Jake Chervinsky: Defending Crypto from the SEC

Jake Chervinsky

The following is a transcript of a conversation between Anthony Pompliano and Jake Chervinsky, who serves as Defense Counsel in U.S. government criminal investigation’s at Kobre & Kim, about Securities Law, accreditation standards, terrorism financing, the applications of the Howey Test to crypto, and why Blockstream may be the most important company in the industry.

You can find the recording here: Off The Chain Podcast: Anthony Pompliano and Jake Chervinsky

Anthony Pompliano: All right, guys, I’ve got Jake here. This is gonna be pretty epic, because I think we’re going to go down a bunch of rabbit holes, so thank you for coming on.

Jake Chervinsky: Yeah, Pomp, thanks for having me.

Pomp: Absolutely. All right. So, as a lawyer, I know you can’t say a bunch of stuff and you could say a bunch of other stuff, so we’re gonna see how we can make this work. But let’s go through your background first. So where were you born? How did you get into law and then how’d you get into Crypto?

Jake: Yeah, sure. So, I’m from Massachusetts originally, Newton, Massachusetts, just outside Boston. I came down to Washington, D.C., which is where I live and work now for college. Went to George Washington, undergrad. I then went to George Washington Law School, and after that started working for a law firm in D.C. I’m sort of an adopted DC native.

Jake: I started working after law school for a pretty large law firm doing mostly anti-money laundering and anti-corruption compliance and investigations work. I did that for about two and a half years or so, until 2016. I graduated law school in 2013. In 2016, I moved out to Los Angeles, California. I had a little west coast experience. Clerked for a federal district judge in the central district of California. So, that’s a federal judge at the trial court in the federal judiciary.

Jake: That was a one year position working in chambers, writing opinions, working on trials. When I finished that, I moved back to D.C., couldn’t stay away from the east coast, and I got a job with my current firm, which is called Kobre and Kim. It’s a litigation boutique specializing in complex cross border disputes and investigations.

Pomp: The anti-money laundering litigations just sounds bad ass.

Jake: It was interesting stuff. I mean, that’s one of the things, frankly, that got me interested in the crypto space. It’s the intersection of law and finance, and I’ve also always been really into technology from a really young age. Growing up, I was going to computer camp and I was playing around on computers, programming html websites and like really basic stuff like that. I also was a big video game player when I was younger, so I sort of understood the concept of what a digital asset is and why people would be interested in that. So I think all of this stuff sort of combined to get me into the crypto space later on.

Pomp: Absolutely. We talk at all about all the time, like the revenge of the nerds, right? All the people who are playing the video games are like, “Ah, these are digital assets. We’ve been playing with these for decades.”

Jake: Exactly right. Yeah, for sure.

Pomp: A lot of times you are participating in securities litigation, right? And had quite a background doing it. And then obviously, with all the crypto stuff. Actually, first, how did you get into crypto? So, that’s how you get to where you are today, but actually where did the crypto component come in?

Jake: Yeah, sure. I think, like most people, I came across crypto a bunch of times before it actually clicked for me. The first time I ever heard about Bitcoin was in 2013, when I was working for my old firm, and FinCen, the financial crimes enforcement network, had just come out with these new regulations for what they were then calling virtual currency exchangers.

Jake: For one of my clients, I had to write up a summary of all of the most recent regulations in the anti-money laundering space. I spent maybe an hour reading this regulation, learning as little as I could about virtual currency while still being able to write this explanation. The whole thing struck me as like World of Warcraft gold. It was like some stupid internet money and made no sense to me why you would want to have it or why it would have value.

Jake: I didn’t come across it again until 2016. So, when I was clerking for my judge out in California, we were hiring another law clerk, and I was doing the interviews. There was a guy who came in to interview who had been working at a virtual currency exchange in San Francisco. I was asking him an interview, “Well, that seems really interesting. How has that?” His take, pretty much, was, “No, it wasn’t interesting at all. I’m trying to get away from it,” and I thought, “Okay, that makes sense. I guess this really isn’t that interesting.” It wasn’t until last year, the middle of 2017, honestly, I don’t even remember what was the first thing that got me to start looking into Bitcoin seriously. I think it was an article about price action. Maybe it was when the price had gone up to 3000, and I thought, “Alright, fine. Let me figure out what this thing actually is.”

Jake: And again, like most people, I fell down the rabbit hole, and I couldn’t stop reading about everything to do with Bitcoin, how it worked, what the technology was, why it should have value and that sprouted out into Austrian economics and monetary policy and decentralization, and all of the things that we all spend a lot of time thinking and learning about.

Jake: Then, earlier this year, I realized there’s so much going on in the legal world having to do with crypto that I wanted to make this the focus of my practice. So, in about June, I decided, “Let me get active on crypto twitter,” because that was where I was getting most of my information, and I was realizing there were so many people who were looking for and couldn’t find even basic commentary and analysis about how the laws apply to crypto.

Jake: I thought, “Okay, let me just do a couple tweet threads explaining a couple of these basic things. Like, “Here’s how the SEC’s ETF approval process works,” and it caught on. I guess that’s how I got where I am now.

Pomp: You are definitely famous on crypto Twitter now. You’re like the guy who actually has facts and information.

Jake: Well, that means a lot coming from you. I think you have many, many thousands more followers than I have, but I’m catching up.

Pomp: Those are just the bots. Don’t worry. All right, so you’ve been participating in like the securities litigation and stuff, right? Let’s start with what is securities litigation, and then we can kind of go into why it’s important and how people get into that situation.

Jake: Yeah, sure. Basically, securities litigation is any dispute having to do with the federal or state securities laws. Usually, there are two ways that I get involved in a case involving securities litigation. Either the Securities and Exchange Commission, the SEC, is investigating or prosecuting one of my clients for violating one of the regulations or for committing fraud or market manipulation, or something like that, in the securities world, or there’s a private civil suit, typically brought by investors, against the issue of security. That could be for issuing an unregistered security or for violating some other regulation like the disclosure requirements or something like that.

Pomp: Got It. And so, in those situations, how many of those types of clients already have lawyers on retainer or some sort of litigation-type lawyers around them versus, “Oh, I just got in a bad situation. I need to go hire one.”

Jake: Yeah, it depends. I mean, most large financial institutions and issuers of securities that are established companies probably already have general counsel working in house, and they probably have a relationship with some large law firm. The benefit of my firm, Kubre and Kim, is that we have a bit of a different business model. We call it a conflict-free business model.

Jake: We don’t maintain long standing relationships with large institutions, like most law firms do. A lot of law firms here in New York will have a Fortune 500 client, and they’ll do whatever kind of work comes up for that client. We don’t do that. The reason we don’t is because it frees us up, from a conflict of interest standpoint, to take cases that are adversarial to a broader range of clients.

Jake: So, if there are, for example, the investors who are bringing a suit against a particular company that maybe issued an unregistered security, there are other law firms that are already representing that company. They can’t obviously litigate the case against that company. So, we often come in as special counsel or conflict counsel to handle those types of discrete, specialized matters.

Pomp: Got It. So you’re like a seal team six of securities law. Got It.

Jake: I like that. Yeah, I like that a lot.

Pomp: All right, so how does the securities litigation and law apply to crypto, in the sense of we’ve kind of described how it works in the non-crypto world, but crypto’s like a whole new game here. Where do you see that playing out right now?

Jake: Yeah. So the big issue right now is about the issuance of unregistered securities by ICO projects. ICO stands for initial coin offering. In the normal context, if you do an IPO, an initial public offering, you have to register the security that you’re issuing with the SEC. You also have to comply with a bunch of other regulations in the federal securities laws, like doing regular disclosures on a quarterly and an annual basis. You have to do disclosures when certain special events happen. You have to have auditing programs, you have to do certain types of record keeping. These are all regulations that apply to the issuers of securities.

Jake: In theory, if these ICO projects are issuing securities as they are defined by federal law, they should be complying with all of those regulations, except most of them are not doing that right now. So, the big question in the crypto space at this moment is have those ICOs violated the federal securities laws, specifically sections 5 and 12a of the Exchange Act of 1934, by issuing unregistered securities, and how are we going to resolve that problem, if so?

Pomp: Okay, so, let’s take a step back here and really go into the details, because I think this is important, and it’s something that a lot of people in crypto, I think, yell and scream about on crypto twitter, around, “Oh, security’s not securities,” but I don’t think they actually understand what we’re talking about. So, when you’re talking about an issue or there’s somebody who offers a security or an investment opportunity to a set of investors, and the laws that we’re describing are basically governing what you can do, what you can’t do, who you can offer it to, etc., right?

Jake: That’s Right. Yeah.

