Podcast Transcript: Ari Paul on Valuing Bitcoin, Ethereum Killers and Metaverse Bubbles

This is an edited transcript of our podcast episode with Ari Paul, published on 17 December 2021. Ari Paul is co-founder and CIO of BlockTower Capital. BlockTower is a crypto and blockchain investment firm, applying professional trading, investing, and portfolio management to this digital asset class. In this podcast we discuss how to value bitcoin, trends in layer one protocols like Ethereum and Solana, risk of sizing positions  and much more. While we have tried to make the transcript as accurate as possible, if you do notice any errors, let me know by email.

Bilal Hafeez (00:01):

Welcome to Macro Hive Conversations with Bilal Hafeez. Macro Hive brings you the best analysis to successfully invest in markets from crypto, to equities, to bonds.

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Now onto this episode’s guest, Ari Paul. Ari is the co-founder and CIO of BlockTower Capital. BlockTower is a crypto and blockchain investment firm, applying professional trading, investing, and portfolio management to this digital asset class. It’s funded by well-known investors, such as A16z, and Union Square Ventures. Before BlockTower, Ari was a portfolio manager for the University of Chicago’s 8 billion endowment fund and a derivatives market maker and proc trader for Susquehanna International Group, SIG. Now onto my interview.

So welcome Ari. It’s great to have you on the podcast.

Ari Paul (02:15):

Thank you for having me. Happy to be here.

Bilal Hafeez (02:17):

The question I always like to start with, with all my guests are the origin story. Where did you study? Was it inevitable, you’ve end up in finance and eventually crypto, what’s been your journey from university to now?

Ari Paul (02:27):

I’ll keep it brief and I’ll answer also through the lens of what brought me into crypto and which then helps tie into the state of the market and value proposition. So I’ll work backwards. So I run BlockTower with my co-founder Matthew. He’s our CEO, I’m our CIO and we’re a crypto asset management firm. And I launched BlockTower coming out of the UChicago endowment. So similar to most of the large endowments in the US, it’s a fund of funds model. So that was thinking about long term portfolio construction and allocation, as well as really getting into the weeds of why do some fund managers outperform and others who seem really known hardworking struggle to eek out any alpha. So a lot of very high level conceptual thinking about where does alpha come from and how do you generate alpha as a fund manager? And then before that I was a trader. So I started my career as a market maker at Susquehanna International Group, just a leading option market making firm. I traded a couple prop trading firms doing treasury bonds commodities, FX.

So the option market making, short term prop trading and then the endowment world. So I think of my background as barbelled. It’s very short term trading market making arbitrage, and then very long term endowment, allocating, underwrite and fund of funds investing.

On the academic side, I did an MBA UChicago, I’m a CFA charter holder. And then when crypto was becoming a viable asset class in 2016, Bitcoin was $4 billion. All of crypto as an asset class was about 7 billion. So in the very beginning, I bought my first Bitcoin in 2014 and couldn’t even really think of it for the endowment at that stage. It was just so small, so nascent. It wasn’t until 2016 that I started thinking about cryptocurrency as a possible asset class, as something that the endowment UChicago could possibly allocate to. And it became clear to me that it would just be a very long slow road to getting institutions into crypto. I’m navigating the bureaucracy, overcoming the reputational risks, all of that. I was impatient to jump into the industry. And so in 2017, my thinking was, do I spend the next years trying to get institutions into this and to profit from it? And I decided that frankly, you needed an investible assets for institutions. So in early 2017, for example, you had almost no crypto funds. There were a few funds in existence, most were run by one or two people out of an apartment building. They didn’t have addresses.

When I was at UChicago, I interviewed a few of the crypto funds that existed. And one of them, for example, I said, “How do you think about alpha vs beta?” And they said, “What does that mean?” It was run by a 23-year-old kid who had never, literally didn’t know what the term alpha and beta meant. And that some of those funds were great. I’m not trying to insult anyone here but I knew that no institution with the fund manager who can’t answer the question of what is alpha and beta. So basically it was, we needed to build a institutional crypto asset management firm so that we could then go to endowments and pensions and say, “This is a space that you can invest in while still sleeping easy at night.”

Now when I say sleep easy at night, there’s lots and lots of risk in cryptocurrency, operational custodial counterparty, market risk, of course, but that wasn’t really what kept institutions out or what keeps them out today. In a classic portfolio management sense, diversifiable risk is awesome. It’s the holy grail. If you can earn a return for taking a risk that can be diversified away with most industry specific operational risks, that should be extremely attractive. The problem is the reputational and bureaucratic risk. The problem is that if the risk you have to take might cause problems for you as a fiduciary, that was the problem, right? So it wasn’t that, oh, we can’t take operational risk to earn insane returns in crypto. That should be very attractive, right? You allocate 1% of your portfolio. The operational risk is diversified away. You’re just left with this incredibly high expected value. But from an institutional perspective, the problem is that, that operational risk is potentially you’ve given money to a fund manager that is unprofessional or not a proper fiduciary, then that’s just untenable.

Bilal Hafeez (06:19):

No, that’s great. I mean, this leads on to a couple of different questions. I mean, one basic one was it seems odd for someone who was in endowment to go to crypto. I mean, I always think had you been on the option side that would’ve been the more natural transition, but you went from short term to long term endowment. And when I think of endowment, I think of the very conservative long term. And so that jump to crypto, I mean, how did you make that jump to crypto from the endowment mindset to crypto.

Ari Paul (06:45):

For me at least it felt seamless in the sense that at the endowment all day long, we’re asking where do we find alpha? And a classic fund of funds way of thinking or allocator way of thinking is you want to look at spaces that are less competitive, right?

