In this episode I chat with David Fauchier of Nickel Digital Asset Management. At Nickel, David manages the Factors Fund, a multi-strategy, multi-manager fund for cryptocurrencies.

We leave the philosophical discussions about crypto aside to dive into the features of this universe that make it rife with opportunity. What struck me most about this conversation was not just how much crypto markets have evolved in the past several years, but how fragmented they still remain.

Different exchange rules, regulatory regimes, margining rules, derivative contract definitions, and even order book models represent both risk and opportunity. And in exploring these idea, David helps me better understand why traditional high-frequency funds like Citadel, Jump, or Jane Street don’t simply come in and eat everyone’s lunch.

In the latter part of the conversation, we pivot to David’s role as a manager-of-managers, and explore issues such as exchange and custody risk, due diligence, and the types of questions an allocator should be asking.

Finally, David leaves us with a teaser about the new opportunities emerging in the DeFi space. But we’ll have to save that for another conversation.

Please enjoy my conversation with David Fauchier.


Corey Hoffstein  00:00

All right 321 Hello and welcome everyone. I’m Corey Hoffstein. And this is flirting with models the podcast that pulls back the curtain to discover the human factor behind the quantitative strategy.

Narrator  00:18

Corey Hoffstein Is the co founder and chief investment officer of new found research due to industry regulations he will not discuss any of new found researches funds on this podcast all opinions expressed by podcast participants are solely their own opinion and do not reflect the opinion of newfound research. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of newfound research may maintain positions in securities discussed in this podcast for more information is it think

Corey Hoffstein  00:49

This season is sponsored by simplify ETFs simplify seeks to help you modernize your portfolio with its innovative set of options based strategies. Full disclosure. Prior to simplify sponsoring the season, we had incorporated some of simplifies ETFs into our ETF model mandates here at New Found. If you’re interested in reading a brief case study about why and how. Visit with models and stick around after the episode for an ongoing conversation about markets and convexity with the convexity Maven himself simplifies own Harley Bassman. In this episode, I chat with David associate of nickel digital asset management. At nickel, David manages the factors fund, a multi strategy multi Manager Fund for cryptocurrencies. We leave the philosophical discussions about crypto aside to dive into the features of this universe that make it rife with opportunity. What struck me most about the conversation was not just how much crypto markets have evolved in the past several years, but how fragmented they still remain. Different exchange rules, regulatory regimes, margining rules, derivative contract definitions, and even order book models represent both risk and opportunity. And in exploring these ideas, David helps me better understand why traditional high frequency funds like Citadel jump or Jane Street, don’t just simply come in and eat everyone’s lunch. In the latter part of the conversation, we pivot to David’s role as a manager of managers and explore issues such as exchange and custody risk, due diligence, and the types of questions an allocator should be asking. Finally, David leaves us with a teaser about new opportunities emerging in the defy space. But we’ll have to save that for another conversation. Please enjoy my conversation with David fo che. David, welcome to the show. Really excited to have you here today.

David Fauchier  02:54

Thanks a lot, it should be fun.

Corey Hoffstein  02:55

This one I’m really excited about in particular, because in past seasons, I have done nothing in the crypto space, I’ve probably been a little too crypto averse. And I will say that conversations with you. And folks like you have been really enlightening about some exciting stuff that’s going on in this space and just different ways of thinking about the investing world. So I think the audience is going to get a lot out of this one.

David Fauchier  03:16

I hope the response isn’t too far. triolic.

Corey Hoffstein  03:19

Well, let’s get started with just your background. How did you even end up in the crypto space?

David Fauchier  03:24

Sure. So like a lot of people in this space, a long series of coincidences is probably the shortest answer. I did a master’s in history at college, did a lot of economic history sort of became financially better sometime between the GFC. And the European debt crisis. I studied not in Britain, French. So that was kind of a big moment, kind of as a young adult. And that was sort of my introduction to that. And then around the same time, somebody sent me the Bitcoin white paper. And I was already fairly into tech at the time. And so it sort of kicked off, I just found the idea, hugely interesting. And it ended up kind of the more I dug into it, the more elegant it was, at least mathematically in terms of the game theory of it, etc. And that’s really what got me kind of hooked into the space. And then secondarily was, I thought the idea of a kind of non sovereign private digital money, which was a better asset was interesting and totally wacky, crazy, insane, and almost certainly not to work. But it was just really interesting to watch. That’s sort of how I got in. And then I started meeting a bunch of the managers in the space that we’re not many of them back in 2014 1516, things really started to kick off in 17. And around the middle of that year, I was offered the opportunity to build up some kind of a crypto fund. And my kind of answer to that was, we should definitely do a fund to funds. Let’s figure out if that’s actually a good idea, but it seems to be and just build a portfolio of these incredible managers that are starting to come out doing pretty interesting Nishi highly technical things and Yeah, we started setting up the fund to funds by summer of 2018, it was really obvious to me that this was the middle of the bear market. And the kind of alpha side of things that the trading side was definitely the most interesting. We had, by summer of 2018, it sort of mark this interesting point for me where you could go and see one of the big lending desks, and you could borrow or short in size for less than 10% annualized. And at the same time, you had the first large derivatives exchange in the space that had like deep liquid markets. And so it meant that you could go and do all have the interesting kind of market neutral stuff from the traditional space, but in crypto and no one else was doing it. And it just felt quite obvious to us that on a risk adjusted basis, this was like really interesting the place to be, and nobody was really focused on. So we set that up Hydra team raised some money, we launched the fund, we ended up winding the fund down. For reasons I think we’ll get into tangentially around the summer of 2020, mostly for lack of funds, I did not know that we were coming into a bull market that would probably help on the asset raising side. But at the time, my view was kind of the we’re in the middle of a global pandemic, and he’s gonna invest in a crypto fund of funds. That’s been in a two year kind of crypto winter. And around the same time, very luckily, he got a call from an asset manager in London called Nikhil, who I knew very well, because we had actually seeded the first fund, out of all fund, and I really liked and respected the partners. And they called me out and sort of outlined exactly what I wanted to evolve Cambridge on my previous farm into and said, Do you think it’s a good idea? And if so, do you want to come and help us run out. And so just at the right time, started conversation with them and joined them in November to set this up, we launched in December, we ran in tunnel money for two months, just kind of testing the pipes and sort of officially launched in February.

Corey Hoffstein  06:58

Well, so before we dive into what Nikola is, because I do want to use that to sort of maybe level set the rest of the conversation and diving into these different strategies in the crypto space. But I do know, after your experience in running a fund to fund structure, you know how the view that fund of funds may not actually be appropriate for this space. And I wanted to know why you think that’s the case?

