[REPLAY] Crypto for Institutions 1: Eric Peters – The Macro Case for Bitcoin (Capital Allocators, EP.180)

26:53Same thing if it goes down, by the way. And so the reflexivity in that just means that there's this new dynamic that people can't wrap their heads around, which leads to a situation where if prices do start going up the only way you can create more supply is to push the price sufficiently high that these people who have held through perhaps six boom bust cycles that have been utterly gut-wrenching and most human beings couldn't possibly hold on to through that who have thought this is going to go up a long way you have to actually move the price far enough for these people to go yeah you know what you got me like at 50 000 i'm gonna let a bunch go okay and so there's reflexivity in that because the higher the price goes the more money you suck in the more money you suck in the more institutionalized it gets the more institutionalized it starts becoming the more the regulators have to focus on it the more the regulators focus on it at higher prices hopefully the more sensible the regulation becomes which invites more money in.

27:56And then you have this reluctant kind of supply response as prices go higher. Where along the path did you decide it was sort of time for you to start buying? Our clients are, broadly speaking, they think a lot about how to build robust portfolios to all kinds of market environments, big market ups, big market downs. We've expressed views that it's highly likely that the late stage of this long economic and market and debt cycle will lead to a large monetary debasement, essentially, which, by the way, if you're a market historian, that's kind of obvious that that happens. The question is, when does it happen, really?

28:38And so I think this latest, you know, the pandemic and the policy response coming out of the pandemic seems very clearly to us to mark the beginning of that cycle. That's incredibly important for every investment strategy out there and every portfolio out there. But one of the things that's extremely difficult is if you have the Fed and the Treasury, in many respects, co-joined, and the Treasury is issuing a lot of debt, and the Fed is creating money to buy that debt, and then it's being spent and kind of pumped into the economy. And the Fed is actively trying to keep interest rates low so that the real interest rate is deeply negative then you kind of know your bond portfolio you're guaranteed to lose money you're either going to lose money slowly by owning it in the front end and just having your real interest rate work negatively or you might lose money fast in the long end where you know the bond market really tanks and you get destroyed so our clients have been really focused on that and by november it seemed that we had the right time and some of our clients were really interested in actually making that kind of allocation.

29:44We'd just gotten through the election. And I think as you saw these assets increase in value from the March lows, it became clear that policy was just going to continue to move toward this highly accommodative phase. And so these assets looked really interesting in that macro quadrant where you think about what policy is really doing. These assets are just uniquely positioned to do well. By the way, gold should do well as well, except these are just this really interesting, highly convex version of gold that's, I think, just deeply discounted. So that's what got us in. And thankfully, we were able to and we did.

30:22How have your clients thought about the use of Bitcoin, maybe other cryptocurrencies in the context of their portfolios? You speak with all the same people. I think one of the major struggles that guys are contending with is, okay, let's say everyone in the world has a 60-40 portfolio that they dress up in one way or another. Maybe they leverage it and it's some form of risk parity. Maybe they amplify it with private equity, whatever. But it's a 60-40 portfolio in one way or another. The problem is the 40 just doesn't work anymore, right? And the reason that you love the 40 for the last few decades, our entire trading career, you're in mind, has been that interest rates have been declining and they finally got to a point where they just really couldn't decline meaningfully.

31:05So investors are looking at their portfolios. And by the way, this is, I think, a slow and painful realization because it lacks great answers or great solutions. But they're slowly realizing, it's like, okay, so I own a lot of equities. I need to make 7 %-ish. And maybe it's 6 % or maybe it's 8 % or whatever. But it's in that zone. Equities are really expensive. My 10-year bond yields 80 base points. The math just does not work. So they're looking at that and they're going, okay, so how do I think about a more robust portfolio? And some of them are thinking about the risk to monetary debasement and inflation.

31:43And that's very scary risk, right? Because then your bonds turn into losers. And if you look, you can try to convince yourself that equities are going to do okay in a mild inflation. But if inflation is even a little bit more than you'd hope, as a fiduciary, you can't help but look at the 1970s and go, that could happen too, right? So your equities might lose money and your bonds lose money. Some of our clients think deeply about gold and some have allocations to gold. The ones who are thinking about digital assets are thinking about it in kind of that debasement hedge part of their portfolio.