So we know that for example, you’re not going to earn outrageous ROI alpha trading treasury bonds. Because treasury bonds are a very efficient market, very liquid, right? You’re not going to find a treasury bond mispriced by 15%. So generally it’s easier to earn alpha in where it’s less competitive, right? So small caps, frontier markets, emerging markets, new asset classes, and at the endowment, we were having those conversations. So while endowments and pensions are certainly more conservative in many, many ways, you do have allocators there that are asking the same basic questions, which is how do we earn alpha? How do we earn the best alpha we can get? And endowments have actually historically been in some ways, risk takers. So for example, they were very, very aggressive allocating to VC. So today, many of the biggest, biggest endowments have a 20% plus allocation to VC. And maybe today that doesn’t sound aggressive, but they were some of early innovators in upsizing that VC like David Swensen at Yale, really pioneered the idea. You could have 30% of an institutional portfolio allocated to VC. And frankly, I’m not sure I entirely agree with that. You get into a debate over just how illiquid and how high beta are these assets. Actually, I’m a geek about this stuff. A project I did when I was in UChicago was, what is the real beta of VC to public equity. And 15 years ago, a lot of endowment professionals actually would argue with a straight face and VC professionals that the beta is less than one. And they would say that because illiquid books are marked quarterly. And so they would literally do the math using lagged, quarterly valuations regressed against public market and say, “This is low beta.” Incredibly simple error, but the point is, it’s actually not. It’s subjective and debatable, what is the real beta, right? You have to correct for a lot of subjectivity and marks.

So I did projects like that and found it really interesting. So my point is endowments and pensions are… particularly Canadian pensions by the way, Canadian pensions are very, very innovative. They’re very, very conservative when it comes to regulatory risk, fiduciary risk and reputational risk, but they have been somewhat aggressive in portfolio construction. Because they are perpetual life investors, they do try to generate higher returns making use of that advantage.

How to value Bitcoin and the drivers of crypto markets

Bilal Hafeez (08:59):

Yeah. Actually, that’s true what you’re saying. I mean, I do find that when I have conversations with pension funds and endowments, you end up having more strategic conversations about asset allocation, the true underlying returns of assets. So there are some more deeper, meaningful conversations. I guess the issue one would have then is when you have a new asset class like crypto let’s focus initially on Bitcoin, how do you think about the return of Bitcoin when it doesn’t have a coupon per se, not like a bond, it’s not obvious what valuation framework you can use either. And to some extent, it’s just like a supply and demand market. You know okay, there’s certain scarcity and you just got to hope there’s a network that kicks in. So, I mean, how do you have confidence that there’s some inherent value in it.

Ari Paul (09:41):

To rephrase the question, It’s almost, how do you invest in crypto, right? Broadly, what investment frameworks, how do you think about it? Yeah, obviously a lots to unwrap there. So I would say first, I think of Bitcoin as at least today, closest to a commodity.

Exactly as you said, it’s supply and demand. And so I approach it first and foremost as probably like a global macro trader. So what is the current market psychology? What are its current co-variances to other assets, very non-stationary by the way. So when I say it’s… I’m not approaching it in a stat are sense. When I look at its relationships to other assets. That’s to give me insight into how the world is currently thinking about it and trading it. And then I’m trying to predict how that will evolve and change. So for example, if gold rallies, all else equal do we think Bitcoins up. If treasuries rally, if US dollar is weaker relative to other FX. All of these relationships are a bit non-stationary, but you see key patterns and themes that tie into the market narratives. So there’re points in time where the marginal buyer of Bitcoin are global macro traders, thinking about it as an inflation hedge. And then there’s other points in time where those market participants are on the sidelines. They don’t care about Bitcoin. They’re not interested, or they’re at least not the ones marginally moving it. And who is moving it? Maybe it’s people excited about retail in El Salvador or it’s people excited about tech improvements like liquid network and tap route. In which case it’s a little more of a tech thesis and it’s reacting a bit more to fundamentals. But very, very often it’s pure supply and demand Like when there’s a crackdown on Chinese miners and the Chinese miners look to liquidate Bitcoin holdings they mined five years ago and you just get $5 billion of Bitcoin selling and it goes lower. Doesn’t matter anything else that’s happening, you get enough selling of an asset and that’s triggered by this very idiosyncratic behaviour. So, okay, direct answer, Bitcoin, I think of is a very commodity like, very supply and demand driven where when I’m trying to think about it and price it, I think very global macro, where are we in the market cycle? Who’s the marginal dollar? Let’s look for patterns of adoption and patterns of, I’ll call it market narrative.

You see ripples of adoption. So for example, Q3, Q4 last year, the marginal buyer of all crypto, but particularly Bitcoin were Western Hemisphere high-net-worth individuals. People like Michael Saylor who bought personally and then had micro strategy buy. People like Elon Musk who bought personally and then had Tesla buy. Then once Bitcoin made a new all time high, that triggered the retail phase of the whole market. So Bitcoin made a beat its 2017 high, settling you have headlines all over the world. Bitcoin makes new all-time high. Every time Bitcoin ends the day a dollar higher than the day before there’s a new Wall Street Journal headline. That triggers retail adoption. And retail, they like different coins. So retail says, “Well, Bitcoin’s already up four X on the year.” And it’s a big number, right? Buying Bitcoin 40, 50, 60,000, it feels hard to get a 10X out of that. So retail says, how do I make Bitcoin like money in something newer? Right? So they invest in do Dogecoin or Shiba coin or maybe stuff like Ethereum and Solana that feels like they can more easily imagine it giving them a quick 10X. So a lot of BlockTower’s investing and trading is with the mindset that I just walked through.