David Fauchier  07:20

I do. I know I mentioned something. Similarly, kind of along those lines to you. And maybe to tweak what I said a little bit, I think that there are some great fund of funds in the crypto space, I think they make a fantastic access products. I think they make sense if you want to make one crypto bet, and just give your money to a manager and say, I don’t know anything about the space, you go figure it out. For me, I think that funds of funds are sub optimal as a way of managing money in a kind of multi manager way in the market neutral trading kind of alpha side of things, because we’ll get into this, but this market is changing. So noticeably quarter, on quarter, and quarter, like really, really at a pace that you just don’t see elsewhere. And all of the managers are super new. So you want to be nimble with your capital, you want to monitor things as closely as possible. And that means not sort of writing a check to a manager, subscribing it to a fund and checking in with them once a month to see how things are going and have to take everything that they say on faith. Essentially, what you want to be able to do is just monitor trade by trade every single thing that’s happening in your entire book in real time and be able to step in and intervene if that happens. And so that takes you more towards a model that looks like a multi manager platform like a millennium version of Boothbay Bay, from the traditional space, but applied to crypto.

Corey Hoffstein  08:41

So I think that tees up maybe nickel digital nicely for you to explain Okay, what does the nickel digital platform actually look like? And and how’s that setup?

David Fauchier  08:49

So nickel is a kind of large, at least for crypto institutional grade asset manager in the crypto space based in London, where a team of about 20 people, it’s got three products. The first one is their flagship Arbitrage Fund that runs a bunch of arbitrage strategies. That’s managed internally. The second is a Bitcoin tracker product, which tracks the price of Bitcoin, which is really just kind of a fidelity cost studied daily liquidity type by coin tracker, super simple. The third is the factors Fund, which is the one I came into run. And that’s the multi manager platform. And what it really does is kind of copy paste all of the trading infrastructure and the operational infrastructure that they built for that Arbitrage Fund, and makes that available as a multi manager platform for external managers. Because one of the things I think people don’t realize until they get into the space is that all of your EMS to execution management, portfolio management, exchange, connectivity, etc. does not really exist in the space you have to build everything from scratch. And that’s just a really big load. And for that reason, and others, like managers sometimes want to just plug into a platform like this and just focus on the trading and have us focus on raising the assets, doing execution, taking care of the operations, the middle office and back office, everything.

Corey Hoffstein  10:08

So when we start talking about the different managers on this platform, and I know you guys have a quantitative and systematic bent, what does that landscape look like? Does it mirror the traditional quant landscape in more developed markets? Or are there strategies that are totally differentiated and new in the crypto space

David Fauchier  10:27

that all but mainly, the bulk of it is a really nice clean copy paste, the way I kind of look at or break out the landscape in the crypto world at least is you have the structural arbitrage strategies. And these are where there’s a structural reason why spread is going to close. So a really simple structural ARB is a basis trade. So typically, your futures traded contango, which is to say a premium to spot. I’m gonna guess your listener bases pretty quanti Okay, great. Oh, yeah, good. So yeah, bases trade, if you can hold that contract through to expiry, if the contract doesn’t blow up, if the counterparty doesn’t blow up, there’s a structural reason why you’re gonna capture that that spread. And so this kind of first bucket is your structural OB strategies, it started out in spot. So buy Bitcoin for dollars on this exchange, and sell it on another exchange at a premium, move the dollars back, rinse and repeat, then you’ve got triangular strategies. So buy bitcoin dollar, sell Bitcoin, Euro, convert euro to dollar, and rinse and repeat. But we’ve had, especially in the past three years, really a booming derivatives market that’s been growing. And that really started with Delta ones. And so there’s been a range of delta one, two spot orbs and delta ones against each other futures against perpetuals futures listed on different exchanges on the same path. And the same with perpetuals. And crossing all of those things together. And more recently, introducing options into the mix. So you’ve got your kind of like spot arbitrage, you’re scalping your basis trades, your funding rate trades on normal contracts, inverse contracts on cuantos. There’s just a lot of different contracts in the space trading on lots of different exchanges. And the prices dislocate very easily. And that presents opportunities. The second bucket is sort of your predictive strategies. So these are the ones where basically, you look at the past to predict the future, you hope to be right 60% of the time and make more money when you’re right than when you’re wrong. So this is your like trend, following your momentum, your startup, your relative value, these kinds of strategies. And then kind of the third bucket is liquidity provision. And really, that’s market making, which sits somewhere in between the to its arbitrage, but it’s also stochastic in nature. So I sometimes break that out. But I think all of these kinds of strategies I’ve described will sound very familiar to someone in the traditional space, and they are kind of copy pasted over in concept, but the implementation is very different. And then to your point on totally different strategies. That’s really something we’ve seen in a defy space. So decentralized finance, which is basically there’s a quote unquote cryptocurrency called Aetherium, which is not really a currency, it’s more like a giant, global decentralized computer that people can run stuff on. And people have rebuilt financial primitives on that. So stable coins tokens, which exist on Aetherium, which are pegged to the value of $1. That’s handy lending, borrowing, Orderbook markets, automated market makers, so the ability to exchange assets, and it’s the sort of budding ecosystem that’s been built in parallel, which is really its own beast, we can get into it. But it gets pretty complex, I think, to explain in a few minutes,

Corey Hoffstein  13:46

I think that leads nicely into something I wanted to go into next, which is, what would be very different to someone coming from a traditional marketplace. And I think you touched on it there, but how rapidly market structure is ultimately changing. And these opportunities are changing, and it has really rapidly evolved over the last several years. How does that change an impact strategy HalfLife when you’re operating in this space?

