They say there are two certainties in life: death and taxes. And while we don’t get know of anyone who has managed to cheat death, we certainly know of people who have dodged their taxes. In this episode we unpack the myth that cryptocurrency can help you evade taxes, walk through the history of offshore accounts, and discuss some of the open questions about paying tax on your bitcoin!

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Show notes and links for the episode 👇🏽 below

For as long as governments have been levying taxes, people and businesses have been trying to evade them — and competing jurisdictions have been providing a way to do so. We call these, of course, tax havens.

Dating back to Ancient Rome, republics, empires, and city-states have fought for commerce and capital flows using tax policy. In the 2nd century BC, the Roman Republic went to war with the successor to Alexander the Great who ruled Macedonia — King Perseus. The isle of Rhodes, a major port known for its low tax rate, was caught quite literally in the middle of the conflict, quibbled over which side to support. When Rome ultimately won, the Republic declared the neighboring island of Delos to be a tax-free area… punishing Rhodes by undercutting her low-tax status and stealing away her commerce and her capital.

Delos and Rhodes constituted the offshore tax havens of their time — the ancient versions of Bermuda, Singapore, Jersey, and the Caymans.

In this episode, we’ll be covering everything from ancient naval raids to 9/11, from biblical sinners to Swiss bankers… we are talking taxes, tax havens, privacy acts, money laundering, and — of course — bitcoin.

History of Tax Havens: http://www.historyandpolicy.org/policy-papers/papers/history-of-tax-havens

200 Years of Offshore Tax Havens: https://www.bloomberg.com/news/articles/2013-05-03/offshore-tax-havens-in-spotlight-after-200-year-history

On Bank Secrecy: https://en.wikipedia.org/wiki/Bank_secrecy; https://en.wikipedia.org/wiki/Federal_Act_on_Banks_and_Savings_Banks

The (Short!) History of KYC/AML: https://www.fincen.gov/history-anti-money-laundering-laws

The demise of Switzerland’s numbered accounts: https://www.reuters.com/article/us-swiss-secrecy/era-of-bank-secrecy-ends-as-swiss-start-sharing-account-data-idUSKCN1MF13O

The Stairway to Tax Haven game: https://www.icij.org/investigations/panama-papers/stairway-tax-heaven/

2018 IRS Presentation on Crypto and Taxes: https://www.irs.gov/pub/irs-utl/2018ntf-bitcoin-cryptocurrency-an-introduction-and-tax-consequences.pdf

Episode 26: Death and Taxes was originally published in What Grinds My Gears on Medium, where people are continuing the conversation by highlighting and responding to this story.

Most of us take our connectivity to the internet and other telecommunications networks for granted. But behind the simple and benign act of connecting to the internet lies an intricate maze of physical hardware, wires, and complex routing logic consisting of layers upon layers — and many curious parties sniffing your web traffic. In this episode, we discuss the origins of mesh networking topologies and innovations in using cryptocurrencies to enhance security, facilitate more complex logical ordering, and incentivize resource sharing in these new networks.

Special thanks to Daniel Onggunhao for helping us compile some of the research for this episode — follow him on Twitter!

Listen to the episode | Subscribe on iTunes or Spotify

Show notes and links for the episode 👇🏽 below

The year is 1962. The United States and the USSR are in the depths of the Cuban Missile Crisis, and both sides are building nuclear systems and figuring out how to use technology to ensure mutually assured destruction in case of an attack. US authorities, deep in their planning, were facing an interesting challenge — how would they communicate in the aftermath of a nuclear attack?

Paul Baran, a research at RAND, the private think tank, dreamed up a new system. He envisioned a network of unmanned nodes that would act as switches, routing information from one node to another to their final destinations. The nodes would use a scheme he called “hot-potato routing” or distributed communications. Furthermore, the information would be divided into “message blocks” before sending them out across the network. Each block would be sent separately and rejoined into a whole when they were received at their destination.

This was the foundation upon which the World Wide Web was built.

Baran’s work was published in 1962 and expanded upon in 1964. Using these foundations of packet routing, or as Baran called it “Hot Potato Routing”, and packet switching, ARPANET was launched in 1969. It was intended for scientists and researchers who wanted to share computers remotely. But within two years, the network’s users had turned it into something unforeseen: a high-speed, electronic post office for exchanging technical and personal information. By 1989, ARPANET became the “internet.”

This episode is about the architecture of networking technology, and the evolution of networking hardware, software, and networking models in the context of cryptocurrencies.

How Communication Works Today

When I go home and connect to my WiFi network — what actually happens behind the scenes?

Your phone has a radio in it, and it translates chunks of data into a radio signal which it transmits. Your router, which is plugged into your wall, has an antenna and receives these radio signals and decodes these into packets.

You may have heard people talk about TCP and IP. Transmission Control Protocols (TCP) are used to direct packets to specific applications on a computer using a port number. Internet Protocols (IP) are used to direct packets to a specific computer or server.

Our router connects to an Internet Service Provider (ISP) which gives us access to the Internet through a range of technologies. A single device is assigned an address when it connects to the Internet: an Internet Protocol (IP) address. This address distinguishes our device in the network from all other devices. It’s kind of like your router’s unique address.

However, our national ISP can only connect us directly to servers located in our country. If we want to connect to servers located in a different country, then we need that country’s ISP to connect us to those servers. In this way, the internet is a bunch of local networks joined together to form a larger, global network using internet protocols and standards.

In the digital world, every connection requires our device to send “packets of data”, which is quite similar to sending letters by post. In both cases, we need an address, a system which handles our letters and a letterbox. On the Internet, an example of an address we might want to “send letters to” is www.myshadow.org. Similarly to a post office, our IP address helps direct our “letters”, while the Transmission Control Protocol (TCP) disassembles and reassembles our “letters” into a single port, which can be compared with a letterbox.

So one simple interaction has a lot of moving parts, and a lot of different layers. We have our phones, our local networks (WiFi), our regional ISP’s, and Twitter’s servers. These layers are often referred to as network topology.

Our device’s data (such as our IP address and any browsing cookies) travel through so many nodes and layers in a network, which means that we can be tracked all along the way. In other words, when we access a website, all the intermediary parties included in the network are aware of it.

Now why does this matter? This architure we describe makes our communications and online behavior susceptible to a number of different flaws:

• Hardware failure (phone, router, ISP, servers)
• Network failure (if one of the networks breaks down, how do you reconstitute it)
• Man in the middle attacks (if someone is spying in one part of the message and intercept it, read it, and potentially change it and send it onward)
• Loss of privacy (my IP ties to a physical location so location services / Twitter knows where I am, as does every other party)
• Throttling access based on consumption patterns (this happened to my Bitseed in 2015, but also happened when you consumed too much streaming content back in 2013–14)
• Routing hierarchies

Now the reason things developed this and in all these layers is because centralization enables efficiency in planning — where to put towers, where to lay wire, where to build servers, etc and private companies can finänce it and charge for access to it.

The idea of mesh networking — or changing the topology of networks to flatten the architecture — has been around for a long time. It just hasn’t been as fast or as cheap, and the right tools haven’t existed to incentivize people to contribute resources to the network until now.

Mesh 101

The goal for a mesh is to keep all components decentralized, so the only way to shut down or otherwise disrupt a mesh network is to shut down every node in the network. This makes them much more resilient to interference or other disturbances. To understand how meshes work — let’s touch quickly on one of my favorite things — network topology.

Physical topology pertains how the various components of a network (e.g., device location and cable installation) are placed, while logical topology illustrates how data flows within a network.

Physical topology is determined by the capabilities of the network access devices and media, the level of control or fault tolerance desired, and the cost associated with cabling or telecommunication circuits. A transmission medium is used to link devices in the physical topology of the network. Often, this is conductive or fiber optical cabling, and centralized parties plan the locations of nodes, and the links between the nodes and the cabling.

In contrast, logical topology is the way that the signals act on the network media, or the way that the data passes through the network from one device to the next without regard to the physical interconnection of the devices. A network’s logical topology is not necessarily the same as its physical topology. Logical topologies are often closely associated with media access control methods and protocols. Some networks are able to dynamically change their logical topology through configuration changes to their routers and switches.

A mesh network is a local network topology in which the physical infrastructure, like nodes, bridges, switches, and other infrastructure devices connect directly, dynamically, and non-hierarchically to as many other nodes as possible and cooperate with one another to efficiently route data from/to clients.

This lack of dependency on one node allows for every node to participate in the relay of information. Mesh networks dynamically self-organize and self-configure, which can reduce installation overhead. The ability to self-configure enables dynamic distribution of workloads, particularly in the event that a few nodes should fail.

In future episodes, I hope we’ll discuss fog computing, which is an extension of cloud computing but focused on enabling infrastructure-less computing, and other innovations in hardware.

The History of Mesh

Like many innovation, mesh networks are by no means new. Mesh already exists on localized basis — as WiFi networks. There are was a wave of VC funding of devices that allow you to run a mesh locally on your WiFi network:

• Most famous is Eero, acquired by Amazon for $97M. Eero consists of a home port you plug in and Eero beacons which look like a glade air freshener and plug into your wall — they help you build a faster, bigger home wifi network. Kind of like the Apple airport express (one of my favorite products)
• Google WiFi is Eero’s well capitalized competitor, and very similar
• Plume is another new router device with local nodes for your house, but Plume adds in a cool software app that lets you apply parental controls, manage device access, and monitor the use of your network in real time.
• Disney even rolled out a device called Circle that lets parents control the network like parental controls, but also freezing wifi for certain hours

These meshes rely on connection to a master node, which is the router plugged into your ethernet or fiberoptic cable. But the problem with all of these is you’re still at the mercy of an ISP.

Despite their many benefits, mesh networks are still niche. This is partly because connecting to a mesh network is still far more difficult than just signing up for Internet service via an ISP and paying a monthly Internet bill.

