Portfolio Construction: Beyond BTC & ETH (w/Jeff Dorman, Joey Krug, Ari Paul, and Raoul Pal)
ASH BENNINGTON: If you love our crypto content or are looking to learn even more about crypto, be sure to checkout and subscribe to our new youtube channel after this video dedicated to all things crypto. Find new videos every week. Be sure to check the link in the description. RAOUL PAL: As you know, I don't think it's all about Bitcoin. I think this whole digital asset space, whether it's Ethereum, Polkadot, Cardano, non-fungible tokens, all of these things that are developing are moving so fast that almost none of us can keep on top of it. Even the true experts in the field was struggling with the sheer amount of innovations, network effects on top of network effects, and nascent projects on top of nascent projects, all builds into something. We've seen the explosive rise of defi, and this astonishing new rise in NFTs, digital artwork and IP. There's so many things that really I want
to get to the bottom of it all, to ask some of the best investors in this space, the people I truly trust, to say, hey, how are you thinking about all of this, and how can we all benefit from this? How can we really understand the future of the alternative investments that laid outside of Bitcoin, or even Ethereum? Things that we may not yet understand that we need to get up to speed on. I want to ask them how they construct their portfolios as well. That's going to help all of us to figure out what to do because it is risky out there, because some projects will work, and some projects will fail. It's my fundamental belief that we're at the start of a journey of something so enormous that we can't get our heads around what is coming. We are moving into a digital metaverse where everything is digitized,
all value is digitized and many of the assets that we own an exchange of digitized. We can't yet get our heads around the world that's so different to the world we live in, a world where we become the owners of those protocols, where we can invest actually in that new system as opposed to being a bystander and letting a corporation or a government controller to make all the money. These things are literally revolutionary. I think there are many narratives within the market and yet Bitcoin- - there can only be one and everything else is a shit coin narrative, I think is so far behind the truth, the innovation, the network effects that are going. Anyway, I got my three favorite people together. We've got Jeff Dorman, Joey Krug, and Ari Paul to take us through
all of it. Let's first hear from Jeff. Jeff is fantastic to frame this whole thing for us. Jeff, it's been a while you've been on the platform, and I've not spoken to you on the platform for a long time now. Welcome back, good to chat to you. JEFF DORMAN: I'm excited to do this. RAOUL PAL: Listen, I'm a huge fan of
what you guys have been doing. I blurt all about Arca to everybody, because I think it's really interesting. This whole piece, I'm trying to get deeper understanding and let the audience come on the same journey of knowledge about the alt space. Come the world outside of Bitcoin that people are less familiar with but is massively exciting. First, I want to get an idea of how you're thinking about this at Arca and personally? JEFF DORMAN: Sure, yeah. It's important to note the reason that we started Arca, and the reason that we have a team now of almost 20 people all from traditional finance. We don't have a single software developer on our team. We
are all traditional finance people. We came here not because of Bitcoin and not because of Ethereum. We came because we saw all these other areas where blockchain-based assets and digital assets were taking off. That's where we saw the real value.
We love Bitcoin, and we love Ethereum and we have nothing against that, but it really is these other assets that we're so excited about. -- RAOUL PAL: Hi, I’m Raoul Pal. Sorry to interrupt your video - I know it’s a pain in the ass, but look, I want to tell you something important because I can tell that you really want to learn about what’s going in financial markets and understand the global economy in these complicated times. That’s what we do at Real Vision. So this YouTube channel is a small fraction of what we actually do. You should really come over to realvision.com
and see the 20 or so videos a week that we produce of this kind of quality of content, the deep analysis and understanding of the world around us. So, if you click on the link below or go to realvision.com, it costs you $1. I don’t think you can afford to be without it. JEFF DORMAN: That's where we saw the real value. We love Bitcoin, and we love Ethereum and we have nothing against that, but it really is these other assets that we're so excited about.
You'll never even hear me use the word altcoin, or anybody at Arca to use the word altcoin. The reason is it's not because we're dismissive of that term, it's that this asset class has evolved so fast that a lot of the terminology we use from five years ago or three years ago even is just immediately obsolete when you start to see these other assets grow. Altcoins made sense when it really was an industry of just Bitcoin plus a bunch of other stuff that nobody knew what it was. Now, the term altcoin doesn't even really make sense anymore, because it's really different sectors in different pockets of digital assets that do different things. It's almost more
like the fixed income market. You wouldn't say that there's Treasurys and then there's alt fixed income. There's Treasurys, there is munis, there's corporates, there's high yield, distressed, investment grade product, structured product, etc. It's the same thing now. This has evolved into so much more that you almost have to put that fixed income hat on when you think about this space.
The first thing that we do when we educate investors or when we speak about what we're doing is we say, let's get rid of everything you want to do. It's almost like if you come in with a bad golf swing, instead of trying to fix your swing, let's just turn you around to the other side and start over. We think cryptocurrency is one of four types of digital assets. Bitcoin obviously is the biggest cryptocurrency. You could even argue it's the only cryptocurrency of any real relevance, but it is a cryptocurrency.
It is a macro investment vehicle. It is meant to be a store of value, potentially one day, a medium of exchange, but there's no underlying asset value here. It's very difficult to model any cash flows or anything regarding it. It is a purely currency. The second type of digital asset is where Ethereum falls into, and that is your protocols and platforms. Ethereum is clearly the market leader, clearly the biggest. Almost everything built in this space to date has been built on Ethereum, but there's hundreds of other protocols and platforms. These are other chains that are trying to do
exactly what Ethereum did. Sometimes I think about it almost like the iOS App Store. If you have the iOS App Store, then you have 1000s of different apps that are built on top of it. The same thing is happening, only there's hundreds of different app stores, all of these different block chains are being built and ultimately, developers and other projects will be built on top of these blockchains. That's a totally different category, totally different risk reward than anything related to Bitcoin or monetary policy or macroeconomics.