David Fauchier  14:14

Yeah. So I think it’s probably worth us talking about kind of what market structure looks like today. And based off of that, I think it kind of answers your question, and it sort of leads very nicely to talking about what kinds of strategies makes sense, like everybody knows crypto, trades mostly on technicals and narrative does a large retail involvement, not many institutions, not many professional traders or trading firms Citadel is, to my knowledge, not trading, for example, the crypto markets, and that brings with it volatility, fragmentation, a lot of kind of hiding and behavioral biases that have been shoved away in traditional markets. All of that’s kind of present. And that’s kind of your surface level. Everyone knows this. I think the next layer deep is really to realize quite how fragmented about liquidity as I am not aware of any other market in the world. Now, historically, Someone, please correct me if I’m wrong here. But that presents a greater breadth of arbitrage opportunities or depth, not in terms of the capacity, but just how many different ways there are two specific markets or instruments, you have hundreds of exchanges, existing today, which are listing related products. So, in equities, you have Apple is listed in one place, you can go and trade it on the New York Stock Exchange against dollars, and that’s it in crypto assets, trade money to money. So you can buy bitcoin against the dollar, but also against the euro, the pound, the punish sloty, the Indian rupee, and you can do the same for Aetherium. But you can also trade a theorem against Bitcoin directly. And all of these other altcoins, a pad to USD, as well as the Bitcoin as well as to a theorem. So you have this many to many model in terms of the pairs, and you have 1000s of cryptocurrencies, they’re not all liquid. But if you take the top 20, top 50, and then figure out all the different trading permutations between them, the numbers get really big. And then all of those trading pairs, and that liquidity is fragmented across all of these exchanges. Each of those has their own operational frictions, the simplest being, some exchanges don’t allow Americans to trade and other exchanges allow Americans but don’t allow Koreans. So like the operational side is real. Then there’s the counterparty risks, which differ between exchanges, you have different buckets of exchanges, you’ve got the highly regulated American ones, you’ve got the lightly regulated slash semi regulated exchanges that have sort of pick their jurisdictions. So running a derivatives exchange in Singapore is less onerous than London, for example. And so you might choose to locate yourself there, or Malta versus New York, to pick an extreme. And then you’ve got the unregulated exchanges. And then, between all of these, you have different pools of capital that have access to them, and have different preferences as to which ones they’re going to trade on. There’s also kind of your lot of the Asian exchanges are locked in there. And weld Chinese exchanges is kind of a whole other story. But kind of moving on from that, what I’ve just described is basically just the spot market. But we have a huge derivatives market, especially on the delta one side. And each of these exchanges, there’s probably like five to seven main delta one exchanges in crypto. But each of those, these contracts need an index price. And the index that is calculated is actually different on each of these exchanges. So the way in which they’re calculating the price of say Bitcoin at a point in time differs between exchange ABCD and D, that sort of leaves a lot of room for dislocations, then you have different structures of the contracts themselves. So the largest derivatives exchange till recently was called bitmax. And they listed in verse perpetuals, only, so you margined in Bitcoin, and got us dollar Bitcoin exposure, or you margined in Bitcoin, and got eath USD exposure. So that’s a quantum. And that kind of inverse product has interesting microstructure characteristics and features. Because especially if you think about it on the way down, if you have a collapse in price, the value of your contract is going to drop, and at the same time, the value of the collateral you’ve placed against it is also going to drop. So you have this kind of super linear relationship where you can get these huge crashes, because you need to suddenly be putting more collateral on than if you were margining, with something stable, like $1. And so there’s kind of introduces a bunch of ways of trading around that, which is kind of interesting. And to your point around how fast these markets move, that exchange, did not perform well, during March, pissed off a lot of traders essentially. And then the founders were indicted for breaching the Bank Secrecy Act and AML Rules in September. And one of them was arrested and released on bail. The other two are basically on the run. I mean, it’s really spicy stuff. But a lot of people basically said we’re going to stop trading now. They’ve never been hacked, they’ve never lost money, but people are understandably hesitant to trade that as they probably should be. And so they’ve moved to other exchanges. But there’s other exchanges that dominant products, USD T margined. USD, t is the dominant stable coin, and just that move of volume and open interest from an inverse to $1 backed to a cash margined. Future and perpetual has actually like noticeably shifted market structure. And the way in which Bitcoin crashes is actually different. And then you’ve got on the perpetual side, they’ve each got different funding rates, but the funding rates crystallize every hour or every eight hours or every 24 hours. It depends. The way in which they’re calculated differs. Sometimes the way in which they’re calculated is out actually not the same exactly as how it’s SPECT in the contract, which means that it’s exploitable, because they’re being priced wrong. Sometimes even on a cash margin, like the base pair will be actual dollars, or a stable coin, or a different stable coin, or another stable coin. So, in so many kinds of different ways, you have all of these fractures in liquidity.

Corey Hoffstein  20:22

So you have this exploding number of pairs to trade, you have this exploding number of derivative contracts and new ones are coming out. You have all these different exchanges, which I think one of the most interesting things you said to me in the past conversation was even talking about the fragmentation among exchanges in terms of how their order books, even work, which I found very fascinating. I mean, there’s all this fragmentation, ultimately an opportunity, or is it really just a risk from the perspective of trying to manage a fund,

David Fauchier  20:57

it’s an opportunity, if you make money off it, it’s a risk of money because of it. I mean, it’s both, I think it’s an opportunity in the sense that it’s just incredibly easy for the prices of all of these related assets to dislocate. It’s also an opportunity and like, there are real rare times to hard walk, if you are willing to kind of put in the hours to get intimate, like really deeply intimate with exactly how these matching engines work. And the nuances between the different order types, and how those are handled. The example you just mentioned on the order books, take binance and debit to different exchanges with pretty different matching engines and different order types. But if you get really intimate with that, when you post an order, is it first in first out or not? When you move into the order book, and if it’s first in first out, then you want to be posting your orders as soon as possible. And if you want to change your order, or take it out and then put it back in, then you’re going to go to the back of the queue, which sucks. For example, for a market maker, this is a important consideration for them, because they might be laying orders into the order book, a couple bids deep waiting to get hit and make you know, 50 reps just like that, because someone put through the fat finger trade. But if you’re constantly updating that, quote, moving to the back of the queue every time, but maybe just maybe on Durva Yes, it’s FIFO. But actually, once you’ve posted an order, you can edit one of the parameters or all of the parameters. So maybe you could quote for one contract or a 10th of a contract and get into that queue. And then once you’re in the queue, you can actually edit the volume. So you could move it from a 10th of a contract to 10 contracts at the drop of a hat without losing your place in the queue. And maybe that’s not true on finance. And maybe that opens up kind of an opportunity to have between the two. So what I mean, when I’m talking about getting intimate, I really really mean intimate, like, beyond the contract specification that’s provided to you actually trading these markets day in day out running experiments to figure out exactly how these audit types work, and trying to figure out how the matching engine itself works. And the same can kind of be applied to where these exchanges sit, and how they’re structured at a networking level, because all of these are, to my knowledge, all cryptoexchanges Sit on Amazon Web Services. So you can’t really communicate with them. And they won’t tell you exactly where they are. They’ll tell you the availability zone in the region. But ideally, you want to be sitting in the box next to the matching engine. But there’s not really any way for you to figure out what that is, there’s no one you can ask. But that always where you could run kind of interesting triangulations to try and figure out how close am I? And what if I move over here or over here or over here? Can I find my way closer to this box? So there’s a lot I think that you can do. Because there’s so much fragmentation, there’s just loads of little opportunities all over the place that you can just pick up on and the risk side of things. Yeah, it introduces risk. But I’ve said and just like the flip side of risk is that it’s a source of opportunity. The big one, I think, is the margining systems, which vary quite a lot between exchanges. So some exchanges don’t have portfolio margin. It’s contract by contract, which can make things pretty inefficient. And it can affect kind of how you trade and how you quote, for example, as a market maker, some of them do have portfolio margining. And so the way in which we’ll trade across all of these needs to be different to take that into account. That makes things harder, and by being harder, it means that there’s more edge, there’s sort of this strong correlation between hard work and edge everywhere, which is definitely true in the crypto space. And then you’ve got like, if you need to move collateral between two exchanges. At some point, probably you’re going to need to make an on chain transfer. So actually like moving Aetherium on the Ethereum blockchain from one exchange account to a different exchange account, but each exchange is going to handle that differently. It’s going to do it in different timeframes. And it’s possible that they’re going to reject them. So if they’re in fees spike really, really high for some reason. And that’s typically during periods of high dislocation, either turmoil or just a really big bull run, and just a rip higher. If you want to move at that point, your collateral move might actually just fail, trading on by Nance, for example, and you need to be able to take that into account in your trading. And because you and everyone else is suffering from the same thing, it’s going to cause a dislocation with a different exchange. So in a perfect world, it would be easy to build robust bridges between all of these different liquidity pools. But that’s really hard, it would make fragmentation less of a feature and an opportunity. But building them is just operation, a lot of grinding work, and making them robust is really hard as well. So if there’s a free lunch in crypto, it’s this just the hard work involved in getting intimate with these contracts, these exchanges and building those bridges.