Examples of existing mesh networks

• NYCMesh is a community-run internet network. It has “supernodes” large antennas in Manhattan and Brooklyn, which connect directly to internet exchange points (IXPs) through fiber optic, thus bypassing ISPs. Supernodes provide internet access through mesh network consisting of community-installed routers throughout the city.
• In January 2009, Jalalabad, a city in Afghanistan wanted to bring high-speed internet to a village, hospital, and university and implemented a mesh called FabFi. Jalalabad has 45 remote FabFi nodes, and the system is extensible by anyone without getting central permission, and the materials needed to make an endpoint link are $60US, and are available locally.
• Guifi is a country-wide mesh network in Catalan villages in Spain, and has 34,000 active nodes.

Enter Bitcoin: Incentives in Mesh Networks

Meshes face a number of challenges that have historically been difficult to resolve:

• Traditional identities don’t work on a mesh — need a new way to identify people (how do I find Jill?) One idea is to use cryptographically secure wallets as an ID
• If I relay for other people with my node — how do I manage who is consuming resources and how much? Mesh has been around a long time but hasn’t taken off due to the payment system issue — I would have to rely on PayPal or credit card. But now, with bitcoin we have decentralized digital money
• And tragedy of the commons / how do you throttle people who consume too much or interfere in the network? We make it prohibitively expensive to do so.
• Lastly, how do you enable handshakes and handoffs between networks?

And then you need:

• Compatible Hardware — radios don’t work well and current device bandwidth is limited
• Zero start problem in a mesh — how do you get enough people on the network to make it useful
• Compatible Software and open standards — need tools and standards that existing developers can incorporate

Increasing Redundancy in the Bitcoin Network

Some projects have been focused on leveraging new networking architectures to make the bitcoin network more resilient as reducing dependency on ISPs. Some examples include:

• Bitcoin Relay Network: High-speed block-relay system, that helps to relays blocks around the world, and acts as a fallback in case public Bitcoin network encounters issues.
• Fast Internet Bitcoin Relay Engine (FIBRE) as a follow-on to the BTC Relay Network, relays blocks with no delay beyond the speed of light through fiber. Allows the BTC network to operate incredibly well even when faced with suboptimal internet conditions. Anyone in any country can easily join the Bitcoin network, and be able to participate on-par with 1st world country nodes with strong internet connections
• Blockstream Satellite: Even if ISPs or governments find way of blocking Bitcoin (e.g. through deep packet inspection), you can set up a satellite dish and be able to receive data blocks from the Bitcoin network. Passive receipt outside of the traditional ISP system. The Blockstream Satellite currently broadcasts real-time Bitcoin blockchain data to ⅔ of earth. The Blockstream satellite currently uses commercial satellites, but in the future could be expanded to run a full node on a satellite. The satellite even has an API that allows users to pay with BTC to broadcast data to the world through Blockstream Satellite, paid for using the Lightning Network.
• Blocksat, a test of “proof of news” run by pseudonymous bitcoiner going by “SafetyFirst”, and started broadcasting bundles of news using the Blockstream Satellite. (source)
• PushTX via SMS: users in censored areas can push transactions to a Bitcoin node via SMS, through transaction relayers who help to publish transactions onto the Bitcoin network. (source)
• BitSat program (Jeff Garzik) wanted to construct 24 nanosatellites, able to fully process and propagate blockchain. (source)
• Cubesats: (very small, 10cm x 10cm x 10cm satellites), can carry a Raspberry Pi device and run a Bitcoin nodes. Often pitched as a platform for space-based cloud computing. Small, inexpensive, significantly cheaper than traditional satellites. (BitSat cost was ~$1mn for a single cubesat). 1mb per minute radio uplink / downlink is sufficient for small transaction sizes of Bitcoin network. (source)

Building Mesh Networks with a Crypto Incentive

Now mesh architecture isn’t just about making the bitcoin network more resilient. It is also about enabling new types of mesh networks using cryptocurrency as an incentive layer.

In 2017, the bitcoin community and mesh community started to intersect, and started experimenting withe public wifi access points with an app-based micro-payment system. This would theoretically incentivize network development by providing a profit incentive to invest in and share infrastructure.

However, some very real challenges exist:

• Physics of telecommunication networks depend on large “supernodes” proximate to internet exchange points. Difficult to incentivize large capex investments (e.g, supernodes antennas that have to be mounted on skyscrapers / high places). “Supernodes” in mesh networks should get most of the payment as their capex and network contributions are the most important
• Mesh composed of small devices is technically unfeasible: bandwidth decreases by 50%, latency increases by ~10ms on each hop, routing table would be too big. Would be significantly less performant than centralized alternatives. (source)
• “Proof-of-work” on router is difficult because of CPU limitations on router. “Proof of transfer” is difficult without compromising privacy. (source)

Examples of Bitcoin-related Mesh Networks

• TxTenna: uses GoTenna, a compact, off-the-shelf mesh network dongle. A network of GoTennas can create a mesh network, enables Bitcoin to be used even when traditional internet infrastructure is down. It rebroadcasts Bitcoin transactions to the nearest full node that has access to the Blockstream Blocksat receiver. An alternative transaction channel that makes the Bitcoin network more resilient to disruptions. (source)
• Bitcoin Venezuela Mesh Network: mesh network developed in response to local downtime for LocalBitcoins, and possible future political censorship. Inexpensive Turpial and Harpia mesh network devices create inexpensive mesh networks, that relay transactions to internet gateways to be transmitted to the Bitcoin network. The Harpia node (slightly larger) can connect to the blockstream satellite through a receiver (source, source)

Altcoin-based Networks

• Althea: Routers pay each other for bandwidth, allow people to set up decentralized ISPs in their communities. Uses Ether to pay for bandwidth. Network topology is divided into Gateways (connected to wholesale internet backhauls), Relays (forwards bandwidth from end users to Gateways), End user (who pays in ETH for bandwidth per GB) (source)
• Helium: $495 physical hotspot that uses “LongFi” wireless protocol that is optimized for miles of range. Claims to be able to blanket an entire city with just 50–100 hotspots. Introduces a native currency called “Helium” that routers are rewarded with, and data credits can be bought with
• NKN: Network infrastructure for P2P network connectivity. Proof of relay / transmit. A project out of China. Does not explicitly address the hardware layer, but provides a secure tunnelling overlay on top of TCP/IP, and marketplace for selling excess bandwidth without centralized coordinator nodes.

Conspiracy theories?

If meshing actually starts to work at scale, the entire world we have built comes crashing down — so many companies rely on keeping the existing power structure. I call this “the great flattening” as layers of fees and hierarchies get compressed down.

Either way — this topic is fascinating!

Episode 25: Mesh Much? was originally published in What Grinds My Gears on Medium, where people are continuing the conversation by highlighting and responding to this story.

Encryption has long walked the line between weapon and tool. While the so-called “Crypto Wars” ended in the 1990’s, in 2013, Edward Snowden showed us why the fight was long from over. This week, we discuss the brink of another type of Crypto War, the one over cryptocurrencies.

Listen to the episode | Subscribe on iTunes or Spotify

Show notes and links for the episode 👇🏽 below

In the 1990’s, as mobile phones were first taking off, the NSA introduced a mandatory bit of technology to be integrated in them — the Clipper Chip. The Clipper Chip was part of the Clinton Administration program to “allow Federal, State, and local law enforcement officials the ability to decode intercepted voice and data transmissions.” In other words, this would give the government a back door.

This was just one battle waged in what has come to be termed the Crypto Wars… the fight between government and (often) individuals, technologists, and even corporations over how encryption technology should be treated.

A Brief History

Post-WWII, encryption was treated solely as a munitions export and was regulated as such. In the 1960’s this started to receive some pushback from financial institutions as they started to realize encryption was useful for a whole bunch of other things, including protecting sensitive information. And finally in the 1990’s as technologies like mobile phones and the internet started to take off… this all came to a head with the Clipper Chip.

We have seen companies like Apple take a stand and encrypt iPhone data in such a way that even the company itself would not be able to access it. We have seen T-shirts with Export-restricted RSA encryption source code printed on them, making the shirt an export-restricted munition.

We may have thought the Crypto Wars ended in the ‘90’s. Edward Snowden showed us otherwise… But now we may be on the brink of another type of Crypto War.

Washington has finally taken notice of this little thing called bitcoin.

Crypto Goes to Washington

July was a busy month for bitcoin, but let’s hone in on the one week that pushed bitcoin from fringe into mainstream.

• Thursday, July 11: Jerome Powell testimony
• Friday, July 12: Donald Trump tweet
• Monday, July 15: Mnuchin Monday’s press conference
• Tuesday, July 16: Senate Banking Committee Hearing with Facebook’s David Marcus
• Wednesday, July 17: House Financial Services Committee Hearing with David Marcus and Expert Panel

Now — tons of interest, but still fundamental misunderstanding about bitcoin and regulation!

The Status of Bitcoin

The US has a patchwork of agencies and regulations that oversee bitcoin, and the line between regulation (making rules) and enforcement (following the rules and punishment if you don’t) is an interesting one.

• SEC | The Securities and Exchange Commission (SEC), as its name implies, oversees securities issuance and exchange. According to the SEC, Bitcoin is not a security.
• CFTC | The Commodities Futures Trading Commision (CFTC) ensures the integrity of futures and swaps markets. . According the the CFTC, Bitcoin is a commodity. Any swaps and futures involving bitcoin are part of the CFTC mandate.
• IRS | According to the Internal Revenue Service (IRS) Bitcoin is property, taxed as property, like stocks or bonds, any gain or loss from the sale or exchange is taxed as a capital gain or loss.
• FinCEN | The Financial Crimes Enforcement Network (FinCEN) oversees financial crime as part of the Bank Secrecy Act or BSA.
• OFAC | The Office of Foreign Assets Control (OFAC) administers and enforces sanctions. Sanctions have been applied to bitcoin addresses.

And there are many more acronyms in the episode.