32:18And it's really attractive because it is highly convex. So you could have a relatively small allocation and it could go up 10x or it could go up more than 10x. And so at a 2 % allocation, by the way, that saves you from a lot of portfolio pain elsewhere in that kind of environment. So I think that's how they're thinking about it. The last thing I'd say on that is they're also looking at this differently from gold in that you kind of have this call option on technology when you buy these assets that you don't have in gold. Gold will be the same in 2 ,000 years as it was 2 ,000 years ago, but these assets are going to be different and improved in a year, in 10 years, in 100 years.

32:58So you have that exposure to that. We're going to take a break in the action to tell you more about Morningstar. Data isn't just a byproduct of your business. It's the driving force. But where's it taking you? Morningstar data clears the way forward. a decisive language of insights for investment professionals to implement conviction-led strategies across both public and private markets. Visit wheredataspeaks.com to see what Morningstar data can do for you. And now, back to the show. How do you think about the historical analog of Japan in their zero interest rate environment for whatever it is now, 20 years, where it seems like they've continued to do just fine?

33:47I'd say that's something really important to get right. And anyone in your seat or mine has thought about that probably their whole career. Let's look at a couple differences. Okay. So Japan, while it has a big economy in the world, it's a very small nation and it's aged very rapidly. US isn't. Japan is a very homogeneous society. US is kind of tearing itself apart right now. There are a whole host of differences that we could also go through. You know, Japan is sitting right off the coast of China and China had a big boom. And so Japan was kind of able to spend a couple decades just churning away really and dealing with its aging demographics and some of its internal issues but had this big customer right off its coast that was supplying machines too as they industrialized and things like that so japan kind of had it easy because they were the first to go through this the world pretty clearly doesn't have it so easy anymore and the u.s definitely doesn't so when you look at the u.s and you look at just the massive deficit that we ran last year this year's deficit is going to be 15 to 20 percent with an economy that's actually bouncing back to life.

34:59I think it's pretty clear that the whole world got to this place where Japan had gotten to, which was very low rates, in some cases negative like Europe. Monetary policy really wasn't lifting the economy anymore. Nothing was working. And every central banker in the world was pounding on the table for the last two years and saying, we have to borrow a lot of money. Fiscal policy needs to be involved or monetary policy won't work. And it's barely working anymore. They didn't want to say it doesn't work anymore because then the markets would have freaked out. But they said, we need your help. And so now you have this global catalyst, which was COVID.

35:35And you've broken through this mental barrier that we, over the course of our career, there's been this economic orthodoxy that said you have to have an independent central bank or all hell will break loose. Well, guess what? We no longer really have independent central banks. They're working together with treasury and politicians are looking at that as a solution right now. And inflation hasn't taken off. So I think that we're just in a different mental framework at this point from a policy perspective. And that makes all the difference. It really does. Let's talk a bit about what could go wrong from here.

36:08You highlighted some of the risks in the earlier years of Bitcoin with the infrastructure in place. How about going forward? There definitely are risks like there are in anything. And I think when you consider the investment proposition in anything you do, there obviously are going to be risks. And you have to, I think you have to try to understand what they really are and then ask yourself, are they well reflected in today's price? And so, so let's go through the risks. I'd say that one of the big obvious risks is the regulatory risk. And those risks differ around the world, by the way, because theoretically the US could outlaw the holding of Bitcoin.

36:50And that would, by the way, they could not make Bitcoin illegal. It's this decentralized network that exists globally. You'd have to have every country in the world deem it to be illegal with harsh consequences. And it probably still wouldn't go away. The price would be a lot lower. So let's just talk from a US perspective. It's possible that the US regulators or this government or a future government could come in and say it's illegal to hold it, just like at a point in history they said it's illegal to hold gold. That would knock the price down a long way. And then I think what would likely happen is that that decision would harm the U.S.

37:27interest to such a degree that that policy would be reversed, just like it was in gold eventually. But that's a risk. So that could happen. I think I've gotten much more comfortable with it as I've gotten to understand the regulatory environment and have interacted with them. I think that what people misunderstand is the intent of regulators is to create a sound foundation for digital assets upon which American entrepreneurs and financial institutions can innovate and can build. And financial services are a super important part of the U.S. economy. And so if you were to allow the foundation to be filled with cracks and cracks are just bad actors you know illicit activity if you allow that to happen you undermine the potential value of everything that you can build on that foundation whereas if you come up with sensible regulation which doesn't mean everyone's going to love it and that's the thing in this industry a regulator will come out and say something and most people in the digital asset community will react very negatively but really it's just that's a normal push and pull between private and public sector right But at any rate, I'm comfortable that they will not do that, but that's a risk.