The third type of digital assets is what we call asset-backed tokens. This is exactly what it sounds like. These are tokens that are backed by something real. They're backed by equity. They're backed by debt, maybe it's backed by an income stream. Maybe it's backed by other digital assets, but it is something tangible. You can model this in the same way that you model a debt or equity instrument using free cash flow, using dividend yield models, things like that. There's some really creative examples of this, most people are probably familiar, or at least heard about Spencer Dinwiddie, the NBA player who tokenized his NBA salary. That's an asset-backed
token. That's a token that is explicitly and legally backed by the income that he's earning with his contract with the NBA. You're going to see a lot more asset-backed tokens. Again, this has nothing to do with Ethereum, nothing to do with Bitcoin, they're totally different.
Then the fourth type of digital asset, which is probably the most evolutionary, if not revolutionary, is what we call pass-through tokens. These are tokens that are accruing real economic value, and they are passing through this value directly to token holders. Usually, it's in the form of like a hybrid security where maybe it's quasi equity, quasi loyalty points. Binance coin, which I think BNB just got added to the top three for the first time ever, that's the best example of the pass-through token, so Binance is a real company with real equity with a real CEO, probably a real Board of Directors, even though it's an Asian company, and they introduced the BNB token where if you own it, you get utility and rewards. You get to use it to get discounts trading on their platform, you get to use it to get access to deals that they bring on their platform. In that regard, it's more like a
loyalty reward card, but also Binance takes a percentage of their profits every quarter, and they actually go out and buy back and burn existing tokens. In that way, it's almost like an amortizing token or like a sinking fund. You can see how this works all of a sudden. You have the economic value created from the buybacks and burns or from the profit pass through, and you have the rewards and discounts you're getting as a member or a customer of Binance, and you're basically putting that together into one security. These pass-through tokens is what's driving defi. It's what's driving sports and gaming. It's what's driving NFTs in some way.
There is a lot of other things happening in this space, and when you think about those four categories that I just mentioned, you can see why I draw the parallel to fixed income. You have these different pockets of digital assets that are only related in structure. They're all digital assets, just like all fixed income vehicles are all bonds, but ultimately, they're totally different in their sectors and in their makeup and in their structure. That's why
this asset class is becoming so incredibly interesting from an investment standpoint. RAOUL PAL: When you're building a portfolio, are you building separate portfolios for each one of these asset classes, or are you diversifying across them and doing a sector weighting? How are you thinking of this when you put it all together because they're very different? Very different, yes, they all have a correlation to the market overall in some respects, but not necessarily and it's very complex. JEFF DORMAN: It is very complex. Arca is an asset management firm dedicated to digital assets. We are creating products, vehicles, and strategies that we think have investor demand. The first part of your question has to be answered by, do the investors even know this other world exists yet and is there demand for that? The reality is right now, there's not. Most people coming into this space either
don't even know this other world exists yet or they have an on/off switch in their head saying, I'm either going to be involved in digital assets or I'm not. If I am, just give me the exposure. I think in two or three years, you're going to see a lot more specialization, the investors are going to get more sophisticated. They're going to get more focused on, well, I don't want everything. I just want my Bitcoin exposure, or I just want my platform exposure. I just want asset-backed
exposure, maybe I want a yield strategy. That's going to start happening over time, and you're going to have asset managers like ourselves and others who are going to start feeding that, but right now, it's a little more all-encompassing. We built a team of people from the M&A world, people from venture world, people from traditional debt and equity world, and we are looking at anywhere that we can find value in the space. Sometimes that's in Bitcoin, sometimes that's in a pass-through, sometimes that's in a yield vehicle or an asset-backed token. I think, ultimately, it's growing so fast that you have to be a little nimble and evolve as this asset class evolves for now. Then later, you'll see a lot more specialization where again, you'll have your separate Treasury funds, your separate corporate funds, your separate distress funds. You'll see
that happen in digital assets pretty soon as well. RAOUL PAL: How do you manage the risks in this, because this is a very volatile asset class, which is skewed upside so great, but we also know it's got pretty harsh downside. How do you think about risk management within the portfolio of particularly these less liquid investments that you've got? JEFF DORMAN: That's a great question. It's a huge part of what we're doing at Arca. The very first thing we did when we started this company was we outsourced to a risk analytics firm. We said, we need to figure out how to model this stuff. How do we look at the correlations,
the betas, the VARs, the inner correlation between assets? This may sound crazy to a lot of people coming into this space, but we're downside investors, we're not upside investors. That's because I spent two decades in the distressed world where all we think about is the downside and not the upside, but that's how we model this stuff. We're looking for assets where there is clear tangible value, where there's clear downside protection. We're trying to build a portfolio from a construction standpoint. These assets are completely non-correlated to each other, as well as being non-correlated to other asset classes.
