Stopping Pig Butchering and Crypto Scam Epidemic Podcast Ep. 93

https://www.chainalysis.com/blog/crypto-scam-epidemic-ep-93/

Episode 93 of the Public Key podcast is here! Investment schemes, pig butchering and romance scams are plaguing the crypto industry and we get a chance to speak to Nicola Staub (CEO and Co-Founder of CYBERA) who is bringing together victims, law enforcement and crypto exchanges to combat these cybercriminals once and for all. 

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 93.

Public Key Episode 93: The Future of Crypto Scam Prevention

Investment schemes, pig butchering and romance scams are plaguing the crypto industry in this episode Ian Andrews (CMO, Chainalysis) finds out from Nicola Staub (CEO and Co-Founder, CYBERA) how the crypto industry can fight back.

Nicola discusses CYBERA’s mission to combat crypto scams and fraud by providing a platform for victims to report incidents and for financial institutions, crypto exchanges and law enforcement to share information and data. 


Nicola emphasizes the importance of speed in preventing and recovering assets lost to scams and highlights the role of financial institutions and messaging and dating app service providers in the fight against fraud. 

He warns the industry about the growing use of AI by scammers and the need for a collaborative approach to combat the use of deepfakes in crypto scams. 

Quote of the episode

“The faster we can react after the fraudulent transaction, be it crypto or wire [transfer] and the faster we can inform relevant parties, the higher the chance we get money back.” – Nicola Staub (CEO and Co-Founder of CYBERA)

Minute-by-minute episode breakdown

  • (2:15) – Nicola’s background as a prosecutor and passion for fighting scams led to CYBERA
  • (6:40) Lack of resources and technology in law enforcement
  • (8:25) – The scale of CYBERA’s impact and partnerships
  • (12:27) – Shift in fraud methods, from wire transfers to business email compromise and investment scams
  • (17:50) – CYBERA’s approach to information sharing and prevention 
  • (22:21) – Differentiating CYBERA from crypto recovery companies
  • (31:50) – The impact of AI on scams and deepfakes

Related resources

Check out more resources provided by Chainalysis that perfectly complement this episode of the Public Key.

  • Placeholder – Announcement of CYBERA Partnership 

Speakers on today’s episode

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Transcript

Ian:

Hey everyone. Welcome to another episode of Public Key. This is your host, Ian Andrews. Today I’m joined by Nicola Stab, who’s the CEO and Co-founder of a company called CYBERA. Nicola, welcome to the podcast.

Nicola:

Hey Ian, thanks for having me. It’s a great pleasure to be here.

Ian:

I am super excited to talk about your company, because I think you’re working on one of the biggest problems of our day, which is stopping what seems to be an epidemic of financial scam activity. I hadn’t heard of your company until just the last few months when our respective companies started collaborating together. So maybe we can start with a bit of background on what does CYBERA do, how do you help people? What’s the mission of the company?

Nicola:

Yeah, sure. And I’m glad you’ve heard about the company now, and you know what we are doing because it is truly an important mission we run. And just to back up a little bit, because it’s important about talking about CYBERA is also very much linked to my personal background. And so before CYBERA, I worked as a public prosecutor in Switzerland and long story short, I dealt on a daily basis with scam and fraud victims internet crimes and I realized how big the problem is, how easy it is for criminals to carry out these attacks and how horrible on an individual basis this is for an individual or a person that falls victim to a scam and it sparked a big passion for me to do more against these kinds of crimes. And one of the result, let’s say, is CYBERA, a company that we started three years ago based on some insights that I had on the job as a prosecutor dealing with these crimes and seeing a way where we can improve some big pieces by building technology.

Ian:

That’s quite the pivot. I mean, we talked to a lot of founders on this podcast. I think you’re the first who’s gone from prosecutor to leading a technology company. How did you have the confidence to make that jump? I mean, that’s a very different career path I would imagine.

Nicola:

Yeah, yeah, you’re absolutely right. And yeah, I should put that out there, but I think it’s true. I don’t know any other prosecutor who went from prosecutor to CEO of a startup. Well, to tell you, I mean honestly, when I first started studying, I actually never thought that I would end up working for government in the first place and it’s in my family, my dad is quite logical, entrepreneurial, and I always liked to improve things. And I liked also technology, but I studied law, I loved criminal law. I did a traineeship at the office of the Attorney General in Switzerland. And I kind of, if you want, fell in love as much as you can say that with the work of law enforcement, with investigations, working with the police and they fighting crime and helping victims.

But so yeah, how did I make the jump right after four years, five, almost in law enforcement, I still loved the job, but I kind of merged with my entrepreneurial spirit and I saw some way how we can really make a bigger impact. And I have to say, of course, I have my co-founder, who is also my twin brother who had the business background, who knows the startup world a bit better, so that helped to give me some confidence to team up with him and kind of form that dream team joining these forces and building a company. But it’s been exciting.

Ian:

Incredibly fortunate to have a built-in co-founder.

Nicola:

Exactly.

Ian:

Your twin brother as well, that’s amazing. So you mentioned as you were a prosecutor, you spent lots of time trying to help victims and fight these scammers, and you uncovered a couple insights that led you to realizing there might be a more impact that you could have than just prosecuting the bad guys. Talk us through what some of those insights were.

Nicola:

Yeah, sure. So in general, I was just amazed by the amount of these scams and the money lost. It really happens on a daily basis. And how they happen in the detail of course, is different case by case, but overall, they have very similar elements. And it’s always that in one way or the other, criminal scammers trick somebody or a company, it’s usually a person and they trick the person into making a financial transaction.

Now, eight years ago, it used to be mostly wire transfers, and then increasingly of course it’s crypto. And so this happens in all of these fraud and scam cases. And I saw very key thing in how we can improve this is by working with the financial sector because they’re very much involved in these crimes unwillingly they don’t want to be and that of course, well is Chainalysis. And where I saw a gap, to put it very simply, is one in crime reporting and two in information sharing. I can give some examples if you like.

Ian:

Yeah, please do.

Nicola:

Okay, yeah. So let’s take a romance scam often starts on a dating app. I know that would never happen to you Ian, but just imagine, right? You’re on a dating app and somebody kind of start conversation with you and they end up scamming you. And the result is that you, let’s say make a wire transfer, you’re sending 80,000 from the US to a bank account, let’s say in Germany, and then they trick you into making also a crypto transaction by Bitcoin transaction. Now, once you realize you’re a scam victim, you usually go to your police or you seek kelp, you want help with recovering your essence mostly. But frankly, what do you think if you go to your local police, I guess you have some experience, what happens?

Ian:

I’d love to say that they open up Chainalysis’ reactor and they do an investigation, they contact an exchange and they freeze the funds and they return to the victim, but that’s the rare occurrence. The more likely case is first, the victim’s embarrassed because they realize they’ve been scammed, so they’re going to be hesitant and they may let it go for weeks or months before they report it and then when they do show up at the police station, that frontline officer often has no experience with financial crime. And so they hear, “Oh, the funds are likely in crypto. Well then they’ve probably been transferred overseas. There’s nothing that can be done and you don’t even open a case.” So it doesn’t get recorded usually is the experience, right? It’s under reported.

Nicola:

Yeah. So I mean from my experience, and I mean this is not the bashing of law enforcement of course, because my heart beats very much for law enforcement and I would say 99% are doing an amazing job. But what I realized, there’s just lack of resources. There is so many cases, an incredible amount of cases. Even when I used to be a prosecutor, I had hundreds of cases and I could deal with one after the time. And then often as you said, they don’t have the technology resources.

And I would go one step further, law enforcement and the police’s job is primarily to investigate catch to criminals, but it’s not primarily to help you recover assets. And it’s a tough way to find a solution, but that’s exactly where CYBERA innovates today, basically and to recover assets and the response side of things, and for prevention, speed is key.

The faster we can report, the faster we can alert the bank in Germany, let’s say, where that money went to, the faster we can help tracing and alerting, like you said, the crypto exchange. And the faster we can share the crime data that is reported across the ecosystem, the better everybody can use it for prevention. And so that’s exactly that gap that we are every day trying to fill with more and more success.

Ian:

It’s amazing in valiant that you’re trying to solve this problem because it’s what I encounter every day. You’ve been at it for a number of years now. Give us a sense of who are you working with and what’s the scale of the business in any dimension you’re happy to share?

Nicola:

Yeah, sure. So I mean, I started around three years ago, pretty much alone with my brother. So we came a long way from there. We’re now kind of a global company. We built technology, a platform that helps exactly with what I said before. We have built a platform where a scam or fraud victim can report, they get resources, they get help, we then alert banks or help with tracing and alert crypto exchanges immediately and very fast in the case. And we share these alerts through our partners, which includes now chain analysis, which is quite amazing of course.

In that sense, yeah, we came from, I would say zero to today, helping every single day scam and fraud victims give you a little number. We’ve helped close to 10,000 total victims now that reported through the platform, and I would say between 10 and 30 every day and for this year, we have additional partnerships that will go live very soon where this number will increase a lot. And it has to because as you know, that’s still the tip of the iceberg and that is still the tip of the iceberg. And our platform’s goal is really to help pretty much every legitimate scam fraud which demo out there.

That’s not possible alone. So we are very much about building a community ecosystem and we work with financial institutions, so banks, also crypto exchanges, they work with us to help scammed users or customers. They also use our data for prevention, but we also work with law enforcement and with victim nonprofits. For example, in Switzerland where I’m from, the police officially works with us. And whenever there is a fraud victim, they now hand out the leaflet saying, “Hey, report also with CYBERA.” It just boosts the resilience of the ecosystem. And in the best case, it can help you get your money back even.

Ian:

Amazing. So I imagine that there’s a bit of a tension between the prevention side and the recovery side. Ideally, we would be able to stop all the scammers before they steal anyone’s money and we don’t have to worry about recovery at all. Looking at your website, it looks like you’ve actually got multiple different products that are one set oriented towards a bank or a crypto business or other financial institution and then you’ve also got services that you offer to individual victims as well. Am I following that correctly?

Nicola:

Yeah, yeah, that’s pretty much correct. And you’re right, if we can prevent every scam, then we can kill the recovery side of things, which I’d be more than happy to do, but it’s not very realistic. Unfortunately, so we just have to become much, much better and do what we do, which is information sharing at scale to fight back, basically.

So in terms of the solutions right now that we offer, you’re right, it’s what we call it the CYBERA Watch List, which is basically a very high quality block list of suspect of crime data reported to us. And so that is useful for banks who for example, include accounts that we flag for crypto of course, but also for individual people or companies.

So if you trade a lot in crypto, you can actually can access also as an individual, our watch list and check if a name or a social media account or even a bank account provides a hit. And that really boosts prevention. And you said right, if prevention fails, it’s important We have something almost like an insurance that we try our best as CYBERA, but as everybody involved to help try to get that money back before it ends up in the hands of the scammers and that’s where our response solution comes into play.

Ian:

Can you talk a little bit about the relative scale? I know you said when you first started as a prosecutor, almost all fraud in the financial context came back to wire transfers as kind of the means of getting money from victims. And that I sense that mix has shifted quite a bit. So on this podcast, we’re generally talking crypto, we talk a lot about pig butchering. If you can, give us a sense of the relative dollar value behind different methods in which people are being taken advantage of.

Nicola:

Yeah, sure. I mean, one of the key statistics or I would say at least today, who has the most reports in crimes? It’s not yet CYBERA by the way, but soon, it’s the FBI, right in the US with IC3 where people report also on victim behalf quite a lot. And when you look at that, the statistics, the FBI provides, then the two clear number one types of fraud and scams is today, one, it’s business email compromise, CEO fraud, which often companies are a victim of, and that’s most of the time wire transfer.

