off, outside of my brokerage account? And then I have to be like, oh my God, like, this is not… So if you’re going to blow yourself up there’s so many ways that that can go wrong, but they’re doing it anyway.
So then I don’t give them advice and then they go and blow themselves up and put in way more than they should. I think advisors who recognize the risk to their clients’ retirement needs recognize the potential asymmetric upside and can provide liquidity, need to act. You just can’t sit there on the sidelines anymore, you’re doing a disservice to investors. And by the way, let’s assume that it has a possibility of going to zero. One to 2% allocation isn’t going to be the end of it all. And as we know from some work that we’ve done, even on the way down with high volatility if you’re rebalancing enough, you’re scraping and you’re harvesting volatility premium, while it’s going flat to up, that might offset a total loss of 2% down the road. So, these are the things … asset management that are required. So without any opinion, you just can’t ignore access to an asset class like this.
Mike:00:36:23And on that note, Dave, what have you guys? Because you mentioned that you guys are publishing some crypto research and whatnot and you’ve worked with Matt. So what have you guys got that investment advisors should be looking at? Is there anything that’s complementary to what Matt mentioned and that would help advisors continue to educate themselves?
Dave:00:36:40Yeah, for the most part we’re in the business of providing investment information to advisors, helping them down their research journey, whatever it is. So we stood up a crypto channel and we’re discussing all of these things article by article. So it’s much more day to day news flow but in that channel you’ll find articles about how to access these things, and Matt’s so called wrinkly ETFs, and the tax implications, and how advisors should be thinking about DeFi. So we’re covering all those bases and I think you’ll see us continue to grow that as advisor adoption continues. But like we did that not because we’re trying to get ahead of the game, but because of demand. We did a survey with Bitwise over the last couple years and advisors want this content. The name of our site may be ETF Trends and we don’t necessarily have the non-wrinkly version of those ETFs trading yet. We’ll get there eventually.
Rodrigo:00:37:33So let’s talk about the tax implications for a second, because those are interesting. Everybody seems to be confused. What are the tax implications? And is there any difference between holding them outright and having to report and the type of slips that your fund would give out?
Crypto and Taxes
Matt:00:37:50Well, the first thing people should know about crypto and taxes is if you buy crypto and it goes up, you have to pay taxes. That’s surprising that many people think they live outside of the tax royal but that’s not true.
Rodrigo:00:38:04Upon the sale, or is it marked yearly like in the 60/40 rule in futures?
Matt:00:38:09Great question. Crypto’s taxed as property, which means effectively is taxed like equity. If you hold it for more than a year, it’s long-term capital gains, it’s taxed only on sale. It’s not taxed like gold which is taxed as a collectible even though people call Bitcoin digital gold. It’s not taxed like futures and marked to market, unless you’re buying crypto futures in which case it is. But traditional crypto assets are taxed as property. The two wrinkly bits, wrinkly seems to be my word today Dave. The two wrinkly bits are, there’s a little bit of confusion around tax loss harvesting and a little bit of lack of clarity about whether you have to have a 30-day delay when you harvest taxes. There’s debates around that. And there’s some confusion around airdrops and hard forks. The way we handle it for our investors, we issue a K1, we’re very proud, we’ve always gotten our K1s out in February or March, it’s an extraordinary achievement. And so we make it easy for them to file taxes on it, make it very simple. But there is more confusion than there should be, mostly their taxed like stocks.
Dave:00:39:22Yeah, but isn’t the wash sale thing, the issue here is wash sales right? So you can sell your Bitcoin down a bunch and then theoretically buy it back the next day and get the reset on that basis, book the loss now, offset it against your ARKK that went up a bunch whatever. I get that there’s no positive ruling on it but there hasn’t been a negative ruling on that, and that is currently how property is treated. So are you actually concerned about an IRS claw back or is this just mostly an issue that this could change any time, which that I agree with. I think it could change anytime, but it’s hard for me to see how they can simply say Bitcoin is a different kind of property so you have a 30-day window. You still have the sham transaction issue which is true throughout the tax code. You can’t make a transaction for the purpose of avoiding taxes explicitly with no economic gain. That’s fraud, that has nothing to do with what asset it is you trade.
Matt:00:40:17You have it right Dave. There’s just risk and uncertainty in the future because from an outside perspective you’d be surprised that you can do that non 30 day harvest thing. It doesn’t make sense from a first principles perspective even though I agree that’s how the tax law lines up. I’m not a tax professional, I just think people should be careful about that and careful about how much they rest on that understanding.
Dave:00:40:40Right. But if you are somebody who’s like one of these crypto degenerates who’s out there day trading Bitcoin all day, it significantly changes how your taxes work, right? You can’t just plunk those transactions into QuickBooks and call it a day. Like they are fundamentally treated differently in terms of how you deal with the gains and losses.