For instance, when we first started this fund three years ago, almost everything was very highly correlated to Bitcoin for a lot of different reasons. One is a lot of these tokens I just mentioned didn't even exist yet. A lot of these have come in the last few years. Two is the entire infrastructure was built around Bitcoin, you had to trade through Bitcoin to get to these other assets. As a result, they traded together. Our fund's correlation to Bitcoin has gone down pretty much every single day since we started our fund. Our correlation, actually, to the Russell 2000 and to the NASDAQ has actually gone up because these are largely early stage technology companies. Bitcoin, again, has graduated, it's just being this macro asset that is being touched by every part of the world. You have insurance companies, you have macro fund,
you have individuals and emerging economies, you have corporate Treasurys. There's no other asset in the world other than US Treasurys that are being touched by this many people. Bitcoin is now a completely different asset than anything else that we are investing in in our portfolio. Bitcoin's correlation to gold into the dollar has gone up while its correlation to other assets in the digital asset space has gone down. We can monitor all this stuff from a risk standpoint, and we can say, okay, at the portfolio level, how are these assets going to relate to each other? Then at the individual token level, we can say, is there asset coverage? Is there a DCF model that tells us what this should be worth? Is there a yield that we're generating on some of these assets? We have real models and real techniques for how we value these assets. In some ways, it's actually easier than in the fixed income and equity world
because we have all these public data available to us to see how these companies and projects and tokens are performing. I'll give you an example of that. There's a company called Nexus Mutual. Nexus Mutual is part of decentralized finance, it's defi. They are writing insurance coverage on all the things that are happening in the decentralized world. If you decide you want to use Uniswap to trade but you're afraid of maybe the risks of hacking of Uniswap, you can go take out insurance on Uniswap getting hacked to protect your assets. Well, Nexus Mutual, the way it works is it's an insurance mutual, it's very similar to any other insurance company that you may or may not have ever invested in. You have to invest capital
into the pool, and you get back the NXM token. That token is explicitly and fully backed by the capital that's in the pool plus, obviously, as an insurance company, they're going to make money as their premiums are being paid and as they earn a float on that capital that's sitting there. Well, if you looked at anything from like Lemonade to Route Financial in the public markets, these growth insurance companies are trading at 50 times book value. Nexus Mutual trades at 1.3 times book value and actually earlier this year, it was trading at a discount to book value. That's insane for any growth asset with real hard assets behind it. These are the kinds of things that we can do where you mentioned risk management. I know exactly what my downside is here,
it's the book value of that company. It doesn't mean it can't trade below that value, but I know what it's worth. That's from a risk management standpoint, we can do it at the portfolio level and at the individual token level and run this no different than investors are used to in the debt and equity world. RAOUL PAL: Fascinating. Let's go through the top
because there's a lot for people to absorb in this space, so what I want to do is just point people in some directions of things that are interesting. What are the top three most interesting projects, tokens, whatever that you think are out there, that are available to people, because some of this stuff is still pre-trading, and blah, blah, blah. What are the three things you said, since you're new to the space, here's three great projects to look at? JEFF DORMAN: I use this one a lot as an example because I think it's both really interesting conceptually and also a great use case for blockchain. There is a company called Socios,
which is a European company, and they have a token called Chiliz, CHZ. This is in the theme that we call the digitization of the fan experience. This is using blockchain to connect sports teams and athletes and musicians, etc. to their fans. Socios came up with the idea of what's called a fan token, they are issuing tokens on behalf of sports teams like FC Barcelona, Juventus, they actually just came out with an AC Milan token recently. These tokens are issued to the fans. If you own one of these tokens, you become part of the governance of that team. You get to vote on what jerseys they're going to wear, who might start
in an exhibition friendly match, what sponsorship they're going to take. You're a part of the team. You actually have a real vote in how your favorite team transacts, but also, these tokens are traded on an exchange, so the price of the token actually goes up and down as there's demand for that team-- not so much like in your game, it's not like the price is going to go up if a goal is scored but you actually can see the prices of these fan tokens going up and down as the teams make trades for better players, as they do things that improve the prospects of the team. More importantly, for our standpoint, from an investor, we're not investing in the individual fan tokens, but we invested in CHZ. Chiliz is the exchange which is basically acting as the
underwriter and the trading platform for all of these fan tokens. When you think about the addressable market of all of these teams that are out there, they have a partnership not only with English Premier League and some of the soccer league, but they have a partnership with UFC, and they're going to be doing some things in cricket coming up as well, you can just see how big the fan base is. All of these transactions that are happening are going to accrue value back to the Chiliz exchange, which eventually accrues value back to the Chiliz token. It's a really exciting company that I talked about for a lot of reasons. One is there's three different investment types here. You can invest in Socios, the equity,
if you're a private equity investor, or a venture capital firm, you can invest in the Chiliz token if you have a Binance account or if you trade digital assets, and you can invest in the individual fan tokens if you're a fan of the team. Right there, it's really cool in terms of thinking about a capital structure. There's different ways that you can invest in this project. Then from a thematic standpoint, we really believe that blockchain assets are going to change the way sports and entertainers directly engage with their fans. From a thematic standpoint, it's huge for us. You've seen the rise in eSports, you've seen the rise in musicians and stuff directly and going to their fans, this is the next level. Sports teams, sports channels, they're going to start
directly engaging with their fans in this way and it's a perfect use case for blockchain assets. That's really exciting to us. We love something like that, and it's probably something that makes sense to everyone, but it's probably under the radar that people have never seen before.
RAOUL PAL: I've been talking about exactly this for a long time, how big this is going to be. In an influencer driven world, whether it's team and a community driven world, this stuff has huge value. People have not even started to scratch the surface of this. I'm interested in this. There's one question I want to ask. Let's say FC Barcelona issues their own token, is that a once off sale to them and they get some money upfront for it, or do they participate alongside bear fans in the tokenomics somehow? JEFF DORMAN: Again, this is what we talk about in fixed income. There's an infinite number of combinations of how you can do this things. With a bond, you could have how many different coupons or
maturities or call structures, etc. A lot of these tokens are being structured in the same way where there's not a one size fits all. In the case of these fan tokens, I think the early participants were a little maybe skeptical or at least wanted to see some proof of concept before they did it. They basically did it in a no risk situation to them, they basically said,
here, go ahead and issue this token on our behalf. If it works, then we'll participate. Now, that there's some proof of concept, and there's some success, the teams are doing a little bit more hands on. They're saying we want to be involved with how many tokens are outstanding, with the schedule for future release of tokens, maybe they're going to own some of the tokens themselves and give them out as rewards to fans for certain things. There's a lot of iterations happening right now, but it's definitely working.