Pomp: Okay, so, let’s start with the knowns. So, there’s definitely securities regulation or offering regulation around Reg D, Reg A+, S, CF, et cetera. What are the other main concerns or main points of focus in the known bucket around securities law that ICO projects or crypto projects need to be focused on?

Jake: Yeah, so I think you, I think you’ve nailed a lot of them. I think the big issues right now, like you said, are Reg D and Reg S. Reg D is about whether you’re doing a private placement, meaning you don’t need to comply with the registration and disclosure requirements. Reg S is about whether the SEC has jurisdiction over an issuance that is conducted either in the United States or executed sufficiently outside of the United States that the SEC doesn’t have jurisdiction over it.

Jake: I think the problem that we’re still trying to work out is whether a token is a security by definition, or whether it fits some kind of consumptive use, some kind of utility token, for example, where the person who’s buying it isn’t buying it with the expectation of profit, they’re buying it for their own personal use or benefit or enjoyment. If that’s the case, then the token would not be a security under federal law.

Jake: And I think the last couple of years, one of the main ways that ICOs we’re trying to do these issuances, to raise capital for the purpose of developing their networks without subjecting themselves to the securities laws, was to say, “We’re not issuing this for investors to make money. We’re issuing it because it’s going to have some use in the future. Therefore, it is not a regulated security.” That was one of the main ways people were trying to get around the securities laws.

Pomp: Absolutely. And really, what you’re describing and what they were depending on was the interpretation of this Howey test. So maybe you can go into detail of what is the Howey test, how did it come about, and then we can talk about how it gets applied to crypto.

Jake: Yeah, sure. So the Howey test is the federal standard for determining whether a particular financial instrument is an investment contract, which is one type of security regulated by the federal laws. When we talk about Howey, we’re talking about a 1946 United States Supreme Court case, Howey v SEC. So, here’s basically the story.

Jake: Howey was a hotel operator that owned an orange grove on its property, and Howey decided to split up the orange grove into different parcels and sell the parcels to investors. Howey said that this was just a real estate transaction. They were just selling property. It wasn’t supposed to be a security, but when they did the sale, they combined the sale of the real estate with a lease back contract, which said that the investors were giving Howey the right to continue to cultivate and harvest the orange groves, and then the investors were going to get the profit from Howey doing hopefully a good job in harvesting and selling these oranges.

Jake: The Supreme Court said this is still an investment contract and basically, the ruling was, it doesn’t matter what form your security takes, it doesn’t matter if it’s a stock certificate or a lease back contract or anything else. It doesn’t matter what you call it, either. All that matters is whether it fits these four factors in this test that the court set out.

Jake: The four factors are, number one, you have an investment of money. Number two, the investment of money is in a common enterprise. Number three, you have an expectation of profit, and number four, your expectation of profit is based substantially on the efforts of a third party or promoter.

Jake: And so, applying that to the crypto space, if you have a digital token that you issue and you hit all four of those factors set out in the Howey test, then you have a regulated security.

Pomp: What percentage of projects, just on an aggregated basis, what percentage do you think are likely to be meeting the standard of the Howey test? Meaning that they are a security versus not.

Jake: So that’s a hard question to answer for a couple of reasons.

Pomp: That’s why I asked it.

Jake: Yeah, no, for sure. The reason that it’s hard to answer is because it depends who’s going to make that decision, and so it’s important to understand how these regulatory enforcement actions go. There isn’t really going to be a concrete answer whether any token is or is not a security. All there’s going to be is, hopefully, an agreement between a particular project and the SEC about what the project is going to do to remedy the issuance that they made.

Jake: So, here’s basically how an enforcement action works. You’re an ICO project. You issue a digital token. One day, you get a subpoena from the SEC, and it says, “The SEC thinks that you may have violated the securities laws by issuing an unregistered security.” You then start this long, drawn out process of exchanging information, probably exchanging documents. You sit down at a conference table like this one, and you negotiate about how the issue is going to be resolved.

Jake: A lot of times, the company won’t even admit that what they issued was or wasn’t a security. They will admit no fault but settle the case by, for example, paying a fine or deciding to register their security while maintaining that it wasn’t a security in the first place. So, it’s pretty hard to answer whether any of these tokens definitely are, or definitely aren’t.

Jake: I will say, I think that most of these companies, in the end, will negotiate with the SEC, will come up with some deal where they pay a fine, they register their tokens as a security, or, alternatively, they give up and they decided to dissolve the company and liquidate all of their tokens. So, I think all of this will get handled one way or another.

Jake: What would be interesting, and what I’m waiting to see, is for one of these companies to say to the SEC, “Pound sans, we don’t agree with you. You’re wrong. Our token’s not a security. If you want us, come get us, we’re going to court.” That’s when we will finally get an answer from the courts on what a digital token is or isn’t.

Pomp: Got it, and so really the way you described around that negotiation is the SEC saying, “We think that you did this.” The company can go in and, if they want to play nice or they don’t want to kind of drag this out into the bare knuckle fight, then there’s some negotiation, and even if they do still believe they’re not a security, they may just settle because it accelerates their ability to get over the issue.

Jake: Yeah, exactly. It’s often a better way to resolve an enforcement action. It is less risky, because if you do end up going to trial against the SEC, they’re going to pull out the big guns and if you lose that trial, the consequences for you can be much greater than if you work out some deal with the SEC. So, if you’re not interested in what we call the company litigation, then you’re going to make some kind of deal, whether you think what you’ve done is wrong or not.

Jake: That said, when you sit down at that conference table and negotiate, what you’re doing is pointing out all of the weaknesses in the SEC’s case from the perspective of, “Hey, if we don’t make a deal, we’re going to go to trial. Here are all the arguments we’re going to make to a judge why your case should be dismissed. Here are all the arguments we’re going to make to a jury, why they should side with us. Are you really willing to take that risk?”

Jake: SEC lawyers who have career risk, if they try one of these huge cases and lose, and that’s how you end up using all of these issues as leverage to negotiate a good settlement.

Pomp: Yeah. And part of this plays into the SEC, from what I understand, they don’t want to go to trial unless they have a very, very high level of competence that they are going to prevail. Right?

Jake: Yeah, exactly. And the reason for that is, if they lose one case, it will impact every other case that they’re trying to settle in other conference rooms in other parts of the city. So, they don’t want to set any bad precedent that’s going to hurt them, as far as their broader enforcement strategy.

Pomp: Got it. What’s the saying? When you come at the king, you better not miss?

Jake: You better not miss. Yeah, exactly.

Pomp: Absolutely. Okay, so that all makes sense. What are we talking about in terms of these settlements? SEC subpoenas somebody, they come to the table, they’ve got all of their reasons why they think what they did was not wrong. The SEC’s got all the reasons why they think what happened is incorrect. Are we talking about big fines, like tens of millions, hundreds of millions, or are we talking about hundreds of thousands? Does it matter on how much capital was raised? Walk me through. Is there a framework to think about these settlements?

Jake: Sure. So it can be anything. As a foundation, I would say this is just a business negotiation. Like any business negotiation, you’re trying to expand the pie, you’re trying not to treat it as a zero sum game, you’re trying to make whatever the best deal is for everyone. It can include anything that both sides will agree to.

Jake: The typical things that a settlement in the securities enforcement world will include is a fine of some kind. The fine is usually punitive, meaning it is a punishment for what you have done. There’s also something called disgorgement. Disgorgement is the SEC taking back whatever you’re ill-gotten gains are, so you usually have these two separate calculations of how much money you’re going to pay.

Jake: Then there’s gonna be some remedial requirements. Like I said, if you issued an unregistered security, now you have to register it, or if you fail to make a particular disclosure, now you have to make that disclosure. There could be heightened requirements. So, if you were chronically failing to disclose a certain type of information, maybe you need to do even more disclosures than would normally be required for a securities issuer.

Jake: There’s something called a compliance monitor, which is usually another law firm that gets assigned to watch everything you do for a certain period of time, and then report back to the SEC to tell them, “Okay, they’re complying with everything that you agreed to.” So there’s a lot of different ways that this can go.

Pomp: Got it. Okay. And then, if there is a fine, that goes into the SECs pocket, do the investors get a piece of that? Where does that money go, and what is the potential value that the investors in that security or non-security have a claim on potentially?

Jake: So that gets super complicated, both from the investor perspective and the government perspective. There is an entire infrastructure in the government devoted only to figuring out when there is one of these penalties paid to the government, who gets what piece of it. And everyone who is involved in an investigation fights over how much should the SEC get, how much should the DOJ get, how much should the FBI get?

