ETF Expert Corner

Cryptocurrency Expert Ari Paul Explains Bitcoin

September 12th, 2017 by ETF Store Staff

Ari Paul, cryptocurrency expert and Co-Founder of BlockTower Capital, offers his perspective on bitcoin, the technology underlying it, and whether it should be owned in an investment portfolio.  He also discusses the potential for a bitcoin ETF.



Transcript

You can listen to our interview with Ari Paul by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: Let’s now welcome into our discussion, Ari Paul, Co-Founder of BlockTower Capital. BlockTower is a leading cryptocurrency investment firm. Ari is the Chief Investment Officer there. Ari was previously a portfolio manager for the University of Chicago's multi-billion dollar endowment. He's a Chartered Financial Analyst and we're very pleased to have him joining us via phone today from Chicago. Ari, our pleasure to have you on the program.

Ari Paul: Hi Nathan. Thank you so much for having me on.

Nate Geraci: Ari, there's a lot we want to get to today, but I think the best place to start is with some of the basics. Everybody is seeing the headlines - the price of bitcoin has gone from about $1,000 to $4,300 this year. I think most people probably can't explain what bitcoin even is. So, first, how do you describe bitcoin to the layman?

Ari Paul: It's even a challenge to explain, because I'm going to give you the really, really basic, kind of what it is. The challenge is, it doesn't really encapsulate the value. What it is ... Bitcoin with a capital B, is the Bitcoin network, which is roughly right now, 100,000 computers globally in every legal jurisdiction, that all run the same software. It's basically a new type of database. It's really not that interesting from a computer science perspective. It's a way for people all over the world, who don't necessarily trust each other, to come to consensus, to come to agreement on the state of a shared database. Now, that sounds kind of boring right? What's really innovative here is there's a mix of game theory and computer science and cryptography that allows these people, who don't trust each other, to agree on a shared database state, as well as a method of adding new transactions or new information to this database that everyone agrees on. Now, what that does is it sets the stage to then have some kind of a store of value, or unit of money on there, that isn't relying on any particular third party. When I say that people often think, "Well, who's that valuable to? You know, people who are doing illegal things, or drug deals or anything like that?" My answer to that is really simple, which is ... Think about all the money in Swiss and Cayman bank accounts, in hidden bars of gold. Think about how much of Wall Street is devoted to creating judgment resistant trusts. Think about how much time, how big of a legal department, even firms like Apple have to structuring their assets in such a way that they're resilient from any particular judge just being able to say, "Freeze their accounts." You have a fundamental demand that's very, very easily 10 trillion dollars globally, that we can see. This isn't speculative. There's more than 10 trillion dollars, right now, allocated in places and in assets and in trusts specifically to be judgment resistant or judgment proof. And it's not just a question of it being illicit. You think about, if you're a wealthy Indian, you just faced demonetization. If you're in South Korea, you face capital controls. It's not really your money. You can't take it outside the country. If you're in Argentina, you have capital controls, plus inflation. If you're in Russia, or China and you're wealthy, you're afraid that if you upset the wrong judge or politician, you might have your assets seized or frozen. Even in the US, we have civil asset forfeiture and we have the IRS freezing accounts pre-trial. Because of this, the key feature of this shared database is that, because it's distributed over every legal jurisdiction and because there's no single party in control, it means that there is no government, no third party, no judge, no malicious actor who can seize your assets. People sometimes say, "But hey, I've heard stories of Bitcoin being seized." The proper way to store Bitcoin is with encryption, where there's a password. The password could literally exist only in your head if you want it to. There is no physical location of your bitcoin. You can access it from anywhere in the world, because it's a distributed ... it’s kind of like a cloud network. If you're physically able to escape an oppressive regime or if you're physically able to access the internet from anywhere, you have access to your wealth. And I would argue that we see fundamental demand for that today, in the trillions, by mediums that are far, far less efficient at it, than cryptocurrency.

Nate Geraci: Ari, when you look at Bitcoin or even other cryptos, how do you view them? Are they simply a means of transacting similar to PayPal? Are they stores of value? Are they currencies? Are you saying they don't necessarily fit neatly into any of those boxes?

Ari Paul: Different cryptocurrencies function very differently. Bitcoin, for example, I think of as a commodity. There are others that are a bit more equity-like. Some of them even have ... there are actually cryptocurrencies that even pay dividends, that can be modeled using, like a Gordon Growth Model. Most of the big ones, though, are really commodities. Where I disagree with Warren Buffett - and there have been some brilliant investors who forgot more about investing than I've ever learned - where they make a mistake, and I feel quite confident calling it a mistake, is they actually don't address the core value proposition that I just described. Warren Buffett, Robert Shiller, Howard Marks. They all criticized cryptocurrency, literally, without addressing the fundamental demand I described which is it is the first and only unseizable store of value in human history. That's a really critical concept. All the assets that Warren Buffett described, you know, Warren had the benefit of being really in America during, kind of, one of the most law abiding periods in human history, in a part of the world where you could be relatively confident your assets wouldn't be arbitrarily seized. Most of the world, probably 70% of the world, doesn't have that luxury. A lot of the early adopters of cryptocurrency were people whose relatives had to flee, let's say, a country with the clothes on their back. People who had relatives in Nazi Germany or Khmer Rouge or Peugeot, Chile, or even Argentina today, where your wealth is confiscated effectively through, you know, through inflation. I think a lot of the investing world right now, they're comparing it to say, PayPal, and they're comparing it to Visa. I really don't think that's the value proposition, because the reality is that the database system we're talking about, a blockchain, is hardly inefficient. Like, let's be clear about that. A centralized payment system like Visa is always going to be more efficient than a decentralized payment system. Bitcoin is a horribly inefficient payment channel. The one thing that Bitcoin has going for it, is that it's decentralized. Decentralization isn't necessary for everything. I don't need a decentralized payment system to pay for coffee. I probably need a decentralized payment system, for example, if I live in Iran and I want to support a political dissonant group.