There's a site called CoinGecko, where they have a section called Fan Sports Tokens. You can see all the different fan sports tokens that are out there, and how they're trading and how they've grown. It's really cool because this is like a grassroots effort of just fans that are not only getting to engage with their favorite team, but now they're being rewarded economically for it as well. RAOUL PAL: Also, it creates a market where I can now bet on the future success of AC Milan vs FC Barcelona, because you've now created a market which is not sports betting, but it's betting on the team. Yes, some of these have equity so you could do it that way, but this is a democratized version of that. Again, amazing breakthrough. What else on the radar screen that people should look at?
JEFF DORMAN: Another one, we've been big investors in decentralized finance for a long time, we were a big believer in that. To dumb down what decentralized finance is, it's really just taking all the traditional finance applications that you're used to, everything from banking, to insurance, to asset management, to exchange trading, and you're doing it in a decentralized way where there's no actual middleman. We've been big believers in defi for a long time. Obviously, that's a buzzword now, but a year ago, most people have never heard of it. There's a lot of really interesting innovation happening in defi. One that we like that is a little off the radar and a little smaller cap is a company called Hxro. They tried to gamify
options trading. For anyone who's familiar with [?] trading options, options can be complex. Not only do you have to think about the strikes and the vol, and the time value of money, but also obviously there's a fair amount of risk involved when you're doing binary options. Well, these guys at Hxro, they're their ex-floor traders from Chicago who had been doing this for 20 years. They said, why can't we gamify this? Why can't we make it in a way where it looks more like gambling? Where it's like, I know exactly what my odds of a payout are, I can go buy a 60,000 Bitcoin strike, but instead of worrying about my faders, and my deltas and my gammas, here's just the payout. It's going to be two and a half to one if you hit 60,000 by the time February 26th rolls around. Well, they did it as, again, they started as a regular company, a real CEO, a real organization. They are slowly decentralizing this. They have a hero token, HXRO, and there's a
proposal out there right now to make the HXRO token own 100% of the revenue that this company generates. They're decentralizing the ownership of this company and incentivizing you to go on there and play and then you get rewarded financially if you're a customer of this project. It hits all the themes and buttons for us. It's a strong management team. It's a growing market, digital
assets. It's gaming and blockchain, putting it together. It's decentralization all at once. It's totally under the radar. It's less than $100 million market cap compared to some of these $20 billion, $30 billion market caps, but they're really hitting on something that has real product market fit and real demand. The way I think about it, this is again an example of that pass-through token. Not only do you get rewards when you own the HXRO token when you trade on their site, but you also get the financial benefit of those revenue pass-throughs. It reminds me of Amazon versus Amazon Prime, and I've used this analogy before. If you're an Amazon
Prime member, you're getting all the benefits of Amazon. You're getting Whole Foods discounts, free shipping, movies, music, but you're not getting any financial benefit. If you're an Amazon shareholder, you're getting all the financial benefit, but you don't even have to be an Amazon user if you don't want to be. What these digital assets are doing is they're
combining those two. If you're an HXRO token holder, you're a customer, you're getting benefits by using their platform for owning the token, but now you're also getting economically rewarded to bootstrap that growth and it's brilliant. RAOUL PAL: As a behavioral incentive system, this is just mind blowing. The change in this, the merging between user and equity owner is incredible because it creates network effects everywhere. JEFF DORMAN: We think tokens are the greatest capital formation and customer bootstrapping mechanism that have ever been invented. We think it's only a matter of time before every company
has a digital asset in their balance sheet and in their capital structure at some point. The way we think about it, again, using those examples like think about McDonald's. McDonald's has almost probably no overlap between their shareholders and their customer base. That's insane. We can change that, we can make it to a point where your customers, the people who are driving the interest in the company's future are also the ones who are economically motivated. When you think about that, what you're doing is you're turning all of your customers immediately into evangelists. It's going to bootstrap the growth of every company you can think of, from your local gym to your local restaurants, to your hairstylist, you name it. I think every
company from the airlines to Starbucks, etc., they're all going to have a token. This token, like I said, it's going to be part of the capital structure. You're still going to have debt, your debt is going to be a claim on the assets of the company. You're still going to have equity, the equity is going to be a claim on the revenue and growth of potential the profits. Then you can have a token, which is a claim on future customer growth or a claim on
network growth. All three of these are going to sit in a company's capital structure, and every company is going to have a token. RAOUL PAL: The only issue is still, and I've been thinking through this, is in M&A, the traditional holders know what happens in a change of ownership structure. JEFF DORMAN: Well, I think it's more of a liquidation than M&A. We've seen M&A. In fact, there was a company, Voyager, who just did a merger with LGO, both of which had public stock, but Voyager has a token. It just improved,
the token went up from 10 cents to $5 because all of a sudden, this was a bigger, stronger company and those revenue pass-throughs are going to be bigger. As long as the company in an M&A scenario is still a going concern, you can tweak the token to fit whatever that going concern is going to be. That's the beauty of tokens. It's not locked into one thing. It's not like stocks or bonds where you know exactly what you own the day you buy it. With tokens, you can change the
tokenomics anytime you want. It's frightening from that standpoint. You have less protection from bad actors, but it's also riveting from the standpoint of "great, I can evolve as the company evolves", instead of backing a company and hoping that they pivot into a new market, they can stay in the market, but pivot the token to make sure it works within what the company is. I think in an M&A scenario, there's not a lot of precedent here. Like you said, you're going to see bankers emerge, you're going to see different token structures and how it reacts. I think the issue with more is going to be in liquidation scenarios.