Corey Hoffstein  25:55

How often are those contracts backs or margin rules or even order book matching engine algorithms changing? And how rapidly Are you aware of that they’re changing.

David Fauchier  26:06

So matching engines are quite opaque. So you don’t really know you wouldn’t necessarily know if they moved. About two Fridays ago, one of the top exchanges went down for six hours, like this stuff just happens in this space. And you need to build your system so that by robust to these kinds of failures. But the entire thing went down, including the marketing website, like, and hobbies exchange all went down, because they were sitting in one region in I think it was an AWS, Tokyo, and on a Friday night, they just had an outage, that may change in the future, I suspect that they’re probably going to spread out over different at least availability zones, if they do that might have implications on latency, for example, or some other feature. So you don’t necessarily know. But the stuff you do know about is new contracts, new indices, or changes to how the contracts or the indices work happens quite a lot. I do know, every week, maybe like I know, for example, if you’re market making, like the market maker programs will change every couple of months. So there’ll be making adjustments to quoting requirements or volume requirements. And across all the different exchanges that you trade across. That means that you’re gonna have to put up with differences on quoting requirements, but also on how many API calls can I make a minute? And what’s the limit on 10 minutes? And do I need to adjust my throttling algorithm, because I always want to reserve like 100 calls, basically, where if shit hits the fan, I need to get out quickly. I’ve always got that buffer of 100 cores that I could call in an emergency just to get out of my positions and pull my quotes. So these things change all the time. It’s a lot of work.

Corey Hoffstein  27:43

So why don’t traditional firms like a citadel or a Jane Street or a jump, who we would expect to excel in a market like this? who are experts at building infrastructure, low latency, infrastructure, understanding market models and market algorithms, dealing with arbitrage? Why don’t they just come into this space and clean up?

David Fauchier  28:05

Yeah, they should, right? Conceptually, it’s a straight copy paste. So they absolutely should. And this is a question I worried about a lot three years ago. And then I’ve been asked all the time for the past three years, observably the crypto markets have gotten much more efficient. But the big players aren’t playing in size. And when they all their own very specific exchanges, quoting very specific contracts. So it’s not really hindered the ability of sort of cool them crypto native players to start from scratch. And bear in mind, these guys typically come out of these shops that coming from Tala would do W, or Jane Street jump Susquehanna, a lot of come out from optiver. So they know some of the tricks, at least, what they don’t have is the resources that these big firms have, but that typically hungry and smart and entrepreneurial. And they have three years had stopped. So conceptually, yeah, sure everybody should be in this space, in practice. Firstly, the dollar pool of profits that’s available to you is really small for citadel. I mean, this is a joke, it’s a crime. And the possible legal or regulatory exposure from participating in the space is totally outsized to the amount of dollars you could make. I mean, there’s a couple guys that every quite firm that are dabbling in this over the weekend, and maybe running some in house experiments. But that doesn’t mean they’re just pivoting the entire fun to go and figure this out. And when they do, what’s interesting is it’s actually far harder to transpose these strategies into crypto than you would think at first blush. And I think that’s really true on the kind of high frequency trading market making side of things. I think we discussed an example of if your jump Well, I guess there’s two ways to make money in this space, you can be better at pricing or you can be faster. And if your jump then your edge is basically to be faster to my knowledge and and you have hired really expensive colo space in particular spots. And you probably have access through like trunk fiber optics that are in a straight line between X and Y place. And you’ve hired a bunch of guys that are really good at registry level optimizations to run these computations microseconds faster than the next guy. And maybe you’ve even got custom hardware in there as well. These guys are really expensive. They’re hyper professionalized and specialized, and they’re super good at what they do. And if you take that team, and you just say, hey, go be the fastest market maker and crypto. Well, the first thing they realize is that there is no exchange to kowtow into. And it’s sitting on AWS. And actually, what you want is a guy who is amazing, like an amazing Rockstar at network optimization on AWS, specifically, and building extremely, like highly available highly performant systems on AWS. And that’s not necessarily the guy coming out of jump, because why would it be? And so your environment is completely different. And so hyper specialization doesn’t put over. And so it’s harder, it’s not so simple. As I’m just flipping a switch and quoting in this market,

Corey Hoffstein  31:17

one of the things that became pretty apparent to me in conversations with you is that alpha opportunities in this space seem to pop up and then very rapidly degrade, in many cases. How do you think about trading a market like that? What are the skills that you look for? What do you need?