Matt:00:40:58That is definitely true. I will say, the IRS’s FAQ on crypto taxation is the best thing they’ve ever written. It’s actually shockingly clear. It’s even kind of clever and cute. I mean it. Out of every piece of IRS writing of all time, the FAQ on crypto is remarkably good.
Rodrigo:00:41:18I dare say nobody’s ever said that the IRS has written something clever and cute in their entire time. I’m legitimately going to read it over the weekend.Mike:00:41:29That’s a whole new string of words.
Rodrigo:00:41:31I’ll read it to my daughter.
Dave:00:41:32Never been said again, millions of monkeys couldn’t have come up with this.
Rodrigo:00:41:37Is this because it just provides, it covers most of the major loopholes and the clarity that is required because that would be news to me.
Matt:00:41:47It doesn’t cover the nuances. It doesn’t cover things like airdrops and hard forks and exactly how those should be handled. And those are very complex. What if there’s an airdrop but you never claim it? Did you actually receive that value? Should you have to pay taxes on it? It doesn’t get into those things. But in terms of the basics, in terms of 98% of the tax rules that impact people investing in crypto, someone who buys Bitcoin and Ethereum and sells them a year later, it is crystal clear about that.
Rodrigo:00:42:18Okay, that’s interesting. Got to take a look at that.
Mike:00:42:23The tax conversation’s already got me a little bit sleepy.
Dave:00:42:28Have another drink Mike.
Rodrigo:00:42:30There you go.
Mike:00:42:31Can we stop talking about tax for a minute.
Rodrigo:00:42:35Let’s talk about the fact that Dave calls you a crypto trade, trading degenerate, how about that? Dave is looking straight at you.
Dave:00:42:41I wasn’t looking at Mike.
Rodrigo:00:42:43You’re looking at me?
Mike:00:42:43I didn’t respond because I don’t know whatever that means.
Dave:00:42:48Degeneracy, not familiar. Sorry.
Rodrigo:00:42:53Okay, so let’s talk about the risks here. Just generally, like you said, there’s a crypto world that believes people talk about crypto the believes it’s going to go to zero. And so, as time goes by, and one would have expected ETFs to be approved by the regulators and governments. It just, time keeps going by and we don’t see any movement in the United States, the most powerful nation on the planet that also has the most powerful currency on the planet. Where do we see these dynamics going? And are we starting to falter a little bit?
Identifying the Risks
Matt:00:43:31Mm-hmm, that’s a fun question. I think the ETF question, I’m not actually concerned with the pace of progress in ETF land. So there are people in crypto who have a view that the SEC hasn’t approved a Bitcoin ETF because the Fed is worried about Bitcoin taking over for the dollar. I think those people are a little self-delusional. Bitcoin is a long way from replacing the dollar. And I don’t think there’s like an explicit don’t approve an ETF. David, I’ve lived through ETF approvals forever. They take forever in the US. Canada is always ahead of us by two years. That’s been true since the founding of an ETF, it’s still true today. Bonds took like four and a half years to get approved.
Dave:00:44:15Non transparent actives, up to seven years.
Dave:00:44:20Non transparent actives.
Matt:00:44:20Non transparent actives, which is just like an active fund. We’ve had I think it’s 16 meetings with the SEC over the last 14 months and we don’t even have an ETF filing right now. They’re extremely engaged, they’re asking very good questions. I think we’re close, I think we will get there. So I’m not worried about the ETF specifically, I do think we will get over that hump. I will say, there is a broad push right now, right now, by which I mean this moment, from every major US regulatory agency, to develop new standards around crypto regulation. And I think those standards are going to have a big impact on the stable coin market. I think they’re going to have a big impact on part of the DeFi market, I think they’re going to be very positive for parts of the crypto market, very negative for other parts of the crypto market. But regulatory risk and how that regulation breaks over the next six months is going to determine whether we’re in a generational bull market in crypto, or whether the industry faces real challenges. So outside of the ETF, I think there are big regulatory things to discuss.
Rodrigo:00:45:27Can we unpack that a little bit. What are those things that are the big pain points for them?
Matt:00:45:34Well, I think they’re very worried about stable coins. Stable coins are crypto representations of dollars, is one way to think of them. And there are varying qualities of stable coin providers. The largest is unfortunately the worst quality – Tether. And these are large 50, 60,70 billion, 100 billion dollars. And there’s concern both about whether there’s systemic risk there from those assets, say owning commercial paper and unraveling and having to dump that paper and impacting the market. And they’re just generalized concerns about how should these private versions of the dollar be regulated, and they form an integral part of the crypto market. They are where people withdraw from crypto’s volatility to hold money in a stable asset and they provide liquidity that interweaves at all.
So I think regulators are going to, I don’t know what they’re going to do in that space but I think it’s going to change. My guess is it changes for the better. I actually think the removal of poorly regulated stable coins removes a major risk in the crypto market and a risk that could cause violent deleveraging in the Defi space if it went wrong. So I’m in favor of it, but I do think it’ll be a painful journey, I think they could overreach, I think there’s risk there.