I don't think you're going to have liquidation preferences if there's bankruptcies or if there's defaults. I think in pure M&A or just growth stories, you're going to see these tokens evolve to fit exactly what the company is doing. Because like we just talked about, if this is helping drive customer growth and this is engaging your users, you're going to find a way to keep this going and not kill the golden goose. RAOUL PAL: Okay, what's the third one? JEFF DORMAN: Third interesting company. I'll try to find one that's maybe a little off the road, because I think everyone's probably heard of some of the defi ones at this point. They've heard of some of the other ones. All right, I've got one for you.
Axie Infinity. Axie Infinity is a game. I'm going to preface this by saying that I'm 41 years old, I don't play video games anymore. I've got a team of youngsters here at Arca, who do this. When anybody who has played a video game, you know that you're at the mercy of the game. Whatever you do in that game, the game owns it, you don't own it outside the game. One of the unique attributes of blockchain is that you become the owner of the asset. If you earn an asset in a game, you in theory can take that asset out of the game and trade it or do whatever else you want with it.
You can envision, maybe I need to get a sword one day to unlock a new level but that sword is also valuable for other games, I'm going to take that sword with me and bring it over to another game, or maybe I'm done playing because I just turned 41, and I'm old, I'm going to go sell that asset to someone else who's going to use it. Blockchain-based games are on the rise, and Axie Infinity is a pretty cool game where you build these characters and you build these characters to fight battles, you buy land, you do all these things in a mini ecosystem, in this Axie Infinity ecosystem. The Axie token actually backs the treasury of the company and that treasury gets built every time there's one of these transactions. Every time one of these
characters gets traded, or a piece of land gets traded, or there's transaction value, there's a revenue. There's a fee attached to that, and that revenue sits in the treasury, and the Axie token holders own that treasury. Again, this is a combination of a pass-through token with an asset-backed token. It's asset backed in the sense that you own the actual assets in that treasury, but it's pass-through in the sense that when you're an Axie token holder, you get to participate in this game and use those tokens in the game. It's just one example.
There's a lot of different games out there, but we think it's really interesting because it combines again all those elements that we're looking for. Strong management team, strong product market fit in blockchain gaming, really unique use case for how the token integrates into the game as well as economic value. These are the things that we're looking for. You mentioned earlier, like, how are we doing this across an entire asset class? RAOUL PAL: I'm just thinking the same thing as I'm listening to you. I'm thinking, how the hell do you keep on top of all of this?
JEFF DORMAN: This is a 24/7 market, and we have a team of eight people on our portfolio at Arca that are working basically 24/7. This is not the easiest thing in the world for a retail investor to come in and just do on your own but inevitably, because of this network growth, because of the way people are incentivized to talk about the things they're doing, inevitably, you're going to hear about one-off assets here and there and there is a way to go in and do some research on it on your own and learn about it. The younger generation of investors is the smartest we've ever seen in terms of doing their own work and learning about things. They just need
to be brought to the attention of what it is. I think the takeaway for me when I'm thinking about talking to other people is don't classify everything as an altcoin. Don't think of everything as a cryptocurrency. If somebody presents something to you,
break it down in your head. Okay, what sector is this? Is this gaming? Is this defi? Is this Web 3.0? Is it something else? What does the token actually do? Is the token not attached to anything and we're just going to figure it out later, or is it actually attached to something? Is there real cash flows? Is there a real yield? Is there a real use case for it? You're not going to be able to cover the entire space. It's growing. Just in the 30 minutes we're talking right now, there's probably three new tokens my team is evaluating that I've never heard of. You're not going to be able to cover the whole space,
but you are going to be able to think about this space in a more logical way and not just think, oh, there's Bitcoin and hundreds of other coins. RAOUL PAL: Jeff, that is fantastic. I just learned so much in half an hour. It's just really inspiring. The opportunity and the change, a lot of change. What's going on here is just like you and I've been in the traditional finance business
forever and we've just been given entirely new sandbox and realize it's not a sandbox, it's the size of the Sahara Desert. It's massive. JEFF DORMAN: Yeah, you can see it in my voice, you can see in my face. I've never been more excited in my career than doing what I'm doing here. Like you just said, we spent decades in traditional finance, and there's pockets of traditional finance that are really exciting and interesting, but this is this whole new oasis that nobody knows exists. We are the pioneers in something that the world doesn't even know
exists yet. You can just see how exciting and fascinating the growth of this is going to be. RAOUL PAL: Jeff, brilliant, my friend, good to speak to you as ever, and we'll catch up for a longer chat one day soon. JEFF DORMAN: Looking forward to it. Thanks for having me, Raoul. RAOUL PAL: Jeff, as ever, brings the
goods. I'm so interested in what they're doing at Arca. They're approaching a space really differently. I think now, it's time to get to some of the most established players in the space, and the really big established player is Pantera. They've been in this for a long time. Dan
Moorehead's a good friend of mine, and I really admire what he's managed. Joey runs the portfolio for Dan in this whole space and I think it's going to be great to hear what he thinks is going on, because he's going to be slightly different to Jeff and would be focusing on different things. Joey, good to see you. JOEY KRUG: Yeah, you too. RAOUL PAL: I'm trying to get my knowledge base up faster about the old sword digital asset space, because I think many people came into this world in Bitcoin, and maybe a bit of Ethereum. I think people are starting to realize that there's actually a much bigger revolution going on. I'd love to get your thoughts on what really is going on in this digital asset space, where are the areas that you see it building out, and how are you thinking about that in managing portfolios? JOEY KRUG: There's really two big areas, one, which is just massive. The first massive area
that's really exciting right now is decentralized finance. It's this concept of you take the existing financial system and you remove most of the middleman, you open it up, you make it global, and everything trades 24/7. There's no bank holidays, you transfer the money in 30 seconds. I think that's just the direction that finance is going to go over the next 5 to 10 years, and there's a huge amount of assets in the space in that area.