Let’s Ban Bitcoin

Banning bitcoin is an interesting idea. There’s a fundamental distinction between regulation and enforcement.

Protocol: Code is protected under free speech statutes, and the encryption bans of the 1980s and 1990s — which effectively weaponized software — resulted in encryption being allowed. However, Github (a Microsoft company) recently blocked Iranian and Syrian users, because Microsoft is a US company subject to sanctions.

Network: The physical implementation of the bitcoin protocol is where code meets meatspace. How would you stop people from running nodes? Well, the dependence on corporate ISPs and telcos, who have helped the government before and will do it again, means the network supporting bitcoin is fundamentally insecure (more on next week’s episode),

On and Off Ramps: This is where the enforcement rubber meets regulation road. See Operation Chokepoint, or how banks cut off high risk (read: bitcoin) companies. Anecdotally, helping find and open new bank accounts for bitcoin companies was basically my job from 2015–2017.

Even if you try to avoid banking, The Finland-based LocalBitcoins.com is now under pressure to do KYC / AML which defeats the purpose. In fact, in the US, local bitcoins brokers are being convicted of running illegal money transmission schemes.

Lastly, governments have no issue seizing bitcoin. The Silk Road auctions resulted in the DoJ auctioning 144,336 bitcoin for $48,238,116 or $334 per bitcoin (ppl put together syndicates to bid on the auctions, remember working on this). The Bulgarian government sitting on 213,519 of bitcoin, a little over 1% of total, fully mined bitcoin supply, which was worth nearly $3B at its peak in 2017 — although they say it’s been liquidated through open market activities over the last year or two. And Venezeula and Iran are going straight to the source and seizing bitcoin miners, not a bad way to shut it down.

Why it Matters

The challenge of enforcing bans on P2P networking and P2P file sharing are legendary. One glance at PirateBay hosting servers in drones in open water to escape jurisdiction, servers in Ascencion on a volcano, craziness! show that

1. Jurisdiction is challenging to define in a fully digital world. Historically jurisdiction have been defined by physical boundaries. However, these are difficult to draw in a world that is already fully digital and concerned with privacy.
2. Regulation is dependent on jurisdiction. If you don’t have a jurisdiction, how do you identify relevant regulation? Without harmonized global regulation, people will use jurisdiction as a tool to change the rules.
3. Lastly, enforcement is what scares people into following regulation. Enforcement requires penalties, which is what makes people fear the consequences of *not* following the rules. Hence, enforcement will continue to be aggresssive.

Episode 24: Banning Bitcoin was originally published in What Grinds My Gears on Medium, where people are continuing the conversation by highlighting and responding to this story.

Bitcoin: is it a safe haven or a risk asset? This week we are (for once) talking price. We try to make sense of the recent run ups and retracements and we explore how the valuation of bitcoin and other cryptocurrencies fit into the larger economic landscape.

Listen to the episode | Subscribe on iTunes or Spotify | Watch on YouTube

Show notes and links for the episode 👇🏽 below

The Macro

This month officially marks the longest expansionary period in US history. It’s been over 120 months or 10 years since the US economy started to rebound from the financial crisis-lows.

What does this mean? The economy tends to go in cycles — both long term cycles and short term cycles — of growth and contraction. Growth is often fueled by debt, that at a certain point catches up with the economy leading to a big debt crisis and a contraction.

The peaks and troughs of these economic cycles have tended to come at semi-regular intervals. But sometimes there are outliers. And it looks like this cycle we are in right now is an outlier.

At different points in each cycle, different types of assets outperform. By and large, you can divide these assets into “risk assets” and “safe haven assets”. In a downturn, investors will flee to the relative safety of assets like gold, strong and stable currencies, and even shares in companies that provide goods and services resilient to a bear market (like healthcare and consumer staples). In a stronger market, however, during an expansion, investors seek out more risk in hopes of a higher return. These risk assets include everything from technology stocks to emerging markets debt.

So our question is: where does bitcoin fit in? Is it a risk asset or a safe haven?

To find out we ran this poll. Let’s just say the results were inconclusive.

Jill Carlson on Twitter

Bitcoin is a:

Tune in to listen to us talk economic cycles, central bank activity, and most importantly… what prices are doing and our predictions for the rest of this year. We might just be reading tea leaves, but, hey, we might just also be right.

Episode 23: Price Predictions was originally published in What Grinds My Gears on Medium, where people are continuing the conversation by highlighting and responding to this story.

What do you get when you put together a consortium of private members issuing a currency that is aimed at world domination? First, the Federal Reserve. And then, 100 years later, Facebook’s Libra! In this episode, we untangle why Facebook needs FaceCoin, how digital money in a digital world is changing the role of banks, and what does and doesn’t make sense when it comes to tech companies issuing their own tender.

Listen to the episode | Subscribe on iTunes or Spotify

Show notes and links for the episode 👇🏽 below

First, there was FedCoin

Have you ever heard of a consortium of private members issuing a currency that is aimed at world domination? Believe it or not, Facebook’s Libra was not the first. You might be surprised to find the Federal Reserve aka THE FED figured it out long ago!

According to the board of governors of the Federal Reserve, “is not ‘owned’ by anyone and is ‘not a private, profit-making institution’. Instead, it is an independent entity within the government, having both public purposes and private aspects.”

The Fed is actually owned by its 3400 member banks, who are different classes of stakeholders who contribute capital to help stability the federal reserve banks around the country.

The U.S. Government does not own shares in the Federal Reserve System or its component banks, but does receive all of the system’s annual profits after a statutory dividend of 6% on their capital investment is paid to member banks and a capital account surplus is maintained. The government also exercises some control over the Federal Reserve by appointing and setting the salaries of the system’s highest-level employees.

What do Banks Do

Banks started, quite simply, as a place to put money. They then evolved into institutions that extended the money supply and resolved some of the timing mismatch around when people receive money and when people need money. We’ve covered this extensively in our Season 1 episodes on credit (Episode 8 and Episode 9)

Commercial banks make money lending. They use retail deposits to make these loans. Unfortunately, in this digital age, they no longer have the best information set about these retail depositors. The social media companies do. Facebook arguably has the richest data about consumers of any company in the World. Ergo — next step — become a bank!

The finance function, or banking function, no longer belongs to banks. Consumer credit of all types has been disintermediated, just look at:

• Lending Club for personal loans, SoFi and Lending Club for student loans, Klarna and Affirm for point of sale / layaway lending
• Factoring is being disintermediated
• Corporate credit will be disintermediated

It’s starting at the edges in places where banks aren’t too concerned, but it’s rapidly moving and it should scare every bank.

What’s also important to note is that in many parts of the world, finance is already 100% digitized and consumer finance, in particular, is already owned by non-banks aka tech companies that ended up becoming banks because they owned the end consumer.

BY THE WAY — Facebook’s non-US competitors have already done this. What Libra describes its intentions to be with its “foundation” is something that its competitors in China, Korea, and Japan already do. The future described in the Libra white paper is already possible in most places in the world. Facebook just added the veneer of “blockchain” and “decentralization”.

So Why This

Facebook is company in crisis (Here’s my take on “why” Libra is happening). Facebook is facing a capital crunch:

• Social Capital: Reeling from PR crisis, political punching bag that both parties can agree on
• Financial Capital: Stock price stagnating, business model not growing outside US, and ad revenue challenged by political pressure and fines
• Human Capital: High level departures, co-founders calling for breakup, morale when stock price is tanking
• Political Capital: Shifting political tides — EU, US, election season, and no one has forgotten Cambridge Analytica

What it Means

Libra is basically creating a new banking function, and the instrument they’re issuing — this stablecoin basket — is basically an ETF where the yield goes to the backers of the project, in the words of BitMEX. And I quote, from their commentary, which you can find here.

Libra is a stablecoin backed by a basket of fiat currencies. The fiat currencies sit in a dumb regulated commercial bank. Libra allows a privileged few the ability to create and redeem Libra at its Net Asset Value (NAV). Libra rides on a blockchain where certain parties operate permissioned nodes. These parties included VC firms, technology companies, retail merchants, cryptocurrency exchanges, and most importantly commercial banks and credit card processors.

So, let’s all agree on one thing. Libra is NOT a cryptocurrency. It doesn’t need a blockchain. And that’s ok!

In the words of David Gerard, writing for “Foreign Policy”

Libra has certainly demonstrated one of the main characteristics of blockchain projects — grandiose claims and egregious nonsense…

Absolutely everything Facebook described in its press conference on Libra last Tuesday could have been done on a conventional financial computer network system — and better.

So What’s the Real Deal?

If you read the white paper, one of the principles of Libra was to “(give) people an inherent right to control the fruit of their LEGAL labor.” If you’re keeping all of the interest on the underlying basket of assets you’re buying with someone else’s money, how is that good?

Mind you, the Swiss Foundation structure that Facebook borrowed from, oh, basically every ICO, is not a non profit.

Facebook’s language around Libra is very vague and hand-wavy, and is heavily focused on “banking the unbanked” - a phrase that really grinds our gears, and its a popular claim for many shitcoin projects. Facebook’s attempts to conflate poverty (effect) with access to loans, pay day lending and loan sharking, and technology not being fast enough or cheap enough (causes) seem a bit simplistic. But, we all know the “unbanked” is not something that can be solved with technology alone. It requires changes in policy, infrastructure, and a host of other decidedly non-blockchain factors.

So What Happens Next

• Every bank and corporation will look at issuing a digital currency, or doing something with a permissioned, centrally managed but “decentralized” digital currency. Note Goldman’s “cool” CEO said issuing a Goldman coin was not off the table shortly after Facebook’s week in the sun.
• Banks are under pressure, and continue to be eroded by smaller, nimbler, and hyper-specialized players
• Central banks under pressure — bitcoin introduced state-less money, now everyone is riffing on that since it has proven it can work. Doesn’t everyone want to be their own emperor king?
• Really, Libra is a competitor to Alipay and WeChat (well not really since it won’t be in China)… but it’s trying to provide that service. It is not trying to be bitcoin.
• Evolution from physical realm into digital realm continues — panopticon money is coming, and you bet your ass you can’t escape it. (See Episode 10: Big Brother Loves Bitcoin)

Mostly — Facebook has a lot to figure out before the launch of Libra, but with their resources, lobbyists, and army of world class engineers, our money is on them figuring it out.