Dave:00:46:59But that implies, sorry I got a call a little BS on that. That implies that what we get for regulation is this sort of clear regulation about what a stable coin has to be to be okay. And that is allowed to then go do the things that stable coins are currently doing, which is largely working in liquidity pools. That’s the primary use case for a lot of them. They’re parking places for movement of liquidity and other crypto ecosystems, Gensler’s comments about the swaps markets, about the derivatives markets the other day, was the clearest negative indicator I’ve heard from the SEC yet, that they believe they have regulatory over…the way I interpreted what he said was, hey, you’re trading a swap against Tesla FTX in Germany? You are regulated by the US because Tesla is a US listed stock. So you want to get a derivative against it, we get the call. That was an eye opener for me.
Matt:00:47:57Well, yeah. To be clear Dave, I was just saying that I think their first focus is going to be on stable coin market. I think their second focus is what you’re talking about and I don’t think there’s a pathway for those synthetic stocks in their current iteration to survive. I think regulators are going to make that… it’s such a clear intrusion on their regulatory footprint. There are synthetic versions of oil that trade and they aren’t registered with the CFTC. I just don’t think that that unfinished circle is going to stay unfinished. I don’t think it means that there isn’t something that emerges out of that, that’s interesting and important. I mean, to step back for a second, FTX created a way to trade US stocks 24/7/365 and have them settle instantaneously.
Dave:00:48:49Which is brilliant. Like, let’s just make that our market system and I’m dying.
Matt:00:48:57I think we need to pause and point that out, that New York had hundreds of years to figure it out and they’re still trading six and a half hours a day, five days a week, some weeks. So we should give them a lot of credit for that. But I do think it’s going to have to evolve to a regulatory pathway. I think it’s really interesting for what it’s worth, that FTX was able to close a $900 million venture round amidst this regulatory uncertainty. I think that’s an interesting point that I’m still working around in my mind.
I’m From the Government, and I’m Here to Help
Rodrigo:00:49:26Well, I think what we’re seeing as always is, the ecosystem in the crypto space has allowed entrepreneurship to just grow untethered. So what you end up getting is a bunch of signals of hey world, this is how it should be. And then the regulators have to come in and like okay, we have to change, but let’s do it in a way that we can regulate, and possibly what all these stable coins were out of necessity. We’re out of people wanting to get out of the volatility of crypto, park it, move it from one place to the next and you could choose to go in FTX and hold your USD or you can choose Tether. But when you try to transfer it from FTX to Kracken, one will take seven days, and you might not get your money and the other one takes 20 minutes. And so what happens when governments and the US government creates a US government crypto coin that has all the same facilities but actually has some sort of regulation and backing that can transfer in 20 minutes? All of a sudden I think naturally you’re going to see people moving towards the more certain of the two.
I’m assuming that most of the new adopters aren’t terrified of the government spying on you and all that stuff. Just assuming that it’s regular people wanting to be in that space, it will likely choose a regulated, efficient coin than a non-regulated for sure.
Dave:00:50:49It’s only convenient if people will use it. And that’s the thing that’s slightly scary about the Chinese central bank digital currency is that it is explicitly being designed as a command and control vehicle for the CCP, it is not really designed to solve the entrepreneurial problems of the crypto class. People are going to use it like crazy because it will be very convenient, because it will tie into everything else in their financial world. The thing I worry about with the US CBDC would be the same thing. It’s like, if they launch one, everyone will use it almost regardless of what’s under the hood. We might talk about the hair that’s growing on it but if it’s convenient, if I can move it out of my Visa account, my bank account and then I can use it to go do some crypto fun thing and then I can pay my landlord with it, it’ll just be 100% adoption regardless of what they decide to bake into it that’s awful.
Matt:00:51:42I agree with that. My biggest concern about the US is they’re going to be too slow they’re going to get passed by on this out of reticence, and they’re going to be too careful because obviously a federal stable coin is a severe threat for the traditional banking system, depending on how it’s designed. And so I think the US is going to move slow, but I think it’s inevitable. I think everything’s moving that way, there’s no way it doesn’t end up in that place.
Rodrigo:00:52:10How does the euro dollar market work? Like you have a bunch of banks that are creating dollars out of nowhere by lending them out. You can also regulate another organization, an other group of people that are using your dollars in ways that are useful to the world and to them. So it might not just be one or the other. It might be the same thing as we see globally today.
Matt:00:52:32I agree. I was sad the US didn’t jump on board the Libra/Diem train. I thought that was the best single way to extend the US dollars’ dominance as the world’s currency and we just blew it, which is a shame.
Rodrigo:00:52:49Yeah, no kidding. It really is the derivative markets that’s driving a lot of this bull market, the demand, the liquidity and one of the use cases is the fact that the rest of the world can trade in New York time when they want to get access to Apple and Tesla. So you’re providing a service to the world that wants to grow their wealth and participate in the best technologies in the world when they’re too small to go to a broker dealer in India, get them to pay attention, open up an account and be able to trade what they want, at the time that they want. So it does answer a question, does create some use cases that we’re going to have to grapple with and deal with. I see no other way.