David Fauchier  31:34

There’s kind of two stereotypes that I’ve seen, the successful traders kind of follow. The first is, their approach to building systems is around enhancing human traders, rather than systematizing. Everything and to make the human trait of data. So there’s a lot of manual oversight. There’s some form of manual execution, it’s someone on a screen saying, Yeah, let’s do X trade, but the actual execution of the trade, the optimization of it, how it gets led into the book, and executed, etc, is systematic, but there’s kind of a superhuman sitting behind the screen, just calculating your p&l in real time as hot in the space. So they have a really good grasp of their p&l, all of their risk metrics. Moving collateral from one exchange isn’t about logging into that exchange and tapping away, and figuring out the address that you need to send it to, and scanning your two FA code on your phone and doing all of those manual steps, you’ve reduced that to an API call. Or even better, it’s just automated in the background. So all of this kind of tooling that you can add, that just makes the manager’s job way easier, is one way, and the kinds of traders that you see doing that, that we look for, it’s a traitor type, that kind of cool, paranoid cowboys, it’s not to say that these guys are cowboys in the sense of, you know, take your money and just go screw around with it, which is something I really detest, but cowboys in the sense that they are willing to jump into a new contract and be like 30% of the open interest or the volumes and just trade that super aggressively from day one. And they’ll just jump in and train up and rely a lot on their human trading skills, but be augmented by systems. And I say paranoid cowboys, because the cowboy part alone just gets you into trouble. And you’ll blow up and basically exit the space very soon. If you’re gonna go and do this, you also need to be paranoid, you need to be really, really thinking about all of the ways in which this can screw up and blow up and break. And just relentlessly kind of build redundancies against that, because there’s a ton of stuff that can go wrong as you trade. And you are in the high frequency world extremely fragile to those things. So these are the guys, we’ve recently been doing work on a manager, if they have a p&l drop, which is unusual for them, like of more than a percent. It’s not like his phone just rings, he carries around two phones at all times. And they both ring in case one of them doesn’t have and they’re with different characters. And I suspect I haven’t asked him but I suspect there was a different phones, because they’ll have different chips in them. And like one of them may have better connectivity in certain areas than the other. And it’s not just him, it’s him and the CTO, I think, who also has trading permissions. So you’ve got two people having two phones, where if something screws up that just getting the cord, that level of paranoia is exactly what we look for. These guys have really thought through like, well, what if a cell tower was down on this particular network, all these crazy things which are bound to happen at some point, they’re just paranoid about them. And they spend their lunch times just thinking about, Oh, well, like I wonder how we could break the system, and then just going and patching them. I think that’s how you trade a market like this that’s constantly shifting and evolving. It’s fast, nimble and paranoid. On the more kind of quantitative side, it’s been one of the most interesting things I’ve seen very rarely, but I’ve seen a couple times, is people that are just really focused on building a model. that builds other models. So they have a super sweet back testing environment, they throw tons of data into it. And they just brute force for features and models and filters and weightings. And they have a system that just automatically pulls models out, changes them, re tunes them across hundreds of different models. And it’s sort of this giant swarm of models, basically, that straining. And that means that as the market shifts, because you’re looking at so many different features across so many different time horizons, you can kind of Chuck these models and replace them pretty quickly. And some of the more kind of interesting from a, at least what my judgment of that durability is the most durable, I think, highly quantitative, statistically minded strategies seem to do something like that. Time will tell the, let’s see,

Corey Hoffstein  35:51

I want to pivot the conversation a little bit from talking about market structure and types of strategies to talking about actually managing a fund in this space. And one of the things you’ve alluded to a couple times in this conversation now is that the price of Bitcoin isn’t necessarily just the price of Bitcoin, there is a different price potentially, in all these different exchanges. And so one of the first questions that comes up for me is even just something as simple as fund accounting. How do you think about determining the fair value of a crypto asset when the price can be so different on these different exchanges? Or even p&l?

David Fauchier  36:26

I mean, I guess, technically, the price of Bitcoin at a given point in time is a judgment call rather than a fact. Because the price well, is the first question because there’s so many different places. So you need to have a reference point, which doesn’t really exist today. I don’t think that this is an issue from a fund accounting perspective, because the differences that we’re talking about immersion basis points, and because most of all, any fund that you would invest into has got their own valuation policy. And in that valuation policy, it specifies this is how the administrator for this fund is being instructed to value assets. And as an investor, you review that we should review that before investing, that is a document that’s available to you, you should review it and say I think it’s robust or not robust, or I’m happy, I’m not happy with it. So I don’t think it’s an issue for investors. But it is an issue if you are market making, for example. And how many exchanges should you ingest pricing data from? And should you wait that pricing data by the volumes on that exchange? Or by the regulatory environment? Or who’s trading on the order book imbalances? are a bunch of other things? And should you price of Bitcoin in dollars? The just look at spot markets? Or should it also take into account derivatives markets? If so, would you take into account a Bitcoin tether contract rather than a Bitcoin USD, or you can sort of go on and on? So I think from a valuation perspective, it’s typically what we saw when we were doing due diligence on funds is they will either have an independent custodian, and the custodian provides the reference prices for these assets that they snapshot monthly. Or they will say we will take the median price across all of the exchanges that we trade on, and potentially even do like a time weighted or volume weighted price for that over a 1530 minute snapshot or something like

Corey Hoffstein  38:28

this. What about the management of the assets themselves in terms of exchange and custody risk? It’s not something we give a lot of thought to in developed markets. But you’ve alluded to exchanges getting hacked at different points, or thinking about how to actually store cryptocurrency to make sure it’s secure. How do you think about managing that risk from a fund level?