It’s thinking, who’s buying right now. Who do we think is the next marginal buyer? What are they going to be buying? And then looking for data to help us better predict that. So we look at on-chain data, anecdotal data. So Q3, Q4, last year we were talking to people like Michael Saylor, the billionaires that were… basically, we were talking to the billionaires buying a hundred million dollars worth of Bitcoin. So when Tesla, right before they publicly announced their buy, we were pretty sure Tesla just bought a billion dollars of Bitcoin. And we were pretty sure that not because we had any special intel, we saw TWAP buying on Coinbase from nine to five, which is bizarre. We had never seen that before. Because crypto trades 24/7, Coinbase is open 24/7. Why would any entity do a daily TWAP of nine to five? So we said, “Okay, this is probably an institutional buyer going through the Coinbase of DC Desk.” We were able to back out the rough amount of buying happening every day. And that was around the time that we knew that some big companies like Tesla were considering. So often, we’re trying to put this mosaic together using a mix of on-chain and off-chain anecdotal data, things like for example, you can see deposits to exchange.

An amazing thing about cryptocurrency is you have this entire new type of data. You can see the on-chain data and people are still very much building the tech stacks to hold in that data, figuring out how to analyse it. It’s a whole new world that for example, sigmas and the RenTechs of the world are still trying to figure out how to parse. I frankly wasn’t sure how novel this would be for them. I’m not really a quant, at least not in the machine learning sense. What they tell us is basically the on-chain data is an entirely new industry for them. So eventually they will be competing in that game, but they’re a long way off.

Bilal Hafeez (14:20):

I’d agree. I mean, we’ve be looking on-chain data as well. And what’s quite amazing is just the volume of data and the transparency that you get. It’s just phenomenal much more than you get in macro. And what we have found is you do need to use some machine learning because there’s so much data and there is some quite powerful leading indicators as well. But as you say though, the challenge is that the stability of the drivers is unclear because there’s lots of new players to the market. Sometimes on-chain works really well, other times it just doesn’t tell you anything. So as usual, there’s no free lunch with all of these sorts of things. But one question I did want to ask in relation to Bitcoin is that the crypto market reminds me of religion or politics. There’s all these tribes and ideologies out there. And you hear about Bitcoin Maximalist or Bitcoin maxes. Do you think that there is one crypto market that will last, not forever, but would last for like 20, 30, 40 years, that’s here to stay or not.

Ari Paul (15:17):

Yeah. I mean, your question about does Bitcoin… I tried to directly answer it, but I missed a piece of the question and I really didn’t address that there’s fundamental value there at all. So you even said, how do you confidence, there is intrinsic value. So I gave the trader answer, but let me give them more fundamental answer, which I very much believe in and is a big part of why I’m in the industry and why I’m… I mean, I bet my career long crypto. So, for example, a lot of what BlockTower does, we do things that are market neutral and are direction agnostic. I bet my career on the beta and that was because of the fundamental and intrinsic value that I see. So first with Bitcoin, I would argue that Bitcoin is trying to be primarily a settlement layer and Swiss Bank in your pocket. I think those are the use cases it’s really targeting and this of course gets debated. It’s interesting, often you’ll have a company or a product and in the earliest days, it’s debated quite what is the use case. It’s kind of like we built this cool thing, but we don’t really know how people are going to use it. And tech was often like that. Much of the internet was like that. It’s hard to anticipate that social media platforms like Facebook would be used in quite as an extensive. I mean, with the birth of Myspace, could you have anticipated LinkedIn? Well, maybe conceptually, but it’s interesting that people use social media for recruiting and hiring and sales, just many different things, right? And we’re still figuring out all the new use cases that social media could get applied to.

So everything I’m saying on this, is a little bit subjective. We’re figuring out in real time what different cryptocurrencies and the underlying cryptography blockchain are best used for it. So if Bitcoin is a Swiss Bank in your pocket, meaning it’s resistant to censorship and seizure of assets, how do you value that? Well, it’s actually the simplest valuation model I’ve ever encountered investing.

If you want to have a dollar of seizure and censorship resistance, you have to own a dollar of the asset. So the analogy here is if you want to have a dollar of your Fiat protected in that way by an offshore banking system, you have to have dollar in the offshore banking system. So with Bitcoin, you don’t actually care about the value. So for this one use case, one lens in which you could view it. I’m ignoring a lot of other stuff like the volatility of the asset, but for a moment in time, if I want to have a million dollars protected from say a bank arbitrarily seizing my account, or the IRS freezing my account or a corrupt judge transferring my account, which may not be a big concern in the US, but is a big concern in much of the world. I need to have a million dollars in Bitcoin. And I don’t care what price Bitcoin is. I need just a million dollars of it. So that’s one way to think about it that the total addressable market of Bitcoin is how much wealth in the world would want to be stored in the equivalent of an offshore bank. If doing so was accessible from a mobile app with zero friction, near zero cost. So that’s one way to frame it.

Bilal Hafeez (18:01):

So, I mean, that’s a good point, actually. So if one did want to pick a clear use case that is very defensible rationally, I mean, that’s a very clear use case that one could propose for crypto or Bitcoin.

Ari Paul (18:12):

Yeah. And the ultra-banking system is around $30 trillion. A lot of that is a legal tax R some of it is an illegal tax R. There’s a lot of reasons for that. I’m not saying that Bitcoin addresses all of those use cases, but we seriously asked a question, let’s say there was a mobile app on everyone’s phone that they could trust completely that would make any assets put into it, not immune, but the most immune offering in the world for censorship resistance and seizure resistance, I think that’s a 50 to a hundred trillion address of the market. Now, Bitcoin is not the only asset competing for it. And Bitcoin is not a perfect asset. So I’m not saying Bitcoin’s going to be 50 to a hundred trillion, but I think that is one framing. Now other crypto assets are very different.