Episode 22: Welcome to FaceCoin was originally published in What Grinds My Gears on Medium, where people are continuing the conversation by highlighting and responding to this story.

For millennia, humans have been building innovative financial products to pool and distribute risk, provide diversification, and make it easier for average investors to participate in new markets with the help of a manager.

You can’t talk about bitcoin for ten minutes without having someone bemoan the lack of a bitcoin ETF. In this live episode, we talk about the history of pooled investment vehicles, why they’ve grown exponentially over the last two decades, and why US firms are so fascinated by making bitcoin, which is already quite friendly to retail, more accessible for institutions.

Listen to Episode 20

The Silk Road and The Beginnings of Investment Pools

The year is 750 AD. It is the golden age of the silk road (like, the trade route, not the black market). Muslim merchants traveling the trade route needed a way to finance their growing trade business. Combining elements of a loan and a partnership, the qirad was created as an informal agreement between two parties — one who had capital, and the other who put in labor. Over time, qirad agreements evolved to accommodate multiple investors in a single venture, and was passed on to children similar to a trust.

Fast forward to 1100, the Europeans are looking for new ways to finance increasingly risky and expensive ventures across the unknown oceans and to unknown ports. They called the contract commenda. The commenda contract became extremely popular with Venetian merchants, and for good reason.

While fortunes could be made at sea, ships were frequently lost and there was no guarantee that a merchant would return home from a voyage. The commenda enabled passive investment (no work needed), allowed for partial or fractional financing and facilitated investment in numerous ventures, and thereby enabled a new system for sharing profit and loss.

In addition to their unique investment partnerships, commenda were known for their liquidity. Investors could easily buy and sell whole (or partial) positions in a merchant’s voyage, which was a true innovation. Now speculative investing could be done in the town square, as news about voyages reached port.

Fast forward to 1774. A Dutch financier Abraham van Ketwich created a new pooled investment vehicle called, Eendragt Maakt Magt (Unity Creates Strength). The prospectus required that the portfolio would be diversified at all times. The 2,000 shares of Eendragt Maakt Magt were subdivided into 20 ‘classes’, and the capital of each class was to be invested in a portfolio of 50 bonds. Each class was to consist of at least 20 to 25 different securities, to contain no more than two or three of a particular security. So — this vehicle, the Eendragt Maakt Magt was an equal-weighted index fund designed to offer investors a broad, diversified exposure across ’20 classes’ of bonds.

The cost was 0.20% or 20 basis points of the total return, and the fund promised there would be no “active management” and safe custody, which in those days meant storing the stock paperwork in an “iron chest with three differently working locks”. If any investment decisions were made, the chest would have to be unlocked by three separate authorities.

The road leading to pooled investment products can be traced back over a thousand years. For millennia, humans have been building innovative financial products to pool and distribute risk, provide diversification, and make it easier for average investors to participate in new markets with the help of a manager.

Why Bitcoin ETF

To understand, we have to go a few steps back, and then a few steps forward:

• What pooled investment vehicles are and how they work
• Why funds have grown exponentially over the last two decades
• How GLD re-shaped the Gold market
• What people actually mean when they talk about a bitcoin ETF
• What a bitcoin product might look like and whether or not it actually matters

Let’s dive in…

So What Are Pooled Investment Vehicles?

As its name suggests, a pooled investment vehicle (PIV), sometimes called a pooled fund, is an investment fund raised by pooling small investments from a large number of individuals. We’ll touch on the three most common types — REITs, mutual funds, and ETPs.

Pooled investment vehicles are sometimes organized as standalone companies, and in other cases they are arranged and managed as entities within a larger business, such as a brokerage house.

When someone participates in a pooled investment vehicle, their investment is managed by a team of professional fund managers.

Unless you are an expert in the financial markets or are extremely confident in your own ability to devise a winning investment strategy, this professional management can be a benefit in that it allows you — with only a small outlay of your own capital — to tap into the experience and knowledge of a team of investment professionals whose fees and reputation depend in part on how well they manage your fund.

Let’s talk about the most popular investment schemes

• REITs , or a real estate investment trusts, which are pools money from investors (individuals as well as institutions) and purchases real estate — a large portfolio of properties. Tax benefits to investors and allow passive investors to get exposure to baskets of real estate. Real estate has created the majority of wealth in our world.
• Mutual Funds, a pooled investment vehicle, where professional fund managers raise capital from many individuals and institutions, aggregate this capital into a single large fund, and then use the fund to purchase and manage a portfolio of investments. Mutual funds can be closed ended or open ended, and can have a variety of different features.
• Exchange Traded Products, or ETPs, are comprised of two types of products, ETNs and ETFs. An ETF, or Exchange Traded Fund, represents an investment fund (a portfolio of securities) that tries to track a specific index. Sample ETFs include:
• the S&P 500 ($SPY), which tracks the return of the top 500 publicly traded US stocks
• the Vanguard Information Technology ETF ($VGT), which holds 300 tech stocks including blue chip stocks and smaller companies
• Vanguard Short Term Corporate Bond ETF ($VCSH) which buys investment grade corporate debt from big-name companies
• Invesco Preferred ETF (PGX) which purchases preferred stock, a kind of hybrid share class with bond-like features
• If you’re me, Direxion’s $NUGT AND $DUST — triple levered gold miners bull and bear. For example, DUST, the bear product, is 80% short an index of gold miners, and applies 3x leverage, so if the index moves down 1%, the product returns 3% to investors.
• And there are lots of more esoteric ETFs that hold private equity, bank notes, active strategies, and more!

A Quick Take on ETFs

Unlike mutual funds, ETFs aren’t sold directly to regular investors. Instead, they use banks and brokerage firms as middlemen. These large traders don’t transact in cash. They make an ETF bigger or smaller by adding portfolio stocks to it, or by taking them out. They call this activity “creating” and “redeeming” ETF shares. (All this is invisible to small investors, who just buy ETFs from brokers.)

All of these features rely on a specific “in-kind” creation and redemption principle: new shares can continuously be created by depositing a portfolio of stocks that closely approximates the holdings of the fund and similarly, investors can redeem outstanding ETF shares and receive the basket portfolio in return. Holdings are transparent since fund portfolios are disclosed at the end of the trading day.

Unlike mutual funds, ETFs are listed on an exchange and can be traded intraday. Issuers and exchanges set forth the diversification opportunities they provide to all types of investors at a lower cost, but also highlight their tax efficiency, transparency and low management fees.

Most importantly — ETFs typically take a passive investment approach, which means that rather than actively making decisions about which investments are more likely to succeed than others, they simply track predetermined indexes.

Now one thing that’s overlooked is the tax advantages associated with ETFs. Unlike mutual funds, ETFs almost never have to declare taxable distributions of capital gains that can add to your tax bill. That lets you decide when you want to realize any gains in the value of your ETF shares by selling them.

Just last month, a change is being discussed to minimize these tax benefits. Typically, when you sell a stock for more than you paid, you owe tax on the gain. But thanks to a quirk in a Nixon-era tax law, funds can avoid that tax if they use the stock to pay off a withdrawing fund investor. This is called a heartbeat trade — and it happens when banks pump billions into an ETF to help the fund avoid tax gains.

A fund manager asks a friendly bank to create extra withdrawals by rapidly pumping assets in and out. In fact, in 2018, State Street reaped $64B in capital gains tax savings by using this method.

Just as wealthy merchants along the Silk Road and wealthy Venetians used pooled investment schemes to provide diversification of returns and lower risk, today’s investors use pooled investment vehicles for a variety of reasons.

Sizing the ETF Market

ETFs are a relatively “new thing” in the world of finance. In less than 25 years, exchange-traded funds (ETFs) have become one of the most popular investment vehicles for both institutional and individual investors.

ETFs are in fact so popular that many brokerages offer their customers free trading in a limited number of ETFs. Many ETFs are now competing on fees, and Fidelity has even explored rolling out no-fee products to accrue more AUM. Why?

For institutions, aggregating positions gives them power and control. Owning 20 to 30% of a stock makes that institution a power player. In the world of asset management, it’s all about AUM (assets under management) and charging fees on that AUM.

At the end of 2010, assets under management in U.S. ETFs reached $1.0 trillion, which was invested across more than 1,100 ETFs, according to ETF.com. One of the most significant drivers of ETF growth has been the shift from traditional commission-based financial advice models to fee-based structures. Many financial advisors have embraced ETFs as a flexible, low-cost way to implement and rebalance diversified allocation models for their clients, and clients in turn have increasingly turned away from relying on advisory services, instead opting to diversify their portfolios through these products that are easy to buy and sell.

To give you a small sample — 2017 was a record year for ETF cash flows — $460 billion flowed into U.S.-listed ETFs, with more than $100 billion going to fixed income (interest yielding ETFs.) The current assets under management in US ETFs is a staggering $3.4 trillion!

Using an ETF to Buy an Ounce of Gold

Now one ETF that’s important to highlight is the SPDR Gold ETF, or $GLD, which is managed and marketed by State Street. For a few years, the fund was the second-largest exchange-traded fund in the world, and it was briefly the largest.

The fund allows individuals to track gold bullion prices — and the idea behind its appeal is that this gold fund could be cheaper than the cost of shipping, storing and insuring physical gold on your own given expenses are just 0.40 percent (or 40 basis points) in annual fees, or $40 each year on every $10,000 invested.

Each share of GLD is intended to track the price of a tenth of an ounce of gold. The ETF price roughly in line with the gold price, although the prices can deviate during each day.