The other one that you’ve mentioned it several times is investment scams, which now mostly goes by the name of pig butchering, which is most of the time crypto. So from what I personally have seen when I started in law enforcement around 8 years ago, there was a lot already of romance scams with wire transfers and I did see that there has been a trend to mix that and start with a romance scam and then get the people, the victim basically to invest in most of the times to invest in a fake platform. And that’s pretty much what you call pig butchering today. That being said, and you know that the president and me, we see at least, yes, there’s crypto, but we also have several victims who were the scammers first they make a bank transfer, then they switch to crypto. So we really see both, right?

Ian:

Yeah. And we’re talking order of magnitude here, billions of dollars a year, right?

Nicola:

Absolutely. So again, one of these numbers that is quite tough to measure, but the FBI says something like I think 10 billion, there’s a big under-reporting now, one of the nonprofits have estimated that it’s already in the trillions. So there is several measurements, but for me it’s clearly the number one crime out there when you talk about victim losses. And one thing I always like to point out, almost everybody has somebody in their family or a friend who has been scammed and sometimes it’s smaller amounts, but if you add all of that up, right, we’re talking billions and that is money that goes from individuals from legitimate kind of people, really more or less directly to full organized crime. And so it’s money, but it’s also organized crime that’s growing and of course there is a lot of emotional consequences for victims themselves beyond losing money, which can go as far as to leading to suicide and really, really bad results. So for us, that’s pure motivation to do more and to fight back.

Ian:

We’ve talked quite a bit about the industrialization of the scammer operations and particularly in Southeast Asia where you have these factories where many of the people that are working there have actually been trafficked into that and forced labor. There was big news out of China just a few months ago where they arrested, I think the number they reported was over 30,000 individuals who were supposedly involved in this. If that were real, I would imagine that we would see a meaningful decline in the new scam activity. I’m curious if you’ve seen any data in your systems to indicate that that was real or has had any effect.

Nicola:

We haven’t seen it, and it’s a bit tough to talk about individual countries rule of law. I mean, I am not an expert on China and China law enforcement, but at least there is some, I think questions marks. I mean, it’s obviously known that I think the judiciary of law enforcement is at least not fully independent how we the investing world like to do it. So I’d hope to see the US or European country publish the same news that would give me some hope. And there is some hope, right?

I really think when I compare 8, almost 10 years ago when I started and the last two, three years, it’s really nice to see that the topic is much more out there. Also thanks to people like prosecutor Aaron West, who’s very publicly about it and about the news, who are rating much more about these stories. So to put that out there I think is really good and that has changed. But for the individual victim, honestly, I don’t think the situation has that much improved because it takes time, law enforcement still has a lack of resources and the scammers increasingly also thanks to AI technology, they are becoming even better and better by the day. And so this will remain an ongoing battle for sure, even if there is more success in prosecution,

Ian:

One of the things I’ve always wondered about is while I might use a crypto exchange or a bank to ultimately send money to a scammer, that’s not usually the point of inception. Like you mentioned earlier that many of these start inside of a dating app. If I scroll back through my text messages over the last year, I’ve got tons of these seemingly random, innocent, wrong number type messages. Occasionally, I’ll interact with them and it’s fairly clear it’s a scam just because I’m used to it, I’m kind of expecting it. I see it as a scam. But I think about the entry points or actually tech companies, the telephone company like my cell phone service provider, that allows these kind of random spam text messages to get through. Are you doing any work on that side of the ecosystem to try and limit the access to potential victims?

Nicola:

Yeah, that’s a very good point, right? You’re right, of course, when the money flows, I would say it’s almost already step three, and it’s often the banks today that are in the crossfire, but I think rightly so, the banks, especially in the UK, are fighting back quite a lot saying, “Hey, this has to be a whole ecosystem approach. We have to stop the scams or put some more pressure, if you like, with the online platforms where they often originate.” And it’s true, even also in our platform we see a lot is originating on WhatsApp, on Telegram, also on online, on dating platforms.

So I mentioned right when you go and report to the police for example, that’s one thing that certainly is not happening or in most cases not right, but actually, and that’s when you report to CYBERA, that’s the vision, we’re actually very close to it is when you report, we don’t just share information with the banks or with the crypto ecosystem to prevent, but we’re also providing that to, for example, a dating app provider.

We are moving towards that and I think that’s the effectiveness we want to achieve also with our platform that when you report, the quality is checked, it’s high this is a scam case, and then at this high quality, this is distributed available to everybody, to all the companies that are involved and they can immediately shut this down or investigate it. So that trend is happening and very important and I fully agree with you.

Ian:

Yeah, I mean it seems like the information sharing the rate at which you can disseminate, “Hey, we have a scam, or this group of individuals are involved in perpetrating a scam,” and get that information shared as widely as possible so that every financial institution, crypto business bank, all have that data. Ideally, we also get that upstream into the messaging apps, the dating apps, so that they can close the accounts that these folks are using. If you can do that after we’ve detected one victim, it just limits the blast radius in such a way that’d be really powerful. Why isn’t everyone using CYBERA? What’s the objection when you go talk to one of these folks.

Nicola:

I hope after this podcast they’ll all be using us, spread the word. Well, I mean, to be frank, we are still also an early stage company. So we are building, we not out there in the market for that long, but let’s say a bit over a year since our platform is really working in that very effectively and it is growing more and more, “Are you using us?”

Two things I would say are very, very important and it’s kind of up to us to deliver that. One is the trust, but trust comes really from security, of course, we have to be secure and the quality. So right, imagine everybody’s plugged into CYBERA. We want people to trust our intel, to trust our data. If we have bad data, that’s not good.

I would say one of the challenge that why what we do is actually quite complex, usually it sounds very easy. It’s say, “Hey, why is that not existing? It should actually exist already since 15 of 20 years. Why isn’t Interpol doing it? Why isn’t anybody else doing it?” Because it’s actually quite complex. But yeah, we’ve built a system that now is already very good and gets more accurate to do that, and we need partners. And one of the big ones is Chainalysis that we’re very excited because you guys have reach much, much wider reach, of course, than CYBERA does. And so that’s also why I’m very excited to partner with companies like you said, yours, and that we can expand that reach and really together make this whole ecosystem much more safer from these horrible scams.

Ian:

All right, so we got to get the word out there is what it sounds like.

Nicola:

That’s one piece of the puzzle for sure.

Ian:

Now, are there people who don’t feel good about the information sharing? I know on the victim side, obviously there can be embarrassment getting scammed where they may not want to report. But I’m curious more on the financial institution side. Is there a reason why they wouldn’t want to participate in an information sharing network? It sounds like this is all upside for them.

Nicola:

Yeah, yeah, very relevant of course. So I would say the biggest hurdle is actually the law. Let’s put it legal provisions to some degree and then the risk if you want. So one way of course to share information is bank to bank or crypto to crypto, or law enforcement to bank. But one of the biggest hurdles are legal provisions.

So for example, law enforcement is actually in most cases not really allowed to share. In some countries this is now softening up, but that’s very, very slow progress and it’s risky. And the same is kind of with banks, especially then when it goes global and cyber crime scams are completely global. So even if they’re allowed to share, sometimes it’s within its own country, but it’s not global. So there’s all these hurdles and that’s actually where when we started three years ago, and that’s more true now than ever.

That’s one part where the innovation with the tool solutions it promotes makes sense because with us, any bank or crypto exchange can recommend this additional support for their users who are scammed, but it’s actually in most cases, the victim or the user that comes and reports with us. So we get a lot of the data that makes sense to share for the whole ecosystem, but we get it ourself on our platform legally checked so we can then actually provide it. So it’s kind of a win-win win, actually and you don’t have to wait for all the laws to change, which they never will. I’m a lawyer, so I know this, it takes a lot of time.

Ian:

So in this case, the user reports the scam or the fraud to CYBERA. CYBERA then combines all of the reports you’re getting all around the world and then any one of your customers now has a very accurate, relevant list of known scam activity that they can use as a means to prevent their other customers from falling victim to it. So blocking withdrawals to a particular person or a wallet address in the case of crypto like that, that makes all the sense in the world. That’s great.

Nicola:

Yeah, yeah, yeah, exactly right. And maybe one thing to mention is what sometimes we forget is that I always say every scam incident, every scam or fraud is also money laundering and not to get too legal here, but this sometimes operates in two different spheres, but every fraud and scam results pretty much in a financial transaction and for the bank, and same for crypto.

This is a money laundering transaction, a money laundering risk. And so it’s actually not just important voluntarily to be better and detect that stuff, but it’s also from a regulatory point of view, very important that as a exchange or as a bank, you do the best possible thing you can do to detect this stuff. And if you don’t, we’ve seen it, you know that better than me. Binance is the latest example, but many are fined because of not taking enough measures when it comes to money laundering. So I think it’s important to always point out this is not scam fraud, but it’s really, there’s also trillions we’re talking of money laundering that we need to prevent.

Ian:

That’s a great point. I’m curious about the other side of the business. So after a victim is contacted you and recovery, I saw on LinkedIn you posted a look back at 2023 and I think it said that you had helped victims recover almost 5 million US dollars. How does that work? And I am particularly curious because there’s been some reports of recovery firms that are maybe not really operating in the best interest of their customers. They promise the world and deliver nothing, and the result is the victim is kind of victimized twice. So I’d love to hear your approach to recovery, how you’ve been successful, and then maybe if we can contrast to some of the other things that are happening out there just so people can tell the difference. That would be great.

Nicola:

Yeah, that’s a very important point and it’s one of them why we are so public about it. Why I do post? I love to speak to you here on the podcast because there it’s called recovery scam, right? There is a lot of recovery scam companies out there, and I would say then there is also other investigators mostly or individual firms who are actually legitimate. More, some of it less. Then looking at that is actually one of the reasons why CYBERA is so valuable and we strive to make it clear. I mean, we’re a VC backed tech company. We use technology as much as we can and we make the process as transparent and clear so it benefits the victim and so we can make sure that reaction happens in the best possible way to improve this chance of recovery. Now, more specifically, what does that mean?

It’s all about speed, I’m going to put out there. If it’s one thing to remember, we see that in our data, we know it from law enforcement, the faster we can react after the fraudulent transaction, be it crypto or wire, and the faster we can inform relevant parties, the higher the chance we get money back. And just briefly, I have to separate between wire transfer and crypto because we also have a lot of success cases with wire transfers, but it’s actually not that different.

With a wire transfer, coming back to the example with you, let’s say you sent money from the US to German bank account. When you report with us, we immediately create a criminal report or complaint and send or dispatch that to that beneficiary bank where we have a contact that happens within the platform and to the relevant police in Germany, we translate that report with all the information into German even, which also is sometimes important.

And so within minutes, police and the beneficiary bank have at a high quality all the information about this case, the victim, the transaction, and that can help them, or that usually triggers them to take action to investigate the account and to freeze money if it’s still there. So that’s on the wire side. Now, on crypto cases, as you of course know better than me, there is always the element of the crypto like tracing.

So we have to follow the flow of funds, identifying which potential crypto exchanges we can inform similarly to informing a beneficiary bank and here in the best case scenario, I always say, you can go to your police, the offices are there, they help you in one or two days, they do the tracing, they do all of that for you. But as we discussed, that doesn’t happen often. Resources are still limited and it’s also not the main job, even legally speaking of the police to help you with that.