Business for exchanges like UniSwap

Ari Paul (18:52):

So you have some assets that are very equity-like. So for example, Uniswap is a decentralised exchange. Uniswap functions, pretty similarly to Coinbase, in the sense that a user can go and convert one asset to another and Uniswap charges fees. Currently those fees, they have the fees set very, very low. They’re trying to accrue network effects. And none of those fees get paid to the token holders, currently. But the token holders have the right and the ability to vote every cash flow to themselves. So it’s extremely similar to an equity holder of say, Amazon. Where right now Amazon equity, you could argue is, may be worthless. Because there’s no dividends, there’s no cash flows, but of course no rational person would think that way. We would say currently the equity holders of Amazon are choosing to reinvest cash flows, but we know that at some point they can divert that growth spending to share buybacks or dividends.

So there are a bunch of tokens in crypto that are very similar. Some of them are literal equity. They’re actually registered securities. There’s a legal LLC. More of them are equity like. So they don’t have the legal protections of equity, but they have the exact same rights programmatically where the token holders can choose to vote themselves cash flows. And you have a business model that is fundamentally value accruing. So Uniswap decentralise exchange, doing something like a billion dollars in volume every day. The fee range, if we apply something like a 10 base point fee in every trade, you end up with nontrivial cashflows, and then there’s a whole gamut.

The real benefit of crypto in co-ordination power

Ari Paul (20:15):

I think the most interesting thing about cryptocurrency to me is not the technology, it’s the coordination mechanisms. So if you think about the birth of the company and what that enabled. I took a class as an undergrad, the history of the modern business corporation that was one of the most fascinating classes I ever took. And there’s so much that wasn’t intuitive and that I think a lot of people just usually wouldn’t be aware of. So, and I’m not an expert on this by any means. I took the intro class. Well, the simplest framing, you introduce companies and you allow people to economically coordinate on much greater scale than ever before, without relying on direct trust.

So one way to frame it is when we reduce the cost of trust, by an order of magnitude, we enable entirely new types of economic coordination that unlock not just quantitative improvements, but qualitative transformations. So as an example, we couldn’t really have international companies until we had the technology to support communication in near real time. Before the telegram, you really couldn’t coordinate economic activity across oceans. I mean, you had some exports and imports, but it was a trivial percentage of GDP. Because you couldn’t be real time, very, very hard to enforce contracts internationally. And so a mix of the economic coordination of the corporate entity with technology to enable near real time or real time communication internationally plus international diplomacy to allow for enforceability of contracts internationally. And we get a global economy. Which unlocks all sorts of cool comparative advantage and just unbelievable economic growth. So with cryptocurrency, one analogy I like, and this is not a direct analogy it’s to frame where value may come from, Bitcoin is a little bit like triple entry accounting, or like the introduction of time keeping. So in the middle ages, we got more reliable clocks that allowed you to coordinate things like a shipment across countries. You could say, “You’d be ready to accept this cargo shipment in four days at 4:00 PM,” right? Without the 4:00 PM, it was actually very hard to coordinate economic activity or distance. And then the triple entry book keeping of accounting is a little bit analogous to the Blockchain. Which is just a method of even tracking economic activity in a way that is much more trustless.

Basically, it’s a way for all parties to confirm that the books are accurate without having to review every piece of information individually. And that’s analogous to blockchains and using hashes. So the analogy here is an individual can completely trust that infinite history of complex economic transactions is valid with a single cryptographic hash. Is just a very, very efficient way of confirming a vast amount of information that allows for not just savings on back office and auditing and legal costs but again, transformation. Because, imagine if I could get complete confidence in a company’s accounting and books, not in a month long auditing and legal and accounting deep dive, not in a week, not in a day, but in one 10th of a second. What new economic activity does that unlock by reducing the cost of trust by three orders of magnitude? So I’ll pause there just a lot of very cool value practises.

Trends in layer one protocols like Ethereum and Solana

Bilal Hafeez (23:21):

No, that’s great. I mean, that’s a really powerful way for looking at this. I mean also leads on to, it’s very hard for us to forecast what impact this is going to have or types of companies or technologies will come about from this. But at the same time, it tells us that there is something qualitatively different that’s been introduced here through this whole phenomena. You did talk about Uniswap and I did want to talk about some of the differentiation we’re starting to see in crypto markets, which I think is quite interesting. So, for me, and this is something we’ve started to track at Macro Hive, we look at the performance of Bitcoin as a benchmark, you could say. Then we look at universe of smart contract, layer one protocols. So Ethereum, Solana, Cardano and so on. Then there’s the Metaverse side and maybe NFT as well. You could bucket within, and then there’s DeFi as four or five groupings. So, it would be good to get a sense of your views on each one of these. So maybe if we start with the layer ones, Ethereum and so on, how do you view them and how do you assess them? Do you have a longer term view? Do you want to pick a winner or not?

Ari Paul (24:23):

Sure. So on any question like this, I’ll give you both a trading answer and a fundamental answer. So trading-wise, Ethereum looks quite good through the remainder of this bull run, whatever that means. I’m assuming bull run’s not over, 25%, that it is, 75% that it continues into next year, just as a high level framing. So Ethereum, I think is well poised in our regards to do well on the medium term. And medium term, in my head, I mean, six months right now. Although, what I really mean is more through the end of the bull run. So fundamentally it’s introduction of EIP 1559, causing it to be deflationary with high activity is really critical for its institutional narrative. And basically that was a big win. I was pushing very hard for the Ethereum community to do that. I was publicly tweeting at Vitalik, if you want Ethereum price to do well and not saying that you should or care or whatever, this is really, really critical to the medium- and long-term narrative of Ethereum. And for people not aware, Ethereum introduced a change to its protocol that basically all activity on Ethereum causes some ETH to be destroyed permanently. What that means is, and it answers a really challenging question, which is why should ETH benefit from stuff happening on top of Ethereum? So if you have lots and lots of very successful projects that are all generating huge revenue or all have lots and lots of activity, kind of like TCPIP, or SMTP or FTP don’t benefit from Facebook. Right. And if there was a token for TCPIP it’s not clear that the token would go up just because Facebook is making money.