38:38Another risk is that there's some kind of flaw in the code or major attack of some sort that takes the whole thing down. This has got to be the most hacked or this piece of software, this protocol has got to have withstood more attacks than probably anything in the history of mankind by super smart people. And there are also very smart people who are constantly working to fortify it. It's almost like a living technology system that has not viruses, but it's fending off attack. And so that's one of the other reflexive features of this. The more money, the more valuable this becomes, you could say the more it becomes a target.

39:17I mean, it's almost a trillion dollars, a big enough target, right? The more value that people have in this, the more incentive there are for the people who hold their assets to make sure that it's as strong and robust as possible. So I think that there are some risks there, but the system is incredibly anti-fragile. And so would bounce back from some type of attack that was moderately successful. There are ways that this can bounce back from some type of awful attack. And then I'd say the other risks are more around the custody of these assets, you know, things being stolen. Because at the end of the day, they're bare securities, right?

39:51They're bare securities, by the way, that can be tracked everywhere. So even if someone steals something, a huge theft, you can see where that money goes. You can see what walls it travels to. And the FBI and law enforcement and SEC, everyone's going to be all over that. But if there were a large theft of some sort, then I think institutional investors could say, you know what, I'm not going to touch it for three years. And the price would go down. And so incidentally, that's one of the risks that we seek to mitigate with our fund structure to kind of insulate our clients from that. Because to the extent that we can educate clients about why these risks are overpriced in the market, and we can also help mitigate these risks.

40:29I think as a fiduciary, we're doing the right thing because I think the market is overpricing all these risks. And that's why the price is low relative to where it will be. So I know in November, there was a story that hit the news about the big trade that you did and the work you're doing with Brevin Howard. I would love to hear the story of the trade. So walk me through the trade, what it was like being in those markets, That's what you saw and learned. Sure. It's fun to tell trading stories, I guess. And this is definitely the most fun trading story that I have because it was incredibly important that this be super secret just because you're dealing with an illiquid market.

41:12So I knew that we had to be super secretive. And so pretty much I only knew how much we were going to buy in terms of anything external. And we worked with the Coinbase team. We selected them having done due diligence across the whole industry, everyone in the field. And we felt most comfortable with them as an initial partner for us. And we've, we since are diversifying our holdings elsewhere, which was always the plan and their other great firms. It's just, if we were to do the one significant transaction and do it with a team that I had high conviction would, would have great discretion. It was with that team and with that solution where they have an agency desk, meaning I was able to interact with their institutional trading desk.

41:53They don't have a proprietary trading desk. They don't take principal risk, which just meant I knew that unless someone there leaked information, and I only dribbled information to them. So they never even knew exactly what we were doing in its full size. But unless someone leaked information about what we were doing, there was no one over there to try to front run our orders, which is always the terrifying thing when you're trying to do a big transaction. and incredibly to their great credit, they put a very tight team together. We had a code name for the project. And I spoke with Brett Tejbal, who runs their institutional sales and he's fantastic.

42:23We've done business in the past. So I knew him professionally and he's just outstanding. So he kind of delivered the firm to One River. We had this very tight group of people and I spent five days working with their institutional trading desk. And so what you discover with this asset class is their pockets of liquidity, their pockets of illiquidity. It's 24, seven, three 65. So I spent five days working with these guys and we tried all different types of things. So there are all these great algorithms that are available through their to go me system. And so I use those, but I also kind of brought in, I don't want to say old school nineties FX trading, but kind of really.

43:02So, you know, it's like what you discover is if the market goes up to certain levels, there's so many algorithms in these markets, the market hits a certain round number, let's say 15 ,100, for instance. And if it starts backing off, there are all these algorithms that come in and just drill the price down. And so we'd observe that and we'd let things like that happen. Or one of the things that was kind of fun is, as I was speaking with the team, I was like, well, why don't we put some really big, chunky bids in on the market? Like, well, you can't do that. I was like, well, why can't you do that?