Dave:00:53:32Let me ask you Rod. I agree, I think the derivatives markets are the most interesting thing in crypto right now and I think they are driving an enormous amount of what we’re seeing. But at the same time, can you just strip all that away and say actually all this is access to ridiculous amounts of leverage, because that’s what I see when I start peeling back that onion, it’s like it’s not that trading futures this way is so much better and giving you access to betas you could never do derivatives against on the CME, it’s that you can get 100X leverage without really trying very hard.
Rodrigo:00:54:01Well, okay, so if you look at the actual numbers and Matt maybe you know more than I do on this, the actual 100 times levered guys represent like less than 1% of the ecosystem. So Dave, let’s not exaggerate…
Dave:00:54:17If the levered guys are 1% of the system, then they are 100% of the notional. That’s the whole problem.
Rodrigo:00:54:24Wow. Let’s take a second. Let’s take it back. I think the use cases for the derivatives market oftentimes aren’t leveraged. They’re just, if you’re going to choose to trade Bitcoin straight up or trade the perpetual, the perpetual is more liquid, it settles instantly. You don’t have to wait for it. So it’s like a second layer that becomes a way to get exposure to those markets. So it’s not as massively explosive as one might assume. But certainly, some regulation will probably help. We need to get in there and say…
Dave:00:54:58Just in keeping up with the margin calls?
Mike:00:55:01Well, that’s the other thing in the self clearing nature of the margin calls is kind of interesting. But on this I want to go to Lightning, the Lightning Network and the adoption that’s happening there too in that layer of payments and being maybe more of a threat to the dollar dominance in everyday payments. What are your thoughts on that?
Matt:00:55:22I certainly think there are two ways that crypto can penetrate the traditional payment use space, or maybe three ways. Lightning is a good example. So the Lightning Network allows you to throughput a lot more transactions much more efficiently than you can if you have to write everyone to the blockchain. So it makes Bitcoin more functional as a cryptocurrency. And there’s a lot of layer two side chains that do this for other assets as well. I do expect Bitcoin to become more of a transactional currency on the margin, I think you already see it, tackling places where traditional fiat currencies are truly atrocious, like remittances or in certain capital controlled markets. Over time, as the volatility declines, as things like Lightning make it more usable, I suspect it will eat into more and more of those markets. And I think there’s a nonzero chance that over politicization of fiat currencies causes the world to want an apolitical currency, and you can see a step function increase in interest in Bitcoin.
For what it’s worth, I don’t think it has to penetrate any of those use cases to be a phenomenal investment. But I think those are gravy on top. And I think it’s indicative of the level of innovation, the speed at which this is being adopted and the speed with which new technologies are being built is really almost, it’s kind of breathtaking and probably going to accelerate as more VC money comes into the space.
Mike:00:56:53Just take a look at the Overton window of the general zeitgeist of 12 months ago to today. It’s breathtaking. How much this has moved from, if you’re an advisor, an allocator or an individual who’s talking about this asset class 12 months ago, July 2020.
Dave:00:57:15You were a lunatic, yeah. And now you’re one of those guys who’s a little on the edge.
Mike:00:57:23Yeah. That is very much like that ETF journey.
Dave:00:57:27It’s the Overton window shifting what is acceptable behavior and all of a sudden it’s like, well, MicroStrategy straight down the middle.
Mike:00:57:35You don’t have 10% Micro Strategy, what’s going on?
Matt:00:57:37I will tell you, it’s so true. The percentage of advisors who asked us about will it go to zero has vanished over the last year. And the flip side of that is the average allocation of a Bitwise client I think has gone up from about a percent to two and a half percent of their portfolio because that binary risk has disappeared. So I think that is a very real material change. And I think it’s driven by a very real and material … of these binary risks. Crypto really did live by a thread for many years, at a level that many people don’t understand. It could have gone to zero almost instantly for the first eight or nine years of its existence and it didn’t. And I do think we’re past that point now.
Rodrigo:00:58:22And is that partly to do with the DeFi space, the different crypto coins and that general ecosystem that is kind of creating different use cases and opening people’s eyes to the new technology?
Matt:00:58:39I think that that’s definitely a piece of it. It’s gotten a second story through DeFi and things like Uniswap, which I think is the greatest entrepreneurial story of the past 10 years. But even more basically, I’ll tell you a story about Bitwise. It was an early startup, was backed by some of the leading venture capital firms in the world, Vinod Khosla and Neval were invested. Craft Ventures, Catalyst, General Catalyst. We couldn’t get a bank account to make payroll because there were no banks that would provide payroll services to anyone involved in the crypto space. This was 2017. At the time there was one bank who would do it the whole nation. When I talk about like crypto living by a string, that’s the kind of example I mean. Today, dozens of banks, anyone will do it. But even four years ago, an asset management company backed by blue chip venture capitalists with people with 20 years of experience in financial services couldn’t pay payroll to provide funds through Wilson Sonsini as the lawyer. It’s insane how…
Rodrigo:00:59:44The fertilizer wasn’t there.