Bilal Hafeez (25:54):

And just to be clear, TCPIP is the protocol for the internet, that currently exist.

Ari Paul (25:59):

Yeah. So one way to think about, Ethereum is kind of like an internet protocol, and then you have valuable stuff being built on top accruing value, why should the plumbing get value? And some people have argued, but it has to otherwise the whole thing fails. Basically, if you don’t have enough value in the plumbing, the game theory doesn’t work of these consensus mechanisms. True, but that’s not a good enough answer. Just because a system will fail if something doesn’t happen, doesn’t mean that thing happens, right? It’s a little bit like saying my parachute has to open otherwise I’ll die. Well, you might just die. That’s not logic that says your parachute will open. So yeah, this was an existential question and problem for Ethereum, which is we understand why there’s value growing on top.

There’s these great apps, but why should that value leak down to Ethereum? And so EIP 1559 fixed that. And now there’s a very clear answer as to why ETH will accrue value as long as there’s sufficient activity happening on top. So there’s a great fundamental narrative. The fundamentals themselves look reasonably good to me, which is you basically, most of the new interesting usable stuff in crypto is being built on Ethereum. A big problem with Ethereum was the lack of scalability. That’s not in a great place right now, but I think it’s good enough. So you have roll-up chains like MATIC, like Arbitrum, like Optimism, that are layer two chains that sit on top of Ethereum that are more scalable than Ethereum. And what’s happening is basically everything being built on Ethereum is migrating to those roll up chains. The reason I say it’s not great is because the fees on those chains are too high, particularly the less trusting ones like Arbitrum. I think Arbitrum had last I looked at $2 per transaction fee. That’s definitely not the scalability we were hoping for. And that’s a layer two. Ethereum itself last week at least had $40 transaction fees. So it’s not where it needs to be. That produces room for competitors like Solana. So if Ethereum roll up chains had a tenth of the transaction fees right now, it’d be much harder for projects like Solana and Hadera and Algorand and Avalanche to be pitching themselves as viable competitors. But basically you have this competitive niche, which is even the layer twos on Ethereum are too expensive. So that’s a bad point for Ethereum, but it’s also a self-regulating one in that Ethereum is high fees because it’s getting a lot of usage. It’s like, could that kill Ethereum? Well, not really. It’s like saying, “Can a restaurant die from being too busy?” No. If people get annoyed that it’s too busy, some stop going, and then the problem goes away. So it’s a self-regulating problem, but it does create room for these competitors. It does create that space for competitors to arise and gain meaningful traction. So that’s Ethereum, I’m bullish through the end of the cycle. I think it’s likely to be.

Bilal Hafeez (28:40):

Do you have a price target or do you not like to have price target? It’s just more direction.

Ari Paul (28:45):

It’s really tough, especially when you’re targeting all time highs. Right. It’s very hard to do TA on brand. It’s much easier to do technical analysis when you’re within a range, you can define levels. So I tend to think more in terms of like, I think about market cycle and what would a moderate bubble versus extreme bubble look like. And then I try to maybe apply some prices. And then I look at a little bit of, like TA to find new levels is very weak, but then once I have a general… so with ETH the way I’m thinking about it now is let’s say the bull market is over and Bitcoin is never making another all time high in the next year at least. ETH could still extend a bit more. And in that scenario, I’m probably targeting 6K and something like eight to 10K would be a hyper extension in that environment. So I would probably be betting for 6K. I might have some exposure through that eight to 10 area and I probably wouldn’t be shorting until… I’d be wary. I’d say there’s some chance we get a hyper extension. Now, if the bull market’s not over, then those becomes floors. So then I could see if Bitcoin, for example, gets to a hundred or 120K this cycle, I could easily see ETH at 20K easily. So that just gives you a sense of how I’m thinking of about it. But no, I don’t have a real spot target.

Will a switch to Proof of Stake make a difference?

Bilal Hafeez (30:01):

No, that’s fine. That’s fine. And just, you mentioned the change in the protocol earlier this year. I mean, how about the move to proof of stake?

Ari Paul (30:08):

I’m a little ambivalent on it. I think they should be able to pull it off and it will likely go reasonably smoothly and once doing so that’s probably a win for Ethereum, both a little bit narrative wise. It went to the ESG theme among institutions and frankly, I think it’s just better for Ethereum.

I just don’t see, basically the current… well, a whole tangent is around proof of work mining, but I think it’s a positive, but not really game changing and mostly priced in. There are some risks there where they could mess up the transition and the lot could go wrong and miners. So one issues, there’s a political issue that miners have, and it’s weird. Ethereum needs the miners up to the very last second when they don’t need them. And so there’s a bit of a conflict there with incentives. And so the miners are the one securing the network and the miners can do a lot of harm. And let me add this, crypto works a little bit because of altruism. So many, many points in time, crypto has been more centralised than people would like including mining, including for Bitcoin. And the main reason that hasn’t caused giant existential problems is because for the most part, people in crypto have been historically on average a little bit altruistic. As much as we say in crypto that we’re trying to build a world where we assume everyone is a malicious adversarial actor, Bitcoin probably wouldn’t exist if that actually was the world we lived in because there were many points in time where, for example, you had a single company that was the source of more than 50% of all shots 56 mining. And they couldn’t instal the hardware level back door in all of their chips that no one would’ve discovered and taken over the Bitcoin network. Bitmain came close to doing that in 2018, it was discovered that they were putting hardware back doors in their chips. People discovered that six months later, it’s extremely hard to search for that. A hardware back door in a mining chip. You basically need a microscope and extremely, extremely talented hardware to spend months pouring through the chip. So the point is, TLD on this is Bitmain installed a backdoor in some of their chips, but it was an incomplete backdoor that they claim couldn’t have worked and they never turned it on regardless. And they say they did that so that if chips were stolen, they could brick them. I don’t know their actual intentions, no harm ever came of it.