David Fauchier  38:52

So this kind of comes back to I mean, the way we do it, which is different to a fund of funds is we control all of these assets, they sit inside our exchange accounts. So we can unilaterally close down an account, withdraw assets, move assets, do whatever we want. So we have our own views as to counterparty risk exposure that we enforce effectively in our allocation decisions to different managers with staring managers from or towards certain exchanges. The main risk in general in trading strategies and crypto your counterparty risks, but the risks are diminishing. And I think that people’s perception of those risks is somewhat lagging, which is to our advantage. The exchanges themselves are getting safer to trade on. It’s not so simple, at least anymore as saying an exchange gets hacked and all of the Bitcoin just disappears and you lose everything. And that’s it. security practices, especially since 2018 have gotten a lot better. So these exchanges firstly, the best practices around storing crypto generally have gotten much better. But as these exchanges have gotten bigger The fluctuations in kind of daily deposits and withdrawals, has shrunk as they get bigger, which is what you’d expect. And that means that they can store a larger and larger and larger portion of their assets in cold storage. So I think Coinbase, which is a big US exchange just found the rest one. And I think it was in that I think something like 97% of the assets are held in cold storage. Cold storage is a really, really, really safe way to store crypto assets. And then that leaves you kind of 3% Float effectively sitting on top in warm or hot wallets. And if someone’s going to succeed and actually hacking you, it’s going to be a subset all of those hot wallets that are really at risk rather than the entire stack of crypto assets being held by the exchange on behalf of clients. So the first thing is like the security has gone up. And there are different tranches of assets being stored by the exchange, which have different risk levels. And the high risk level has really, really shrunk. The next is, I guess, at the user level on these exchanges, security practices have gotten better, you can now whitelist your withdrawal addresses. So again, like taking Coinbase an example. But pretty much any exchange, now you go and you will specify certain addresses that can be withdrawn to. And if you’ve got a lot of money there, you can get a corporate account. And if you have a corporate account, and like you can have your account manager, do a video call with you, in order to do that. And they will implement typically a time lock, which means you add an address, and you can’t withdraw to that address for 48 hours. And there’s tons of different ways that you can cancel the adding of an address to a whitelist. You can also whitelist or API’s that you’re trading from two factor authentications these time locks. So there’s lots of things that were done actually at the user level. The next kind of step down is if things really do go bananas, and the West sort of happens, these exchanges have built up very large insurance funds, which is if something goes wrong, if the other side of your contract is insolvent, then the exchange is going to make you whole out of that insurance fund. And these funds have gotten really big. And some of the big exchange hacks that we’ve seen in the past couple of years 50 million gets stolen, the exchange just makes people whole straight out of the insurance fund, they don’t bat an eyelid. So it’s gotten really sizable. And then finally, like the large exchanges have huge balance sheets. And they absolutely print money in real size. And so partly, they just have a really big balance sheet that they can use if things go wrong. And partly, it’s an added incentive kind of not to kill the golden goose, because it’s sort of worth it for them to go out and borrow or dilute themselves in order to sort of keep the gravy train running in a way. So they are heavily incentivized not to screw the people trading on their platform. So you’d need something that’s really really catastrophic to, you know, blow up a contract with no recourse or for your assets to just disappear. of the different ways that that could happen. security practices are basically getting better. On the hacking side. And on the blow up side, insurance funds are getting bigger, the exchanges themselves are getting bigger. And I think, God March 2020, the volatility levels that we saw in fixed income and equities, crypto is five and 10 times more volatile than either of those two asset classes that magnify the level of craziness by that. And that’s pretty much what cryptomarkets looked like on an around March the 12. It was really heavy stuff. But ultimately, markets cleared, and no exchanges were taken down. And to my knowledge, not even a contract blew up. A lot of crypto traders individually got taken out a lot, but the system as a whole ran. And I don’t know if you can say that about many traditional asset classes, like we got bailed out. And there was no one bailing crypto out. So I think it’s very much testament to the space. And this is not something I would have said in 2018, even 2019 I think the space has gotten a lot more robust and resilient. And part of that is because it’s volatile all day long. There are you can take out 100x leverage, but no one ever does. Because you’ll just get carried out in your back within minutes in an environment like this. So the use of leverage and crypto and the rehypothecation of assets. And basically getting too cute on all of this stuff is almost non existent compared to what we see in traditional markets. People just don’t get too cute because it adds too much complexity. And that just ends up blowing you up. And so I think these markets are right and and they seem to love we’d probably like them if he didn’t hit Kryptos that much, because it’s lots of little stresses to the system, but ultimately I think it makes up more as a man. The final thing, which is sort of the Holy Grail is off exchange settlement. So this is the idea that I can deposit assets with my custodian And my custodian also has accounts with the crypto exchange. And the custodian can make an internal ledger movement from my account to the custodians account. And I can use those crypto assets, which still sit with the custodian as my collateral and margin for trading on the exchange. And that means that the assets never actually go to the exchange, they sit safely with the custodian. And sure, you can say that there’s counterparty risk with the custodian themselves. But I would take that any day over an exchange. And the custodians themselves are getting more robust, more regulated, and better insured, generally. So this is kind of largely in, in progress towards being a salt problem.

Corey Hoffstein  45:43

As you start to scour this space for partners, let’s talk a little bit about the wisdom you’ve gathered. What are the red flags that you see when you’re doing due diligence?

David Fauchier  45:53

One of my favorite kind of red flags is trying to tease out, like, How wide is the distribution of events that they consider possible in that training. And a lack of paranoia I keep coming back to those is a sure sign of trouble to come. Because, in my mind, the distribution of events in crypto over the past eight years now that I’ve been following these markets is extraordinarily wide. And crazy shit happens. And if you’re not ready for it, you’re finished. I meet pseudo quant guys that ran a backtest over three years of data on their strategy and have traded it for three or five months, and absolutely smashing up. And they have no monitoring in place. Like no, no, like, our strategy doesn’t go down. It doesn’t lose money. So we didn’t really need to get woken up in the middle of the night, if it’s trading, and it’s lost 50% Because that would never happen. We’ve never lost more than 5%. And you nod and thank them for that time. And three months later, they’re gone. Or they blow up, lose 20% and give you a call and say, hey, thanks. What should we have done? And how do you suggest we kind of claw our way out of this? So this kind of paranoia side is, or lack of paranoia is for me a really interesting one. Something else I’d say is the manager strategy fit. People often ask us like, what does the perfect manager look like? And the answer has to be well, what’s the strategy that they’re running? How well does the skill set and background and experience of the manager map onto whatever strategy it is that they’re running? But also, how well does that character map onto it? In the same way, as I don’t know, imagine if you’re like, long term, buy and hold equity investors with ADHD. So if a guy who’s just completely like schizophrenic and bounces around all the time, and is just jacked up, is telling you that he wants to buy and hold stocks for 10 years, that just wouldn’t work. And someone who’s extremely kind of like thoughtful, pedantic slow in their thinking and gets to that conclusions very slowly and holds them very strongly, you wouldn’t want them being a trader. And so there’s this kind of, depending on the strategy, you’re looking for different characteristics in the character of a manager, as well as in that background and skill set. One of my pet peeves is the inability to answer a question straight. We talk to a lot of managers, it is my job to talk to as many as I possibly can. I think I’ve spoken to more than 80% of the managers in the space. It’s very, very rare that someone described something to me that I haven’t heard before. And the managers that will not give you a straight answer, when you ask them a simple question, also tend to think that what they’re doing is unique, and proprietary. And they’re also the guys that will take down the competition and say, no, no, no, no one else is doing what we do. And they’re all idiots. And we’re Wonderful. So there’s all kinds of like, fit together. And I think it’s bad for a couple of reasons. The first is they get complacent. So they’ll spend less time on research, because they think that model is durable, and it’s not. And they think it’s great. And when it stops working, they just don’t know why. And also, because if someone’s going to be difficult, no, we’re not asking them to tell us their secret sauce and reveal what’s proprietary about that model. But if you can’t have a five minute conversation about how it all fits together, then you probably don’t have much of an edge. Because if an idiot like me could recreate it, then how much is it really worth? If that’s how the conversations are going, then when something goes wrong? You just don’t know that this guy is gonna give you a straight answer. And so I tend to avoid those kinds of managers. The other easy one is referencing we do a lot of referencing typically. And if it’s less than gushing, even after you really push and find references that haven’t been sent to you find really independent ones. That’s always a good sign. If you can find eight people that just think the world of a particular manager, and he doesn’t know that that talking to you. That’s usually a good thing.