As of March 31, 2019, $GKD had 24.5M ounces of vaulted gold in its custody, representing an asset value of $32B and earning State Street $128M in fees annually. SPDR Gold Shares is one of the top ten largest holders of gold in the world.

The gold bullion is stored as London Good Delivery gold bars and held in a vault in London and by several other custodians worldwide. The ETF has been criticized for its lack of transparency and lack of redeemability, as well as claims it may not be 1:1 backed.

Now the reason the GLD ETF matters is this:

• Before the ETF, the price per ounce of gold was $332. At the peak of gold mania, it reached $1,600. Given gold is naturally scarce (until we mine asteroids), the idea was more captive demand for gold via an ETF would constrain market supply.
• Investing in gold was fairly inaccesible to retail investors prior to the ETF — investors had to buy coins or bars and find a way to store them. It was largely a market for specialists, like investment managers. The introduction of the ETF made investing in gold as simple as point, click, gold — and enabled people to buy and sell gold on a daily basis.
• Gold ETFs rival bank holdings of gold. Effectively, a bunch of circulating gold supply has been locked up and taken off the market. In fact, only three entities hold more gold than physical gold ETFs — the US, Germany, and the IMF.
• The introduction of gold ETFs has created a more liquid market for gold.

Now this doesn’t come without problems. Some of the key challenges of a physically backed ETF that is matched with the underlying are:

• Sponsors of these gold ETFs are beginning to move the market and impact the global market for gold.
• Tellingly, the introduction of gold ETFs shifted investment away from gold mining companies, and more of the value has accrued in the asset itself than the companies focused on finding, acquiring, extracting, and processing gold. Gold companies have had a hard time out-perfoming the price of gold.
• The largest source of demand for gold is still pure physical, in the form of bars and coins. About 25% of global demand for gold comes in the form of ETFs.
• Lastly, the redeemability of gold is problematic. There are many blockchain projects (like Tradewind Markets, started by the team behind IEX) which aim to resolve the 1:1 relationship between a share of a gold product and a physical ounce of gold.

Many people will tell you gold’s success as an investable asset was largely fueled by the GLD ETF and the rise of pooled investment vehicles. However, they miss one important element. The World Gold Council.

The World Gold Council, which can be found at gold.org, is the market development organization for the gold industry. Its sole purpose is to stimulate and sustain demand for gold, provide industry leadership, and be the global authority on the gold market. It’s a membership organization

Just last year, they teamed up with State Street to launch another Gold ETF, this one offering 1/100 of an ounce of gold per share (as opposed to the $GLD product launched in 2004 which holds 1/10 ounce per share) and the very low fee of 0.18% to attract more investors.

What a Bitcoin ETF Actually Means

When new ETFs are created, they have a benchmark or index to follow, like the S&P 500 which is the most widely followed by institutional investors . One such index could be bitcoin.

ETFs have been huge for bringing historically institutional assets to retail…But crypto has the OPPOSITE problem, it’s very friendly to retail but NOT friendly to institutions.

When we talk about a bitcoin ETF — what we really mean is we want to make it easy for people to get bitcoin.

To create a bitcoin ETF, an AP would buy bitcoin in the open market and use to create shares. These shares, representing 1/10 or 1/100 of a bitcoin, could be easily traded in a normal portfolio — no private keys or Coinbase account required — by all sorts of investors looking to speculate on the price of bitcoin.

Bitcoin is friendly to retail but NOT to institutions. An ETF is basically putting a regulated, controlled product wrapper around bitcoin to repackage itand distribute it to a broader audience.

BTC is a digital currency maintained by a decentralized network of nodes. The whole point of Bitcoin is to allow people to serve as their own banks, without the intervention of centralized parties like banks or governments — which prompts this question: Why would we want to put Bitcoin in an ETF in the first place?

Unlike gold or oil, BTC is a digital asset that can be purchased easily on a number of exchanges and transferred to a digital wallet. While a Bitcoin ETF might usher in wider investment from institutional investors, it’s unlikely that a Bitcoin ETF will intrinsically have a large impact on the market.

Now, when ETFs were first being created, they required a virtual warehouse to store the stocks, and State Street was the firm that was willing to be a trustee and custody agent .The real threat to bitcoin is centralized custodial models that aggregate coins in the hands of a few institutions. In our very attempts to make bitcoin an asset class, we are arguably destroying the very features that make it valuable.

According to CoinShares research, here’s who controls large volumes of bitcoin today:

The recent Binance hack impacted 7,000 BTC or 0.03% of all bitcoin in circulation. This is a teeny tiny number compared to some of these others, and already people were discussing a possible miner-led block re-org and claiming it was “genius.” That’s the craziest thing I’ve ever heard.

Now let’s imagine what would happen if, say, a Xapo got hacked. With at least 7%, if not more, of every bitcoin ever mined being stored in Xapo’s vaults, a hack of Xapo might actually be enough to force a block re-org, much like Ethereum did after fully 15% of all Ether ever mined were re-appropriated (I refuse to say stolen) by the DAO hacker.

The more that bitcoin flows into these controlled, regulated, institutionally owned pockets, the more we cede control of these coins to their managers. We are creating the most perfect choke point for regulators to come after.

In my view, the real key to making bitcoin more accessible is not by wrapping it in a 30 year old Wall St created wrapper, but by creating a new product wrapper that preserves the very features that make bitcoin so appealing.

These products must be redeemable for bitcoin, and preferably, enable users to hold their own private keys. Anything less is a direct affront to bitcoin.

Tune in to the podcast to hear the rest!

Episode 20: ETF! F No? was originally published in What Grinds My Gears on Medium, where people are continuing the conversation by highlighting and responding to this story.

Whether you are a retail trader sitting in front of a Charles Schwab screen or a BSD on a bond desk, when we go to place a trade, we don’t often think about what’s happening beneath the surface. We don’t give much thought to the tools we are using or to the venue in which we are finding our counterparty. We use what’s available to us and take for granted all the trade-offs of the infrastructure that exists.

But small differences in architecture can vastly impact how markets function, who gets to participate, and who stands to benefit. In this episode we tackle the issue of market microstructure. We look at market rules and standards, fairness and transparency, and how a million little design decisions can transform how we exchange assets.

We cover the history of how we got to what Wall Street is today, from the Buttonwood brokers to the Flash Boys, and apply these lessons cryptocurrency’s most interesting emergent infrastructure: decentralized exchanges (DEXes).

Listen to Episode 20

The Stock Exchange

Since the first company shares were issued in the 1600’s, stocks have generally traded in set venues — in a more centralized manner than OTC trading. In the early days, this venue was a “pit”.

From the 1600’s until roughly the 1980’s, the majority of stock trading and speculation happened through a process called “open outcry”. This is the trading floor that you think of with everyone yelling numbers, waving madly with different hand signals.

But these pits are largely now a thing of the past. The NYSE still keeps a pit active on Wall Street (worth a visit if you find yourself in Lower Manhattan) in New York that is worth a visit, but it’s really only used for the trading and auction of a few companies.

In the late 1960’s, Instinet came along, which for the first time created an electronic orderbook, trading platform, and matching engine. It was only open to select, large institutions and only offered trading of pink sheets. Initially volumes grew slowly. It took over a decade to gain real traction, but by then the benefits of better execution, increased transparency, and heightened accuracy were realized, the system took off and competitors began to enter the fray.

Today, the vast majority of stock trading happens electronically.

Dark Pools

When you go to place a stock trade, how does it actually happen? Well, it largely depends on who you are and what you are trying to do.

If you are a big player, looking to move “size” then it might get pretty complicated. If you are a hedge fund manager and you send a market order to an exchange’s orderbook to try to sell a big chunk of, say, Garmin stock, then you are likely to spook the market and move it lower before you’ve even executed a trade!

Enter the dark pool. Dark pools developed in order to provide a forum for big trades to get done amongst big traders without spooking the market.

If you’ve ever used Tinder, you will get how a dark pool works.

On the dating app Tinder, you are presented with a stream of dating options but critically you don’t know ahead of time who has or has not swiped right on you already. When there is a match— when two people swipe right on each other — Tinder will present that to both sides!

A dark pool is not dissimilar. In a dark pool, I can enter my interest in selling a big chunk of equity. If someone else comes in to buy the stock at the price I want to sell it, my sell order will fill their buy… but critically they won’t know who is on the other side and they won’t know how big my order is.

This provides a service to the market. It increases liquidity. It enables big buyers and sellers to trade more seamlessly. But, as the ominous-sounding name suggests, dark pools also have drawbacks.

There are all kinds of ways market participants take advantage of dark pools.

One example is by using what’s called latency arbitrage. This exploits the infinitesimal lag time that it takes to update buy and sell prices in the dark pool relative to where the stock is trading on the transparent exchange. High frequency firms use specialized hardware and literal, physical proximity to the public exchange infrastructure to arbitrage the stale dark pool prices with the updated transparent price.

Another way that dark pools get taken advantage of is through something called “pinging.” Pinging is a process by which a high frequency trader sends small orders to a dark pool in order to uncover a big block trade. The trader can use the information that there is a big block trade to make profitable trades ahead of that big trade getting filled. It’s a little bit like a game of battleship.

DEX

The way market microstructure evolves dictates who gets to participate in the market, where risk resides, and who stands to benefit.

As we examine the evolution of crypto’s decentralized market structures, we can start to see these tradeoffs emerge all over again.

One of the most interesting examples of this is that of the decentralized exchange (or DEX).

So what is a DEX?

To say “decentralized exchange” is something of an oxymoron… an exchange is, by definition, a centralized venue for trading. How can a venue be decentralized? If we were to take the words literally, we’d probably end up with something like OTC trading.

Really, what decentralized exchange has come to refer to is the ability to execute and settle trades in a censorship-resistant manner, without reliance on a third party. When I talk about decentralized exchange, the important thing to me is the ability to perform trades without a third party custodian. Why is this important? Well, it turns out cryptocurrency exchanges don’t exactly have the best track record when it comes to custodying their customers’ funds. From Gox to Quadriga and everything in between.