Jake: There is an entire office, the General Accountability Office, the GAO, that litigates disputes between different federal agencies over which one of them should get how much money. So this sounds like typical government stuff, right? When you’re trying to figure out with investors, again, there is a typical negotiation trying to settle a civil case. Most of these kinds of cases brought by investors are class actions, which have some more procedural requirements around them.

Jake: The deal with the class action is you settle this one case, but the settlement is supposed to apply to every single person who could possibly have brought this type of claim. So, for example, Ripple, right now, is subject to three class action cases in California. In theory, the class is any US investor, whoever purchased XRP.

Pomp: And that is at the issuance, or if I went on Coinbase yesterday and I bought XRP, I potentially could join class action?

Jake: So the allegations are that XRP is still, today, an unregistered security. Now, in theory, the Ripple fans who are listening to this podcast will say that XRP stopped being a security at some point in the past, if it ever was, because it became sufficiently decentralized. All that means is that Ripple would be liable for less of a period of time during which they had issued an unregistered security. That would affect the damages calculation but not their liability. But what’s going to happen is, when you settle that one case, you have to follow a lot of procedural requirements to make sure it’s not unfair to all of the thousands of people in the rest of the country who are not directly involved in that litigation. So, a federal court is going to do a whole analysis to make sure that whatever the settlement is, which probably involves the defendant paying some amounts of money to these investors who are theoretically injured to make sure that’s fair for everybody. And so it’s a very long and drawn out process.

Pomp: Absolutely. And we are pretty much describing is there’s regulators of the markets, right, the SEC, etc., and then there’s a second layer of the regulators of the regulators. They’re the ones who are figuring out where does the money go, who gets it, why do they get it, etc. So, you can kind of stack the bureaucracy on top of each other pretty quickly.

Jake: Yeah, that’s true. And look, this is a big revenue stream for the government. We haven’t really had any big settlements yet in the crypto space, but just to compare this to another area that I’ve done a lot of work in, which is the Foreign Corrupt Practices Act team, which is the law that prohibits bribery of foreign government officials, you can have cases that result in hundreds of millions of dollars in penalties that are paid by defendants. I think one of the largest ones was over $1,000,000,000. The number of lawyers who are working for the SEC or the DOJ prosecuting this, they’re not getting paid that much. So this is making a lot of money for their agencies.

Pomp: I guess this is one of the times where we’re probably glad that SEC employees or lawyers don’t get paid incentive fees.

Jake: Right? They would definitely be going after a lot more. They’d be a little more aggressive than they are now if that were the case.

Pomp: Alright. Just making sure. So, one of the things that we start to see teams do is say, “You know what? I understand that there is uncertainty around securities law, in terms of for crypto specifically. So, we know what the laws are. I’m gonna go ahead and I’m gonna issue this token. I don’t know if you are going to come down and say it’s a security or not. I’m not going to register it, but what I am going to do is I’m only going to sell it to accredited investors.”

Pomp: It’s this almost hybrid approach where it’s not a registered security with the SEC. Sometimes they go ahead and use an exemption, sometimes they don’t, but as long as I sell to accredited investors that I’m okay. That’s kinda their belief. Where does that fall in terms of less likely to be enforced on? How does that play into all of this? Maybe people should be doing that.

Jake: So yeah, what you’re referring to is Regulation D, and specifically rule 506b and 506c of that regulation, which pretty much say if you only sell a security to accredited investors, you do not need to register your security. You don’t have to do all of the disclosures that are otherwise required. So, if an ICO project succeeds in only selling a token to accredited investors, it has essentially complied with the federal laws because it’s going to enjoy the safe harbor that rule 506b or 506c provide.

Jake: I think what we’re seeing in 2018 is most ICOs that are coming out now are only selling to accredited investors because there’s enough capital there for them to raise what they need to raise, but almost no risk as far as securities enforcement down the road.

Pomp: Got it. And then, with that accreditation law, how much of the accreditation laws are driven by the issuance problems versus the other side, the enforcement problem? What I mean by that is, as these accreditation laws were kind of created and put into place, is it because they’re actually seeing what issuers are doing and they’re trying to react to that, or is it they’re trying to design a market from scratch that protects the investors? Or maybe it’s a hybrid of the two.

Jake: Yeah. So, well, let me explain how the accreditation rules developed. I think that might help clarify this. So the accreditation rules date back to 1982. Prior to 1982, if you were an issuer and you wanted to raise capital by selling equity, by selling an equity security, you had to register it with the SEC. You had to comply with all the disclosure requirements. There was almost no way around that unless you were just going to stay outside of the United States.

Jake: In 1982, as a deregulation measure, Reg D was adopted for the purpose of saying, “If you’re a small business and you only sell to accredited investors, we will allow you not to follow all those other regulations.” So, in a way it was a strategy to allow more capital formation by only allowing investors who could take the hit if the security ended up going to zero to purchase that security.

Jake: You have to understand. The point of the securities laws is to close the information gap between issuers and investors, to make sure that investors have basic information about the securities that they’re purchasing, about what the company’s assets and liabilities are, what the risks are facing that company, so that they can make an informed decision about whether they want to purchase or not.

Jake: And the idea of the accreditation laws is if we are confident that the investor will not go broke, if they make a bad decision because they don’t really have the information we would otherwise want them to have, then we’re going to be okay with that. So, I think that the accreditation rules are really to target both of those areas. It’s saying, “We’re going to relax the standards for giving information to investors, and we’re also going to take away some of those protections that they have as far as filing lawsuits after the fact if something goes wrong.”

Pomp: So really, what you’re describing is pre-1982, this idea of is a really high bar. You had to register, which probably took a long time. It costs a lot of money. Reg D comes in and there’s some deregulation, or the ability to make it easier for people to raise capital in certain situations from certain types of people. It’s a little bit shorter timeframe, probably a little bit less expensive.

Pomp: And then really, if I extrapolate that out, Reg A+, which allows you to take certain types of offerings and offer it to nonaccredited investors, is another form of deregulation along that same vein, making it easier to raise capital in certain situations.

Jake: Yeah, that’s exactly right. So, all of these are legal mechanisms allowing issuers to raise capital by issuing securities without complying with the core requirements of the original 1933 and 1934 securities laws, which were the original laws passed in the wake of the Great Depression, requiring issuers to go through these registration and disclosure obligations.

Pomp: Got it. Hence, why they’re called exemptions, exempting you from that law.

Jake: Exactly.

Pomp: Okay. So walk me through the counterargument to the following. A lot of people say, in crypto, we’re using things like accreditation laws that were created in pre-1982, using regulation that was introduced in 1982 and the Reg A+ recently, and we’re using the Howey test, which was created decades ago. That was, Howey test, for example, the orange grove. We’re now talking about building a deflationary decentralized, a global reserve currency or a world’s computer, all these high tech type projects. How do we use legislation or regulation from decades ago to apply in these situations? What’s your take there? Is that appropriate? Is it not? Should we change it? How do you come out?

Jake: So I think you make a good point, which is, sometimes events develop in a way where hold laws just don’t make sense anymore, and I think, particularly, when you move from the 1930s and 40s, and then even the 1980s, the pre-internet age, to a digital age, it is kind of hard to take these old regulations and apply them to this brand new type of asset that no one could ever have contemplated before, the rise of the internet and particularly …

Jake: I could never have contemplated before the rise of the Internet and particularly before Bitcoin came on the scene. That said it is a foundation of our legal system that we take laws that are drafted a long time ago and then apply them to conduct and assets that were not contemplated at the time the laws were drafted, right? We have the United States constitution drafted in the late 18th century were very little about modern life, could have been contemplated at all and yet we are taking those principles and we are applying them to modern life.

Jake: I think as long as the core principles make sense, you can still apply them to new types of products and new types of conduct. Like what’s going on in the Crypto Space now when you look at the securities laws, again, that core principle, which is we want investors to have basic information about the securities that they’re buying and holding. We want other market participants like exchanges and brokers and custodians and brokerage firms and investment advisors and all these kinds of people to operate honestly and not commit fraud and not be affected by conflicts of interest.

Jake: All of these core ideas make perfect sense in the Crypto Space, right? If you’re going to raise capital through the issuance of a digital token, it’s really no different from raising capital through any other means that someone has used in the past. I think the difference is a digital token is fundamentally different in the sense of you can issue it as a security and then as the life cycle of the token continues, it evolves from a security into not a security as it starts playing a role in whatever the network is that it was issued for.

Jake: That is extremely unusual and not something that was truly contemplated by the securities laws where you’re talking about an investment contract or a stock certificate. These are not things that develop and change over the course of their lives. And so I think we really need some more clarity as far as when does a digital token go from being a security to not a security, how do we define that shift and how do we handle it as it goes forward?