The second area I think that's interesting, it's much, much smaller, but is potentially interesting is the non- fungible token space. This is the idea of you have digital art, you have artists who are basically taking the advantages of blockchain tech, which lets you send something that's non-counterfeitable, and applying that to things like snippets of songs, digital pieces of artwork, that kind of stuff. That's much earlier than defi, but I think it's another interesting area in this space. RAOUL PAL: Let's dig in a bit of defi first.
There's a lot going on. How the hell do people stay on top of all the things going on? People don't really know what the risks are, and that kind of thing. How are you thinking through the whole space of defi? How are you asset allocating in? JOEY KRUG: Yeah, there's a zillion things going on. That's correct. One thing is you have to read all the time. There's tons of different mailing lists where people send out
updates of what's going on in defi this week, because you can't pay attention to every project all the time, so newsletters and mailing list is a big thing. Then you have the major projects. As an investor, when you first start looking into this space, I think about constructing a portfolio around the major assets. If you look at defi, the major assets really fall into I'd say two buckets. You have decentralized exchanges. Think Coinbase, or Binance, but decentralized, and then you have lending protocols. Within each of those categories on the decentralized exchange, or DEX in short, category, you have Uniswap, SushiSwap, Eurex. They're the major players. Then in the lending protocol space, you really have three big players, MakerDAO, Aave and Compound? RAOUL PAL: How do people think about the risks in this space? Because obviously, the yields are pretty high, that's in the lending side, how do you think about risk on the lending side? We'll talk about a bit about the decentralized exchanges as well. Talk about the risks, how people can think through this?
JOEY KRUG: I think on the lending side, there's a couple risks. One is the risks that you have with using these smart contracts. If you think about a legal agreement in the traditional world, if your lawyer makes a mistake, you can generally work through it. In a smart contract, if the computer programmer made a mistake, you could potentially lose all your money. That's a big risk. One thing that has popped up is there's these protocols that will let you buy insurance, so you can loan some money out or borrow some money, and then you could buy insurance on it. If the protocol gets hacked, or something bad happens, you get an insurance payout. There's a lot of
different people working on that. The other risk is just if you're borrowing on these protocols, you have traditional margin call risks that you would have in any market where you're basically borrowing on margin. I think those are the two big risks. RAOUL PAL: In terms of the insurance space, what premiums are you paying? Let's say you're getting a 6% yield on something and you want to buy insurance on that particular thing, what kind of cost is it? JOEY KRUG: Costs can be a lot. Costs for a protocol could vary anywhere from-- for a really secure protocol, you might pay a few percent a year to insure it. If you get something that's
been around for a very long time like MakerDAO or Compound, or something that's more speculative, you have to do like a protocol like Alpha Homora, which is a leveraged borrowing and lending protocol. Insurance on that one very recently cost you about 25% in premiums a year. That was actually for good reason, because Alpha Homora actually recently, there was like a hack incident that happened with it so the insurance markets were right to make the cost higher. RAOUL PAL: Talk to me about decentralized exchanges, because people aren't familiar with it. It sounds a bit weird, because everybody's using these exchanges. That's where you go, it's run by a company, you have recourse, you interact with a company, and you buy and sell through that. Talk to people who aren't that familiar with what the DEX is all about? JOEY KRUG: One thing that's interesting, too, we talked about this recently in our investor letters, if you look at what happened with GameStop, it actually exposed a lot of reasons why decentralized exchanges exist. If you think of traditional exchanges and financial markets, you have the exchange, you have a broker, which provides an interface to the exchange, and then you have a clearinghouse that handles a bunch of capital and handles the shares and handles settlement and all that stuff. All of that stuff takes a lot of time,
the trades take two days to settle. They used to take three days. Before that, they took five days. If you look at the crypto space, this concept of decentralized exchanges, it basically says, what if we remove the broker, the exchange, and the clearinghouse, and replace them all with a pretty simple usually 500- to 1000-line computer program? Once you use it, it's really hard to go back like when I trade do something traditional on E*TRADE, it feels like you're a dinosaur compared to what you do on these defi exchanges, because you do the trade, it happens, the trade goes through, and you have your money immediately after. That's the huge benefit. Even if you're comparing within crypto, decentralized exchanges versus say a site like Coinbase or Binance, with Coinbase or Binance, you have to send money to them. It takes 30 minutes to an hour for them to confirm that it arrived. You do the trade,
you're doing it for dollars, you have to withdraw back to your bank account. It takes a long time, and so most of trading on decentralized exchanges is between other cryptocurrencies or between cryptocurrencies and stablecoins. Most the time when we're trading these days, we rarely ever go back to actual US dollars. If we wanted to sell something for fiat, we'd sell it for USDC
and not even have to touch the banking rails. RAOUL PAL: And you get yield on the USDC anyway. Which is amazing, because you're getting a high yield that you get in the dollar market. JOEY KRUG: That's right. RAOUL PAL: It's extraordinary. Let's talk a bit about NFTs as well because that's really exciting, because it moves out of the world of finance and now gets into the internet of value, I guess, and the tokenization of everything. Talk us through what you're seeing in that space and how you think it's evolving. JOEY KRUG: In the NFT space, when I first saw this space a couple years ago, I wasn't really sure whether it was digital Beanie Babies, or whether it's something actually interesting. Over the past couple years, it's evolved a lot and you see a few different players in the market. You have marketplaces that are like eBay,
but for all digital goods. There's a website called OpenSea that lets you basically buy and sell and trade all these digital goods. Then you have like these more curated experiences. Think of an art gallery that you might go to in the physical world, but these are for digital items. You have sites like Foundation or Wearable that you can go to, and they basically have these curated selections of various pieces that artists have made. Then the way it works is it's a really wacky concept to wrap your head around because you're buying a digital good. There's no reason you couldn't take a screenshot of the artwork and download it and display it on your computer or whatever, but the big difference is that when you're buying it from the artist, you have the provenance. If I downloaded a digital item
and display it on a display on my wall in my home, I could tell somebody that I did it, but I don't actually own the artwork that I bought from the artist, just a different steering. That's the insight behind this NFT space. RAOUL PAL: We've seen that in photographic art. If you've got signed a photographic original or a limited edition signed by the photographer, you can have the same picture, but they have two very different values, because of digital scarcity.