There is a whole spectrum of DEXes that exist… from semi-centralized entities that enable semi-non-custodial models, like Abra and Shapeshift, to the more fully decentralized models of 0x and Uniswap.

Until late 2018, Shapeshift required no account set up, no username or password, and no KYC. It functioned as a widget for transforming your altcoins into other altcoins. Recently, however, they have begun to require KYC calling into question just how decentralized or censorship resistant the model really is.

The development of 0x marked an important milestone in non-custodial exchange, leveraging smart contracts in a new way to enable “trustless” trade. Despite strong developer traction, volumes, however, remain sparse on 0x and most competitor platforms.

It’s important to remember here that all market infrastructure suffers from a two-sided market problem when it is first coming to market. Instinet, you may recall, took a couple of decades to really catch on!

But there are other issued that exist with decentralized exchanges… most notably frontrunning. A recent study controversially demonstrates how bots are being used to arbitrage these types of exchanges in a brand new way: paying miners higher fees to prioritize and reorder transactions. Of course these issues have been anticipated and addressed by the creators of the protocols themselves.

Of course there might be other ways to enable non-custodial exchange that don’t run into these types of issues. Arwen is creating a new model that enables centralized exchanges to implement channels for traders to use, allowing their customers to retain self-custody while accessing the exchange’s liquidity.

However these new forms of trade, custody, and exchange continue to develop, tradeoffs are getting made that will determine the fairness of these markets, who gets to access them, and what kind of risk exists in the system. Tune in for deeper dives into all the exploration we have yet to do in the next evolution of trade and where we can draw lessons from the past.

Further Reading

• DeFi Liquidity Models
• Ecosystem of Decentralized Exchanges
• Upstart IEX Holds a Candle Above Dark Pools

Episode 19: Let’s Talk About DEX, Baby was originally published in What Grinds My Gears on Medium, where people are continuing the conversation by highlighting and responding to this story.

If you follow crypto, you may have heard rumblings over the past week that the New York Attorney General’s Office has some beef with Tether, Bitfinex, and their affiliated banks. Well, we are here to play a game of Fact or FUD on the matter and try to untangle it.

In this episode, we explore the good, the bad, and the ugly of collateralization, fractional reserve, and — everyone’s favorite no-return crypto asset — Tether.

Listen to Episode 19

What is a Tether Anyways

Getting money into and out of bitcoin is HARD — how do you take fiat dollars and turn them into bitcoin when crypto and banking don’t connect

Before 2013, anyone who wanted to get their hands on bitcoin would have to resort to mining it themselves (not that difficult, but also not that easy), get on local bitcoins, or wire money to Mt. Gox in Japan. In 2013, the first retail brokerage platforms in US, Coinbase and Circle, made life a little easer. Of course, once you had your bitcoin, there were also the unregulated, or simply, less regulated crypto to crypto exchanges, like BTCe.

In January 2012, a bitcoin enthusiast named J.R. Willett described the possibility of building new currencies on top of the Bitcoin Protocol, through a cryptocurrency called “Realcoin.” The idea was to allow complex financial tasks on top of bitcoin, and to enable “smart assets” (via smart contracts) and a second layer that would be the capital markets layer for bitcoin. This project was re-named and launched in 2014 as “Mastercoin” by a group of founders including Brock Pierce, Craig Sellars, and Reeve Collins. These founders were part of an associated entity, the Mastercoin Foundation, which would use the funds from the Mastercoin ICO to promote the use of this new “second layer.”

The Mastercoin protocol would become the technological foundation of the Tether cryptocurrency, and the first “tokens” were issued in October 2014, via the Mastercoin protocol but anchored to the bitcoin blockchain. This was really the pre-cursor to 2017’s ERC-20 tokens.

In November of that year, these tokens were renamed as “Tether” as part of a new company, Tether Limited, whose leadership included executives from both Mastercoin and Bifinex. At that time, Tether was widely publicized to be backed 100% by its original currency, and to be redeemable at any time with no exposure to exchange risk. The company’s website states that it is incorporated in Hong Kong with offices in Switzerland, without giving details.

Then, in January 2015, the exchange Bitfinex enabled trading of Tether on their platform for the first time. While representatives from Tether and Bitfinex say that the two are separate, the Paradise Papers leaks in November 2017 named Bitfinex officials as responsible for setting up Tether Holdings Limited in the British Virgin Islands in 2014, and the Tether website currently lists Bitfinex executives as also being Tether executives. The CEO of both firms is Jan Ludovicus van der Velde. Bitfinex is one of the largest Bitcoin exchanges by volume in the world.

When Tether first launched, volume was small, since the bitcoin market was small.

• At the end of 2015, Tether’s “market cap” crossed the 1M for the first time
• 2016 ended with $7M of Tether in circulation
• In 2017, Tether exploded as the crypto market exploded, and at the end of the year, the total volume of Tether in the market was $1.3B. That was a straight run, in 12 months, from $7M to more than $1B.
• Today, the market cap sits around $2.8B, and hovers within a $500M range of that number.

A few final notes on Tether

Tether was originally built on top of Mastercoin, one of the first ICOs, which later re-branded to Omni. Omni currently has a market cap of about $2M. Here’s is a great example of value not accruing at the protocol layer, but in the instrument itself. This might (clears throat, sips tea) just be an important lesson about the future of Ethereum and the stablecoins built on top of it. At peak crypto mania, Omni only reached a $50M market cap, nowhere close to the billions the token issued on top of it, Tether, has reached.

Today, there are two constructions of Tether, Omni / Bitcoin and ERC-20, although Tron and other protocols are also looking to get Tether onboarded.

• Tether was originally created to use the Bitcoin network as its transport protocol — via “Omni — to allow transactions of tokenized fiat. This version of Tether therefore “inherits” the stability and security of the longest established blockchain network, Bitcoin.
• Tether on the Ethereum blockchain, as an ERC20 token, is a newer transport layer, which now makes tether available in Ethereum smart contracts or decentralised applications on Ethereum. As a standard ERC20 token it can also be sent to any Ethereum address.

Since Tether is currently built on top of two different protocols (Bitcoin and Ethereum), when users send tethers to other addresses, they need to carefully check the destination address to confirm the format and select the correct protocol. As we discussed in Episode 13 on interoperability on the Cosmos bitcoin hub, Tether is another such bridge to enable digitized dollars to enter the crypto ecosystem.

So How a Tether Actually Work

Someone needs to get USD into the crypto ecosystem. They deposit dollars with Tether Holdings Limited, a BVI based company, and receive an equal amount of Tether. At any time, any holder of those Tethers should be able to redeem them for those dollars. In this sense, Tether is a bit like a depository receipt.

However, this reimbursement is dependent on meeting the terms and conditions of the Tether service agreement. However, Tethers have an active secondary market, so most people opt to trade tether for other assets. This is why Tether doesn’t always have a price of $1 — it fluctuates depending on the market’s sentiment about the redeemability of a Tether and the need for stable cash.

How is Tether used?

Why do people hold US dollars? See our notes for Episode 14 about liquidity, where we discuss this in depth. Because the US dollar is backed by the strength of the US economy and governance system and ability to protect its borders, which is what makes the US credible and credit-worthy. The US dollar is highly exchangeable, and it is deeply liquid.

Tether was originally created to solve a few problems in crypto exchange:

1. Provide a Reliable USD trade pair, especially in places where there is no USD liquidity, say, on a crypto to crypto exchange.
2. Enable Rapid Settlement. If two parties make a trade, can settle instantly on the same network where the trade happened. Tether enables this on BTC (via Omni) and ETH, more coming in the future.
3. Pooling of Liquidity. Enables aggregation and pooling of USD balances outside the correspondent banking system, and enable this liquidity to move across exchanges.
4. Manage Volatility. Many traders who cannot touch fiat may opt to store their crypto in Tether at times of high volatility. Likewise, regulatory events where bank access is cut off could also result in an increased demand for Tether.
5. Circumventing Restrictive Regulation. Once tethers are in the secondary market, they can be exchanged anywhere without limitations. Most of the newer, regulation-heavy stablecoins lack this feature and can only be traded in one venue or a small handful of approved venues.

A Brief Detour to Quantity Theory of Money

The daily volume of Tether changing hands ranges anywhere from $2B to $10B per day, which means the velocity of a tether is 1 or greater. The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent per unit of time.

The velocity of money provides a perspective on money demand.

You may have heard the equation MV = PQ, which is called the quantity theory of money. It comes from Monetarism, also called the Chicago School of economics, which was popularized by Milton Friedman. This school of economic thought that holds that the money supply is the main determinant of economic activity.

In the equation MV = PQ, M is the money supply; V is velocity — the number of times per year the average dollar is spent; P is prices of goods and services; and Q is quantity of goods and services. The equation suggests that if V is constant and M is increasing, there must be an increase in either Q or P.

In other words, if the money supply is growing, the economy will grow, and if money-supply growth is accelerating, so will economic growth. We’re not debating economics here, but simply providing context for Tether’s astronomic growth, with a 100x increase in issued tether, M, and a corresponding increase in crypto P and Q. The insane velocity, V, and issued supply, M, of Tether has to be viewed in the context of changes in the crypto market.

Lastly, we would be remiss if we didn’t compare Tether to the overall market for digital on-chain dollars. Tether is still the favored on-chain digital dollar.

So What’s the Deal with These Dollars

Ok. So now we get to the important part. The main reason Tether has been under so much scrutiny is because the question is — are the dollars that are supposedly backing Tether actually there?

All tethers are pegged at 1-to-1 with a matching fiat currency (e.g., 1 USD₮ = 1 USD) and are backed 100% by Tether’s reserves. As a fully transparent company, we publish a daily record of our bank balances and the value of our reserves. Tethers can be securely stored, sent and received across the blockchain and are redeemable for cash (the underlying pegged asset) pursuant to Tether Limited’s terms of service.