43:31Well, if you do that, then it'll be all over Twitter in two seconds. It's like, well, why is that bad? It's like, well, that's bad because then people will raise the market up. But our view is that the price was pretty high at that point. And what we were trying to do is get the position on when everyone was worried that the contested election was going to tank stocks and bring Bitcoin down with it. And so what I really wanted to do is get some big holders to think that someone stupid was in the market putting big orders in and make it look like we were really dumb money and then drill it through.

44:01Because Oftentimes people do that, right? They'll drill it through those big orders, hoping that they hit stops below. And then we would let those stops get hit below. They weren't our stops. And then we put even bigger orders down to try to scoop up all the stop loss selling. So there are all kinds of games that we played, which was fascinating to see. It was really helpful to understand the liquidity of these markets. But yeah, it took five days. And by the way, we barely moved the price. And so what was the total size of that purchase? We bought, I think this is all public information. We bought over$600 million of digital assets.

44:32It sounds like when you talk about buying Bitcoin and having to be sensitive to Twitter, it's hard not to raise the alarm bells of what's happened with all the crowdsourcing convexity of these assets, Robinhood and whatnot. How have you thought about what that means for cryptocurrencies? It's a good question. I would say that there's a near-term and a long-term answer for that. The near-term answer is that it's just a feature of the market. And there are a lot of people saying all kinds of things in the marketplace. We've chosen to be very selective. This is the fourth formal thing that we've done in this interview with our activity in the space by design, because we're kind of treading very cautiously into what to say and when to say and how to say it.

45:22And it's been interesting because I think we're viewed as having important insights into what institutions are doing. So each time, well, the first three times that we've said anything, Bitcoin has moved by 15 to 25 % within a couple of days, which is kind of wild. But I think that that's, if I were to think about what's really moving the market and I look at the various things that have happened, obviously Elon's announcement was really important. I think those times that we've had something to say, not because it's one river, but because it reflects what we've done the first large institutional transaction.

45:54And I think are seen as being knowledgeable in that space. Those have had real impact. So my view is don't say a whole lot. I think a lot of the Twitter stuff that people say so many things that it's part of the landscape, but does it really mean anything? I think Elon's thing was important. I think Michael Saylor, some of the things that he said have been important and he said bought a lot, right? So those are all important things. I think longer term to me is more interesting because everything I just described is kind of market noise. Whether markets moved because Elon did something or someone else said something, maybe they move faster than they would have moved.

46:30But it's not like that's sustainably moving markets and keeping them in a place. Markets move because there's some underlying factor that's being priced in. And I think that underlying factor is the realization that this is part of the future and they're just wildly underpriced for that. And so that's why we're seeing kind of a repricing move. But I think for the longer term, one of the things that could surprise everyone is what a world looks like when you have billions of people who can move money on their phone and are susceptible to information, are susceptible to misinformation. You know, I think if you asked Mubarak whether he was surprised that there were flash protests and riots and that some of these new forms of social media combined with cell phones could ultimately topple his regime, I think he would have said that was impossible, right?

47:26Which is probably why it happened. So I don't know what's impossible and what is possible. If you think about where the world will be in, let's say, 10 years. in 10 years, I have a high degree of confidence that almost everyone on the planet will have digital wallet on their phone. And they'll view it as being as secure as Citibank or anything. And they'll be able to move money between currencies, both government fiat currencies globally. They can already do that or in cryptocurrencies. But at that point, the little like the Twitter chatter, I don't think that will matter because I don't think that stuff ever matters.

48:03But in big events, maybe it does matter. Maybe there's a run on a currency in Japan or, you know, I don't know what happens, but I think it's interesting. Things will be able to happen in a decade that today is impossible for them to happen. So it doesn't mean that wild things will happen, but new things will be enabled by this functionality. So when you imagine what that might look like a decade from now, what are some of the things that you're envisioning? Well, I always think about risks and opportunities. I think in its fullest form out a decade, it's hard for me to see that the ability for people to move money like that, it'll provide a lot of information to governments about, in a sense, how people vote with their feet around government policies.

48:53that'll be something really interesting because if you were in Switzerland and you weren't happy with what the Swiss National Bank was doing with policy and you felt like well literally in 30 seconds I could move all my money from Swiss francs to euros or vice versa that just could be kind of interesting right and I think some of that stuff will happen what probably will happen is those countries that have the most reckless policies will find that there is a greater check on them. And so historically, those have been countries like Argentina or Venezuela. But maybe what will happen is that that group of countries that have more check and balance because of these private systems of moving money around, they may find that their policies are scrutinized more.