So as transparently as possible, we try to bridge that gap and we’ve been doing it more and more successfully. That means we help by doing that tracing with our own team, using of course tracing tools. And we don’t just trace, but we also like with the bank example, then immediately send the report and the tracing to the identified crypto exchanges. Doing it at a high quality and high speed has allowed us to then have these exchanges or banks trigger funds, which is a key first step to then recover it, which obviously takes law enforcement and so on.

Ian:

Yeah, I mean that is really the critical thing. I couldn’t agree with you more is the speed of recovery or the speed of notification in order to help with recovery, I should say. Because at least in the crypto world, at some point there’s a funds go through compliant exchanges, almost always. And if you can reach that exchange in time, they can freeze those funds in an account. And there’s a high likelihood you can have those recovered.

But once they’ve passed through the exchange, it becomes difficult to trace. They often will then go to non-compliant exchanges and jurisdictions where they don’t really respond to legal process and the likelihood of recovery goes significantly down from there. I’m curious, if I were a victim and I was trying to decide which recovery firm to talk to, what would be some of the things that you would say would be a good indication that the firm is maybe not one that I should be doing business with? How should someone tell the good guys from the not so good guys in this recovery world?

Nicola:

Yeah. Well, for me, that goes even for scams in general, when you look at the website this organization has, even though it gets much easier and easier now with AI to do professional websites, if they don’t communicate too much, I think about the company organization, who’s behind it. If you click on their LinkedIn and they don’t have one or it looks dodgy or has 10 followers, for me these are some red flags.

Now again, it can be that you have an amazing person that just started out and it’s just the beginning, right? These are some signs, and I know they can be hard to spot. The other thing is, in general, I would say turn to the places you can trust, which is law enforcement, but might also be your sending bank or the exchange or whatever wallet provider you used.

And if they have a recommendation of who to work with, then that’s also another sign you can take and it’s one of the approaches we do. We put it out there as much as possible that we have the best interest at heart of victims. And that’s why we already successfully work together with police, with exchanges, with banks, and with a lot of nonprofits that support victims and they’re convinced with what we do and that we can make a difference and so they’re happy to work with us. But yeah, that’s as much as clear answer I can give you because as you know, the scammers are creative and they might try to impersonate CYBERA, and it’s not always easy, but just take your time, I would say as a victim, do as much research as you can, but then once you’ve done that, it’s important to act fast.

Ian:

That’s right. Yeah. We’ve even had impersonators for chain Chainalysis.

Nicola:

Yeah, that doesn’t surprise me.

Ian:

Multiple different speeds.

Nicola:

You’re the real deal, right? I’m speaking to the real Ian.

Ian:

That’s right. This is not a fake podcast. This is a real podcast today. And actually, that brings me to my next question, which is actually about deepfakes. So I’ve spent a lot of time over the last year kind of diving into the world of artificial intelligence and the things that you can do, whether it’s building a website or translating audio and video from English to German or another language, it’s incredible. And it can be done with such high quality, low cost, and done quickly that I have to imagine that this is going to change the way that scammers operate. I mean, I would expect it to be more scams, maybe shorter lived scams, because the cost of setting one of these up kind of goes down. You can just quickly build a new website or quickly invent another online persona. I’m curious if you’re starting to see this show up in the data yet, or is it still too early? Are we still in the beta testing phase of artificial intelligence?

Nicola:

Yeah, no, I think we’re way past the beta testing. Well, I’m personally still in a testing phase and I already see the potential. But again, criminals are often unfortunately even a step ahead. So they’re usually some of the first ones who adopt these technologies. And I mean, frankly speaking, in our days at CYBERA, it’s not the majority. We don’t have every day a case where AI is involved. But on the other hand, the victim who reports might most cases not know that, right?

So from stuff I’ve been reading, the people I’ve been talking to, it’s quite obvious that AI is already widely adopted and in use by organized crime. And I mean, we see it, for example, in how these attacks or the social engineering is carried out. You mentioned it, the emails, the phishing mails, that initial message or the text they send with AI, so much easier to make them sound good.

I mean, if you use sometimes AI for your emails, or especially me as a non-native English speaker, obviously. So it’s really amazing how it can help you, but it also unfortunately, amazingly helps the scammer and the criminals, right?

Ian:

That’s right.

Nicola:

And it goes beyond that. So I’m sure you’ve read some of the reports. There has been AI applied in voice kind of cloning. So this will happen much, much more often. I mentioned CEO fraud, but it can be used for a romance scam, pig butchering anything. If you have a recording of a voice of let’s say me or you, you can use that voice and you can call your CEO and say, “Hey, Michael, please make the transfer 50K or something,” right? He wouldn’t fall for that, but that’s already happening and then video the same thing. So the tools the criminals have are becoming much more effective, unfortunately and so it’s even more important we fight back.

Ian:

Well, and I think a lot about that audio case, because obviously I’ve got a few hundred hours of high quality audio for anybody to train on. It’s available in any podcast.

Nicola:

Hope’s you’ve got good security.

Ian:

I just have to tell all my loved ones to ignore a phone call from me asking for money ever. I wish there was a better solution, but that’s all I’ve come up with so far. But we’ve also seen, I think humans, it seems in this day and age, tend to trust video more than they do text and audio. We’re all maybe on the lookout for fake emails.

Even my non-technical friends, they tend to have a skeptical eye towards anything that comes into their Gmail inbox. But when you see a video, I don’t know if it’s a human brain thing, it is hard to imagine that it’s not real, assuming that it’s of reasonably good quality. And with AI, we’ve gotten to this moment where you can create videos of well-known people saying and doing things that they never did.

There was one scam, I think with Mr. Beast recently where it was something like an iPhone giveaway that you could register for, and totally unaffiliated to Mr. Beast. But given his draw and popularity, it drew in, I think millions of people who fell for this. So be safe out there, I think when it comes to AI.

Nicola:

Yeah, no, a hundred percent. Yeah.

Ian:

Be safe. Be skeptical. I guess as we come to the end of the conversation, Nicola, I’m really curious, what’s next for the company? What do you see on the roadmap for the coming year here in 2024 that you’re excited about?

Nicola:

Yeah, a lot of course we’re excited about, as you’ve heard a bit throughout this conversation, we’ve come really a long way basically showing that this information sharing concept in the way that we build it is working. I mean, our collaboration is a big milestone towards that way and so we are excited to build upon that, right? And we have a lot of partnerships that are going to happen in this year, in 2024. And in the end, our business is about scale, so the more victims we can reach, the better. The better for the recovery side of things, but also the better for the prevention side of things. So yeah, we’re very, very excited of course, to just continue and build on that success that we had and now double and triple and 10X that. So as you said, pretty much hopefully everybody soon knows about CYBERA and that we can, together with our partners, really make a big difference against this crazy scam epidemic.

Ian:

Awesome. I am so excited for the partnership and the opportunity to make a dent in these scammers activities and to help as many victims as we can. So thanks so much for the time today, Nicola. I really enjoyed getting to know you.

Nicola:

Likewise Ian, it’s been a great pleasure talking to you.

The post Stopping Pig Butchering and Crypto Scam Epidemic Podcast Ep. 93 appeared first on Chainalysis.

The Rise of Malicious DApps in Web3 with Raz Niv – Ep 92

https://www.chainalysis.com/blog/dapps-in-web3-ep-92/

Episode 92 of the Public Key podcast is here! When we were recording this episode with Raz Niv (Co-founder and CTO, Blockaid) back in December of 2023, the web3 industry was on full alert due to a Ledger supply chain attack. Blockaid was first to break the news and this episode talks about the attack as it unraveled and how they are working to keep web3 secure. 

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 92.

Public Key Episode 92: Protecting Web3 Users from Malicious Transactions and Scams

When  Ian Andrews (CMO, Chainalysis)  was recording this episode with Raz Niv (Co-founder and CTO, Blockaid) back in December of 2023, the web3 industry was on full alert due to a Ledger supply chain attack. Blockaid was first to break the news and this episode talks about the attack as it unraveled and how they are working to keep web3 secure.

In this episode, Raz expresses Blockaid’s mission to provide security tools for web3 builders and protect users from malicious d’apps, wallet drainers, address poisoning  and suspicious transactions and connections, particularly in the realm of scams, phishing, and hacks.

Raz discusses the company’s partnerships with major players in the ecosystem, such as MetaMask and OpenSea, and how their technology is providing real-time indications of potential risks and malicious activity in web3. 

Quote of the episode

“Something that we’re seeing on every integration. So like every new wallet or every dApp or marketplace we’re starting to work with around 10 percent of malicious dApps or like malicious transactions.”  – Raz Niv (Co-founder and CTO, Blockaid)

Minute-by-minute episode breakdown

  • (2:15) – Introduction to Blockaid and the problem of security in Web3
  • (4:05) Raz’s background in Israeli Cyber intelligence units and interest in Web3
  • (6:40) 1 in 10 dApps are malicious, data collection and trends
  • (10:25) – Blockaid’s backend architecture and data sources
  • (12:27) – Ledger supply chain attack and explanation of how similar attacks work
  • (15:50) – Highest fund loss per capita in Web3 than any other industry 
  • (19:45) – Blockaid’s role in MPC wallet architecture
  • (23:02) – Privacy considerations and data collection by Blockaid
  • (26:35) – Address poisoning attack and its dangers
  • (28:44) – Blockaid’s plans to improve detection and expand integrations

Related resources

Check out more resources provided by Chainalysis that perfectly complement this episode of the Public Key.

Speakers on today’s episode

  • Ian Andrews * Host * (Chief Marketing Officer, Chainalysis) 
  • Raz Niv (Co-founder and CTO, Blockaid)

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Our podcasts are for informational purposes only, and are not intended to provide legal, tax, financial, or investment advice. Listeners should consult their own advisors before making these types of decisions. Chainalysis has no responsibility or liability for any decision made or any other acts or omissions in connection with your use of this material.

Chainalysis does not guarantee or warrant the accuracy, completeness, timeliness, suitability or validity of the information in any particular podcast and will not be responsible for any claim attributable to errors, omissions, or other inaccuracies of any part of such material. 

Unless stated otherwise, reference to any specific product or entity does not constitute an endorsement or recommendation by Chainalysis. The views expressed by guests are their own and their appearance on the program does not imply an endorsement of them or any entity they represent. Views and opinions expressed by Chainalysis employees are those of the employees and do not necessarily reflect the views of the company. 

Transcript


Ian:

Hey everyone. Welcome to another episode of Public Key. This is your host, Ian Andrews. Today I’m joined by the co-founder and CTO of a new exciting company called Blockaid, Raz Niv. Raz, welcome to the program.

Raz:

Hey hey, Ian. Thank you for having me. Excited to be here.

Ian:

Well, your company is working on what I view as the number one problem in Web3, which is security around the user experience. At Chainalysis, we monitor closely all the scams that are out there. We see the dollars that unfortunately are going directly from end user wallets into phishing and hacks and wallet drainers, and it’s incredible. The dollars are massive, but the number of victims really, it’s just daunting. I personally can’t see the ecosystem moving forward if we can’t get a handle on this. For people that haven’t heard of Blockaid, maybe we can start just an overview of what is the product that you’re building, what can it offer to people?

Raz:

Yeah, sure. In Blockaid, we provide security tools to Web3 builders in order to stop malicious transactions or malicious connections, and protecting users from scam phishing hacks. So far, we’ve been fortunate to work with some ecosystem giants such as MetaMask, Xerion, Rainbow, OpenSea.

Ian:

Those are massive, massive companies. I would guess that almost everyone in Web3 is using MetaMask, at least as one of maybe a few wallets they use. It’s certainly a primary wallet for most people I talk to who are doing anything in the EVM ecosystem. What’s your relationship with MetaMask like? What is the solution that you’re actually providing there? What would I experience as an end user maybe with using MetaMask?