Pomp: Absolutely. And what you’re describing is we’re just entering a new type of environment, right. So one of the things in the news that’s recently come out is the SEC chairman Clayton are contemplating ways to give access to non-accredited investors. Right? So, is there a way for them to evolve or change accreditation laws to allow a subset of the population access to investments that maybe today they’re precluded from? Right?

Jake: Yeah.

Pomp: Good idea. Bad idea. Maybe even have an idea as to what the solution could be. Where do you come out on that?

Jake: I don’t know what the solution is, but I agree with you completely that we need one. I don’t think that the accreditation laws make a lot of sense in 2018, in the 1980s I think it made a lot more sense and I’ll tell you why. At that point, there weren’t that many people who qualified as accredited investors, right? The standard be an accredited investor is you make $200,000 in income if you’re an individual or 300,000 if you’re married. And you also have to or you can have $1,000,000 in net worth, right? That number has not changed since the early 1980s. At that time there were very few people who qualified for that level of income just given inflation. And as a result, the pool of private equity was pretty small and the number of private placements was very low.

Jake: This just wasn’t that big of an issue at that time the expectation was if you want to raise capital through the issuance of the security, you’re doing it through an IPO. And now it’s true for a very long time. It’s only recently that we’ve seen a huge drop off, maybe in the last 10 or 15 years or so, a huge drop off in the number of IPOs. And there are a lot of reasons for that, but it just doesn’t make sense anymore to be a public company. It costs between one and 2 million dollars to do an IPO, depending on the scale.

Jake: That is a huge amount of money for a smaller company that wants to raise capital, you have to comply with all of these registrations and disclosure requirements. They’re not easy to comply with. You end up paying auditing firms an extraordinary amount of money every single quarter to do audits and release financial statements. It’s just at this stage doesn’t make a lot of sense to be a public company, particularly when you have all of the scrutiny of the markets looking at on a day to day basis or on a quarterly basis, how are your margins doing, right? What is your balance sheet look like? And a lot of people, this is not specific to the Crypto Space, but for example, Warren Buffett is saying we shouldn’t be focusing on quarterly earnings. We should change that.

Jake: These are all the reasons why going public and now it doesn’t make a lot of sense and we see so many more of these private placements which are only done to accredited investors. And what that means is there is now very little opportunity for unaccredited investors to get access to high quality capital. And that I think is why we have to change something about this rule, whether it’s changing the wealth test to be something else that better reflects whether investors are qualified to get into a particular investment opportunity or something else, I’m not sure but I do agree something has to change.

Pomp: Yeah. I mean, the classic argument is we allow people to buy lottery tickets. Right?

Jake: Right. Exactly. No, for sure. I mean, look, the problem I think with doing a knowledge test, which I know is something you’ve talked about before is, I think one thing people don’t understand about accredited investors is you don’t apply to the SCC to get a license or to be an accredited investor. Right? It’s on the issuer to make sure that the people, they’re selling securities to our accredited investors, if they mess up, then they are liable for dealing and unregistered security.

Jake: And the wealth test, while I think it’s a rich get richer, the poor get poorer proposition and it’s a bad proxy for whether someone is sophisticated. I don’t think being rich makes you any smarter. It is still a very easy bar for an issuer to decide are the investors that I’m selling to accredited or not. And if you ask a those issuers to develop and administer some kind of knowledge test, you are asking for a lot of problems and a lot of litigation.

Pomp: Could you imagine like Elan Musk, Mark Zuckerberg, Sergey, all these guys saying, hey, I want you to invest in my company but, it’d be great if you took this SAT test first.

Jake: Right. It’s crazy. So, I mean, I don’t know what the solution is, but hopefully someone smarter than me will figure it out.

Pomp: I always joke around and say that I know a lot of dumb rich people, right?

Jake: Yeah.

Pomp: That should be the first warning sign. All right, let’s switch gears real quick and let’s talk about some non-security based, legal issues. So, taxes right now, I think a ton of people are dodging taxes for sure they’re not reporting this stuff. The number that we always joke around about is I think this year Credit Karma did a study a less than 100 people out of the 250,000 people they surveyed reported any sort of taxable profits from Crypto. Right? So if you look at all the numbers on the exchanges, Et cetera, it’s probably more than 100 out of 250,000. Are people like at big risk here? If so, what does that look like? Like just talk to me about, these people who aren’t reporting the taxes. How big of a problem is this?

Jake: Yeah, so as a legal matter, I think people are at huge risk if they are making capital gains in the Crypto Space and they’re reporting those capital gains and paying taxes on them. For a long time I think people just didn’t think about paying taxes on Crypto gains when you’re thinking about the people who are trading Bitcoin. In 2010, 2011, 2012, I don’t think taxes was even something on the radar for them. We’re also talking about some people who are, shall we say, more on the anarchy side of things and maybe they don’t want to pay taxes in the first place is.

Pomp: Is it though she’s getting a tax bill, you think?

Jake: Who knows, right? Hey, none of those coins have moved, right? So no taxable events yet anyway. Also, then for a really long time, there was this thought that Crypto to Fiat exchanges were not taxable events because they were like kind exchanges, which is this exception in the tax code that says you don’t have to pay taxes if you’re moving from two different types of products that are essentially the same thing. And the IRS came out I think last year and said, that is incorrect. It never was true. We are clarifying for certain now that it’s not true, every exchange of Crypto or Fiat was a taxable event.

Jake: I think there is a huge tax liability out there that has not been paid. Whether the government has the resources to go after that is a separate question. The IRS is known for being a little bit less aggressive. They’re under resourced to begin with. They have some really smart people in their criminal section, but they just don’t have the resources to be tracking down a trader who is making money on an early exchange on knock ox in 2011 or something like that. I think legally there’s a lot of risk, but I think it remains to be seen what the government is going to do with tax enforcement because up to this point, security is enforcement has been the main issue. We haven’t seen a lot of movement from tax regulators at this point.

Pomp: Would it be fair to say that there is a higher risk for people who have made those gains recently and the more gains you made, the higher risk you’re at? Or do you think that everyone from the person who made a couple of a hundred bucks in 2011 compared to the person who made millions in 2017, they’re all have a similar risk profile?

Jake: I think that practically speaking, the risk is a lot higher for people who are making money more recently. And the reason I say that is because number one, the government is watching now and I don’t think that they really were five years ago even. Number two, the government is developing new channels to get data and information from the OnRamps where people are putting Fiat in, in order to get Crypto. So somewhat recently, for example, there was a subpoena to Coinbase where Coinbase had to start turning over information to the government about some of it’s more high value clients.

Jake: So the government is getting more information and I would guess they’re going to be focusing on the transactions that are happening most recently when they’re sifting through that information and figuring out who do they need to send enforcement letters to say, hey, you didn’t pay taxes on X amount of profit that you realized last year where is that money?

Pomp: I mean the Crypto thing was interesting, right? Because I think the government came in and said, hey, tell us everything about everybody and I think Coinbase put a foot in the ground and said, we’re not going to give you everything about everybody. But there was, again, I don’t know if it was a settlement or an agreement around … and I may get this wrong, so correct me if I do. They’d give information on people who had more than $25,000 or something that they’ve either transacted or held. Walk us through as much as you can disclose there around what the government was looking for and in Coinbase disposition and why they took that position.

Jake: Yes, I think that’s right. I don’t remember the exact dollar amount, but basically the government as always wanted all information about every person who would ever open an account with Coinbase more or less, if I recall correctly, and Coinbase wanted to give over no information at all because that’s how this works when you get a subpoena from the government. There are in a normal circumstance two ways to deal with this. You can either make an agreement as the person who was received the subpoena to provide the government less than what they asked for or you can file a motion to quash and go to court and ask the court to say, okay, these aspects of the subpoena are all right. The rest of this is too broad. It’s not relevant.

Jake: If I remember correctly in the Coinbase example, they went to court, filed a motion to quash and they got the court to limit the scope of the subpoena. But in the end they did turn over a lot of information about their clients and my guess is, I don’t know this, but my guess is Coinbase and Gemini and any other exchange that’s trying to do business in the US is now providing some type of information to the government on a regular basis.

Pomp: Got It. And then maybe we can even touch on a ShapeShift. Right? The whole situation there were they’ve pretty much always said that you can come, you can transact, no accounts, we have the information and there’s people who found kind of peace in the no account type model. Recently they had to change that or are they did change it. And so there was a bunch of debate around did the government force them to do this? Is this something that they’re opting into proactively. Talk to us about why did they do that? And do you think that even the decentralized exchanges, Et cetera, are going all have to move to this model? Or do you think that there will be some ability to kind of live outside of these requirements?