But my point is when you have a single factory producing more than 50% of all the shot 256 ships in usage, that could be disastrous. And historically it hasn’t because you have entities like Bitmain that are ideologically aligned and may be long term aligned economically because the industry was so young. Basically the value of their brand and the value of them as an ongoing enterprise with a brand as a mining chip creator had arguably more value than the entire crypto ecosystem at that time. And that’s literally true. So for example, a single crypto exchange today routinely is valued at 20 billion. Many of those exchanges were born in 2017 when all crypto assets combined were worth less than 20 billion. So the value of that entities brand was worth more than all of the assets in existence in crypto if they believed they could continue executing and the industry would grow.

Bilal Hafeez (33:05):

And in terms of how to invest in these smart contract platforms of these L1s, is your approach then to take a diversified approach or are you trying to pick some of these alternative theory like Solana, Avalanche or whoever?

Ari Paul (33:17):

We’re trying to do everything. So we trade these assets. We trade every timeframe, like short, medium and long term holds. So to answer very explicitly with larger cap assets, we are traders. So, I personally have a little bit of Bitcoin outside of any of block towers vehicles that I don’t trade. I just have as part of my own personal portfolio. And that’s the only crypto, maybe there’s one or two others that I would want in a portfolio that I can’t look at for 10 years. And even there, I’m not blindly confident that Bitcoin will exist in 10 years. It just, I like it as part of a 10 year portfolio, same with any company, right. I’m like, “Sure, Amazon’s going to exist in 10 years?” No, and I wouldn’t sleep easy if you told me all your entire net-worth as an Amazon and you’re going to wake up from a comma in 10 years, that wouldn’t be the ideal situation. Amazon seems like a solid 10 year bet, but who knows? So Bitcoin’s kind of the same for me. I really like it as a 10 year bet probabilistically. I think it’s got great right tail asymmetry. I wouldn’t have a hundred percent of my net-worth in it for 10 years if I couldn’t actively manage that risk.

Okay. So let me directly answer the question and give your viewer something useful. I’m always looking for things that could be Bitcoin killers or Ethereum killers. So we were in, I believe it was the second seed round of Solana. We were very, very early investors in it. I liked it for a bit of a weird reason, basically in crypto, in this industry in cryptocurrency, anytime you find a credible team solving a new technological problem that matters, it’s been a good VC investment, every single time. And whether that ends up turning into a used product, whether the team ends up executing on something that people want, doesn’t matter. From the VC side, just the fact that you have a credible team solving or tackling a hard engineering problem that no one’s tackled before, basically at some point, not even the world, the crypto industry sees that and rewards that project with a billion plus valuation. So Solana was that. They were telecom engineers attacking the communication layer of crypto protocols with a set of skills that no one and crypto had really. Crypto, you can think of there’s a cryptographic layer and a lot of the best and brightest in this industry are cryptographers on the development side. There’s a comm side engineering layer for the front end, backend and database side. All of those are being tackled by pretty good people, but then there’s a communication layer, which is how do nodes actually talk to each other? The people who built that for basically every cryptocurrency prior to Solana, they weren’t specialists in that area. You would’ve a database engineer who knew a little bit about that. So here you had a team that were world class at the communication layer, and they basically said, “We know how to produce an order of magnitude or two orders of magnitude improvement in this.” And I thought that’s worth a seed stage cheque to a start-up. And as always, when you’re investing early, it’s hard to know what a project will eventually become. And that the founders usually don’t really know, right. They have a vision, but they’re very likely to have to pivot along the way. So I think actually Solana’s pretty close to that original vision, which is a much faster, more scalable, smart contract platform with some trade-offs towards more centralisation. And then you get into a big discussion debate around which axis of decentralisation matter and how does decentralisation matter. And so with Solana, I currently have no view on it. It’s a great project. It’s a great team. It’s a great community. All the things that I saw two years ago are now priced in. So at this point it certainly has a lot of hype and excitement around it. I agree with the excitement and hype it has, I’m not shorting it, but I don’t know anything that all of these people so excited about it don’t. So I have no opinion on it.

Bilal Hafeez (36:51):

And is there any one that you are very excited about now?

Ari Paul (36:54):

So a year ago and a year and a half ago, and two years ago, I was giving people two answers, one with Solana, because no one was talking about it, no one cared about it. And I thought it would be a crypto project people would care about. And then another was Handshake, which is H and S, which is a project that is the opposite of Solona in terms of performance, it’s been a bit of a dog for the last a year or two.

It’s a decentralised domain name solution. So the way the global internet works is there’s basically, what is it, a fifth exact number 13 entities that control the internet in a very literal sense. So you have ICANN, basically it’s the main registrar system that is controlled basically by the US with an independent third party entity that’s really a US entity and there’s a bunch of cosigners to the decision making and something like 60% of those are US institutions. There’s two universities that were part of DARPA. Basically it was the companies and academic institutions that were really there with the creation of the internet.

So the problem with that is it’s US control which other countries don’t like. So the US can basically arbitrarily shut down individual domains, including those of other countries. It’s a weird group of entities that is just this legacy of 20 years ago or more than 20 years ago. Basically when this was set up, no one cared, no one wanted to be one of those signatories. Now it’s like you control the internet. So it’s very, very obsolete from a governance perspective and it’s very opaque. So it’s really run by a shadow bureaucracy and you as an individual have zero recourse at all. So if for example, you have domain and your domain is seized by the FBI without either a shadow court order or whatever. Ultimately it’s this group that you have to appeal to. And it’s like being on the no-fly list. You don’t even know who to talk to. There’s no phone number, there’s nothing. You’re at their mercy. So Handshake is an alternative to this that does a very, very simple service. So what those domain registrars do is actually a really simple service, which is basically I want to navigate to your website. I need to know the location on the internet that your website exists. It’s just converting from a URL to a server location. It’s not hard. So Handshake is a decentralised version of that. I really like Handshake as an idea and a project. It’s been slow to get traction. So the difference between Solana and Handshake is Handshake built an incredible, massive vibrant community. Handshake has been much, much, much slower at that. So I don’t know if I would recommend Handshake as a trade.