Matt:00:59:45Exactly. It’s insane.
Mike:00:59:49Were you like a construction site on Friday with the envelopes full of cash for everybody?
Rodrigo:00:59:54Everybody got a USB card?
Mike:00:59:56I’m reminded of my days working on the farm and going to the labor pool picking up all the labor and then having to pay them at the end of the day with cash.
Matt:01:00:03It’s so true. It was brutal. We had to call in a bunch of big favors in order to get a bank account, it was amazing.
Mike:01:00:13So where are you seeing flows in Bitwise? You’ve got a suite of products, and so where are you seen the general emphasis of interest if you will? And maybe where do you think if that’s not the right place to be where do you think the next layer of interest would be or what are you seeing now and what do you think might be the future of opportunity?
Matt:01:00:35Yeah, sure. Most of our assets are in our large cap index fund, the Bitwise 10, because most of our clients are financial advisors who just want beta exposure to the space. I will say that our DeFi Index Fund which launched in February was one that was much faster out of the gate to grow. We pulled in more than $100 million in a private placement DeFi fund in the first six weeks it was on the market, which is very fast for a private fund. By comparison, it took three years for our index fund to get its first 100 million dollars. Most of my money’s invested in our Index Fund. I’m really personally excited about Eth. I think Eth is the, is the crypto asset of the summer and maybe of 2021. And so if I were an advisor looking outside of the large cap core, I think there’s a lot to be said for focusing on the Ethereum space right now. It’s going through a few technological upgrades that are really big deals, and really smart.
And yeah, I just think it’s a phenomenal ecosystem. There for what it’s worth, there are more like off piece down the road stuff I could talk about, but I really do love Eth right now.
Rodrigo:01:01:53So let’s talk about Eth and why you’re excited about it.
Matt:01:01:57 Yeah, three reasons. One, everything in DeFi is built on Eth. So it’s fair to think of Eth as the internet that Defi exists on, so if you’re excited about DeFi you should be excited about Eth. Two, there are two major technological upgrades coming in the next 12 months. One of which is coming August 4, which is called EIP1599. EIP1599 is an upgrade to the Eth software. It makes it easier to use in a cool way, but the great thing it does for investors is it changes what happens with the transaction fee. Currently, when you can transact on the Ethereum blockchain, the fee goes to the miner who typically sells it. After EIP1599 the base fee will be burned. You can think of it like a stock buyback. It turns Eth into a consumable commodity like oil or gas. So in order to run DeFi on Eth, you have to burn Eth. And I just think that makes it so intuitive as an investment. I think it’s going to bring a lot of institutions in.
Rodrigo:01:03:00Walk me through that again Matt. Sorry. I want to fully understand that.
Matt:01:03:03Yeah. Right now, if you’re processing a transaction on the Ethereum blockchain, if you’re using Uniswap and you have to write that transaction to Ethereum, you typically pay a transaction fee. It could be 0.01 Eth, it could be 0.02 Eth, it could be some small fraction of Eth, as a tip to the miner to process your transaction. Today that goes to the miner and they typically sell it because they have to pay for electricity, they have to pay for mining equipment, etc. After this upgrade, the miner continues to get newly minted Eth. That’s the other way they’re compensated, the same way Bitcoin miners do. But this transaction fee, instead of going to the miner, the base fee is burned or destroyed forever. It’s like you’re putting gas into the Eth engine and it’s consuming it.
And I think as an investor when you think about Eth today, it’s abstract as an investment. What are you buying when you’re buying an Eth token? You’re buying like a stake in this protocol and how is it monetized? What valuation characteristics? Hard to think about. But if you say, you’re buying this gas that powers the Internet of Finance, and every time you want to do a transaction someone has to pay in that gas. I just think that’s a very intuitive way. It also reduces Eth inflation. If you think about the Bitcoin halving, a lot of people attribute Bitcoin’s run to it’s halving. This is about half of a halving. So it will reduce Eth’s inflation from 4% a year to about 3% a year, which is a material reduction that no one is talking about.
And then the second thing just to finish and we can keep going. Next year, we’re supposed to evolve Eth, I’m not part of Eth. Eth is supposed to evolve as decentralized, maybe I am. Eth is supposed to evolve to Eth 2.0, which everyone’s excited about this move from proof of work to proof of stake, which will move it to a carbon neutral consensus mechanism. But that will reduce the inflation from 3% to 1%. So Eth’s inflation rate is going to fall from 4 to 1% over the next 12 months. That’s like a halving and a half. And I think that’s a very big deal in terms of the supply demand dynamics. And I’m pretty excited about it.