Corey Hoffstein  49:52

There seems to be a lot more institutional appetite in this space. I know just from the conversations I’m having more More people are taking it seriously, as a potentially alternative asset class. If someone is new and looking to allocate to this space, what questions should they be asking?

David Fauchier  50:12

I mean, my advice to them would, firstly, to come to the States with an open mind, which people in finance, typically don’t seem to do, I think, especially in Europe, because it has the word currency in it. The cryptocurrency space is sort of seen as as being within the purview of finance. And if I’m in finance, then I must know, but I think the reality of it is that these aren’t trying to be currencies, by and large, and it’s PhD level tech. And you wouldn’t go and pick biotech startups, or have strong opinions about different areas of biotech research, without having a degree in it. So why do you feel so sure about yourself when it comes to crypto? So I would say the first thing is just to have an open mind. The second is, I think that there are three ways to allocate to the space that makes sense. I think there’s a reasonable case to be made for Bitcoin, as a digital gold type asset, that is private and fixed supply, and is a bearer asset, I think that there’s a reasonable case to be made for not being part of your portfolio that you may agree or not agree with no pressure. The second is, is to say, Okay, well, I feel like there’s some promising kind of technology here. And I want to bet on that. And I think if you’re going to do that, to the PhD point, go and find people to do that for you. And by that I’m really talking about this as tech, an early stage tech, and it’s deeply technical tech. So go and find a venture capital manager that really knows what he’s doing, and allocate to them, find someone you can trust, and give them your money to go and invest with a truly long term horizon into this kind of emerging area of technology. And then the third way of thinking about it is really what our focus is, which is, I have no view as to whether bitcoin is good or bad, I have no view as to whether this thing is the next version of the internet or a big fraud, but I can observe factually, that this is a market that is inefficient. And I can objectively see this. And therefore there are ways to trade this and make money on the office side. And two of those three things require you to go and I think find a manager to go do it, unless you’re doing it full time. And if so, I’ve never found any better advice than Peter Calvin’s. He’s a great investor. And he has this concept to a story about the five aces. I don’t know if you’re familiar with that.

Corey Hoffstein  52:33

But the you know, that one’s new to me.

David Fauchier  52:34

It’s great. He’s wonderful. And this framework is the best I’ve ever found for picking managers. The first one is, you should look for total integrity, with really no caveats to that whatsoever. The second is like an actual deep world class fluency in whatever strategy it is that you’re running, you should be the best at it. And then it’s a fair fee structure, and uncrowded investment space. And then the final one is a long runway. So like pick a manager that can manage your money for 2030 years, because finding these guys is hard. And so once you find one, you should be able to kind of hold on to them for a long time. I can’t do any better than that for advice. I think it’s wonderful.

Corey Hoffstein  53:15

We talked a lot about how the space has changed in the challenges and opportunities that has presented over time to operating capital in the crypto landscape. What changes do you see on the horizon coming up? And what opportunities and challenges do you think that that’s going to present?

David Fauchier  53:34

So the space has always been changing, and it’s going to keep changing. So there’s not much to be said, I think in that sense, novelty, we said that, I mean, the exchange was just kind of settling down. So each exchange was more or less, the top ones have kind of found their spot and their niche, and busy kind of developing those. But if you look at the kind of market share between the different exchanges, it’s it’s really starting to settle down. There’s a lot of new product launches. So all exchanges are launching new products, they’re broadening out the amounts of pairs that they’re quoting on, and giving you the ability to trade and the different ways in which you’re able to do that. And they will seem to be adding the functionality you would expect in the traditional market. Things like portfolio margin, more robust trading engines, the ability to make more API calls, better collateral movements, etc. The options space is pretty new and growing really fast. I mean, it pretty much didn’t exist a year ago, and it’s pretty big now, then much more options are far more multi dimensional than spot or delta ones. Obviously, the shocks from that are really going to start to be felt in the crypto space, I think you’re starting to be able to see like the effect of options pins on price and spot. Gamma hedging options are starting to kind of make that mark and the volumes keep growing. And so that’s going to start to look similar to the traditional space and I think a lot of the question Since people are asking themselves on stocks, and the impact from options dealers on that, and then you’ve got, I mean, doesn’t exchange called FTX, which has just been busy listing will tokenizing, like real world assets, like stocks. So when the Gamestop saga happened, like a week later, they had listed on a basket of Wall Street bats, I think the contract was called Wall Street bats, and it was, like, backed by the top Wall Street, but stocks, and you can just go and trade that as a future on this exchange. And then it was very tongue in cheek, and it was great publicity for them. But it’s a continuation of the unmatching. And the growing ferocity between the traditional finance space and the crypto space. And I think we’re in the last Bull Run, the previous bull run we had in 2017 18, I said was the last one in which Bitcoin risk would be binary, like it’s either going to walk or it’s not in this could go to zero, I think that risk has basically gone at this point, I think, from a trading perspective to kind of mock it character that’s going to be in question this time around is that after this bull run, Bitcoin will no longer be the uncorrelated asset, it’s being financialized, in this bull run, and it’s going to start trading along with everything else. And that’s going to be important. And then the final thing, which is just the defy space, as so decentralized, finance has just gone from like curiosity to mainstream and the cutting edge of trading. Research is happening here. I mean, it’s completely different. Centralized crypto trading is somewhat similar. I mean, it’s basically similar in its foundational aspects to equities, or whatever you want. Defy is just a beast of its own. And the you have completely new virgin territory to figure out how to make alpha in that space. And it’s just been fascinating to

Corey Hoffstein  56:51

watch. Well, I can’t let the show and like that the show, the show goes on, we got to talk at least a little bit about defy, you can’t leave me on that.