Bilal Hafeez (39:13):

But it’s still sounds like an interesting part of the infrastructure, that whole area.

Ari Paul (39:19):

It is. And I’ll say I’m long it. I have a position in it, but a small one. So I’m not here to show it, but just saying it’s interesting. If it starts getting traction, it could be huge and nothing is priced in, but I don’t know if they’ll be able to cross that chasm.

What stage of the hype-cycle are Metaverse and Defi tokens in?

Bilal Hafeez (39:32):

Okay. And we have got limited time so just quick thoughts on Metaverse and quick thoughts on DeFi.

Ari Paul (39:37):

Metaverse got insanely hyped with the Meta transition. Everything in crypto that’s Meta theme took off. Now everything is retracing around that theme. I think we’re on the wrong side of the Gartner hype cycle with both Metaverse and most DeFi use cases. So for those not familiar with Gartner hype cycle, very, very simple idea that with basically every new technology people correctly see that it’s world changing and they’re even pretty good at saying, “This is how it’s going to change the world. ” The biggest thing they get wrong is they think it’s happening now or happening over the next year or three when it’s actually 10 to 20 years. And so they price in 10 to 20 years of growth and profits. And then at some point you get a very radical repricing. So you think about tech stocks in the internet, every company that we laughed at in 1999 is now a successful billion dollar business, including pet food over the internet. The problem wasn’t that those entrepreneurs were wrong. It’s that the investors were 15 years too early. So it was valuations that were the problem. Pets.com, maybe it was too early to even exist as a business. But the joke was really that only 1% out of the world was… no, sorry by 1999 Maybe it was something like, I don’t even think it was 10% of the world had internet access at that point, but certainly less than 1% of the world was prepared to buy pet food over the internet, right? People weren’t used to using their credit card on the internet. Most of the world didn’t have it. You didn’t have last-mile infrastructure, you didn’t have delivery services. And so the idea was basically Pets.com was priced as though they were going to capture like 75% of the entire global physical pet food market in the next three years. Right. It was just clearly absurd. So problem with Meta and DeFi, very, very real going to change the world, going to conquer the world. But I think they’ve got a three to seven year, very, very tough rebuilding slog where it’s like, nothing is ready for prime time yet. The products stink. They’re buggy, they’re risky, it’s bad UXs. On the Metaverse side, they’re just bad products.

So getting something like a crypto boxes or sandbox to the point that it can compete with a Roblox or Fortnite, the stuff that users actually want to engage with. You’re talking about hundreds of millions of dollars and many tens or hundreds of developers. And you’re talking about coordination that a game studio does. It’s very hard to do in decentralised out type form. And then for DeFi similar concept, but it’s a little bit less about the product and more about security. So with DeFi it’s one thing for something like NFT collectibles for stuff to be buggy and rough around the edges. It’s okay if my NFT collectible design, if I’m unable to access it every once in a while, if there’s an uptime issue. It’s okay if I hear rumours that every once in a blue moon, someone loses their collectible. That doesn’t work for banking. It’s not okay for your life savings to sometimes arbitrary downtime or to just be lost. And you can’t even assess the risk, right? That’s okay for collectibles. It’s not okay for money. It’s not okay for banking. So I think we have a, I said three to five or seven, maybe it’s five to 10 years, very similar to internet issues. In 1994, people weren’t ready to trust the internet with most financial things. You had downtime, you had bugs, you didn’t have bandwidth to do streaming video.

Risk of sizing positions

Bilal Hafeez (42:40):

I mean, it’s great to hear some realism to this, because lots of people in the crypto space are really hyping it. Now I did want to ask a few personal questions. One was what’s the best investment advice that you’ve ever received.

Ari Paul (42:50):

One piece that I really liked comes from Seth Klarman’s Value Investing, I think was the name of his book, right? That he wrote when he was 30, Value Investing. And he had a line in there where he talked about that you can derive alpha from reputational risk and he gave a really cool case study.

So a couple of them, one, I think this is from his book. So when Enron was in default, basically everyone on Wall Street got creamed by Enron in one way or another. Either they were investment bankers to it underwriters, they owned the equity, they owned debt. It was I think like a non-trivial percentage of all outstanding institutional debt was Enron debt. Because they just had so much debt outstanding. They had such a complex cap table. So, everyone on wall street was scarred by it.

So then when they went into default, people were emotionally scarred. Reputationally they had already taken pain, they didn’t want anything to do with Enron. I mean, it’s one thing to lose money on Enron when everyone else did, it’d be another to lose on Enron after. So one reputational risk and then two complexity, which isn’t something you think of as a source of output because right, aren’t hedge fund managers, some of the smartest, hardworking people with infinite resources.

But the reality is that, so this example was it was the most complex bankruptcy ever. It was an insanely complex cap table. So what he did was he assembled a team. I think it was like four or five people, some lawyers, some debt specialists who for three years did nothing but the Enron cap table. And I’m going to get the exact numbers wrong because my memory’s going to fail me here.

But I think at one point they had something like potentially 50% about post group was Enron debt, post default. Basically Seth put in the work to have conviction, to bet his fund on Enron debt because they knew it like the back of their hand, right? They had that level of expertise in depth that they felt they understood it. And he said, “I was basically totally confident that in liquidation we would recover 60, 70 cents on the dollar by us taking control of the assets, which we’re ready to do.”