There’s a different between assets that are fully collateralized, or have a 1:1 backing with the underlying asset, and a partially collateralized asset. The difference is RISK. When you buy a note or an instrument that is not fully collateralized, the bearer (holder of that note) takes on the credit risk of the issuer. Reading Tether’s terms of service is important here. So if Tether is not 1:1 backed with dollars, but holders believe it is, these holders of Tethers are taking an unexpected risk. The issue here is transparency and trust.

So What is Going on with Tether, and What May Happen Next?

NY AG wants information. They want to know what risk is posed by Tether, BitFinex, and its banking partners. By the way — if it subpoenas Tether or Bitfinex, it will have a treasure trove of data its counterparties. Given the recent refusal of many exchanges to participate in the AG’s data collection requests, we may see more moves like this in the near future.

Currently, Tether volume and prevalence in the market far exceeds that of its counterparts. This will continue to be the case for a long time to come, in my view, because people are willing to take the RISK of Tether not being exchangeable in order to USE it as an on and off ramp for trading efficiency, liquidity, ease of use, and all the other features it has.

I believe that in the future every platform will have its own stable currency pegged to fiat or other existing financial benchmarks. The technical barrier to entry is basically zero, especially as protocols compete to have dollars and other assets issued on top of them with ICO foundation money. The popularity and use of these dollar assets or pegged assets will depend on the liquidity and connectivity of these assets to the markets where assets trade. The key question will be how these instruments are constructed, collateralized, represented, managed, and audited. As with all things in life, the devil will be in the details…

For the rest — listen to the episode!

Episode 18: Tarred and Tethered was originally published in What Grinds My Gears on Medium, where people are continuing the conversation by highlighting and responding to this story.

There’s this phenomenon that happens when you read a news article on your area of expertise… Michael Crichton, famed film Jurassic Park producer, coined the term and defined it. The Murray Gell-Mann Amnesia Effect.

He describes the effect:

“You open the newspaper to an article on some subject you know well. You read the article and see the journalist has absolutely no understanding of either the facts or the issues. You read with exasperation or amusement the multiple errors in a story, and then turn the page to national or international affairs, and read as if the rest of the newspaper was somehow more accurate about Palestine than the baloney you just read. You turn the page, and forget what you know.”

I’m sure many of our listeners can relate, whether it is about finance, about infosec, about privacy… whatever it is. I’ll bet when you read an article on your area of expertise, your gears start grinding. This is wrong! Where is the nuance? This is misleading!

Well, we are no different. So this week we are here to grind on crypto in the media.

Listen to Episode 17

Trope 1: Dr. Pangloss and the Blockchain

In Candide, Voltaire parodies the eternal optimism of Enlightenment thinkers with his character Dr. Pangloss. Pangloss has a cure for everything — though his cures are impractical at best and harmful at worst. Hearing what the media has to say about “the blockchain” can often feel like a conversation with Dr. Pangloss himself… But “the blockchain”, alas, is no panacea.

The harsh reality behind article’s like “Beyond the Bitcoin Bubble” is that they are both overselling and misrepresenting the technology and what it’s good for.

This is not mention the never-ending flood of press releases on blockchains that are solving everything from supply chain (erm, saladchain) to securities settlement. Note that few of these articles will cite the number of transactions actually occurring.

Trope 2: Subtle and Not-So Subtle Shills

There is a fine line between news… and pumping your own portfolio. In particular, if you are an investor or fund manager, this can get problematic pretty quickly.

We can’t publish this piece without touching on CNBC showing retail investors a step by step tutorial on how to buy XRP at the peak (January 2018) using a step by step tutorial on Poloniex. That said, is it really any different than Kramer (of MadMoney fame) yelling at folks to buy Telsa or ExxonMobil? We argue yes it is, but perhaps if you’re watching CNBC, this is what you came for.

Trope 3: Hunt for Satoshi and the Next (Male) Crypto Messiah

Our obsession with legends is a well-documented phenomenon. The media’s fervent hunt for Satoshi and the next crypto messiah is an incredible thing to watch. It started with Newsweek, who “outed” a man named Dorian Nakamoto as being Satoshi, which ended up ruining this poor man’s life.

Of course Dorian is not the only man who the media has hailed as Satoshi Nakamoto. In 2016, Craig Wright claimed publicly to be Satoshi. Naturally the media clambered all over the story… only to be disappointed when real evidence failed to emerge. While the media has moved on since then, it seems like certain parties are still holding onto either delusion or sour grapes when it comes to this claim. The media certainly hasn’t stopped fawning over the awkward coder crypto heroes archetype, and it’s led to a boom of self-styled and self-proclaimed polymath protocol founders. Enough said.

Trope 4: Stock Photo Images

I mean… I just can’t with the crypto stock photos. There are really only 4 standard stock photos: physical coins, “blockchain” networks as connected dots or clouds, an ominous shrouded figure “hacking” at a computer, and people biting bitcoins.

Coin Center’s head of communications, Neeraj K Agrawal, is a crypto stock photo historian, and if you follow him, you’ll never miss a beat. His job is to explain crypto and policy to journalists, so he probably feels the pain of crypto media most acutely. Some of our favorite stock photos are below — all credit to the original publishers.

Trope 5: Everyone is Getting Hilariously Rich or Absolutely Rekt

The media tends to see-saw between claiming that bitcoin is going to the moon and you’ve missed the boat and pronouncing that those who bought into crypto were foolhardy and destined for destitution.

No article encapsulated this more than the New York Times piece that perfectly captured the zeitgeist of early 2018: “Everyone is Getting Hilariously Rich”. However, just 4 days later the same author published an article proclaiming that the “Crypto Bubble was Deflating”. Now the funny thing is, she was right both times! The whiplash of crypto prices can result in a fair amount of tail-chasing it turns out.

Our favorite articles that fall within this trope tend to be the exposés… like Forbes’ piece: “Tricks of A Crypto Trader”.

Trope 6: Bitcoin is Dead Part 1,949,087

This one speaks for itself.

Check out the Bitcoin Obituaries.

Trope 7: Bring on the FUD (Dice)

And finally, the FUD. The Fear Uncertainty and Doubt.

If you haven’t seen Nic Carter’s FUD dice, you can buy them in the Casa store and check ‘em out. He’s got everything on there.

China FUD. Tether FUD. Energy Waste. It’s not Decentralized. It’s only 7 transactions per second. It’s not scalable. It’s not private. All the FUD.

Oh and don’t forget that bitcoin is supposedly only for dark net activity, money laundering, and tax evasion.

Make Your Own Narrative

All of this is just to say, don’t believe everything you see on TV… or read on the internet. DYOR (do your own research) and make your own narrative. This is part of the value of crypto twitter, or select conferences, and of listening to content created by those who are in the trenches!

Episode 17: Fact or FUD was originally published in What Grinds My Gears on Medium, where people are continuing the conversation by highlighting and responding to this story.

“The curious task of economics is to demonstrate to (wo)men how little they really know about what they imagine they can design.” — Friedrich von Hayek

I have $100 today. I want to invest it, so that my $100 will enable me to buy at least the same basket of goods that I could buy today at some point in the future. The rate at which the price of goods increases is known as inflation, and let’s say its 2%. So I know I need an investment that returns at least 2%. How do I choose what to invest my $100 in?

This is the precise challenge that investors of all stripes must find an answer to. As with everything else, the choice is relative. What’s your appetite for risk? How much of your net worth does that $100 represent? How long can you afford to keep that $100 invested? These are all questions that determine how people think about investing.

After you’ve made that choice, then the question becomes — how do you measure if you’re any good at investing? How do you figure out if you made the best choices possible in picking stocks, bonds, or crypto assets to buy? This question has been explored by some of the most celebrated minds in the domain of economics and mathematics over the last sixty years, and has led to a much deeper understanding of the relationship between risk and reward in markets.

As we’ll explore in this episode, defining and measuring performance is as much an art as it is a science. In fact, some investors have made performance theater out of their efforts to measure performance and justify why they should get paid billions to lose money for their investors (more on hedge funds later). But as with all things in life, in investing, performance is everything.

Listen to Episode 16

Why Performance Matters

For retail investors, the performance of their investments may determine whether they will enjoy a comfortable retirement, whether they will have enough money to send their children to university, or whether they can afford their dream holiday. Likewise, the pension plans, foundations, and other institutional investors want to monitor the performance of their investments to ensure that the assets will be sufficient to meet their needs.

In fact, Moody’s estimates put the US public pension shortfall at over $4 trillion. That means that government workers in the US are relying on pensions that simply aren’t there (yet), and the managers overseeing these portfolios have to generate a much higher rate of return with the time remaining before the pensions are due to be paid out.

For professional investors, the performance of a portfolio or a fund determines how much they get paid. Assets under management, or AUM, typically defines the management fee paid by an investor.

For a simple strategy, like an ETF or index fund, investors pay 0.40% of the total value of the portfolio to the manager. For more “cutting edge” strategies, like a bitcoin ETF, the rate is as high as 2.5 or 3%.

And for more actively managed strategies like a hedge fund, private equity firm, or venture fund, the rate is 2% of assets under management paid per year, plus an additional 20% of every dollar of return generated after the initial amount invested is repaid to investors. So slight differences in how performance is calculated can have a massive effect on how much money investors get back, and how much money managers earn for managing these portfolios.

If investors use performance measures to reward money managers, then money managers have an obvious incentive to manipulate their performance scores.

Measuring Relativity

One of the most fascinating concepts confirmed in the twentieth century was that time — and the measure of its passage — was not universal, but in fact relative. Hours, as measured by clocks, are only relevant as a benchmark by which to measure the passage of time. Likewise, distance is relative to a fixed (well, actually moving) point in space. Space and time is relative to how our planet, earth, is moving through space compared to all of the other points in space. The first two minutes of this National Geographic segment provide a helpful, if somewhat dramatic, explainer.