Where else is this space going? Because we're seeing communities issue tokens, we're seeing sports stars issue tokens, we're seeing all sorts of stuff which fall into this NFT style umbrella. Where do you think this space is going? Because this feels really exciting, and very broad. JOEY KRUG: Yeah, it's extremely broad. I think another area that we'll see a lot that I think is going to be pretty big is musicians. Maybe instead of releasing a traditional album, they'll auction off each individual song to the highest bidder. Sure, anybody can listen to the music, but you get to know that you bought whatever the number one hit is from the artist.
You probably don't even get that much of a benefit from it beyond the satisfaction of knowing that you bought it from them or the cloud or whatever that comes with that. It's very similar to traditional art in that sense, but you already see artists starting to do this. The band Linkin' Park actually recently sold like a portion of one of their songs as an NF T. You're seeing NFTs being auctioned at auction houses like Christie's recently. I think a lot of it's in art, whether that's actual artwork, or whether that's music. I think the other area
that we'll see a lot of NFT stuff happen that's maybe a bit further off is video games. You think about things like a sword in a game like World of Warcraft, that has real world value to somebody. You can't really effectively trade it beyond maybe-- I don't even remember if the game has an auction house in the game or not, but if it did, you could trade it through that. I think someday we'll see these items actually trade on NFT marketplaces where you can buy them with real world money. That's not even that big of a logic jump because already, game developers make-- I think 80% plus of their revenue these days is from the sale of in-game items as opposed to somebody going into the store and buying the video game in the old days.
RAOUL PAL: A lot of people who are of the video game generation don't realize that digital assets already have value for hundreds of millions of people. People buy and sell digital assets all day. When you talk about, well, people need to get their heads around digital art, that's not odd in the gaming world. It's normal. Talk me through what you think the best three or most
interesting opportunities right now that you're looking at, just to give people a context of the differences in just some interesting stuff, because there's a lot for people to get up to speed on this. Give me your top three and why they're interesting to you. JOEY KRUG: I'd say maybe the top category would be this idea of decentralized exchange aggregators. These are things like 1inch and Matcha. What they do is they let you create across 40 or 50 different decentralized exchanges in one click. They'll route your order everywhere and give you the best price for any cryptocurrency pair that you want to trade. That's something that's like, if you're interested in crypto or you want to buy and sell them, that's useful. Today,
actually provides a lot of value, we use it in our hedge funds, we're creating certain tokens because it actually offers better pricing than some OTC desk or traditional exchanges in many cases. That's one I think that just powerful. Then the second one is probably it's a little bit more abstract but this concept of layer-twos. If you look at blockchains today, they're pretty slow. Ethereum still only does about 20 transactions a second,
it really needs to be in the 1000s for it to become this new parallel financial system. There's a lot of projects working on these layer-twos. There's none that you can buy in the public markets yet, but I think there will be over the course of the remainder of this year projects like Arbitrum or Offchain Labs. There's a bunch others like Matic is another one that's out there, Optimism is another one. Those are worth looking into.
Then I think the third thing is probably things like Maker are very interesting. There's people also trying to compete with Maker launching competitive projects to it. What Maker is it's a fascinating concept. It's basically like a central bank, essentially, but it's decentralized, it's community governed, and it issues a currency that's pegged to the US dollar. In theory, you could issue things that are pegged to other assets too, it doesn't have to be dollar-pegged, that's just the first thing that they launched. >What's powerful about that is it's the only stable currency out there that doesn't involve backing things with collateral in a bank. It's totally digitally native,
doesn't require dollars sitting in a bank account, which as you and I both know, there's a lot of problems with that. If you're trying to get away from the old world, you can't just shove dollars in a bank account and tokenize it and call it a day. Maker actually has a solution to that problem. I think that's a great project to look into, too, if you're new to this space. RAOUL PAL: The other thing that interests me is the interoperability layer. People are trying to connect the tracks, how are you thinking through that as well? Because that feels like a big opportunity as well as we build out a stack and get closer and closer to integration of everything. JOEY KRUG: Yeah, I totally agree.
If you think about the internet, it'd be weird if you had only websites that had a backend in, I don't know, C++ that can interact with websites that had a backend in Python or something. That would be weird. That's how blockchains work today. Yeah, interoperability is going to be a thing. There's a lot of projects working on it, I'd say two of the biggest ones are Polkadot and Cosmos. I think the way it will work long term is you'll have what are called bridges between these various block chains, and it may take five minutes to switch chains for your money to get over from one bridge to the other, which sounds like a long time, but if you think about a bank, man, the fastest you can get a wire is same day. If you call them between a certain time window, and then they'll call you back and say, hey, are you really sure you want to do this transfer? Are you really sure you want to send your money out of Wells Fargo? It's like, yeah, I'm really sure. You just don't have that here. It's just a way better experience, I think.