49:42And that's probably a good thing, by the way. I'm a big check and balance kind of person. So I think what's important is that these currencies don't ultimately threaten sovereigns. And here's why I think that they won't. And so it's important for me to add that because I don't want to, I think I do the industry harm by trying to suggest that these assets are such a check and balance on governments that governments lose control. I don't think that that's the case. I think there'll be powerful checks to a degree, but they will not overwhelm a big sovereign country. And here's why. Because the force of regulation right now is moving toward making these wallets and these systems transparent to government.

50:25So initially, when we started the conversation talking about all these markets were anonymous and you could move money anonymously, all those things are still true technically. In practice, before I moved my coin into our fund, I had a PA, I had Coinbase account. And I'm sure if I did something wrong that they would turn me in. So there will probably be some people who continue to have anonymous accounts and they'll live in places like Venezuela and Argentina and Turkey and wherever. But I think that by and large with these big credible nations like the US, what will happen is the regulation will make sure the government knows where money is.

51:04And then if we had an event which pushed the price of Bitcoin to make up a number, a million or 3 million or$5 million or some crazy number. Well, guess what? These guys can tax us. And you know what? They can also, if they're unhappy with how that's developing, they can say, we're going to take the long-term capital gains on cryptocurrencies from whatever, 20 % to 30 to 50 to 80. They can do whatever they want to do. So they actually have not lost control, but there is this check and balance. There'll be a pressure, like their costs of changing tax codes like that. People go, why are you doing that?

51:36And there'll be a lot of people that say that's not fair. But the reality is, in a world where these guys are proactively trying to debase the currency, the dollar, having an account where they can tax a capital gain, ironically becomes this new source of revenue for the government. This isn't Bitcoin gone wild and take over the world. I think in some nations that are very weak structurally, that could be the case. It puts a lot of pressure on them. A place like the US, not the case. A place like the EU, not the case. And in the last couple of months, Michael Saylor's out at MicroStrategy talking about it.

52:11We've seen Elon Musk do a huge purchase for Tesla. What are you hearing and seeing from institutions of their interest going forward? There's enormous interest and intrigue, really, I mean, rightly so. And that's driven by a lot more than just the price of this stuff going up. And I know that just because, I don't know, let's go back to the dot-com bubble, which we lived through. When we have calls with investment firms, it's often the case that we have 10 to 15 people that they're all the senior investment people at every area of a huge firm. And the questions that are asked are a lot less about what do you think is the fair value of this or anything.

52:52They tend to be more questions about what's going to be the impact of these assets in the future of finance in the future of our company and the future of the insurance industry? How do we think about this in a portfolio context? Can we really go into some of the currency debasement risks and what happens with inflation? So part of the discussion is on, this appears to be a new asset class is I think what most people are recognizing. And they want to make sure that they at least have a baseline perspective on what it might mean so they can kind of go and do further research. And I think some portion of them will allocate and some will wait and then eventually will allocate in some way.

53:36There really is enormous interest. We've talked a lot about what you did in Bitcoin and without going too much into it, because we'll do that over the next couple of conversations. How do you think about extending that to other either cryptocurrencies or blockchain assets? So after we did this first purchase of these assets afterwards, only after I called Alan and just said, Revenon's a stake in our firm. And I just said, it's important for all of our clients to have an allocation to this space. It just is. What I've learned through this process is that there just aren't good vehicles for them to invest in, which is not to say there are no vehicles, right?

54:16Because you can go directly to Coinbase, You could go to any number of firms or you could go to some of these firms that have built their businesses for the last five years in digital assets. And there are a number of them and they're great firms. Some of them, I'd say, look more or less like venture capital firms. Some of them look more or less like investment banks. But there's no firm that really looks like One River, which I would say if I were to create a parallel, it would kind of be the vanguard of digital assets. And so I think that there's, in any new ecosystem, you need to have strong players in each of those.