David Fauchier  56:58

I’ll tell you, I’ll give a teaser on that it’s worth another hour of chatting. So the defi space is, I think I mentioned this before, like people are basically rebuilding financial infrastructure on these blockchains predominantly Ethereum. And so you have like decentralized exchanges, which is to say, you can call up a contract that sits on Aetherium, and say, hey, I want to swap USD t my stable coin for some ether. And you can send it, you can put an order in the order book. And the matching engine actually sits in a smart contract, and is matched by a smart contract. So there is no counterparty here, you’re trading against other strangers, none of whom had to sign any paperwork or identify themselves in any way that just an address on Aetherium that you’re trading against. And the entire thing is deterministic. And this deterministic aspect of it is what’s so interesting about it. So obviously, you can arbitrage between a decentralized exchange and a centralized exchange. And just like there were opportunities or differences between equities exchanges and crypto exchanges, in terms of what infrastructure they sit on, whether it’s like physical servers in one place, or whether it’s AWS in crypto, the matching engine set on the Ethereum virtual machine, which is like a theorems version of the cloud. And the way in which the EVM works is totally different to anything else. Because amongst other things, for state to change in Aetherium, which is to say, for like a transaction to happen, you need to mine that into a block. And if Aaron blocks happen every got, I think it’s like every seven seconds on average. And so you have an update, basically every seven seconds in which a block of different computations and state changes get computed at the same time. And so the way in which you would think about like posting orders and sale orders, and arbitrage trades is just completely different between centralized and decentralized exchanges. But taking that one layer deeper, the dominant form of exchange in the defi space is actually automated market makers rather than order books. And with an automated market maker, you basically have a liquidity pool where people put assets into a pool, and those assets can be traded against each other. So you would deposit into a new liquidity pool, 50 bucks worth of Aetherium and 50 bucks worth of dollars. And I could go and say, here are some dollars, I want to buy some theory. And the more I do that, the more I shift, obviously the supply the equal supply in dollar times of ether and dollars. And so there’s kind of this curve where the more you move that pool, the more you disturb the balance between those two assets, the more slippage you’re going to incur. So if I want to buy one ether, my slippage might be 10 pips, but if I’m gonna buy two ether, it might be a percent. And if I want to buy three ether, on basically draining the theory amount of the pool, and so the slippage I incur is exponential. And that incentivizes me obviously not to and on the backside of that by providing the liquidity, you’re actually collecting transaction fees on the Besides that, but what’s interesting here is, and this gets really into the weeds, but I’m posting a transaction to Aetherium. And that goes into a public memory pool waiting to be mined in that public memory pool, anyone else can go and look at that. So if I’ve identified an arbitrage trade, I’m posting, basically an order that writes in code, buy from here and sell over there for a profit. And someone else can pick up on that transaction. And we can get into a gas bidding war, where he’s going to pay more transaction fees in Aetherium, than me so that his transaction gets mined ahead of mine, because while we’re in the same block, that block is mined sequentially. So all of these different state changes and computations are lined up one after another, typically, in order of who’s paying the highest fees per unit of computation. And so I post them to the mempool. And then someone else sees the transaction and goes, Jesus, there’s $10 of profit here, I’m going to post with a higher transaction fee than him. And then I would see that and go, I’m being front run. So I’m going to repost my transaction, again, into the memory pool with an increase. And so we get into this auction. And we’ll basically auction each other up until the marginal dollar basically. And what’s interesting at that point is that I might have a computationally less expensive way of expressing that trade than the other guy. And if so I can afford a higher transaction fee per unit of computation, which is your gas. And that means that like, by being able to write a smart contract better or more efficiently than the next guy, I might be able to kind of sweep these trades. And this gets back to the point of this is arbitrage and quote unquote, high frequency trading. But it looks absolutely nothing like trading on a crypto exchange or what jump is doing on equities. There’s a bunch of different examples that we can get into. But that’s the high level,

Corey Hoffstein  1:01:52

oh, this might require a whole other hour as someone who just wrote their first contract on the Ethereum blockchain, just two weeks ago, just that just the mess was understanding that computational intensity and coming from a computer science background, I get all that. But actually seeing it come out in a transaction cost was a really fascinating way of thinking about this sort of virtual computer and the cost of doing business. Very fascinating space probably going to require us to do a little bit of laying the foundation for listeners, but a conversation I would love to revisit with you in the future. Last question for you. I know that you’re sort of going through your third lockdown right now I just saw on the news, it looks like in London, the restrictions are starting to ease up a bit. What are you most looking forward to when you get out of lockdown,

David Fauchier  1:02:40

travel? Spend as much time in London before. So it’d be good to get out. We have terrible weather here. And it’s uniformly bad over the whole country. I’m very jealous of Americans in that respect.

Corey Hoffstein  1:02:54

Well, David, this has been an amazing conversation. Thank you so much for your time, and hopefully we can schedule something again in the future.

David Fauchier  1:03:01

Thank you so much. And if anyone is trading in the crypto space, we would love to chat to you. Please don’t hesitate to reach out.

Corey Hoffstein  1:03:11

If you’re enjoying the season, please consider heading over to your favorite podcast platform and leaving us a rating or review and sharing us with friends or on social media. It helps new people find us and helps us grow. Finally, if you’d like to learn more about newfound research, our investment mandates mutual funds or associated ETFs. Please visit think And now welcome back to my ongoing conversation with Harley Bassman. One of the themes that I’ve found has resonated throughout your writing over the years is this idea that there’s just a few major risk vectors, that we would at least from a theoretical perspective, expect to be correlated over the medium term. It’s hoping you could spend a little time explaining this philosophy and why it’s important for investors to be aware of.


Thank you, I think of the very interesting point you brought up. And it’s one of my core foundations for investing. If you look at the world from 30,000 feet, there’s three major inputs to risk, at least in the bond market duration, credit, convexity, duration is when you get your money back credit as if you get it back. And convexity is how you get it back. And the interplay between them is what creates how you choose assets to allocate. Interestingly enough, if you were a supercomputer, blindly pushing money around, you would look at those three risks. And you’d say which one offers the best value? And so if the curve was to flatten, and rates went down, you’d say okay, that’s not as valuable as it used to be. Let’s look at credit spreads, and then they would tighten as people move from the curve to credit and as that tightens in, you then move to options. Melody convexity and you’ll see options selling or various other structured notes being created, where there’s implied options being sold. And thus all three of these things interplay with each other. And although you can’t day trade this, you can’t even monthly trade this. There is a very high correlation of the shape of the curve, high yield and investment grade bond spreads in the level of implied volatility. If you look at this over 20 or 30 years, they go up and down as a wave together.