Nate Geraci: We're visiting today with Ari Paul, Co-Founder of BlockTower Capital. Ari is a cryptocurrency expert. Ari, in just a bit we're actually going to speak with a gold expert and, as I'm sure you know, bitcoin has been called digital gold. Based on everything that you just laid out, I'm assuming you do see bitcoin as a dependable store value and so, if that's the case, do you view it as potential disruptor to gold?

Ari Paul: The short answer is yes. I think bitcoin is going to compete in some investors’ portfolio for the traditional role that gold has played, from a few angles. One, is it's relatively uncorrelated to all other assets. Two, it may be something of a hedge against currency depreciation. There's a common debate over, you know, is gold a good inflation hedge? My own view based on, kind of - and actually this is something I agree with Warren Buffett on who wrote a great essay on this I think 20 years ago - gold seems to be a pretty good depreciation hedge. It won't necessarily make you money in that scenario, but it'll protect it. Cryptocurrencies probably the same, because it's a currency, a store value that central banks can't depreciate. Right? So, right now, the entire world, most of the world is depreciating their currency quite aggressively. Cryptocurrency probably competes with gold as a safe haven against that, as at least a depreciation hedge in your portfolio.

Nate Geraci: You know, as I look at both bitcoin and gold, both are obviously based on trust in the sense that their value is ultimately derived from other people believing there's value. I guess also on the other side, both benefit from a general distrust of centralized financial systems. As it relates specifically to Bitcoin, is there anything that keeps you up at night that could breach that trust and, therefore, undermine bitcoin's merit as that store value?

Ari Paul: Absolutely. I should be clear. Bitcoin is highly speculative, very risky. I mean, its price is incredibly volatile. Calling it a store of value is kind of premature. I think of it as a potential store of value. Its current price is kind of a probabilistic bet that it will become a multi-trillion dollar store of value. There's definitely ... I can give you 12 ways that bitcoin could fail. What I'd say though is that if bitcoin fails, something very similar to bitcoin will take its place, because there is that fundamental demand. It's a little bit like, people sometimes say “Could the whole cryptocurrency thing just go away?” My answer is kind of the same. Could the banking system go away? Well yeah. We've had a lot of countries that have had banking systems fail. It's not impossible for every bank to go bankrupt. There will be a banking system a couple years later, because people demand banking. There's fundamental value there. Cryptocurrency is the same. Bitcoin could fail. I'll give, kind of three ways, just really quickly, the fastest. One, bitcoin could effectively destroy itself - without getting too technical, bitcoin is open source. When people have different visions of what the coin should be, that creates a fork. People create their own version of bitcoin. Those different versions, the communities can fight with each other, and could theoretically destroy one another. Another way is, bitcoin could be replaced by something that's an order of magnitude better. Maybe bitcoin is Myspace or Friendster and we just haven't seen Facebook yet. Right? It's a new technology. Maybe there's a better version out there. Now, it's incredibly sticky. Switching costs are very high. There are big network effects. Something a little bit better than bitcoin isn't going to replace bitcoin. If there’s something, you know, an order of magnitude better, it could kill it. I could kind of go on. It is very risky. I don't want to pretend that it's not, but there is this tremendous, tremendous fundamental value being offered.

Jason Lank: Ari, this is Jason Lank. Much has been written about the anonymity of bitcoin, being able to access your funds from anywhere on the planet, even out of reach of governmental agencies, really with no one knowing who owns what. Is that truly the case? Is there any way to reverse engineer transactions, so that, for example, a taxing agency could actually figure out who owns what?

Ari Paul: Yeah, so bitcoin, the term that's used, is pseudo-anonymous, which means every bitcoin transaction is visible on the blockchain. It's actually incredibly easy to trace. Law enforcement actually loves bitcoin. It's much easier. The single biggest way that illicit activity happens is with cash. Right? So, the US dollar and Euro-cash is the thing used by terrorists, used by drug trades. Cash is fungible. It's basically untraceable. Law enforcement actually loves when terrorists or drug dealers use bitcoin, because it's so much easier for them to trace. There are other cryptocurrencies like Monero, for example, that are truly, probably untraceable.