Jake: This is an issue with the Bank Secrecy Act of 1970, which is enforced by FinCEN, The Financial Crimes Enforcement Network I mentioned it’s a bureau of the US Treasury Department. The Bank Secrecy Act, requires a certain set of regulated financial institutions to do financial surveillance basically on behalf of the government and report certain financial conduct to the government. ShapeShift may in theory be a regulated financial institution called a money transmitter, which pretty much means you are an entity that takes money from one person and then transmit it by any means to another person or a location.

Jake: Erik Vorhees came out a couple of days ago and said that adding KYC, Know Your Customer requirements to ShapeShift wasn’t in response to an enforcement action from FinCEN but it was in response to perceived regulatory risks that may be FinCEN, would go after them at some point for being a money transmitter, but not complying with all the regulations that apply to a money transmitter under the Bank Secrecy Act.

Jake: I think that this will be a growing problem for the Crypto Space. Basically everyone in the Crypto Space could be a money transmitter, right? If you’re running a node at home, you could be a money transmitter because you are processing transactions between different people in different places and there isn’t a lot of clarity about how those rules apply and much like the securities laws, the anti money laundering compliance laws are very onerous. It costs a lot of money to follow those laws and the penalties for failing to comply can be very severe. So I think that this is a problem we’re going to see expand a lot.

Jake: You asked about decentralized exchanges. This to me, is one of the most interesting things that will happen in the Crypto Space. The government has a strong vested interest in maintaining this tightly controlled, regulated, a global financial system that we have that the government uses basically as the only means for detecting international crime. Law enforcement depends almost entirely on financial institutions reporting on our financial conduct to the government. Decentralized exchanges are a way for people to circumvent that regulatory system which will stop the government from having insight into the financial conduct of people all over the world, which stops them from enforcing the anti money laundering laws and stops them from enforcing other laws like trade sanctions, laws and counter terrorist financing laws. And so I wonder once the government starts to understand what decentralized exchanges are and what they enable, how they’re gonna react to that.

Pomp: Let’s go really, really down the deep … the rabbit hole here in the sense of I like to think that the Hollywood movies of tomorrow are going to be based on all of the nuances of Crypto today, right?

Jake: Yeah.

Pomp: So we’ve seen billions, for example, the Showtime Show that they’ve started to now pay people in Crypto and all this stuff. But let’s talk about the legal ramifications of if there is a truly decentralized pseudo anonymous currency like Bitcoin for example, that begins to be used within, let’s say, terrorism financing for example, right? Technically every transaction is written into an immutable ledger, right? So there is some transaction history that is preserved, but you don’t necessarily know who’s sending and who’s receiving, you just know the accounts. How does this play into how law enforcement looks at this, how regulators look at this? Is this actually the biggest threat to a Bitcoin type a currency that the regulators don’t have that control and so they try to kill it? Like how … just walk me through this.

Jake: This is definitely my personal biggest concern about the future of Crypto. We spend a lot of time talking about securities laws. I think the securities enforcement issue is almost a distraction from what we’re looking at five or 10 years down the road. Once we get to a point where you can buy goods and services with Crypto instead of with Fiat, that what’s holding back the floodgates of regulators being suspicious about this space is right now if you want to buy goods or services, you’re still more or less taking your Bitcoin or your Minero or whatever you have and converting it back into US dollars reentering the regulated financial system and then doing your transaction there and in full view of the government.

Jake: I don’t think the government understands at this point what it looks like when there is a new financial system that is not under their well developed financial surveillance regime. That I think develops over time once we can buy goods and services with Bitcoin or even with Minero something that government truly can’t see, that he’s not a public ledger. If Bitcoin develops privacy and there’s a lot of discussion about how that’s going to happen either through confidential transactions or the lightening network. This is in many ways the end of the governments well established method for detecting, preventing, and discouraging crime.

Jake: That includes a drug trafficking, terrorism, any other type of crime that you can imagine where the criminals are by necessity going to try to integrate the proceeds of their criminal activity into this regulated financial system because otherwise they can’t spend it. I hope that the government when they do realize that what Crypto enables is for the world to transact without them watching that they will not try to shut down the entire space. Now I will say I don’t think they can anyway. Right? The whole beauty of Bitcoin is that it’s censorship resistant that government can do whatever it wants. Bitcoin will more or less keep going.

Jake: But I do think it will be a huge setback if, for example, the US government were to say starting tomorrow, holding bitcoin is illegal. I think that we may be able to prevail on the government that first of all, any effort they make to try to shut it down and we’ll fail and so they shouldn’t try in the first place. And secondly that it is a good thing for us to have financial privacy. Privacy, as I’m sure you know, is becoming a much bigger issue in 2018 than it has been in the past. We see that with Facebook and Twitter are going to Congress to do hearings about how they’re using our data.

Jake: People are starting to care more about how their data is used and I think that in a democratic society we hopefully will be able to impress upon the people in power politicians and regulators that financial privacy is something that we not only want but that we should be entitled to. Right. The fourth amendment of the US Constitution guarantees us a right of privacy. And so my hope is that the government will not take drastic action against Bitcoin, but that remains to be seen and I think it depends on whether or not we see a genuine crisis around the use of Cryptocurrency, which at this point we haven’t, right. It hasn’t funded some type of large terrorist action or anything like that. So hopefully that will remain the case.

Pomp: Well, what you’re describing is this argument that the violation of one’s privacy is the violation of all of our privacy? Because it’s the right some people believe we have and I think that the argument that the government makes is the trade off between security, convenience, personal rights, Et cetera. So do you see a world where the government basically says we’re not going to regulate it at all? We just can’t really just throw their hands up and say we’re going to figure out other ways to detect crime and enforced on crime? Or do you think that they tried to develop their own ways, whether it’s the on-off Ramps or something to monitor the best they can?

Jake: I think that they will do the best they can at any given time. Our government is not well known for predicting into the future and developing strategies to handle problems that are going to come down the road. They tend to react to the crisis of the day. I think that has more of the world’s transactions and move away from the regulated financial system and onto Blockchains, whichever ones they may be, the government will simply limit its surveillance to, as you said, the OnRamps where they’ll monitor what they can and the more or less give up on what they can’t.

Jake: That’s how it is now, right? The government can’t see our cash transactions in person. They can’t really see if someone loads a briefcase full of US dollars and flies to a sanctioned country like Iran and make some transaction using those US dollars. The government doesn’t think that they can control everything that happens financially in the world, so think they will simply scale back as the circumstances require them to scale back. I also think that law enforcement tends to do a pretty good job of developing along with technology.

Jake: This is something that Andreas Antonopoulos talks about a lot and very effectively, which is, the first use of any new technology is by criminals. Criminals by nature are going to take as much risk as they need to because criminal conduct is by nature a high risk activity. So for example, the car is developed, one of the first use cases for the cars for bank robbers to get away from the police faster, right? So the police get a car that’s faster than the ones the robbers have or come up with other ways of handling this type of criminal conduct.

Jake: I think that will happen again. We saw that happen already to some degree with some of the dark net drug markets like the Silk Road were okay, law enforcement could no longer track the transactions happening on this dark net drug market. So what did they do? They ramped up other enforcement efforts. They used to undercover agents, they started looking more for drugs that are being shipped through ports and through, UPS and FedEx and things like that. So I think law enforcement will find a way to keep doing its job well while also allowing the rest of the world to have freedom of money.

Pomp: I mean, it is a cat and mouse game to some degree. Right? You mentioned something that we’ve thought a lot about in terms of the way that a government have the heavy handed response to this could be to ban ownership of either one digital asset or all digital assets. They could come in and they could say you can not own Bitcoin. It is illegal and if you are found to own bitcoin, we’re going to throw you in jail. Right. That would be that most heavy handed response I could think of that a government could participate in. Do you think that actually deters people from owning bitcoin or does it actually drive an option because people go and buy the thing that the government tell them they should?

Jake: I think a little of both. I love the idea that if the government bans Bitcoin immediately, the price skyrockets. I think that’s a fantastic idea. I don’t really-

Pomp: It’s like digital prohibition.

Jake: Yeah, exactly. Right. And I mean that is true. I prohibition did not stop the trade of alcohol and marijuana prohibition today is not stopping the trade of marijuana, so this stuff doesn’t work the way that the government wants it to. I don’t think Bitcoin will end Bitcoin. I do think there are a lot of people and I’ll give you the example of my dad who I convinced to buy Bitcoin by explaining to him, here’s what they coin is, here’s why it’s so important and powerful, here’s why you don’t want to be left behind in his old legacy financial system. My dad is not going to hold Bitcoin if the government says it’s a crime to do that.