Markets and performance also rely on something called relative performance. After all, money is also a measure that was created to enable trading of relative value. If one sheep is worth one hundred chickens, that’s a relative value. If one Bitcoin is worth $5,000, that’s an absolute measure, since dollars are a base unit for measuring for people who spend in dollars. Luckily for us, most things in the world are priced in dollars.

Absolute return is simply whatever an asset or portfolio returned over a certain period. A familiar term to most investors, values can be quickly found in stock and mutual fund prospectuses, simple to calculate. This measure does not take into consideration the fact investors have choices, relies on investors to compare returns when researching alternatives.

Relative return gives investors with insights into the performance of an investment relative to a benchmark. If the benchmark chosen is the rate of inflation, it provides investor with growth of money in real terms. The challenge is that relative return requires more work to calculate, and requires investors select a benchmark.

Unless the benchmark chosen is the rate of inflation, relative return still does not provide the investor with an indication of real growth. For example, the relative return could be 10%, but the absolute return of the investment might be -20%, and the absolute return of the benchmark -30%.

Benchmarks and Reference Rates

There are a few widely used benchmarks or reference rates that people use, like fixed points when measuring distance, to determine how something is performing.

Interest rate

As we’ve discussed in the episode on debt, the interest rate varies on the length of the loan and the risk of the loan, so the standard interest rate used is typically the federal funds rate. This is an important benchmark in financial markets, and is often called the risk free rate or Rfr, since US government debt is considered to be a riskless asset.

Another important interest rate is LIBOR, or the London InterBank Overnight Rate — which is set by a handful of british banks, and was famously manipulated in a stunning display of modern day cartel behavior

Market Rate of Return

Another way to measure performance is to look at what you would have earned invested in a generalized market index. In the US, the most common market benchmark is the S&P 500, which is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE, NASDAQ, or the Cboe BZX — 3 different exchange venues.

Industry Specific Benchmark rates

For less liquid asset classes without easily accessible benchmarks, the best method to evaluate relative performance is to define a list of peers, which could include a cross section of traditional mutual funds, equity or fixed-income indexes and other hedge funds with similar strategies.

For specific asset classes like hedge funds, PE, or VC, industry bodies like Preqin, Morningstar, Zephyr, and others publish (expensive) benchmark rates by strategy and market. So if you’re an investor in a global macro fund that deploys a long short strategy, you can compare the performance of the fund you’re an investor in to the aggregated performance of all managers deploying that strategy.

Sharpe Ratio

Lastly, for individual funds, there’s a special metric called the Sharpe ratio indicates the amount of additional return obtained for each level of risk taken. Basically, it determines if the additional risk a manager took with their investors’ money was rewarded with higher returns. It’s use and significance is a hot topic, but Sharpe himself offers some sage wisdom here.

Good god, the greeks!

Since part of this podcast is explaining If you’ve been around a financier, you’ve likely heard terms like alpha and beta thrown around, and perhaps delta, theta, gamma, rho, vega, and more! If you want to sound like a bonafide financier, you can refer to these things as the Greeks — since these are all Greek letters. Each Greek measures the sensitivity of the value of a portfolio to a small change in a given underlying parameter.

For the purposes of this conversation, let’s introduce just two Greeks, the most widely used two — so you can be a financier too (no Patagonia vest needed)

Alpha

…is the excess return an investment or a portfolio of investments generates above and beyond a market index or benchmark that represent the market’s broader movements. So basically alpha is your ability to “beat the market.”

For example, say you want to buy bitcoin, but you typically invest in an S&P 500 index. If the S&P index typically returns you 7% per year, or $7 per $100 invested, and bitcoin returns you $7 per $100 invested, the alpha of your investment is 0 — because it perfectly tracked your reference index. Now say bitcoin generated $7.70 per $100 invested. It’s alpha would be 10%, because every $100 invested returned 10% more than the standard market rate.

If the alpha of a portfolio is zero, then its returns matched the market. This means that investment manager has neither added or lost any value.

Beta

…measures volatility, or how much the price of an asset or portfolio fluctuates, in relation to the overall market, to help investors determine how much risk they’re willing to take to achieve the return for taking on said risk.

The baseline number for beta is one, which indicates that the security’s price moves exactly as the market moves. So if someone says an asset has a beta of 1, that means when the market goes up 1%, that asset also goes up 1%. It moves the same way the market does.

Investors looking for low-risk investments might gravitate to low beta stocks, whose prices will not fall quite as much as the overall market drops during downturns. However, those same stocks will not rise as much as the overall market during upswings. More aggressive investors tend to seek out high beta investments, where they take more risk for the potential of higher reward. Investors can use beta figures to determine their optimal risk-reward ratios for their portfolios.

A quick overview of alpha and beta and the types of investors who deploy these strategies here.

Crypto Performance: More Art than Science

OK — so why does this matter? Who actually cares?

To explain this, I’d like to introduce a fun experiment called The Potato Fund. In January of 2018, I was in the office at 4 am, as crypto markets were going crazy, and I decided to spend a little bit of bitcoin on a fun little experiment. It was a bad idea in hindsight, but I wanted to run the experiment to see how it would perform.

So — I picked 10 coins based on logos and hype and a number of other silly factors and constructed a portfolio. I then tracked the performance of that portfolio in absolute USD terms, BTC terms, and ETH terms over a 300 day period, and ultimately sold the assets for a tax loss at the end of 2018. RIP Potato fund.

Here’s what the potato fund demonstrated. At certain points, I was gaining value in USD terms, but losing value in BTC terms. At other points, I was outperforming ETH, but not BTC. Because most of these coins were priced in BTC, what was the right benchmark to use? Was it worth the risk of buying these coins for so little gain, or would I have been better off buying and holding bitcoin? Or an index? Or ether?

Here’s a more cogent example. Say you invest US dollars in a crypto fund at the start of 2018. At the end of 2018, that fund has lost 30 cents of every dollar. So in absolute USD terms, you have lost money. But say the fund accounts for performance relative to the price of bitcoin, and in BTC terms, the fund is up 40%, because its portfolio is worth more in bitcoin than it was at the start of 2018 (because the price of bitcoin is 75% lower now).

Is that a good investment? Or say, in an event more extreme case, the fund accounts for performance relative to the price of ether, and in ETH terms, the fund is up 70%, because the price of ether is now 90% lower than it was at the start of the year. What’s the right way to view performance?

No benchmark is going to be perfect — ever — and just like hedge fund managers play games with performance is the legacy finance world, you can expect crypto fund managers to do the same in crypto.

Crypto Benchmarks

So how does one actually begin to define a benchmark for the crypto market?

Risk Free Rate

This one is really tricky, but it’s probably bitcoin or cash (ie no return, 0%). Maybe it’s the fed funds rate because that’s the closest riskless asset. Or maybe it will be some digital US treasury note in the next decade?

Interest rate

We don’t have LIBOR, but we have DIPOR or decentralized inter-protocol offer rate as an open finance version of LIBOR.

With crypto lending markets, like our sponsors at Celsius, we have interest rates but they’re not risk free. And moreover, many of these aren’t interest rates, but rather inflation rates. You need to earn a staking reward to preserve your pro-rata share of the network.

Market rate of return

Bloomberg teamed up with Galaxy to create the BGCI, and Bitwise has the HOLD10 index which many funds use as a benchmark. There are nearly as many indeces as there are markets, and of course every crypto platform sells its own “basket” product.

However, I am skeptical of most index funds — buy them at all if all assets have a beta of 1? Crypto is highly correlated, and we don’t yet have distinct asset categories that behave differently enough to achieve some sort of diversification. According to our research, current strategies to “index” or create a market basket fall short of the goal of diversification. Most index products are inadequate as a “smart beta” tracker.

Benchmark rate

Given that crypto asset management is a nascent industry (and as someone who runs strategy for a crypto asset manager, these challenges are front and center in my mind all the time!)

In terms of peer benchmarking, a Fund of Funds called Vision Hill has begun to initiate tracking. Preqin and other traditional investment industry tracking services have carved out a separate sub-section for crypto fund reporting.

Interestingly, without industry consensus on the risk free rate and the market rate, many financial engineering problems are impossible to solve. For example, options are priced using a number of inputs including the risk free rate and interest rate.

Similarly, the optimal capital structure of a firm, as defined under CAPM — a 1960s innovation that led to numerous Nobel prize awards — is impossible without these inputs. So you can imagine that there is much at stake when attempting to define an industry benchmark.

Listen to the rest of the episode for more discussion on crypto alpha generation strategies, mark to market pricing challenges, and why all of this valuation work will someday matter more than we can imagine!

Footnotes

Check out Steven Strogatz’s new book, Infinite Powers. If you were never that excited about calculus, I promise this book will change your mind.

I highly recommend the CFA Institute as a starting point for understanding valuation and performance. It covers Sharpe ratios and other key concepts that are crucial to understanding how performance can be evaluated both in absolutes and relative terms.

Here’s a brief primer on the Greeks in the context of options trading from the fine folks at E*Trade (along with extensive disclaimers about the risks of options trading).

Here’s a brief primer on investing styles, which connects concepts of liquidity, risk, and other factors discussed during the episode with the ways investors might thematically deploy capital.

Practically *everything* Cliff Asness and the fine folks at AQR, one of the hedge funds that have pioneered the realm of quantitative (or math-driven) investing, publish is excellent. The 20 for Twenty is a great (free) eBook highlighting their top 20 research pieces, and I recommend it for those curious about financial mathematics and various asset classes like fixed income, liquid alternatives, and more.

Lastly, if you’re thinking about valuation, performance, and benchmarks, I host periodic CFO roundtables to discuss the evolution of the crypto finance function. You can sign up here for future sessions.

Episode 16: Beating the Market was originally published in What Grinds My Gears on Medium, where people are continuing the conversation by highlighting and responding to this story.