Jason Lank: You mentioned the term fork in the road. Talk about what a fork is. My understanding is that they are a limited, at the end of the road, a limited number of bitcoin and we recently, bitcoin, experienced a fork. Is that a new currency created? Is that more bitcoin? Talk us through that.

Ari Paul: There's both kind of simple answer and almost an existential one. The simple answer is a fork occurs whenever people modify the software in a way that is incompatible, such that there are two versions of the Bitcoin network running, that are incompatible with one another. Now, because this is open source, anyone can do a fork anytime they want. Nathan, you could create Nathan Coin and it could be a fork of bitcoin, with some change in it. You would do that very easily. It wouldn't matter, right? No one would take notice. It wouldn't have economic value. Let's say you were able to create Nathan Coin, or we can call it, bitcoin two, and you were able to convince maybe a quarter of the bitcoin users that this was the real bitcoin and you got it listed on exchanges and it had real economic value. That would be a fork. It could potentially be confusing. Right? Because there might be debate over which is the real bitcoin. We've had some forks. For example, there's a cryptocurrency called Litecoin that's a fork of Bitcoin, with some major changes, that doesn't call itself bitcoin. There's no real confusion there. The creator said, "I'm going to fork bitcoin. I'm going to create something new." It's kind of a friendly separation or spin off. What happened on August 1st was something in between. It wasn't totally friendly. It wasn't totally unfriendly. We had the creation of something called bitcoin cash. Bitcoin cash is currently worth about 600 dollars. Some bitcoin holders view it as a dividend. The fork happens, the value of bitcoin didn't fall. It was kind of a market inefficiency. You received bitcoin cash and you had the option of immediately selling it on an exchange for a profit. There are other people though, who think that coin cash is what they want. They think that is the true vision of bitcoin. The difference there in one sentence is, bitcoin really emphasizes decentralization in every regard. That comes at a cost. It comes at a cost of throughput. Bitcoin can only handle a small number of transactions per second. Bitcoin cash basically said, "We want to be more of a payment channel. We want to be more like Visa. We're willing to accept some loss and decentralization." They're kind of two competing visions.

Nate Geraci: Our guest today is Ari Paul, Co-Founder of BlockTower Capital. Ari, we have just a few minutes left here and sort of boiling this down, I think you've done an excellent job of laying out bitcoin and some of the risks involved with bitcoin. Do you think bitcoin is something investors should consider owning as part of a well-diversified investment portfolio? If so, why?

Ari Paul: Frankly, I think you almost have to at least seriously consider it. Anyone who has taken a portfolio theory class, as part of the CFA, or an MBA class, you know, here you have an asset that is relatively uncorrelated to everything else, has been compounding at 150% a year for eight years. There are very clear fundamental reasons to believe the expected value is very high over the next three to five years. Mostly, to explain that in one sentence ... Accessibility. Right now, endowments and pensions own zero cryptocurrency. Sovereign wealth funds own a tiny, tiny bit. Most retail investors own zero. The main reason ... There are a huge number of groups that want to own it. They can't. They can't because it's hard. It's becoming easier every day. So, it's hard because there aren't yet custodial services or prime brokerage. We don't yet have an ETF. We don't yet have derivatives in the US. All of that is changing over the next year. It's going to become much easier, much more accessible, which means you're going to have this kind of accessibility discount is going to fade away. I think that's going to cause huge price appreciation. Even if I'm wrong, which I very well could be, as an investor, you have something that has very high risk, but it's idiosyncratic risk. It's uncorrelated to your portfolio. It's high expected return. That's kind of the golden goose, right? That's exactly what, as portfolio managers, we’re desperately seeking to add to our portfolio, sized appropriately.

Nate Geraci: You mentioned not having an ETF yet. Before we let you go, I did want to ask you - back in July, you penned a letter to the SEC in support of a bitcoin ETF from Grayscale Investments. You specifically mentioned the accountability and transparency and liquidity that the ETF structure provides. Do you think we'll ultimately see a bitcoin ETF? If so, what hurdles do we still have in getting there?

Ari Paul: It looks very promising. There are a few very credible ETF proposals in front of the SEC right now. There are more coming. We're starting to see them from big asset management firms. For example, VanEck actually recently produced an ETF proposal that would be based on bitcoin futures. The CBOE is going to launch bitcoin futures within the next year. You're having big, institutional players moving in the space. It's becoming more regulated. It's becoming more professional, more transparent. I'm very optimistic. I think my best guess is that in about six months we'll have a bitcoin ETF. That is a guess. It might be 12 months. If we don't get one in the US, we'll almost certainly have one in either London or Hong Kong or Macau or Singapore. It's very likely I think that, over the next year, somewhere in the world, in a major stock exchange, we'll have an ETF.

Nate Geraci: Ari, with that we'll have to leave it there. Tremendous insight today into a very complicated, but I think fascinating topic. We certainly appreciate you joining us. Thank you.

Ari Paul: Thanks very much.

Nate Geraci: That was Ari Paul, Co-Founder of BlockTower Capital. I've got to mention, if you're on Twitter, I would highly recommend following Ari. His Twitter handle is @AriDavidPaul. He's a fantastic resource - I would say a must follow if you're interested at all in cryptocurrencies.