Raz:

I think as a user you will get an experience that is very much similar to a non-HTTPS site on a regular browser. Basically what we want to do is to indicate to the user that the transaction they’re about to sign at the moment or the DApp they are about to connect to will be a malicious one. From the user perspective, as soon as I’m connecting to a DApp, if this one is flagged as malicious by Blockaid, by our attack, you will get an indication of, hey, this is a malicious site you might don’t want to proceed through.

Then on the transaction phase, so whenever you will be prompted to sign a transaction, we will help your wallet to first of all explain it to you, making sure you understand exactly what are the technical implications of this transaction, but secondly and even more important, giving you some indications of whether this transaction imposes you to any sort of risk. I think, for example, we can help you understand that this transaction is an approval, but more precisely we can help you to understand that the spender that you’re about to approve your funds to is a malicious one.

Ian:

I think that last point you made there that you’re actually helping the user understand what it is that they’re signing is so critical, because often it’s really opaque. My experience, every time I hit approve inside of MetaMask, I sweat a little bit, because you’re never quite clear what the contract is doing and what you’re actually approving by signing it, which I’ve never really understood how we ended up in that position in a Web3 world so I’m grateful that you’re working on this. If I’ve got the latest version of MetaMask on my phone, is Blockaid already there or do I need to take some action as a user to add that capability?

Raz:

Blockaid is there, you should just enable it on your settings, on the experimental settings, and very soon we’re going to be on by default.

Ian:

Amazing. And it’s not just MetaMask. So people that are using Rainbow wallet, which I think is pretty popular in the Solana ecosystem, the Xerion wallet, they’ve all similar setup with all of those as well.

Raz:

Yeah, exactly. 100%. We’re helping these wallets and more that we’ll be able to announce soon.

Ian:

Well, I’d love to hear about your background. Like so many, I think security experts, you’ve come through the Israeli Defense Forces experience. Of all the things in security, what led you to this place of Web3 and brought you into the world of protecting unsuspecting crypto users?

Raz:

So Ido, my co-founder and myself, we were lucky to serve in the Israeli Cyber intelligence units, both in 8,200 and the Prime Minister’s office. So we actually met there the first day of our army service. A couple of more other folks have been with us on this exact same day as well. And I think when you’re handling real operations, so there is a lot to do in regards of making sure you have access to the relevant networks. But I think when you’re looking on a broader thing such as open source intelligence or even a trace of funds, like blockchains and crypto is something that is heard often on these operations because unfortunately, as you know better than us, a lot of these organizations are using blockchains as their infrastructure.

So I guess this was not the first time where Ido and I heard about blockchains. For me, I already heard about it during high school when I did my first degree in applied math, so there were a lot of nerds talking about blockchains. And right after the army, Ido and I knew we’re going to start a company in blockchains in Web3. We were fascinated by the technology, but also by the potential that this ecosystem has. And we started to look for problems. Now, funny enough, we didn’t know that we’re going to solve security, we just looked for general problems to solve.

So there are a lot of people that are finishing their army service from these places, and they were open a cybersecurity cloud company. So we always had this joke on this alumni list of hey, we’re yet another cloud cybersecurity company, but please join us because we have these great VCs and these ninja engineers. And then when we looked on problems in Web3, the first thing that hits us in the face was security. How is different from regular security infrastructure? What is done pre-production? What is done post-production? What is done manually? What is a service? What is a product? And we’re both pretty technical, so we started to dive into it. And we started to Blockaid.

Ian:

Such an amazing story. We’ve had a few founders with similar backgrounds who were lucky enough to work in 8,200 or some of the other branches of the defense forces, and it’s amazing to me the talent and expertise and great companies that are coming out of that experience. I was reading one of your blogs, I think the launch blog actually had this quote, we’ll link to it in the show notes, but you made the point that one in 10 DApps are malicious. First, I’m curious, how do you collect the data to figure that out? I assume this is part of the back end of Blockaid, but I was also wondering what’s the trend line on that, if you have any insight. Is that going up or down as we think over time?

Raz:

I think this is starting that we’re seeing on every integration, so every new wallet or every new DApp or marketplace we’re starting to work with. We’re seeing on their traffic around 10% of malicious DApps or malicious transactions. The way we’re able to get this information is both via the data we’re getting from the customers. So for example, a wallet user is not connecting to a site. This site is sent to us, we’re able to scan it in real time, and we’re seeing of course, a massive decrease as soon as we’re starting to work with them. But this stuff of on the initial integration, when we’re starting, we’re seeing around 10% of the sites that users are browsing it, specifically on consumer wallets. It’s just a constant thing.

Ian:

It’s incredible. Do you get any data about the origination of these malicious sites? One of the things that we’ve noticed in research here at Chainalysis is about 75% of ransomware payments accrue back to actors that are operating out of Russia. So you can categorize ransomware broadly as being a Russian national driven category of cyber security or security issues. Is there a similar Nexus here when it comes to these malicious DApps, or is it more widespread?

Raz:

Actually one of the things we’re doing at Blockaid, rather than just improving our detection engine, is to track and follow these attack groups. Basically we’re gathering information in regards of the signatures of different wallet drainers, both on-chain, the contracts, the addresses, the byte codes they’re using, but also on the web, two sides of things. The size they’re using, the infrastructure they’re using, where they’re hosting their sites. And I think you can see a variety of different types of actors. One of these is, as you mentioned Ian, are these nation-state attackers that are related with the country you mentioned and other countries as well. And you can see they have a much more organized infrastructure and their attacks are very targeted.

We’re seeing this also very aimed to institutional users. But also on the other hand, we’re seeing a lot of groups of whether these are script kiddies or more of a scam as a service type of infrastructure. So actually we’re seeing someone that is developing a wallet drainer, and then they’re selling these wallet drainers to other, and you can see actually a rev share done on-chain. So using their contracts, they are giving you 80% of the profits, 80% of the funds that were drained from the user, and the rest 20% are going to them, to the infrastructure builders. So seeing different sorts and types of groups starting from script kiddies to more of organized development groups to these nation state attackers.

Ian:

Yeah, we’ve seen the similar category of the as a service offering where it’s like, here’s a complete toolkit, you get contracts, you get a website template, you get some domain hosting services like Go, which is just wild to me. It gives me the sense that it’s very hard to think about stopping these malicious DApps from getting deployed because the ability to scale this out horizontally at relatively low cost just means that anybody looking to make a quick dollar off people unfortunately can stand one of these up. It doesn’t require a high bar of technical difficulty, so you’re going to have lots of people coming after it, right?

Raz:

Yeah. I think all in all, it’s an economical play where attackers will keep do it as long as it is profitable for them. For an attacker to dispatch a new domain and just use the same infrastructure, is something that is very easy. This is why, by the way, the usage of a deny list or statically comparing domains or statically comparing addresses is not good enough because for attackers, it is very easy to move their funds to another address or another contract or to host their domain on another domain. But if you’re actually looking on their patterns, you might make it much more harder for them. But for your point, it’s very easy. These things are built as a service. Just type here the address you want the funds to get into, and we’ll do the rest for you.

Ian:

So now this brings me around to, well, how does Blockaid actually work? How can you possibly keep on top of this ever expanding list of malicious apps? What does the backend architecture actually look like?

Raz:

I think when we’re talking about data sources that are relevant in order to train our engine and to keep it being able to handle the greatest and latest type of attacks, we’re looking on mainly three data sources, which are on-chain. So we have a very heavy on-chain infrastructure that we build to index on-chain activities. We have a lot of components on the off-chain side of things. So living on the wallets, you’re seeing both the domain, the Web2 elements of the interaction, but you’re also seeing the Web3 ones. So this is the second one that we’re looking into a lot of. For example, signing these SDKs and trainers of these attackers, their different network operations, their anti [inaudible 00:14:43] techniques, their obfuscations, their evasions.

So this is the second data source. And the third one is data that we’re able to see from our integrations. So as I mentioned before, being able to get this data from our different integrations to see all the different applications that are listed on OpenSea, to see specific trends of consumers goes into different DApps, just gives us a better idea of what is happening at the moment and where the attacks are taking place. I think even just now, before starting recording this show, so we were in the middle of an attack that will take place, I think it’s public now, a lot of people talked about it on Twitter.

But Ledger Connect Wallet SDK was compromised using a supply chain attack, and we were the first one actually to publish a message in regards of it. And we’ve seen a malicious transaction translated from one of… There were a lot of very known sites, for example, hey.xyz of the Lens protocol. So someone just contacted us and said, “Hey, why is hey.xyz flagged as malicious? This might be a false positive.” And then we had a researcher from the other room said, “No, no, it’s an ongoing attack.” And now we know everyone are panicked. But we were able to actually get this from our data, from our engine, without any human in the loop, which is very cool.

Ian:

That’s incredible. So that gives you the machine side of being able to scale to effectively an unlimited number of these malicious DApps being deployed. Talk more about what’s going on with Ledger. So you said there’s a supply chain attack that is affecting Ledger devices. So if I use their hardware wallet, and I would assume updated it to the latest version, I’ve mistakenly installed some malicious code. Is that what’s going on?

Raz:

Not exactly. This attack has nothing to do with the actual Ledger device and the Ledger wallet. I think what it’s done is basically Ledger has a model to embed on that. So similar to how MetaMask has a model for anyone to connect and other wallets, so also Ledger have their own code that is enabling an integration with Ledger. But with this attack, the presence of this code was the problematic thing because we believe there was a supply chain attack and the NPM package was actually compromised. An attacker was able to inject a wallet draining code into this package, and then taking advantage of the majority of the dubs in the ecosystem or importing this package. And then they will just have freeway inside these very known DApps. So there’s nothing to do with the usage of a Ledger wallet, it’s just the presence of this code in any application. So it also basically influences any wallet that interacts with this site, not only Ledger.

Ian:

That sounds incredibly frightening. So for people listening, if you’ve got a hardware Ledger device, you’re fine, but you probably shouldn’t be authorizing any new DApp until there’s a resolution to this issue, because any DApp, even on a legitimate site you’ve interacted with previously, they could have implemented this malicious code just by updating to the latest version of Ledger, unknowingly, accidentally. And if you then authorize that contract by connecting your wallet, you risk having your funds drained. Is that correct?

Raz:

Yeah. Or just use a wallet that uses Blockaid and you’ll be fine.

Ian:

There you go. Do you guys have an implementation with Ledger yet with the hardware wallets or are you working on it?

Raz:

So at the moment, we can talk about the wallets I mentioned earlier, which are MetaMask, Xerion, Rainbow, and OpenSea.

Ian:

Yeah, there we go. All right. So the hardware ones hopefully are coming in the near future. One of the other statistics that I pulled out of one of your blogs, it was a position that Web3 is broken, primarily because the fund loss per capita exceeds any other industry. And this actually was a mind-blowing stat. I spent all day long looking at loss in crypto, we do a lot of analysis in our research, but I hadn’t really contextualized it in that way. For a relatively small industry, we’re far exceeding any other category. Do you think as Blockaid becomes more widely adopted, this is the solution? Just intercepting at the transaction or DApp authorization level, does that solve the majority of that loss that you’re seeing?

Raz:

Yes. So I tell you how I look at things on the ecosystem and why the ratio is so high, as you mentioned. I think coming from a regular traditional security industry, when you’re looking on attacks, whether these are data breaches or code execution on different infrastructures. At the end, let’s assume you’re, I don’t know, a country that wants to make money out of cyber crime. So being able to do it on a regular cybersecurity industry, you have a lot of hops in the way in order to actually be profitable. So you need to create an access to a relevant network to tunnel your data in there, to have an operation going there to get the relevant data, to get this data out, maybe then sell this data or I don’t know, or maybe use this data as credentials to other systems that are enabling you at the end to have assets or to gain any asset value from it.