Jake: And so I think that the immediate reaction would be a big problem for price and adoption. I think it would slow adoption down a lot. On the other hand, the use case of Bitcoin is not for my dad. It’s not really for any of us in the United States or in the developed world. We want to and should have the separation of money and state. We should have border less, trustless, censorship, resistant money.

Jake: But it’s a lot more important for people in countries where the government itself is the criminal enterprise, where the banks are the criminal enterprise, where it is impossible to store your wealth without someone else who has censorship over it, taking it from you. I think in those countries they couldn’t care less what the United States government does with Bitcoin. Those are the people that’s being developed for. And their adoption rate will continue there just as fast as it would, no matter what the US government does.

Pomp: Yeah. And do you think this carries over, not just on the currency side, but we … have been on record of saying I think every stock bond, currency and commodities is going to get digitized. We already see this in kind of the traditional world. Is there a difference in the government’s eyes between owning a censorship resistant a currency versus let’s say censorship resistant stocks or bonds or commodities?

Jake: Tokenize everything.

Pomp: Tokenize the world.

Jake: I definitely think there’s a difference. And one of the tropes that we hear from the legacy financial industry a lot is Blockchain not Bitcoin, right? And that sort of underlies this concept of it’s okay to take some tried and true traditional financial product like a stock certificate and then make it digital, which we’ve already done years ago and now to put it on a Blockchain as long as it makes that financial industry and more money.

Jake: I think that tokenizing some things like stocks probably makes a lot of money for the issuers for exchanges, for a number of other players in the legacy financial system. Maybe not the DTC, but sometimes companies get disrupted, right. I do think that there is a big difference between a currency, which is something that the government controls for the purpose of taking on debt that it seems we have no way of paying off for the purpose of Geo political disputes. Right? So we use our money, we use the US dollar to litigate disputes with other countries. We use it for financial surveillance, right? The government has a monopoly on money and wants to keep it, that is very different from tokenizing other physical assets or securities.

Pomp: Absolutely. In your touching on trade there for a second. A theory that people have and in fact, I probably haven’t looked at enough at the data to have an opinion yet take Iran for example, right, where we’ve put a bunch of economic sanctions on the country and so people’s, thought process here is, oh, they’re going to move to digital currencies where they’re not included or precluded by these early sanctions.

Pomp: And so now all of a sudden we’re entering a new world where trade violations, trade sanctions, via cryptocurrencies has to be addressed. When do we think that’s happening today? And two, is there any work being done in the legal world to address this or either or prosecute it?

Jake: It is happening today. There isn’t really a good answer. I actually had a long conversation with one of my colleagues last week who does trade sanctions enforcement defense.

Jake: Yeah. No, because this I mean, Crypto is everything, right? It touches on every aspect of regulation. So this area, trade sanctions is enforced by a different federal agency called OfAC, the Office of Foreign Assets Control. OFAC is aware of Cryptocurrency. They know that Crypto can be used to circumvent their trade sanctions list. So basically OFAC has a list of people, entities and nations that you’re not allowed to do business with if you’re in the United States, and if you do like if you send some product to Iran, you have violated the trade sanctions laws and you’re criminally liable for that violation. OFAC is the one that’s going to enforce that.

Jake: OfAC has said that they may start adding Bitcoin addresses to their sanctions list, but that’s about as far as they’ve gotten in thinking about how do you regulate or how do you apply the trade sanctions and export controls the laws to Cryptocurrency. I don’t think that’s very effective because the best op sec is to never reuse the same Bitcoin address. And also Bitcoin addresses are not inherently tied to one person. So adding a couple of old dead bitcoin addresses to the sanctions list isn’t going to do a lot.

Jake: But the point my colleague made was the trade sanctions laws are not about stopping every possible transaction with every single person or entity on that list. It’s just about discouraging. It’s about impacting behavior. It’s about encouraging and discouraging US companies from doing business with those people. So if you are, for example, a terrorist in Afghanistan and you are trying to use Bitcoin … I’m not saying that this has happened or is happening, but if you’re a terrorist in Afghanistan, you’re trying to use Bitcoin to conduct some terrorist plot, right? And OFAC puts your Bitcoin address on the sanctions list and you decide to just start using a different address.

Jake: Well, your name is still on the sanctions list and it is still incumbent on us people to make sure that they’re not doing transactions with you, the terrorist. So I think that it’s going to be very hard for OFAC to figure out how to adjust the way that they do enforcement in the trade sanctions space to Crypto. And for now, they’re just going to do it the way they’ve always done it, which is the people.

Jake: And for now, they’re just going to do it the way they’ve always done it, which is the people in cities and nations that are restricted remain restricted. And it doesn’t matter how you transact with them whether it’s US dollars or crypto.

Pomp: Got it, yeah. It’s so fascinating how the evolution … Every time the government comes up with a solution to a problem, criminals are going to be one step ahead. They’re going to figure out some of way that they’re going to kind of circumvent.

Jake: Yeah, it’s like you said. It’s a cat and mouse game. Right? This is how it always works. It’s how it always will work. The government can come up with a perfect solution for a particular problem, and some person who is willing to take on the risk of going to jail for the rest of their lives will decide to circumvent it one way or another. It’s just the nature of things.

Pomp: Absolutely. There’s a list of people I made one time, and I said, I wonder if they own crypto or not. Right? So, like Osama bin Laden? Did he own crypto; did he not? Right? Does a Kayne West? An Oprah? Right? A Putin? Right? Do they actually personally own it? Donald Trump? All these people, and my take is that Congress recently started to require people to disclose crypto holdings. There’s been a couple of Congressional representatives that have come out and said, “I own crypto.” Right?

Jake: Yeah.

Pomp: And they own bitcoin, Ethereum, and all that kind of stuff. And so obviously, that’s going to continue as the market matures and more people kind of come in. But it becomes a huge problem when all of a sudden these sovereign nations begin to create their own crypto currencies, and so how does the government deal with that? Right?

Pomp: We’re seeing it in Venezuela. And then other people are working on it, and so I think there are a lot complexities here that, you know, again the government’s just not prepared to deal with today.

Jake: I agree. I don’t think there’s been a lot of thinking about this. My perception from what’s going on on the Hill in D.C. and when you watch these congressional hearings is that most of the politicians are still struggling to understand the basic foundations of what crypto is and what it can do . It’s like they’re trying to find the president of the bitcoin company so they can bring him in and ask him questions like they’re asking Zuckerberg or Jack Dorsey or something like that. Right? They just don’t get this yet. I think it’s going to take a long time before they do and probably as it often goes with issues like this it will take them longer than they would need to to have any kind of rational response to it. I think by the time our government understands what this stuff is, it will already be so pervasive and so well adopted that they won’t be able to do anything about it anyway.

Pomp: They’re trying to find Satoshi. They just don’t realize he’s not him, her, whoever’s not paying taxes, right?

Jake: Exactly. Exactly.

Pomp: Absolutely. Okay, let’s dive in real quick into rapid fire questions. What do you think is an important company in the crypto space that maybe isn’t on everyone’s radar but should be?

Jake: Great question. I’m going to give you one that a lot of people do talk about, but seems to be less in the news lately.

Pomp: Perfect.

Jake: Which is Blockstream. The reason I say that is because there’s so much focus now on these companies that are building on a theorem or that are doing web 3.0 kind of stuff and much less focus on the developments on bitcoin. I’m sure a lot of bitcoin cash fans if any of them listen to this will be very upset that I’m saying Blockstream.

Pomp: We scared them all away already.

Jake: Yeah, I figured. Right? We’re like Blockstream’s shows here. I think that the people at Blockstream are brilliant. We have this revelation about this bug in the bitcoin code. What I think is most interesting in crypto frankly is what we already have and what we’ve had for a very long time, which is bitcoin, and what may come sometime very far in the future, but we don’t have yet, like whatever a web 3.0 platform might actually be, I think a lot of what we talk about today with the security issuances are probably not going to amount to much just like in the Intranet age. The dotcoms that are coming out in the late 90s didn’t amount to very much.

Jake: I think that most of what could be built can be built on bitcoin, and I think that Blockstream is one of the companies that is doing the most interesting work on that network. For example, if you listen to Samson Mow talk about liquid and the idea of issuing assets on bitcoin, this kind of stuff is to me what is most interesting, and yet I think Blockstream just sits out there as a company everyone knows, but no one really spends that much time talking about what they’re developing and what they’re doing. That’s the company I am watching most closely.

Pomp: It’s so funny you say this because I ask a lot of investors this. I say, “What if we’re actually over thinking the entire space and the simplest trade or investment is bitcoin?”