Dave:01:05:27Yeah, and I’ll just toss in there. I think, first of all I called Matt an idiot when he made the jump. So I was clearly wrong about that. But because of knowing that for all these years, I read all his stuff. I have to it’s in the contract. And so I read all of his stuff about it and I went down the Ethereum rabbit hole really tightly and with a lot of depth, and actually I think you’re underselling it because it’s easy to look at it and point out all of its flaws. You could write a smart contract network better this way or that way. But the network effects are so profound when we start talking about actual utility, because that’s the difference between Ethereum and virtually everything else.
Ethereum provides a utile service. And that’s what’s really unique about it and what’s different, and that utility is explicitly tied to the size of the network. That’s something that’s very difficult to usurp. You can write the better Ethereum version, there’s 100 of them out there. And some of them will find their use cases, they’re hyper secure, they’re faster, whatever it is, but I don’t think anybody’s going to step in and MySpace Ethereum anytime soon. It just doesn’t feel like it, and the protocols itself and solidity and the ways you access it are just elegantly designed from top to bottom. So to me, this is a case where open source works.
Rodrigo:01:06:51Yeah, I mean, The key issue with developers right now happens to be the cost of them being able to transact and anybody to be able to transact right now, and the second thing is it’s slow, so that’s going to be dealt with in 2.0 as well. The issue of course becomes, from what I gather, that they’ve been promising you 2.0 for a long time. The developer’s holding on, holding on, holding on and finally some just splitting off because they’ve got a business to run. Going to Cardano or NAVY, whatever other coin makes sense to them. So it’s going to be interesting to see if they can deliver on some sort of timely transition for the vast majority of the ecosystem to stay with them.
Matt:01:07:34I agree. That is the big risk.
Rodrigo:01:07:39Well, that’s super interesting.
Mike:01:07:44I might just weave in Steve’s question. So do you see the correlation between Bitcoin and Ethereum to remain high in the future or continue to decrease? And I wonder if some of the comments that you’ve made here would lead you to a conclusion that the correlation may decrease in some way or not, I lay at your feet to answer. It’s on the screen.
Matt:01:08:06Great question. It’s definitely. I shouldn’t say that. The lawyer just kicked me in my head.
Mike:01:08:13 It maybe, it could be.
Matt:01:08:15It may. I think the correlation is likely to decrease over time between all crypto assets but particularly between Bitcoin and Eth. Between all crypto assets because the sort of industry wide risk has diminished so much as we discussed, and it used to be that that overwhelmed any coin specific utility between Bitcoin and Eth specifically for the reason Dave mentioned. Bitcoin as a technology and as an asset is really optimized for the store of value use case, potentially the transactional use case. Eth is really optimized as this useful other blockchain and I do think as we see more utility build in Eth, the correlation will drop. They’ll still be correlated, like, .7, .6. But I think they’ll be correlated in the same way that Microsoft and Salesforce are correlated.
Mike:01:09:11What you were saying triggered something for me and that in this early development nascent field, frontier asset class, you’re all going to be together and you’re all going to have very high correlation because the economic utility that you might provide is going to be overwhelmed by the liquidity in the space. But as the economic utility of the business models that you might provide to different business cases deviates and creates a dispersion, then those business cases are going to provide a different sort of discounted cash flow or some sort of expected growth in the future, that have structural relationships that are different from one another, and thus you’re going to get a proliferation of non correlation through the space.
Rodrigo:01:09:52I think that comes down to the commonality and risk right now in the crypto space. It’s that lack of fertilizer for a great seed, a great idea. All the seeds require that fertilizer reset, which is proper regulation, clarity in taxation, banks that are willing to onboard and off board. As that becomes better and better, now you worry less about the big Armageddon event and you start worrying about this specific company events. That’s when I think we’ll start seeing very unique diversification of assets.
Matt:01:10:28I agree. Well said.
Mike:01:10:31I love it.
Rodrigo:01:10:33Okay. So let me let me ask you, right now I’m looking at some of the funds and everybody that’s in this space and trying to index all this stuff. And we talk a big talk about diversification and market cap and then you get into it and currently today, and this is going to change in the future I’m sure, it’s basically like 90%, Bitcoin, 5% Ethereum, and then 20 .3’s allocations to the other asset classes. The concept is there, where we are right now is not necessarily that level of diversification that one would consider, so how do you see that evolving?
Matt:01:11:08I think it’s likely to change over time. Our index is maybe 65% Bitcoin, 30% Eth and the rest is small assets. I think it is likely to change over time. If I were a betting man, I bet Eth’s share will grow and I bet you’ll see some of these DeFi specific apps like Uniswap accrue larger market capitalizations over time. But it is a network effects business. I think the largest will remain the largest. The real advantage of an index strategy is it doesn’t matter how it turns out. If the Bitcoin maximalists are right, it’s all Bitcoin, then the index will be all Bitcoin. If the flippeningists for Ether then it’ll be flipping…I had to pause for a minute on that. But I do expect more diversification in that mix over time, I expect Bitcoin’s dominance to drop, it’s just further along in penetrating its use case than these other assets. Like it’s pretty far along the chain of being digital gold, even further than Eth is to being the Internet of Finance. And that’s why I think its market cap is as high as it is right now.