When you’re looking on our infrastructure, the actual exploitation results in the attacker gaining an immediate gain from it. And I think this is why so many people, and specifically nation-state attackers, are enjoining this ecosystem and the fact that you need to find the vulnerability and to exploit it, but rather than this scam a user, but then you have something profitable in your end. So this chain of gaining value from an exploitation from a scam is something that is very short on our ecosystem. Now to your question in regards of whether a transaction level or a domain level interception solution is the final solution to this problem. In our ecosystem, yes, we’re looking at transactions similar to… So basically transactions are code that is being executed, right? Very similar to how on a modern operating system or on a modern personal computer, when you press a file, it just loads to your computer and it ran.

And I believe every file that is loaded to an important computer is go through a list of inspections, whether it is statical scans on the disk, whether these are scans that are going through on the loading time, whether these are scans that are done on the running time of the actual application. And here it’s very similar. We call it transacting, but we’re actually executing code and this code is actually what holds our assets. So I see no difference in the aspect of whenever a code is executed, we must scan it and make sure there’s nothing harmful of it. Whether this code is emanating from a wallet going through a DApp or running inside of a smart contract, a code that is run should be validated and it should be validated in many layers. And this is exactly what we’re aiming to.

Ian:

How do you think about some of the custody solutions? I think about Fireblocks as an example or Paxos or BitGo, where obviously MetaMask is more of an end-user retail solution, but I would have to imagine that what you’re building ultimately should end up in some of those more institutional wallet management software as well.

Raz:

Yeah. This is a really good question. I can say we are working with some institutional wallets, just can’t expose them at the moment. And I think the protection there is very similar from a user experience perspective. It is also embedded into the flow of the wallet connecting to DApps or transacting. But the attacks there are very more tailor-made and for specific users. Instead of just spray and pray different domains, these attacks that we’re seeing there are more very much targeted to specific users, making sure that the IP that is connecting to them is the IP of the specific victim that they want to attack. And I think these wallets are all exposed to the same risks as MetaMask or other consumer wallets are exposed to. And it’s very important to first of all understand that they are exposed to it, but secondly to understand that these attacks are different and requires different models and algorithmical ways to solve them.

Ian:

How about some of the MPC wallets. Coinbase introduced, I think, a novel solution and I’ve now seen other providers come out with the similar architecture where I self-custody the funds, I control the wallet, but if I were to lose my private key for some reason, my phone gets stolen say, I can go back to Coinbase and they can actually help me effect a recovery. So it’s not quite the despair that one might have if they were using solely MetaMask on their phone, where there’s really no recovery path there. Does Blockaid have a role to play in that MPC wallet architecture?

Raz:

Yeah. I think MPC is a great thing for the ecosystem. It basically enables users to not only rely on their secret phrase among other things that it is enabled. I think the way we like to look on this user stack in the modern blockchain environment is you have the first layer, which is a wallet. This wallet can be an MPC wallet. And I think also it aligns with the type of scams and fraudulent activities and exploitation we’ve seen in the ecosystem.

So I think looking five to 10 years ago, there were a lot of attacks around exchanges that got hacked, like key got compromised then led to user fund to get lost. And I think MPC is a really good solution to these types of breaches and is really great for the ecosystem and I think this is one of the main reasons we’re seeing more and more wallets embedding this solution. But on top of this layer, on top of this, we like to call it an access layer. You have a wallet, you are now accessible to the chain, you’re able to sign things and you’re also able to split the signature process among different variants. You mentioned…

Ian:

Someone losing their phone and then being able to recover.

Raz:

Yeah, social recovery. Exactly. I just forget word, sorry. So it enables us social recovery among other things. But the layer on top of it, the data layer, the application layer, this is something that is not the expertise of a wallet to solve because we talked about them giving you a nice access to the chain and also a way to have more complicated signature flows. But I guess to have this expertise of data and to be able to observe so many data, which some of it prevalent to specific wallets and protect users from, okay, so I’m able to sign and I’m able to be the only one that is able of signing, but what am I signing on? Is what I’m signing is risky? Should I go on and proceed? And this is the second layer and exactly what we’re aiming to solve as Blockaid.

Ian:

I’m curious, did you ever consider building your own wallet?

Raz:

I think it’s not something we aim to do in the near term. I think it’s a different type of company, it’s a different DNA, and we’re the complementary part of the wallet.

Ian:

One of the interesting attacks in the last year you actually mentioned at one of your blogs was when Vitalik’s Twitter account got hacked and he posted… Not he, but the attacker posted a link encouraging people to go visit a site to mint the future, I think was the tagline in the tweet. But obviously it was a malicious site. Talk about how your technology would pick something up like that. Because I get the sense that you’re detecting these malicious DApps upstream of users actually being impacted and funds being lost potentially. How does that actually play out in a case like the Vitalik attack?

Raz:

Just to give some context around this attack, Vitalik Twitter account was hacked and was used in order to publish a group of different wallet drainers. A lot of people of course, trusting Vitalik went in these sites and started to sign different transaction that resulted in a major loss of assets from them. As Blockaid, we were able to detect the exact same group of sites more than 24 hours before they were even published or the first user even connected to them. And the way we’re able of doing it, it is because… So we talked before that we have about us having three different data sources. I think on this case, we’re scanning the entire internet looking for threats, and then we’re able to extract transactions from these sites without requiring users to actually go into them.

So basically we’re simulating the sites on our side and are able to extract all the possible transactions. These are not really transactions, they just like a transaction that are suggested to a user that is connected to the site. So we’re taking these transactions and evaluate them. Also, we’re looking, the SDK that was used is this an SDK we’re very much familiar with from other types of attacks. So we’re able to basically indicate all the words that are working with us and immediately mitigate it on our engine so every wallet that went through these sites was protected, both on the domain level while connecting to these sites, but also on the transaction level while transacting.

Ian:

And is that typical? As new malicious DApps are being launched, that automated protection is happening in the background before even the first funds are being stolen, you’re able to block those transactions, warn users if they come in contact with the DApp?

Raz:

Yeah. This is something that is constantly done by our backends. We’re also combining this with the data that we’re seeing via the different integrations we have. For example, let’s assume we scanned a site and it was flagged to be benign, but then we’re seeing a transaction that is originate from this site and it is the malicious one, it is automatically prompted for us to check whether there is a front-end that is compromised, similar to what happened with Ledger today. So it’s a combination of these things, but we’re aiming to basically indicate the user before even connecting to the site that there is a malicious activity that is related with it. We want to indicate the user as soon as possible on their flow that there is something malicious going on.

Ian:

I am curious about another topic. I imagine people listening here going, “Wow, this sounds amazing. We need something like this.” But you’re also collecting a lot of data, and I know that many people who are using cryptocurrency are privacy conscious. They don’t want information about the places they’re connecting to or funds that they’re sending being shared. In a lot of cases, I think the reason why they’re using cryptocurrency at all is that privacy layer. What should people know about how you’re collecting usage data from individual wallets?

Raz:

This is a great question. I think what we’re doing is very similar to how a node provider behaves. So basically as a user that uses a wallet, there are no external data that is sent that is not sent to a node. So basically you have the same level of privacy of using a node provider.

Ian:

So for people not familiar, a node provider, say someone like Alchemy, you’re connecting, you’re going to be sending a transaction which ultimately ends up on-chain so it’s public data anyway, but you’re not giving up things like your IP address or your physical location or browsing history from the built-in browser in the wallet or something like that. None of that data ends up with Blockaid.

Raz:

Exactly, yeah. We like to say that node providers are similar to the cloud infrastructure of blockchains. Yeah, exactly.

Ian:

Yeah, that’s great. When you look across the security landscape, we’ve obviously paid particular attention to hacks of DeFi protocols. Not all of these are malicious transaction related, right? There’s been things like private key compromise that we saw on the Axie Infinity Ronin Bridge hack last year. We’ve seen things like BadgerDAO suffered an attack that was really Web2 related, I think, where their Cloudflare, the provider of their CDN network, was compromised and that allowed people to manipulate code on the front end to the BadgerDAO site. And then obviously we see things like flash loan attacks. Are those on the roadmap? Are they ever in scope for Blockaid or do you see those as another category of problem that other tools are more appropriate to solve?

Raz:

I think you mentioned the Ronin hack, a key compromised, but the cool thing is they also resulted in a transaction that sent on-chain. Now, whether this transaction should be scanned on the wallet level or on the protocol level, the smart contract level, it’s an implementation detail, but it is all a result of a transaction that is sent. On the BadgerDAO example that you gave, which is essentially like a case that we’re solving even today. The front end was actually hacked and the incident was really more on the Web2 area of things, but it also resulted on users transacting a malicious transaction. So it could have been prevented on the transaction level.

The common thing that all of these attacks have is that eventually, in order to actually trigger the exploit, they require transactions to be sent, and if you’re able to scan this transaction, it can be done on different layers, so you’ll be able to prevent them. It’s similar to how a credit card company, a key can be stolen, but the final result would be a transaction that is made. So if you’re able to analyze this transaction and indicate, “Hey, this transaction behaves differently from what I know,” you’ll be able to also stop it. So it’s similar here. Everything results in a transaction and if you’re able to stop this transaction and to scan it on the relevant place, you’ll be able to just prevent this attack, whether it was a result of more of keys that got compromised front and it was compromised, etc.

Ian:

Yeah. Amazing. And when I look across the crypto ecosystem, we’ve seen obviously a rise of DeFi platforms in terms of transaction volume over the last few years, but there’s still, I would say a significant portion of people that really only interact with some of the more centralized platforms like exchanges. How do you think about that layer of the ecosystem? Is there a product that you develop potentially for exchanges to be monitoring their infrastructure or is that out of scope?

Raz:

So I think anyone that is transacting or have any form of transacting, we can help to them. Whether it is an actual Web3 transaction or a DeFi transaction or just a transfer of funds. But basically we’re aiming to help anyone that is exacting or even receiving funds. For example, we haven’t talked about it, but also we’re seeing a lot of attackers shifting from trying to make you sign malicious transaction to actually send you some stuff to make you interact with malicious components. It can be an airdrop to your wallet that includes some malicious code, it can be a transaction like what is called address poisoning, like poisoning your wallet with different addresses. So exchanges are also exposed to this. So anyone that has any form of sending or receiving transaction can gain from integrating with Blockaid.

Ian:

Talk more about that address poisoning attack. This is a flavor of cyber attack that I don’t think gets talked about as much, but seems very, very dangerous.

Raz:

I think this attack is included on a new attack vector that we’re calling incoming transactions. So up until now, attackers try to just straightforward getting a malicious transaction to be signed by a victim, whether these are from a front end that is compromised or from a site that is impersonating another site, just like implementing another on-chain mechanism to get the funds to, and we’re seeing some sort of a shift into sending you transactions. And this new vector also includes attackers that are trying to send you transactions from addresses that are look similar to other addresses on your portfolio in order for you to copy these addresses and to interact with them. So a lot of indexers and also a lot of wallets are showing you only the first and last four bytes or three bytes of the address so for attacker, it’s very easy to create these type of addresses, just a difference in the middle. So attackers are using this effect and trying to get you to, in the end, interact with these types of addresses.