Jake: Yeah, I mean look that’s what the maximalists will tell you. I would not describe myself that way, but I definitely am a bitcoiner. What attracted me to this space in the first place was the best use case of crypto, which is money, and I still think that’s true. I love the idea that someday we have some of the more esoteric interesting applications like essentialized autonomist organizations and decentralized exchange we talked about a little bit. I think all of that is fascinating. I actually think that the Dow was one of the most interesting developments, and because it fizzled we don’t really talk about it, but I think Dows are really interesting thing to disintermediate essentially the corporate structure, which dominates most business in the world today. Probably all of that can get done on bitcoin. I don’t know necessarily how strong the argument is that we end up in a world with many different blockchains on the theory that all of them can be secured in the way that bitcoin is secured.

Jake: Look, I’m a lawyer. I’m not a technologist or a programmer or an economist, so I don’t know how that stuff develops. I think the development on bitcoin is still the most interesting development going on in this space.

Pomp: If you look historically, you’ve got every time there’s been protocol wars and kind of this competition, there usually is five or less that end up being important. The Internet, the mobile world, et cetera. There’s definitely not going to be 1,900 as there are today.

Jake: Right. That’s based on network effects alone, which that concept is at play when it comes to the blockchain space. That ignores proof of work and securing your blockchain. If you have 19,000 blockchains, how secure is number 19,000 from an attack? Unless proof of stake works, and I have no idea if it will or not, I don’t think I know enough about the game theoretical underpinnings and the technology to say whether proof of stake works or not. I think it’s fascinating. I’m glad that it’s going to be tried. Unless that really works, I don’t think you have can very many proof of work blockchains at the same time that are secure.

Pomp: What you’re describing here is probably one of the most important things that we try to get through to the institutional investors. Right? If you kind of draw a spectrum, on the far left you have security. On the far right, you can draw innovation. Right? Bitcoin is actually probably the farthest left you can get. It’s super, super secure. It’s slow. A lot of people look at the slow speed both in development and transactions, et cetera, as a negative. If you look at through the lens of security, it’s a huge positive because there’s no fraudulent transactions or stuff. When you start to get farther to the right of that spectrum around innovation and kind of all of the things that people are doing and trying and experimenting with, et cetera, you have a tradeoff. You lost some security in order to accomplish some of that stuff.

Pomp: What you go back to is this framework of are really all of the other tokens and networks simply are D4 bitcoin? At some point bitcoin will get to the point where it will just incorporate smart contracts and asset issuance and all of this stuff. We’re kind of seeing some early signs of that. It doesn’t mean that that will play out forever, but I do think that when you go to a decentralized world security actually isn’t talked about nearly as much as it should be. It ends up being the most important thing because without it, the whole thing goes away.

Jake: Yeah, the whole point of the blockchain is to be secure. Right? A blockchain is a database, a very slow, very inefficient database that is also very secure. There’s a great flowchart that goes around Twitter. Maybe you’ve seen it? It’s only two boxes. It says, “Do I need a block chain?” It has one arrow, and it says, “No.” Because pretty much nobody needs a blockchain. Yet you have these studies that come out where CEOs of Fortune 500 companies get asked, “What is the biggest benefit of blockchain?” All of them say, “It’s faster or it’s more efficient.” I think people just don’t really understand what this is about.

Jake: There are a lot of applications for security. The security delivers censorship resistance. It delivers the borderless trustless nature of crypto currency generally, so you need that security before you can build anything else. That’s why I wonder do you start with the most possible security on your base layer and then build perhaps less secure but more efficient solutions on layer two or above, which is sort of the bitcoin model or do you end up in this multi-blockchain world where you have different blockchains with different tradeoffs at the base layer? As a lawyer, I will stay out of that discussion and watch and see what happens.

Pomp: Yeah. What you’re describing right here is this idea that humans in realtime are beginning to trust machines more and more. Right? We talked a bunch about this on the podcast. We’ve written about this idea that as humans begin to trust software and math more than “greedy humans,” what occurs is you can remove lots of the middlemen. You can remove lots of the inefficiencies and if this continues, actually the digitization of assets, whether it’s currency stocks, bonds, whatever, then leads into automation. Right? Imagine how many things in the financial system are inefficient not because we don’t have technology that could execute the transaction or execute the action, it’s actually because the asset is not digitized. Once you digitize it, then you can get more automation and in order for people to do that they’ve got to trust the machines over the humans. It’s scary when you describe it that way, but I do think that we’re watching this kind of evolve in realtime.

Jake: I agree. It is scary. One of the sort of unspoken impacts of blockchain technology generally is a lot of people lose their jobs because you’re right, humans are the problem in many of these systems. When you have a financial institution and you are keeping your records because you have people in the back office who are reviewing them and filing them and trying to make sure they are accurate, human error is the greatest introduction of error in that system. You improve the system greatly by replacing those people with blockchains, which means that they all lose their jobs.

Jake: There are a lot of benefits that come with bitcoin and the decentralization generally and the disintermediation of a lot of rent seeking third parties, which is one of the other reasons I’m really into this space. I think that as you say we are figuring this out as we go, and there are untold implications that we won’t realize until we see them happen.

Pomp: The greatest trade of our generation just may be long bitcoin short the bankers. All right. Let’s get going here. What do you believe in crypto that you think a high majority of other people would disagree with you with?

Jake: I think that most people believe that we are now working through the regulatory issues and that they will get better and more permissive as we go. I think the opposite. I think that things will get a lot worse before they get better. For a lot of the reasons that we have discussed already over the last hour or so, which is we’re dealing with a lot of security issues. The security issue only matters because one of the first use cases for crypto other than money was raising capital, and when you’re raising capital you implicate the security laws by nature. We have all of these security enforcement cases right now, but that’s not really the interesting thing about crypto. Eventually, there will be a professional system established where instead of doing an IPO you will do an ICO. I agree with you about that. This is going to get tokenized. There’s no reason to spend all the money dealing with a traditional IPO when you can do this in the form of a digital token and the normal securities world will simply adopt to this new technology as the single way of raising capital.

Jake: I don’t think that that ends up being very interesting. There’s obviously a lot of litigation to be done before we get to that point. What’s more interesting are these other issues that threaten the government like anti-money laundering compliance and trade sanctions compliance and tax enforcement. These things we’ve discussed. I think that right now the reaction to the securities issue more or less is, “Look, we’ve always had scammers who are trying to screw over investors,” and that’s all this is. They’re just doing it with a different type of security than they were doing it before.

Jake: The reaction will be different when the government shifts its attention to a truly revolutionary disruptive technology that fundamentally changes the way that they enforce the law and go about their business on a daily basis.

Pomp: Bad people do bad things regardless of what industry.

Jake: Right, yep.

Pomp: You got a magic wand. You wave it. You can change any one regulation. What do you change and why?

Jake: Oh, where do I start? I would change the money transmitter laws that we were discussing before.

Pomp: Oh, interesting.

Jake: I think that like I said anti-money laundering compliance I think is the next big issue that’s going to hit crypto because everyone is a money transmitter if you are taking crypto and sending it to somebody else. We can do that individually now. We don’t have to do it through financial intuitions. Regulating money transmitters made sense when in order to transact you had to interact with this regulated financial system that the government had set up and was overseeing. It made sense when money was just one thing. It was the currency issued by the government. Money is fundamentally changing. Right? Money is now whatever we decide to issue on a blockchain and then assign value to and treating every person who transmits that kind of money as a regulated financial institution that needs to implement an anti-money laundering compliance program is preposterous.

Jake: A strict application of the laws as they are now would say if you run a lightning node, you’re a money transmitter. If you are shape shift or you’re in exchange or your bit pay or you’re any one of these entities by virtue of your transactions and crypto currency, you have to comply with these onerous regulations. That, I think, is a huge problem and could slow down development in this space a lot and should be changed.

Pomp: Absolutely. Time for the hard hitting question. Let’s just say that we give up and we say aliens are real. Do aliens have pets? Are there human aliens and pet aliens?

Jake: So are these aliens wherever they are now or they aliens when they come to us?

Pomp: When they show up like are they getting off the spaceship with like an alien dog?

Jake: Not when they get off the spaceship. If they’re like our level of development on another planet somewhere in some other galaxy, then, yeah, I think they have pets because I think life probably develops the same way. We all like companionship, so probably they have pets then. If they’re so technologically advanced that they have interstellar travel they’re coming to earth to see us, I kind of doubt they have emotions left in that way. I kind of don’t think they care a lot about pets, which makes me sad because I’m a dog person. I love my dog more than almost anything.

Pomp: Somebody hit me recently with … It’s like Noah’s Ark. Humans don’t go to space, and we never bring pets with us. Noah’s Ark that was the first thing, two by two, right?