RAOUL PAL: You run a portfolio of a bunch of digital assets. How do you think about these volatile tokens within a portfolio, how do you think about portfolio construction and asset allocation within this? JOEY KRUG: I think if you look at construction portfolio, you want to have exposure to all the main categories. You want to have exposure to layer-one blockchain, so things like Bitcoin and Ethereum. Bitcoin and Ethereum are like the base assets. In our funds, we really underweight Bitcoin. The reason is, I don't think it makes
sense to charge somebody 2 and 20 to buy bitcoin. You can get that really cheap, so go ahead and get that really cheap. Then I think the other assets, Ethereum is this smart contract layer. It's gotten a lot more popular recently than it used to be a few years ago when people love to hate on it.
Then you have this huge universe of stuff outside of those two assets. Outside of that, I think, defi is the biggest next investable asset area in this space. In any portfolio, I want to have exposure to both decentralized exchanges and lending protocols. Then within that, what I'm trying to do is I'm trying to buy the protocols that are seeing the most growth in users traction, volume, etc. adjusted for valuation. If something's trading at like a multiple 200x, it's probably expensive, I might not buy it. If you look at something like SushiSwap when it was trading at $8, that was already after a run up from $1 or something, so it's like a 7x run up, we actually put a position on the dollars. The reason why is it was trading at-- or applying
the pool of about five, and it had grown five x plus in the last couple months. You can't get a deal like that in any market, early stage venture, traditional equities, anywhere. Defi is like super interesting to be looking at from a capital allocator standpoint. Then the last area that I look at is some of the scalability, interoperability layers, so things like Polkadot or Cosmos. I wouldn't put a huge position on in those for like a
broadly constructed portfolio, but if they start seeing more traction, you can ensure position sizing up there. Then the very last piece that I think is interesting to own is decentralized exchange tokens. I wouldn't own a huge amount in a portfolio of these, but things like BNB, MOBI token, that kind of stuff are an interesting exposure to this space.
It's not as correlated with the prices of things. Because even if you'll go back to 2017, prices went down a lot in 2018, the volumes were actually up year-over-year from November of 2017 to November of 2018, and so centralized exchanges, rather, have this exposure that's not super correlated with the prices. It is, but it's not as correlated as everything else. RAOUL PAL: Once Coinbase IPOes, that'd be a reference valuation as well out there. I think it will expose the whole space as being cheap, I guess.
JOEY KRUG: Yeah. If you look at something like Uniswap, which on some days does 40% or 50% of the volume as Coinbase and Coinbase is trading at 100 billion and Uniswap was trading at 20 billion, and the team of Uniswap is 11 people. It's like, what else is app disruption more than that? I don't know. That's an insane statement even just saying it out loud. RAOUL PAL: Do you trade around positions, or do you buy and hold? If so, what time horizons do you have in this space? JOEY KRUG: I'd say we have a couple different funds. One is venture in companies, one is early stage tokens, and in those ones, you basically just hold the position for the most part. Our third fund or hedge fund, that one, we will trade things around. I'd say the main thing is we have a fairly long term
time horizon, though, but we will sell a position if the thesis that we got into it changes. If we invest in something, and the founder backs away into these, not interested in anymore, which sometimes happens in the public token markets, that's a big sell signal. There's also just we will change the weights of things if something gets really overvalued relative to the other. An example of this is looking at Bitcoin dominance versus Ethereum. When Bitcoin dominance gets above 70%, it's usually a good trade to do the opposite.
If you look at defi assets, sometimes you can trade around things like SushiSwap versus Uniswap. That's a really interesting market where SushiSwap trades at a very low multiple relative to Uniswap because people think SushiSwap is like a joke project that might disappear in six months. If it's still around in six months, that multiple is going to go way up, is my personal opinion on it, just because the market's no longer going to think that it's going to disappear overnight.
There's a lot of different things that we look at. The very last thing about trading is we sometimes take risk off when we think that the market Basically, one or two things would happen is what we thought at the time. Either it was going to run up and do a blow-off top like in March 2013-- I think I tweeted about this too-- or it was going to go down 25%, 30% and 25%, 30% drawdown is what happened. Then we got back in and now things are going up again. That's how we think about it. RAOUL PAL: It just smooths out the volatility over time if you get a few of these. You don't get all of them right, but few of them right. Listen, Joe, thank you for letting me pick your
brains on all of this. I think it's really useful for people. You guys at Pantera are trailblazers in all of this, and it's always astonishing to see what you guys are up to. Just well done, and I look forward to chatting to you again. JOEY KRUG: Thanks for having me on. RAOUL PAL: All right. Take care. Thanks. ARI PAUL: Take care. is pretty overheated. If you look back in January, I think it was January 9 30% risk off in our fund because we thought that, well, a lot of the indicators that we follow were just screaming.
RAOUL PAL: Ari is another long standing friend of Real Vision and one of the people that I really trust in his opinion. Again, he comes in a very different way. He's much more of a trader than the others are. That's going to give us a different unique perspective on how he thinks about this. I think all three of these added together are going to give us the full context we need to understand really, how to take advantage of this. Ari, you're one of the people I really wanted to pick the mind of about the whole digital asset space overall, because it was actually when you and I was speaking recently, you were talking about building a basket of other crypto or tokens or whatever for the more risk-on phase of the bull market. That got me thinking a lot about this. Obviously, I've been monitoring a lot of these things,
but I'm starting to think that this whole thing is much bigger than most people realize. People are still very focused on Bitcoin or Ethereum, and maybe Polkadot and a couple of others, but it's a very big thing. How are you thinking of the whole digital asset space?