Ian:

Be careful what you click on is the message, or use a wallet that’s got Blockaid, I guess would be the other solution here. Now excitingly, you and your co-founder have recently announced you’ve raised $33 million so I would imagine that there’s significant growth plans in the future. What’s on the horizon? As we look out to the next year, what should we expect from Blockaid?

Raz:

At a moment we understand exactly what is the problem we’re solving, we’re understanding the value that we’re bringing to our customers, but also we want to make sure that we’re able to improve and to detect these latest and greatest types of attacks. I mentioned earlier that we’re seeing what we do similar somehow to an antivirus on a blockchain environment. And for antivirus to be the best, it should always have these very fast feedback loops, being able to detect this new type of attacks or understanding there are new technologies that should not be flagged as malicious because they’re doing some weird stuff. So there’s a lot of work to do in order to improve our detection engine. We’re going to also announce a couple of more types of integrations and just keep building and protecting as end users as possible.

Ian:

That sounds exciting, Raz. We’re going to keep a close eye on the work you’re doing at Blockaid. Thanks so much for joining us on the podcast today. I really enjoyed the conversation.

Raz:

Thank you for having me.

The post The Rise of Malicious DApps in Web3 with Raz Niv – Ep 92 appeared first on Chainalysis.

Spot Bitcoin ETFs with Jeff Billingham – Ep. 91

https://www.chainalysis.com/blog/spot-bitcoin-etfs-ep-91/

Episode 91 of the Public Key podcast is here.  The first Spot Bitcoin ETFs have been approved by the Securities Exchange Commission (SEC) in what is a watershed moment for crypto. We had the opportunity to speak to Jeff Billingham, who leads Strategic Initiatives at Chainalysis, who has been following these ETF submissions for almost a decade. 

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 91.

Public Key Episode 91: Decade long process of SEC approving first Spot Bitcoin ETF

Hooray !! Spot Bitcoin ETFs are finally approved by the Securities Exchange Commission (SEC) in what is being called a watershed moment for crypto. Now what happens?

In this episode, Ian Andrews (CMO, Chainalysis) sits down with Jeffrey Billingham (Strategic Initiatives, Chainalysis) who has been watching the Bitcoin ETF situation unfold since the Winklevoss twins first filed for a bitcoin (BTC) exchange-traded fund (ETF) in July 2013.

Jeff and Ian delve into the significance of these ETFs, explaining how they simplify access to bitcoin as an asset class and eliminate the technological hurdles of owning and transacting with cryptocurrency.

Jeff also explores the difference between spot and futures ETFs, the role of custodians and authorized participants, and the impact of surveillance-sharing agreements on market manipulation concerns.

They cover the immediate impact of these ETFs on the trading volume of Bitcoin and hypothesize on the future of ETFs and the potential for asset tokenization.

Quote of the episode

“That surveillance sharing agreement was essentially a way to tell the SEC, hey, we’re going above and beyond.. and we’re sort of working with the custodian and listing exchange to share, you know, information that does help either uncover market manipulation or, you know, hopefully prevent that kind of market manipulation and fraud from from occurring” – Jeffrey Billingham (Strategic Initiatives, Chainalysis)

Minute-by-minute episode breakdown

  • (2:13) Overview of the launch of Bitcoin ETFs and significant trade volume
  • (4:43) – Explanation of what an ETF is and its significance of it being a Spot Bitcoin ETF
  • (9:20) – Understanding ETF stakeholders like authorized participants, sponsors and custodians 
  • (11:40) – Impact of cash model for ETF transactions and hope for future in-kind transactions
  • (15:24) – Regulatory concerns about market manipulation and fraud
  • (18:23) – Surveillance-sharing agreements and increased transparency to secure SEC approvals
  • (20:51) – Maturation of crypto as an asset class and its implications on original Bitcoin ethos
  • (24:05) – Potential influence of ETFs on real-world asset tokenization 
  • (26:18) – Expectations for the future of ETFs

Related resources

Check out more resources provided by Chainalysis that perfectly complement this episode of the Public Key.

Speakers on today’s episode

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Our podcasts are for informational purposes only, and are not intended to provide legal, tax, financial, or investment advice. Listeners should consult their own advisors before making these types of decisions. Chainalysis has no responsibility or liability for any decision made or any other acts or omissions in connection with your use of this material.

Chainalysis does not guarantee or warrant the accuracy, completeness, timeliness, suitability or validity of the information in any particular podcast and will not be responsible for any claim attributable to errors, omissions, or other inaccuracies of any part of such material. 

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Transcript

Ian:

Hey, everyone. Welcome to yet another episode of Public Key. This is your host, Ian Andrews. Today I’m joined by my colleague and friend Jeff Billingham. Jeff, welcome to the program.

Jeff:

Thank you so much, Ian. Great to be here.

Ian:

Well, I think all of crypto is excited to cover the topic that we’ve got today, which is the Bitcoin ETFs. Let’s start at the beginning. We saw these launch just a day prior to when we’re recording, which is on Friday, January 12th. What’s happened in the last day? I know there’s been a ton of movement, transaction volume in and out of these things. Maybe start with a quick summary there for us.

Jeff:

Yeah, sure. So I think this was a real watershed moment for the crypto industry, and in terms of the market response, I think we’ve seen over $4 1/2 billion worth of U.S. dollar trade volume go into all of the approved ETFs. So I think BlackRock’s ETF made up over a billion of that volume and that’s either the second highest or I think one of the highest debut volumes for a new ETF, so amazing work to see there. Grayscale was a conversion, so their previously live Bitcoin Trust, which converted into a spot ETF, so they saw volumes of something over $2 billion worth. So a considerable amount of first-day volume across, I think, all 11 ETFs that were approved.

Ian:

It’s something that I think people who follow the crypto industry closely have been anticipating for months, in some cases, years. I read the other day that the first application for one of these was submitted to the SEC way back in 2013, so a decade in the making. Maybe for people that aren’t following quite as closely, what is an ETF and why is this such a big deal?

Jeff:

Yeah, I have really fond memories, I will say, of the Winklevoss Trust ETF getting filed back in the middle of 2013. So it’s been a long, long road since then. But ETFs, exchange-traded funds, they’re derivative products that probably most people are familiar with through their retail brokerage. Instead of owning the underlying security or looking at the stock of a particular company, you can look at an ETF and look at it thematically and say, “What does this ETF cover?” The financial institutions that manage the construction and maintenance of the ETF are the ones who are responsible with actually owning the underlying securities. But you can select an ETF or any retail investor can select an ETF that covers broad themes like energy or healthcare or things like that. So a spot Bitcoin ETF is just a new way to own access to the price exposure of bitcoin without actually having to own the underlying bitcoin itself.

Ian:

Yeah, I think about very common in retirement portfolios in the United States, you see people buying the iShares, S&P ETF, which is effectively allows you to get a slice of every company that’s a component of the ETF. You don’t have to do all the legwork to go and buy the shares of those companies directly. You buy this index product, and it automatically rebalances as people come into or leave the S&P 500 index. It’s a really simple thing. Generally, it’s very low fee loads versus maybe directly trading those assets, so I think about it as a big simplification. But the point you just made in the world of crypto, the simplification is magnified here because in all the talk about the ETFs, no one once has said, “Okay, so this is how you get your crypto wallet, and then you need-

Jeff:

Right.

Ian:

… to fund your wallet this way, and then you need to send something to this address,” all of that goes away. So I think there’s some huge power here for the common individual that’s interested in bitcoin as an asset class but has maybe felt turned off by the technological hurdle to get into the space.

Jeff:

Yeah, I think there’s also just the ease with which you can see this up against all of your other investments, right?

Ian:

Mm-hmm.

Jeff:

For crypto nerds, I’ve been in this for a decade now, and I have no problem having my wallets and working with exchanges and also having my investments elsewhere. But for other people who want to invest in it as an asset class, to see it right alongside all of the other money market funds and ETFs and single stock equities or rates products that you own within your portfolio, I think that really changes the game as opposed to having this little island of crypto-owned assets at exchanges. So it’s a whole different perspective on investing in crypto.

Ian:

A number of people I’ve talked to have been excited about the opportunity to take funds that are in their retirement account. So you and I are both in the U.S., people have either a 401k at their company or maybe they’ve rolled that over into an IRA. Just to be able to very easily allocate some portion of those long-term holdings into Bitcoin without having to go through the machinations of withdrawing funds from the account or finding an IRA provider that allows you to somehow directly acquire digital assets, that whole complexity and headache just goes away in this model, right?

Jeff:

Totally. It totally goes away. Listen, I’m also a huge proponent of owning your own crypto. I think these things are not mutually exclusive, though. You can use these products as a way to diversify an overall portfolio, and also I would continue to encourage people to learn how to own and acquire crypto, but it’s a very easy thing to do for those who maybe didn’t have the crypto bug five, 10 years ago.

Ian:

Yeah, one step at a time.

Jeff:

One step at a time.

Ian:

Now maybe if we can drill into some of the technical details, again, for folks that don’t live and breathe this stuff like you and I do, so this is a spot ETF, which is different because we’ve actually had a futures ETF for a long time. Can you maybe explain the difference between futures and spot and why this spot ETF that’s just been made available is meaningfully different?

Jeff:

Yeah. Sure. So if you think about an ETF, it is the simplification, as you said, of owning exposure to a certain class of products or a certain pool of assets. The spot futures ETF, it’s an ETF that’s based on the futures contracts of Bitcoin. So there are futures markets in the U.S. for bitcoin and the spot futures ETFs are based off of those contracts. It’s not based off of the sole primary asset of bitcoin. So the spot bitcoin ETFs, the reason these are new is they’re not referencing the futures markets contracts. They’re referencing the primary asset of bitcoin itself in this case.

Ian:

Does that mean that when you buy a share in the ETF the price of the underlying asset is somehow different between the spot and the futures ETF products. Break this down for the average person. Does this really matter?

Jeff:

Well, this gets into the discussion about why the ETF for futures was approved versus the spot ETF not getting approved, because the reality is they’re referencing a market that is so closely correlated. But in terms of the construction of the spot Bitcoin ETF, the participants that are managing this ETF are actually purchasing bitcoin in this case. It has nothing to do with purchasing or holding futures contracts for bitcoin, it has everything to do with actually holding bitcoin as a primary asset. You’ll probably hear, and a lot of listeners maybe have heard people relate this to the gold ETF, right? This is akin to that. The way that gold ETFs were started in, I think, sometime in the mid-aughts, that’s all about having custodians actually hold gold for the benefit of ETF holders. So it’s the same thing in this case, the spot bitcoin ETF is referencing actual, quote, unquote, “physical bitcoin” that is held by custodians in this case, and nothing to do with the futures contracts.

Ian:

Physical digital bitcoin.

Jeff:

Correct. I never quite know, we talk about physical delivery in bitcoin, and we all know that that’s not really a thing. But holding bitcoin is really the change that we see that I think is really, really, really exciting about spot Bitcoin ETFs.

Ian:

Well, and I agree because this is a number of players that some of whom have been involved in the crypto ecosystem for some time, like Fidelity, I think they’ve been early amongst the traditional finance players being proponents of digital assets. But others like BlackRock who you mentioned earlier and seemed to be having huge success with the ETF, I would call a recent convert. They had not been attending all the Bitcoin Conferences for the last decade, but suddenly, they’re now a major player in the sector, and they’re actually having to acquire the asset directly. They’re now involved.

Jeff:

Yeah. So I will say that the team at BlackRock has been there for a very long time. They’ve been working on this for years and years and years, so I’ll give credit to where credit’s due. A lot of these institutions that maybe the headlines state that they’re being cautious, they’re anti-bitcoin, what have you, there have been teams that have been dedicated to this for probably close to a decade at this point.