We were ready to go to liquidation and take control of the assets and liquidate them. And so we were going to get 60, 70 cents on the dollar. We were buying the debt for 20, 30 cents on the dollar. What actually happened was once other people realised that the underlying economics weren’t quite as bad as they thought, that debt then traded at 80 cents on the dollar. And he was able to sell it out pretty quickly.

So he had a great mark to market gain. It ended up being a great… it was an equity-like return because he got in and then other people realised that the debt wasn’t that bad, but it was also a very safe bet.

So he got an equity-like return with safety because they did the work. So you look at that, the lesson for me on that was one, the idea that there is an alpha and complexity is BS. You got to reach pretty far because yes, Wall Street’s competitive and people are willing to work hard and they’re smart and they’re willing to put in the time, but you can find areas that are complex enough, that Wall Streeters don’t want to hurt their heads. I think crypto is one of those, right?

To a veteran hedge fund manager, who’s used to being an expert in their field, a lot of them don’t like feeling like novices. They don’t like doing… it’s funny, they’re willing to work really, really hard, but I think there’s a psychological discomfort with a specific type of work, which is accepting you’re a beginner, right? And just getting your hands dirty and trading NFTs and playing in DeFi, and playing with play to earn games, to actually understand this novel space. And then the reputational side, right? I very explicitly heard this in the endowment world. In theory, risk is only sizing. So, if you think Bitcoin is too risky, but you think it’s positive EVN correlate with your portfolio, you could size it at 0.1% of your portfolio or 0.001%. Too risky is never a reason not to own an asset. If something is positive expected value, risk adjusted, and relatively low correlation, you have to own it. That’s peak portfolio management 101. So the real reason so many institutions have been so slow to own it, is not because they disagree. You could argue, of course the crypto could be EV negative, right? The past is not necessarily the future. That’s not the argument they make. They don’t say, “We think it’s EV negative.” They say, “I’m worried that if I lose $1 in crypto, I’m going to lose my reputation.” I’m going to get mocked. And you’d say, “Well, why would someone lose the reputation for $1?” If that was the environment in 2017, if you had one member on your investment committee, and this is how this played out in many cases. One member of the investment committee would say, “This is a scam. It’s a joke. Anyone who touches this should be fired,” like Jamie Dimon. And then if the CIO of the endowment goes forward and makes that investment, right, you have to deal with the internal politics. You’ve now given a gun to the investment team member who wants to say, “You’re an idiot, fiduciary or neglect,” all that, whatever. You’ve given them a gun. Who wants to do that? So, for all those reasons, crypto, I think that’s been… does that result in beta or alpha, kind of a philosophical discussion, but we’re still in that world. It’s certainly much less reputationally risky today. But as we see from… that’s still the discussions in investment committees, it’s still people are now okay often with a small allocation, but no one’s sizing it as big as they should, relative to how that… very, very commonly people will say, “Yeah, we think our allocation to say crypto VC, is likely to be our highest performing VC in our VC bucket.” You say, “Well, how do you size it?” And very rationing you might say, “Well, we also think it’s riskier. So we don’t want to size it quite as big.” Fine, but they’ll say “We size it at 2%.” It’s like, “Wait, you think this is the highest performing VC you’re investing in, why?” Right. So the reputational element is incredibly important.

Books and Articles that influenced Ari

Money, blockchains, and social scalability (Nick Szabo), Shelling Out: The Origin Of Money (Szabo), Debt: The First 5000 Years (Graeber) 

Bilal Hafeez (47:56):

And final question. Any books to recommend, any books have influenced you a lot, anything that you think is really impactful.

Ari Paul (48:02):

I’m going to give an unorthodox answer here. So a problem in crypto is there almost aren’t any books yet? There have been plenty of books written about crypto, but they vary in early efforts, but I wouldn’t recommend any of them. There’s a blog though, by Nick Szabo who some people think maybe Satoshi Nakamoto, I don’t think he is. Although he was part of the founding team. That’s public. It’s called unenumerated.blogspot.com. His last name is Szabo, S-Z-A-B-O. He doesn’t blog that often. He’s not a pundit. He’s not one of these weekly bloggers. I think he’s written maybe 50 essays in total, over 15 years. Several of those essays and the most important being it’s titled something like Scaling Social Capital, are the best explanations for the crypto value proposition. And most of them are two to three pages long and they’re like political economy philosophy almost. So he does an analysis of the history of money, very similar, you know the book Debt:5,000 Years? Actually, that’s a book I would maybe recommend. So he has a very brief essay that echoes similar history and sentiment. And he wrote that before I believe substantially predated the book Debt. So, but that concept, that rethinking of money as actually a just a record keeping system is transformative. What it was for me and it is for many financial people I’ve talked to were like, “That really transformed my thinking on what money is and makes.” And the world makes so much more sense to me now.

Bilal Hafeez (49:24):

Okay. I’ll look out for that. And I’ll include the link in the show notes. So actually, before I say goodbye, how do people follow you?

Ari Paul (49:29):

It’s funny to say today, but Twitter, I’m @aridavidpaul. And if I write any one-off essays or do podcasts, I’ll typically post it there.

Bilal Hafeez (49:38):

Okay, great. Okay. Well, with that big thanks to you. I know you’re a busy person and it was great having a conversation with you.

Ari Paul (49:43):

Thank you very much.

Bilal Hafeez (49:44):

Thanks for listening to the episode. Please subscribe to the podcast show on Apple, Spotify, or if you listen to podcast, either five star rating and a nice comment, let other people know about the show. We’ll be super grateful. Also, sign up to become a member of Macro Hive, @macrohive.com. We’ll be back soon, so tune in then.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)