Jake: That’s a good point. Yeah, I mean look if I was going to go to Mars to live on Elon Musk’s new settlement there, I would be bringing my dog, so I could be wrong about this.

Pomp: Actually I haven’t talked about this on the podcast. So Stephen Colbert did this thing with the Mars Rover. He somehow got the Mars Rover in New York City, brought on Neil deGrasse. They took it for a drive down the block. They get in this thing whatever, and in it Neil says, “Some places in place that we know of, and we would want to go to would take so long to get there that a human could not last long enough in terms of life in order to actually arrive.” There’s a theory in all of this space exploration world that actually we may have to put two humans on a spaceship, send them, and they have to create a baby. On the way to the destination, those people will end up dying, but that baby will have to be taught everything it needs to know by the time it gets to the destination. That just blew my mind. I was like forget alien pets. We’re going to actually send people to space to have sex in order to have a new astronaut. That blew my mind.

Jake: If we want to be an interplanetary species, I guess that’s the sacrifice we make. I don’t know.

Pomp: Absolutely. I let everybody ask me one question before they leave. What other question do you got for me?

Jake: I want to know. You guys have this great campaign that I love, which is Get off Zero. Right? What I want to know is first of all, how’s it going? Secondly, what is the biggest obstacle that you’re seeing? What are people telling you is stopping them from getting off zero?

Pomp: In summary, the Get off Zero is our argument to institutional investors that there’s a qualitative and a quantitative argument for crypto. Everyone usually leads with the qualitative argument. What they say is it’s going to be potentially the global orders of currency. It’s censorship resistant. There’s all these things that we all, I think, generally believe if you believe in crypto are important.

Pomp: Institutional investors, a very small percentage of them today, believe that and kind of understand it well enough to have an opinion and all that stuff. There is a quantitative argument to be made that there’s all these studies where if you’ve got a 60/40 global portfolio, and you introduce 1% of digital assets into that portfolio over one, three, five years depending on how you cut the data, some of the data points are you can add between 100 and 400 basis points of overall yield to your entire portfolio. You get a very similar almost identical standard deviation of risk, and you can increase your sharp ratio by 15 to 20 plus percent. Right?

Pomp: The quantitative argument is even if you don’t believe in anything around the qualitative argument you’re going to make more money. If you are a fiduciary, you should get exposure. You should get off zero percent exposure, get off zero, and kind of get skin in the game. You’ll start learning and you can get some of these increased yields, et cetera.

Pomp: I even go as far as to say I don’t know of another asset class that has a higher yield per unit of risk than crypto currency bitcoins specifically. It’s resonating I think is the best way to say it. In the next couple of weeks, we’ll have a couple of announcements as to kind of who it’s resonating with and how it’s resonating, et cetera, that I think will kind of surprise people as to who some of those audiences have been. The obstacle side is really interesting though. There are some people who just they’re not early adopters. They’re scared no matter what you tell them. You could literally say, “I already have the profit. I’m just going to give it to you.” Not jumping in until a bunch of their peers do. I think that’s one.

Pomp: Two is there’s a lot of people who can’t disconnect ICOs regulatory uncertainty, bitcoin, and even infrastructure investments like buying equity in exchange for example. Right? I think that’s two. Three is many times it’s been the wrong people asking these institutional investors. Even if they’re the best investor in the world, they have the qualitative quantitative argument, they can’t get past the diligence. If you think of most crypto funds, they really haven’t been around that long. We’re talking about people … Most of these funds are like 10 people or less. They’ve got 20 million dollars or less in assets. They don’t have compliance. They don’t have the regulatory licensing. They don’t have track records and compliance departments and administrative support, all these things that an institution looks for when they make an investment or they kind of go through their due diligence checklist so people aren’t failing left and right. I think that that’ll get solved over time as people have more time to build those companies.

Pomp: The part that actually has been the most interesting to me on an obstacle basis is people who say, “I don’t agree with you. I actually think this is a complete fad or farce, but my kids believes.” We’ve actually had conversations where somebody says, “I don’t understand my mobile phone. I don’t understand YouTube or Spotify or all these different services that these kids use, but I also know that my kid was right about Uber. My kid was right about whatever social network or whatever mobile app they use, and my kid keeps talking about this.”

Pomp: What I try to get across to these CIOs that has fascinated me actually works is I tell them “You as a fiduciary and institutional investor would slap some of these kids in crypto who have double digit usually over 50% of their net worth in digital assets.” It’s not going away. Right? Literally, they have over 50% of their net worth tied up in these digital assets. Sometimes they put 1% and it grew. Sometimes they are taking their monthly paychecks and they’re putting in more. When people have that much conviction, you’ve got kind of the virus has spread around kind of which has captured all the mental energy, if it’s not going to go away, now it’s not a question of should you have exposure, it’s a question of how should I get exposure. Should I put 10 basis points into a beta exposure? Should I put it into more of a venture capital? A lending? Buy the crypto asset itself? All these different things.

Pomp: There’s almost like this barbell if you will. You get the younger CIOs who get it. They’re in the demographic. They understand it. They’re digital natives, all that kind of stuff. Then you get like the middle-aged crowd that’s like, “No way. You guys are all nuts. I don’t even want to do a call.” Right? Actually, as you get farther into the older demographic, they actually believe. I think that some of it has to do with they remember when money was backed by commodity. They’ve seen enough government screw over their citizens. There’s some historical context that’s really important in this, and if you look at like the people in crypto that understand the history of money or the history of governments and all this stuff, they believe because they have historical context.

Pomp: If you’re just old, you actually may have enough historical context without having to go do the research. I think that all of that tells me you know there’s some cracks in the armor that the institutional investors are jumping in. There’s some endowments and all of the stuff that has already come into funds that exist, and then there’s some that are kind of on the edge. I think that this idea of the institutional wall of money, the difference is when you go and raise money from family offices, you’re usually talking about five million dollar or less checks from most family offices. Maybe even hundreds of thousands of dollars. You’re talking about institutions that have a hundred billion dollars, and they take 10 basis points, and it’s more money than most of the funds have.

Pomp: It’s just a whole different level of a game. When they start to come in, the thing that I think is actually going to be the most important inflection point in crypto is this. As we see countries entering into hyperinflation and kind of all these issues around their currencies, we’re starting to see some people go into digital currencies. Venezuela I think the numbers are November 2016 is when the Bolivar entered into hyperinflation. The monthly volume on local bitcoins was like $215,000. Today fast forward it accelerated into hyperinflation and local bitcoin’s monthly volume is like over three million dollars, so about 1,200% increase in that.

Pomp: Well, those people are running digital assets because they don’t trust their currency. They don’t trust their government. There’s going to be an institution or sovereign wealth or somebody’s going to buy bitcoins specifically. Then another institution is going to turn and say, “Oh, I probably should do that.” And they’re going to buy a little bit. Then all of a sudden everyone is going to start looking around, and it’s musical chairs. There’s only 21 million. When that scramble happens at the institutional level, there’s a lot of institutions that actually could buy like 20% of the network. Right? If you manage hundred plus billion dollars, if you really believed and you really wanted to, and you weren’t worried about kind of your pension plan or your endowment order ever coming back and getting mad at you, you could take 10 or 20 billion dollars and just go ahead and buy a huge chunk of the network. If we start to see that type of kind of FOAMO and acceleration into the asset from the option standpoint, I think that everyone who understands how economics and supply and demand work, fixed supply, increase in demand. There’s only one thing that can happen, and that’s the price goes up. That’s going to be a really, really interesting moment if we get to that institutional FOAMO.

Jake: Right. That’s fascinating. It sounds very much like the S curve of adoption for technology. One way of saying that is it happens slowly at first, and then all of a sudden. I do think that’s how this happens. It sounds really great. I think your pitch is fantastic. I think you’re doing a service for the space, so thank you and good luck.

Pomp: Yeah. I go around and I beg for money for bitcoin. Right? Some people believe. Some people don’t. I always tell them the same thing. I say, “I promise you the most important thing I will tell you is you won’t remember who I am, you won’t remember where you were, but you’re going to remember somebody came and told you about this, and in 10, 15, or 20 years, you’re going to be like ‘Dammit, I should’ve listened.’”

Jake: Yeah. Right.

Pomp: No, man, listen thank you for coming. You’ve taught me a lot and hopefully everybody else, so I really appreciate it, and hopefully we can do it again.

Jake: This was great. Thank you.


You can find the recording here: Off The Chain Podcast: Anthony Pompliano and Jake Chervinsky

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Founder & Partner - Morgan Creek Digital Assets. They call me Pomp.

Founder & Partner - Morgan Creek Digital Assets. They call me Pomp.