Ian:

Wow.

Jeff:

So kudos to them for getting this across the line and doing all the evangelizing that we at Chainalysis do for the traditional financial markets. So I think it’s important to remember also that BlackRock is the sponsor in this case. For the vast majority of the ETFs involved, the actual custodian, the person who’s actually, or the company, the entity that’s actually holding the bitcoin for the benefit of the ultimate shareholders of the ETF is actually, in most cases for all the ETFs, it’s Coinbase is the crypto custodian; whereas, BlackRock is the sponsor and the manager of the ETF.

Ian:

Interesting. So explain what that custodian role does. When I buy a share of the BlackRock ETF, BlackRock then instructs the custodian to go out and actually purchase the underlying asset, in this case, bitcoins, and they then hold them for the benefit of BlackRock as long as I’m holding those shares. Is that what’s happening behind the scenes?

Jeff:

It’s like a balancing act. It’s a balancing act between the end investors like you and me or any other consumers who might go through Schwab or their retail brokerage account to purchase these. There always has to be a balance between how much bitcoin is actually held and the shares that are representing that ownership. So that fun role is actually played by what we call authorized participants in ETFs. So these are typically broker dealers who are able to go to the sponsor.

In this case, we’re talking about BlackRock, but any of these sponsors, VanEck, Grayscale, Fidelity, and these authorized participants will say, “Hey, I’m looking to either create more shares of the ETF or redeem shares of the ETF, based on how the market is moving.” If that imbalance is occurring, those authorized participants will choose to redeem or create new shares based on where the market is. So they are the ones who are in charge with keeping everything in balance. Whereas, BlackRock will then work with and instruct Coinbase to make sure that the Bitcoin that is owned for the benefit of the ETF is in check with the number of outstanding shares that those authorized participants manage in the market.

Ian:

Interesting. I’ve read in some of the press reports that Goldman Sachs and I think J.P. Morgan are two of the more notable players that have signed up to be these authorized participants. Is that the role that they’re playing?

Jeff:

Yeah. The ones that I’ve read about, I know Jane Street’s involved, Virtus is involved, the broker dealer at J.P. Is involved. I think one of the late stage of speed bumps for this with the SEC was actually a conversation about whether or not the ETS were going to be accepting in-kind transactions. So that’s to say that balancing act, as it was originally proposed, the balancing act would’ve been actually transacting with bitcoin, so receiving bitcoin for shares or shares for bitcoin. What ended up getting passed was a cash model instead.

So that cash model, just as a result of a lot of the ongoing concern and regulatory lack of clarity as to whether or not broker dealers can actually hold and trade bitcoin, the idea here is let Coinbase or the listed named crypto custodian manage the actual bitcoin holdings and have these authorized participants at BlackRock move cash that is representative of the value of that bitcoin. I’m hopeful that we get in-kind transactions, redemptions and creation models going forward, but what that did was actually open the door for banks to be authorized participants in this space as well. So I think the trade-off is you have more legitimate, well-regulated financial institutions who are able to become an authorized participant and a broker dealer for these markets.

Ian:

Interesting. I’m glad you explained that because I’ve been hearing this in-kind versus cash comparisons, and I didn’t totally understand the difference. So what I think you said is because of it being cash rather than in-kind, meaning in crypto, banks that would otherwise probably be restricted from holding and transacting in cryptocurrency directly suddenly are able to act as these authorized participants managing the market for the ETF transactional volume. Is that right?

Jeff:

Exactly. Exactly.

Ian:

Interesting.

Jeff:

So in-kind transactions always happen, for those other ETFs that we discussed that might be a basket of underlying securities-

Ian:

Right.

Jeff:

… all those broker dealers, they are registered and they’re able to legally actually transact with those securities and with cash between themselves. Whereas, in this case, the holding and custody of crypto for broker dealers is still a gray spot. So the cash prepay model that was instituted at the last minute, I would say around November, December, we saw all of the sponsors start to refile with a cash model instead of an in-kind model does allow for just more financial institutions to participate as authorized participants.

Ian:

What would be the process to add in-kind? How do these things evolve over time? Is that a whole new approval cycle? Is there an update model once they’ve been in market? It seems like things are largely working reasonably well. How has this unfolded historically with other ETF products?

Jeff:

Yeah, it’s a good question because I don’t know, or I can’t think of an ETF where it was a regulatory gray area as to whether or not broker dealers could actually hold it and transact with it. So there’s a lack of precedence when it comes to when we might see in-kind transactions happen for a spot bitcoin ETF or a spot crypto ETF. But I’m hopeful that the regulatory discussions around concerns about market manipulation and fraud and all that can be… we can work through those to get some clarity as to whether or not broker dealers can actually hold crypto right alongside any precious metal or any kind of security that they might hold on their books.

Ian:

Yeah. Talk a little bit about market manipulation, because this had been the long-held objection, I think, that was registered by the SEC in rejecting previous applications was the fact that there was maybe no central clearinghouse or just the fact that in certain venues, bitcoin was very lightly traded and therefore, more easily manipulatable than say, other things that underpinned similar ETF products. How did that get resolved in this case where we finally got the approval to happen?

Jeff:

Yeah. So this is where I think the work that Grayscale has been doing has been really consequential for the decision-making in all of the spot ETF applications that we’ve seen come to market just in the last couple of days because they had their trust, which they put in an application to convert that trust, which was denied by the SEC for all those reasons that you mentioned; fraud, market manipulation, concern around what’s actually happening in the crypto markets and inability to understand the dimensions of fraud that might plague this market. In the meantime, they had, over the course of the last several years, approved those futures ETFs.

So the SEC ultimately, through a bunch of court actions between the SEC and Grayscale, ultimately decided not to appeal a decision that was made by the D.C. Court of Appeals that the SEC was, quote, unquote, “arbitrary and capricious” in denying Grayscale’s application to convert their trust to an ETF, primarily because that court of appeals said, “Hey, SEC, your failure to explain why you disagree with Grayscale’s assertion that the spot ETFs of the spot markets and the futures markets are so closely correlated, why would you approve futures ETFs and deny a spot ETF?” Because they were not able to back that assertion up, the court of appeals sided with Grayscale in that case. I think it was towards the end of August or beginning of September of 2023 when it was clear that the SEC was not going to appeal that, that’s when I think a lot of the market that has been watching this for the last several years or several months felt really positive about the prospect of these ETF applications being approved.

Ian:

That all makes sense. I guess thinking a little bit more about this market surveillance thing, I think about rules in equities markets. If you’re a publicly-traded company, it’s very tightly controlled. Insiders aren’t allowed to make public statements except in very specific ways and during specific periods of the quarter, like an earnings call. In Bitcoin, there’s no company, but there are a lot of insiders. There’s people who have lots of accumulated information either through historical knowledge or relationships, and Bitcoin’s not traded on a single or even a small number of exchanges. It’s available widely, but there’s a number of market makers that I think have wired all those trading venues together that probably enjoy advantaged views, if I had to guess, and that’s just speculation on my part. But how then do you get to a similar level of confidence that there isn’t market manipulation and demonstrate that on an ongoing basis? I have to imagine that was a prerequisite for any of these applications getting approved, right?

Jeff:

Yeah. Well, so another novel bit to these applications that I think BlackRock actually really brought to this conversation was the idea of surveillance-sharing agreements, which is not a novel concept within the rest of finance, but they brought a surveillance sharing agreement to their ETF application, which is essentially a way to say, “Hey, there’s an agreement between the listing exchange,” in their case it was Nasdaq, “and the Bitcoin custodian,” the entity that’s responsible for making sure that the Bitcoin that is owned by the ETF is actually safe and secure.

That surveillance sharing agreement was essentially a way to tell the SEC, “Hey, we’re going above and beyond, and we’re working with the custodian of the listing exchange to share information that does help either uncover market manipulation or hopefully, prevent that kind of market manipulation and fraud from occurring.” Their ability to share information about Providence and other details that are private between those two parties was, I think, a great way… most of the other applications followed suit really quickly on creating a surveillance-sharing agreement inside of their applications as well. So I think that’s a really good sign and provided a lot of coverage above and beyond what the SEC was really concerned about in previous application rejections.

Ian:

Yeah, that’s terrific. It seems like it could have some really positive long-term implications for the overall market, and I guess it’s probably similar to how FINRA works in the equities world. They do perform a similar kind of information sharing between broker-dealers and exchanges, I think, if I’m understanding that concept.

Jeff:

Yeah, well, it all comes down to ultimately, it is KYC conversations, right? You have to make sure that in the case of FINRA, they’re licensing broker-dealers or an ETF setup where you’re relying on the KYC and anti-fraud, anti-market manipulation practices that a custodian manages, relying on that in order to make sure that the actual underlying of these ETFs is solid and safe and secure. So I think having that in writing and having those agreements detailed out with the SEC does go a long way to providing a best practice to get people much more clear on what the real risks are when you’re actually investing in a spot Bitcoin ETF.

Ian:

Yeah. I’m incredibly excited about it ’cause I think it’s the first really good piece of news that the crypto industry has had maybe in the last 18 months, and so I’m treating it as a harbinger of good things to come in 2024. But I do have to recognize the original crypto ethos was so much about defining your own destiny, not your keys, not your crypto, “I’m going to eliminate all the middlemen in the financial system. I’m going to directly hold all of my financial worth, and I’m going to interact with the individuals that I want to interact with directly without having to suffer the overhead of the existing financial system and the risks.” This seems like the absolute reverse of that ethos. We’ve taken bitcoin and turned it into a very classic financial instrument with layers of middlemen. As someone that’s been in the space for a long time and I think is very pro-crypto, generally, how do you feel about that?

Jeff:

I love the idea that this is harbinger of good things to come. I’m really excited for this year for the crypto markets. My personal ethos for the year is yes, and, so I take that and apply it here, which is to say I think that bitcoin and crypto, there are aspects and characteristics and possibilities that have absolutely nothing to do with looking at it as a financial tool or a financial instrument or an asset class. But nonetheless, there are characteristics of crypto that absolutely behave like something that at least for me, I would want in my portfolio. So I think this is very, very, very helpful.

This is a great opportunity to look at the use case, if you will, of crypto, of crypto as an asset class. This is the type of industry support and industry infrastructure that we need to build out that use case for a whole class of investors who have really probably heard about crypto and thought, “This is for tinfoil hat, crazy anarchists.” This is a very, very, very different conversation. So I think that maturation of crypto as an asset class, this is a huge, huge moment to be excited about. All of the other use cases of crypto aren’t mutually exclusive to that, right?

Ian:

Yeah.

Jeff:

Like the tokenization conversations, stablecoin conversations, everything that’s happening in DeFi, the world of art, the world of NFTs, all of that, I think, is still absolutely relevant and can grow right alongside infrastructure that supports crypto as a diversifying asset in a portfolio along with other boring TradFi assets.

Ian:

We obviously work with almost all of the crypto businesses out there. Do you think the existence of the ETFs actually pulls some of the transaction activity and direct business that had been happening at those centralized exchanges, or did the ETFs primarily draw in money that was not… they were invested elsewhere? Is this going to be newcomers to the space mostly? What do you think?

Jeff:

Yeah, I am probably not the one to try to read the tea leaves here, but I think there’s going to be a huge push for more and better enterprise-ready financial institution-ready infrastructure that does support the transactions of managing bitcoin on behalf of all these ETFs. There’s still going to be a lot of movement there based on the U.S. dollar inflows to all these ETFs. So there’s still a lot of, I’d expect, transaction activity, but I don’t think this is necessarily taking anything away from anybody who wants to open a Coinbase account. It’s really two very different things. As somebody who just bought some of the spot bitcoin ETF yesterday and as somebody who has crypto on exchanges, those two experiences and I guess those two activities represent something very, very different to me that I want to participate in both. So I can only hope that these spot ETFs bring in maybe new investors who haven’t taken the time to download a wallet or open an account at an exchange. Maybe they will follow suit with doing that after having invested in some of these ETFs.