Rodrigo:01:12:21And can you tell me more, I am really interested to hear and why you think Uniswap is the most compelling entrepreneurial case in your lifetime, or whatever you said. Why are they so special for you?
Matt:01:12:34It’s so amazing. So Uniswap, for people who don’t know, is a decentralized exchange. You can think of it as a decentralized version of Coinbase where any person can be a liquidity provider. It’s trading like $50 billion in trading volume a month and generating a couple 100 million dollars in fees. There have been weeks where it trades more than Coinbase, a $60 billion publicly traded company. It has zero employees, zero offices and no CEO. I just find it hard to imagine a startup that didn’t exist three years ago, that is today generating hundreds of millions of dollars of monthly fees and trading $50 billion in volume, is challenging one of the most successful IPOs of all time for trading volume, and is doing so with no employees. I mean, it’s mind blowing.
Dave:01:13:26And more to the point, they’re sort of like the Vanguard in the space, because the people making all of those fees are the people participating in the process. It’s not all just accruing to…
Rodrigo:01:13:36Talk a little bit more about that Dave.
Dave:01:13:39I mean, the whole idea of what Matt is telling you about Uniswap is that Uniswap is fundamentally just a protocol. It’s not a company in the way we would think about it. And as such, it’s just a way of enabling these mediums of exchange. I don’t know who was first, but they’re the popularized version of the simple liquidity pool. It’s really one of the first examples I’ve ever seen where people stake different assets and you allow the market on some curve to determine whether or not you’re booking arbitrage on either side of it. I mean, it’s fundamentally the creation/redemption mechanism for ETFs on steroids. And it allows people to both create anything they want to trade, any two items they want to trade against each other that can be tokenized, can run through the Uniswap protocol and the fees that come out of that, accrue to anybody who wants to participate, which is a little bit like Vanguard. If you are an S&P 500 index investor at Vanguard, you’re effectively playing at cost and to the extent the company happens to be really efficient at it, that cost just keeps going down.
So, Vanguard doesn’t necessarily pay me to be in that business. But hey, you know what? Add on security lending revenue and in fact a lot of times they do. And so I think Uniswap is a classic case for decentralization, actually Vanguard-ing the rest of the financial services industry.
Matt:01:14:55Yeah. And I will just say, like the Uniswap thing really woke up for me. I was talking with the lead trader at one of the top crypto hedge funds in the world. He said he migrated most of his trading to Uniswap because he was getting better prices. So not only is it disruptive in the way that Dave mentioned, but it’s disruptive in terms of its ability to deliver prices. I really do think if it was started by like two guys from Silicon Valley, they’d be on the front page of The Wall Street Journal. It just happens to be started by a guy who wears a tatty unicorn shirt. And so it doesn’t get as much attention as I think it should.
Rodrigo:01:15:31Right. So these guys are…any market participant can go in, find a crypto pair, that let’s say they own one half of the of the pair, they add liquidity as an automated market maker. So this is kind of like the idea you’re putting your liquidity in and for providing, for staking that coin and allowing other people to trade in and out and creating that balance between the payer, you are getting paid while you wait. So it’s really…
Dave:01:15:59Just like any other market, the more willing you are to provide liquidity on something that is otherwise illiquid, the more money you’re going to make. So it encourages exactly the kind of risk taking that encourages the economies of scale and the network effects we know you need to get to make these things work. But it also makes it really lucrative for what I would call more traditional institutional market making type activity.
Matt:01:16:21That’s exactly right. It also solves a future problem, Dave. If you think about Europe, you can pay market makers to tighten liquidity spreads on ETFs and you can’t do that here in the US. One challenge when people talk about tokenized assets is how you’ll have liquidity and this huge fracture of tokenized assets. Well, this is one example. If you had a tokenized asset or supporting an ecosystem, you could provide liquidity to jumpstart liquidity in that market in a direct way, which you can’t do in traditional markets. And I think that’s sort of like an elegant add on that people haven’t even gotten to yet.
Rodrigo:01:16:57That’s exactly the type of innovation that’s coming out. And that’s only like the tip of the iceberg in so many other ways. The best and brightest minds are going in and coming up with use cases. It’s very exciting.
Mike:01:17:10How much is the regulatory pushback we’re getting being driven by the old guard and their money and influence?
Rodrigo:01:17:19Not yet. Not now.
Mike:01:17:21What’s happening now? I don’t know. I actually don’t know the answer to the question. I think it’s a sort of a very touchy question maybe. But how much do we think that the regulatory pushback is driven by the old guard?