54:50You need to have strong venture players. And of course, you're going to. You need to have strong investment banks. And you're going to. They're great trading counterparties. You need great custodians. And those things have been built. Agency trading desks or OTC trading desks. But then you need a vanguard to kind of bring the best in class parts of the ecosystem together into a well-structured product where your client goes, okay, I'm dealing with OneRiver. They're a great fiduciary. They're QPAM. They've built ERISA compliant funds. All that stuff. They have diversified custodial relationships.

55:24They've got diversified sources of liquidity. So I know I'm going to get best execution. My assets are going to be safe. All those things. So my discussion with Alan was the industry needs this. And so I'm going to build this out. And both Alan and Aaron Landy, who's the CEO of Brevin, who's just terrific. We all chatted about it and it made a lot of sense. And I didn't need to ask permission. I was going to do it anyway. But Alan just threw his full weight and Brevin threw their full weight behind what we're doing because they agree. And Alan's deeply knowledgeable in this space. He has all kinds of investments throughout the ecosystem and is probably the earliest hedge fund person in this space.

55:59So we agreed on that. And so where that leads from a progression standpoint is, I think the most important allocation that can be made right now, given this valuation level, and I said this at$15 ,000 and I said the same thing at$50 ,000. The upside versus downside is so skewed to the upside that the most important thing I can do as a fiduciary for my clients, which are big institutional investors. They're not small mom and pop punters or Robin Hood investors. They're just institutions. So the most important thing they could do is get beta exposure to, I think, Bitcoin and Ethereum, which is not to say that there aren't other interesting assets.

56:35It's not to say that there aren't going to be assets that for periods of time outperform those two. But it's probably the case that a lot of those assets over time won't even come close to the performance that I see out of these two assets. And so if we get our clients invested into this space, we are now deeply knowledgeable about these assets and are building the firm around that capability as well. We will effectively, I think, learn and kind of evolve as this asset class evolves and be able to be, I hope, a step ahead of where the industry goes. And then as different opportunities unfold, our clients can participate in those with us.

57:13Some will be big and scalable. Being in the beta is big and scalable. There'll be other nichier ones that will have more limited AUM products, but that will happen over the coming years. All right, I can't get together with you without asking you a couple of closing questions. And we did run through most of them, but I just got a couple for you. What is your most important daily habit? Making a cup of coffee for my wife, definitely. Definitely. If I don't do that, it's not that I'm in trouble. I wake up. That's just what I do. And what is your favorite book? I wrote about it recently in an anecdote.

57:45So I'll throw out there Moby Dick. I love the classics. And speaking of Mara, my wife, she always makes fun of me because I have so little time to read that when I read novels, I like to read things that have just really stood the test of time. And I enjoy, and it's a big part of what I love about markets and this industry is I love studying human behavior. And I think the classics, they're filled with nuggets that are just great insights about human behavior. All right, Eric, one more. What is the biggest mistake you've made and what did you learn from it? God, I've made so many, Ted. I won't go into details because it's personal and family, but it's an instructive lesson.

58:20So there was a time in my life, I think I did a very poor job of, for most of my life, was really being very transparent. And I felt like I had to keep things that I was thinking about and keep who I was kind of guarded. And my wife, Mara, just, she persuaded me that that was exactly the opposite of what I needed to do. And so the great irony is, is I feel like I've become one of the more transparent people in the industry through my writing, but it's been liberating to kind of be transparent. And one of the things that you discover, I mean, number one, she was, of course, like almost everything in my life, she was completely right.

58:53And I was wrong. And I didn't even realize how non-transparent I was. But once you start becoming transparent with people and relationships that you have, and are just open yourself up to looking foolish or whatever it might be, you end up having much more meaningful relationships. And that's been one of the greatest things in my life. But the reason it's probably the greatest mistake is it just, it took decades to figure that out. And so it's like, I'll never get those decades back, but that's okay. Well, Eric, it is really great to see you. Hopefully we don't, we both took COVID tests, but hopefully we don't, you know, we didn't just get it yesterday and now we're, yeah.

59:32That was great. Thanks so much. All right. Great. Thank you. Thanks for listening to this episode. I hope you found a nugget or two to take away and apply in your investing and your life. If you'd like what you heard, please tell a friend and maybe even write a review on iTunes. You'll help others discover the show and I thank you for it. Have a good one and see you next time.

1:00:04their firm. Manager's appearance on the show does not constitute an endorsement or investment recommendation by Ted or Capital Alligators.