Matt:01:17:36I think they’re pushing for very aggressive regulations; I think is the answer to that. And I do think they’re afraid. And I will add, there’s every risk that regulations are overzealous because they can be story driven and politicized and not based on technology. And you see some elements of that. So I do think the old guard, I think some of them are ignoring the crypto and DeFi markets, and I think some of them are worried about it. And I think a vanishing few are embracing it, because it still seems too foreign to them.
Mike:01:18:06The good thing is that constituents in the voting base are jumping into the boat and so the influence peddlers will be peddling different influence as the aggregate of voters changes.
Rodrigo:01:18:22Yeah, that’s interesting. I think Dave you said that this is adopted by institutions and retail. I kind of feel like the adoption is mostly retail, like retail has really led the zeitgeist here. And a lot of people have it, they are voters. And if the government is going to become…again between them and their Bitcoin is going to be a problem. On the DeFi space people that can’t get a credit card can get a credit card if you own Bitcoin, and like Crypto.com will be offering something like that. And there’s a few places globally that allow you to, if you have bad credit, to actually be able to participate in traditional markets through credit cards that are being backed by Bitcoin. So all these things that are making things easier for Americans and everybody in the world, you take that away, there’s going to be some voter lash back.
Dave:01:19:10I’m taking the under on that one, the American voter’s not showing up to kick people out of office because they don’t like their financial regulations ever.
Rodrigo:01:19:21You’re missing regulation, versus wealth accumulation. Like this is the opportunity for them to wealth accumulate.
Dave:01:19:27It will be a very small percentage of Americans who are both in crypto and connect those dots. But yes.
Matt:01:19:34Although you are seeing activity from like the mayor of Miami, from various states.
Matt:01:19:42Wyoming, parts of Texas. I think they’ve been pro crypto.
Dave:01:19:45I think it’s going to happen and I think there will be a lot of pressure on regulators. I don’t think we’re going to have a presidential election lost over a stance on crypto regulation.
Rodrigo:01:19:59Well, it’ll be more than you think.
Dave:01:20:03It might show up on the agenda as item 37 down on the fifth plank.
Rodrigo:01:20:09It’s going to be right next to legalizing marijuana my friend.
Mike:01:20:13Check the box. It’s already done.
Matt:01:20:16Next up. I love it.
Mike:01:20:23There was one earlier question that was a bit technical and it didn’t want to disturb the flow. But there was Bob H. asked how can in the Bitwise 10, why is ADA or Cardona included over Tezos and with the fork and whatnot? I don’t know if you can comment on that. Or I’m not sure if you can or can’t, but please.
Matt:01:20:48I can definitely comment on it. Cardano is included because it has a larger market cap. The criticism that Bob is making, that there isn’t a lot of development activity on Cardano is accurate, and a topic of great conversation in the crypto markets. It checks out as a cryptocurrency and as a blockchain from a fundamental sort of technological functioning aspect. And from a security aspect and from ability to custody asset, aspect. So as a market cap weighted index, we just have to take the market’s view. Tezos has been a component if they’re successful, I hope they’ll be a component in the future. But right now they’re outside of it from a market cap perspective.
Mike:01:21:34Great. And then one of our own beloved Richard Laterman asked about that, well, Cordano’s role in DeFi and competing with Ethereum. But probably…
Rodrigo:01:21:45We covered that.
Matt:01:21:47Yeah, it’s a slick blockchain, very performant. And the question is, if it can come catch up with Etheeum’s network effects developer community brand and recognition and that’s what makes it fun to watch. We’ll see.
Mike:01:22:02Absolutely, love we’re having a horse race where you got all the horses in the race.
Mike:01:22:08Well, we’ve been that this for an hour and 22 minutes guys, I think that’s been a great Friday and I really appreciate you coming and joining us and Dave co-hosting, you’ve done a fantastic job.
Dave:01:22:19You did give me way, an opportunity to poke fun at Matt.
Mike:01:22:22I love it. But before we go, first of, all everyone listening please hit the like button before you go, share this with somebody all that good stuff. And then I just want to go through for Dave and Matt where people can find you, any recommended spots that you want them to look at or educate themselves on etc. So maybe Dave hit them first.
Dave:01:22:40I’m just all in on twitter @Davenadig on Twitter, you can link to my stuff in my profile page there over at ETF Trends.
Matt:01:22:49And for me @Matt_Hougan which is H-O-U-G-A-N, it’s got that funny U in it, or come to Bitwiseinvestments.com, sign up and I’ll send you my monthly notes from the CIO.
Mike:01:23:01Love it. We all know where Rodrigo is from so that’s fine.
Rodrigo:01:23:06That’s right. I got the worst Twitter handle of all time because all the Rodrigo Gordillos are taken. RodgordoP that whatever, just find me, follow Dave Nadig and Matt and slip into his DM and then you can find me and tag me there.
Mike:01:23:25Happy Friday gents. That was a real pleasure.
Rodrigo:01:23:27Thanks for joining.
Dave:01:23:28Thanks for having us.
Matt:01:23:29Thanks for having me.
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