Ian:

Yeah, that’s my bet, and I have no inside information either, so it’s pure speculation. But just watching the news coverage this week, it seems likely that you’re going to draw in a lot of new people who find the path to involvement so much simplified that it’s like, “Great, this is terrific. It’s exactly what I wanted to do.” May not totally understand even what Bitcoin is at the point of inception, but it draws them into the space and then grows from there.

Jeff:

Right. Right.

Ian:

I’m curious about a related topic. I’ve been hearing nonstop this drumbeat around real-world asset tokenization. I’m curious, does the ETF accelerate that? What effect do you think it’ll have on some of these asset tokenization projects we’ve been hearing about?

Jeff:

That’s a good question. I think to the extent that it provides investors, again, who have maybe looked at all of the different use cases in crypto with a degree of cynicism or maybe a degree of fatigue because we’ve been talking about tokenization for a very long time, even people within crypto have said, “Oh, when is this taking off?” I know that there is a lot of anxiety around the inertia of the tokenization conversation happening, but I think ETFs will again provide that level of professionalization and maturation of crypto in general that might allow investors to take another look at or take another consideration of what are the tenants of tokenization for other financial products?

It also opens the door to maybe consider if you want to take a really broad or a long-term view, how might other ETFs be constructed that are not just solely about bitcoin or solely about Ether. What kind of underlying basket of tokens, be they stablecoins or anything else, what might that actually entail? So hopefully there’ll be maybe a renewed interest and optimism for the thought experiments that would go into looking at or considering ETFs that might represent crypto assets that are not just simply the most classic ones that we on the market know about.

Ian:

Yeah. Yeah, it’s going to be fun to watch. Well, Jeff, this has been fantastic. Just to wrap up, walk us through what happens next. So as we’re recording this, we got 11 approvals yesterday or two days ago, and then yesterday they actually started trading massive inflows. What can we expect next week and beyond?

Jeff:

Yeah, I think immediately there is going to be, I think, a big push on fees. You have a number of ETFs that are out there that are offering more or less the same thing, so I’m excited to see how these different sponsors diversify their offering by either way of minimizing their costs or getting innovative with their sales and distribution channels on this. I think you’ll definitely see a little bit more of that variation like we were talking about with tokenization. Grayscale just filed another application for a covered call Bitcoin ETF. They did that yesterday, which is really interesting. That would put a new flavor of options contracts into the investment goals of that particular ETF. I think Ark and BlackRock have both filed Ether spot ETFs as well. So we’ll see, I think, a lot more variation, and I’m excited to see what the decisions are on those.

In the long run, I think we’ll see a real big push for better infrastructure and better data too. You’ve got a lot more people who need to be confident that they can move and transfer Bitcoin and know where it’s coming from and know where it’s going to and be certain that they’re not associated with any kind of illicit activity, and people will look for better data. People will want to understand the markets more and more and more as they allocate a small percentage of their overall net worth into this asset class. So who’s using it? What region of the world is using it? Why? What are the use cases? Where is it growing? Those are all questions that data providers like us, I’m not [inaudible 00:35:35] too much for Chainalysis here, but those are the kinds of themes that I think there’s going to be a lot of focus on how do you answer those questions with data for investors and potential investors.

Ian:

That’s right. All those questions, that’s exactly what we do here at Chainalysis.

Jeff:

That’s right.

Ian:

If you’re out there listening and you need a little bit of help, you know how to find us. Jeff, this has been fantastic.

Jeff:

For sure.

Ian:

Thanks so much for joining us fresh off vacation and diving into this topic, and we’ll have to have you back on the show soon.

Jeff:

Awesome. Thanks so much, Ian.

The post Spot Bitcoin ETFs with Jeff Billingham – Ep. 91 appeared first on Chainalysis.

Crypto Hedge Funds with Henri Arslanian – Ep. 90

https://www.chainalysis.com/blog/crypto-hedge-funds-with-henri-arslanian-ep-90/

Episode 90 of the Public Key podcast is starting the New Year with a Bang. In this episode, media personality and crypto thought leader, Henri Arslanian (Co-Founder and Managing Partner, Nine Blocks Capital Management) talks about his new crypto hedge fund and the licensing process in Dubai, while evaluating his infamous 2023 Crypto predictions. 

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 90.

Public Key Episode 90: The Rise of Dubai as a Global Crypto Hub and Hedge Fund Licensing

Has Dubai’s crypto regulatory licensing process become the most stringent in the world?

In this episode,  Ian Andrews (CMO, Chainalysis) gets the answer from crypto media personality and thought leader, Henri Arslanian (Co-Founder and Managing Partner, Nine Blocks Capital Management)

Henri discusses the recent news of Nine Blocks Capital becoming the first licensed crypto hedge fund in Dubai and stresses the stringent regulatory framework put in place by the Virtual Asset Regulatory Authority (VARA). 

He also shares his insights on the challenges and opportunities faced by crypto asset managers during market downturns and the growing role of stablecoins and DeFi in the industry.

Ian concludes the conversation with grading Henri’s Top 10 crypto predictions for 2023 and his thoughts on the metaverse, crypto gaming and the need to utilize some of TradFi’s best practices. 

Quote of the episode

“I’ve done, I don’t know, over the years, maybe 60, 70 licensing applications and the VARA (Virtual Asset Regulatory Authority) one was by far the most difficult I’ve ever done. And the ongoing supervision is probably by far the most stringent.”  Henri Arslanian (Co-Founder and Managing Partner, Nine Blocks Capital Management)

Minute-by-minute episode breakdown

  • (2:10) – Discussion of NineBlocks Capital’s licensing by VARA (Virtual Asset Regulatory Authority) in Dubai 
  • (3:58) Dubai’s transformation into a crypto hub and the strict regulatory oversight
  • (8:40) NineBlocks’ success in attracting investments and achieving growth in crypto industry during a downturn in the market
  • (14:25) – Managing risk and counterparty exposure in trading strategy and broader crypto ecosystem
  • (21:27) – Future debate on privacy and transparency in crypto transactions
  • (25:50) – Concentration and counterparty risk in the crypto ecosystem
  • (29:45) – Hong Kong’s resurgence and its position in Asia’s crypto scene
  • (32:02) – Recap of Henri’s 2023 top 10 crypto predictions 
  • (33:35) – Predictions on TradFi best practices, CBDCs and stablecoins as safe haven
  • (35:44) – Predictions on Ethereum domination, regulatory tsunami and growth of DeFi
  • (39:29) – Prediction on lack of crypto gaming surge, global metaverse strategies and self custody make a comeback and NFTs become more mainstream

Related resources

Check out more resources provided by Chainalysis that perfectly complement this episode of the Public Key.

Speakers on today’s episode

  • Ian Andrews * Host * (Chief Marketing Officer, Chainalysis) 
  • Henri Arslanian (Co-Founder and Managing Partner, Nine Blocks Capital Management)

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Our podcasts are for informational purposes only, and are not intended to provide legal, tax, financial, or investment advice. Listeners should consult their own advisors before making these types of decisions. Chainalysis has no responsibility or liability for any decision made or any other acts or omissions in connection with your use of this material.

Chainalysis does not guarantee or warrant the accuracy, completeness, timeliness, suitability or validity of the information in any particular podcast and will not be responsible for any claim attributable to errors, omissions, or other inaccuracies of any part of such material. 

Unless stated otherwise, reference to any specific product or entity does not constitute an endorsement or recommendation by Chainalysis. The views expressed by guests are their own and their appearance on the program does not imply an endorsement of them or any entity they represent. Views and opinions expressed by Chainalysis employees are those of the employees and do not necessarily reflect the views of the company.

Transcript


Ian:

All right. Hey everyone. Welcome back to another episode of Public Key. This is your host, Ian Andrews. Today I have an amazing guest, Henri Arslanian, who is the co-founder managing partner at NineBlocks Capital, also a prolific podcaster, content creator. You can find him everywhere on every platform. Henri, welcome to the program.

Henri:

Thanks for having me, and thank you for all the great work you guys are doing with Chainalysis. A big fan of the contribution you guys are bringing to the crypto and broader Web3 community.

Ian:

Mutual admiration. I’m a big fan of all your content. It’s taught me a lot as I’ve been running this podcast the last year and a half tips and tactics. Hugely appreciated. Hey, I want to start the conversation off with some big news that just broke this week as we’re recording the virtual asset regulator in Dubai that we call VARA. Granted your firm NineBlocks, I think you’re the first licensed crypto asset manager in the region. Talk about what that’s all about.

Henri:

Yeah, we just became this week at a time of recording the first crypto hedge fund to get a license by VARA. Like you said, it’s the virtual asset regulatory authority in Dubai. What’s interesting, Ian, is that Dubai two years ago made a big decision of having the world’s first crypto specific regulator. And as many of your listeners know, the crypto industry, unlike what many people may think, wants to be regulated. They want to actually set up rules that everybody can abide with and operate on a level playing field. And what’s really amazing here in Dubai, they created that framework and we are the first crypto hedge fund to go through. And it’s been obviously very important because for us at NineBlocks we believe in having an institutional setup. We believe in being regulated, we believe in best practices, we believe in governance, transparency, and everything that you would expect that institutional investors want.

And it’s been actually quite an interesting journey and getting the license. And there’s a number of other firms, I think, who are trying now to do the same. It’s a very difficult license. It took us some time to get it and not only getting it is one thing, but the ongoing supervision is very, very stringent. My background, I’m a hedge fund lawyer when I started my career. And I’ve done, I don’t know over the years, maybe 60, 70 licensing applications. And the VARA one was by far the most difficult I’ve ever done. And the ongoing supervision is probably by far the most stringent. I mean, just to put things in perspective, we have as a crypto hedge fund, weekly reporting to the regulators, wallet addresses, confirming there’s no PEP or high risk transactions. There’s monthly reporting of our financials to the regulator along with a suite of other reporting assets from our assets to reserves, counterparties and all the kind of different things.

So there’s an image people have that Dubai is light touch the Middle East. I would challenge any of the regulators listening today on the show, fortunately or unfortunately, I think what happens now with VARA is probably the most stringent regime in the world right now. Unfortunately, not many people know about it. I think VARA should do a better job probably on the marketing side. They do a very good job. And I think in life what you do is very important and what people think you do is also equally important. I think on the second part, like any regulator, they may not be as good as they should, but I’m sure that’s something they can work on over the next couple of months and years.

Ian:

Yeah. It really is amazing what’s happened in Dubai where they went from really zero crypto presence in the ecosystem and have completely transformed that. It seems if we kind of follow the trend out, that they’ve become, if not the financial capital of the crypto ecosystem, one of a few. You’ve recently moved there as well, right?

Henri:

Absolutely. I spent the last, I would say 15 years of my career, in Hong Kong. I’m originally from Montreal, Armenian background, born and raised in Montreal in Canada, then went to China and then Hong Kong. And where I was very active in Hong Kong and the growth, of the birth and the growth, of the crypto ecosystem there. And about two years ago, I was very instrumental also in the early days of the birth of the crypto community here. And I remember very well meeting with a government official here who was telling me, “Henri, we’re not in the top 20 and we want to be number one.” And I was like, “Yeah, famous last words. I’ve heard this” … Before this, I used to be the global crypto leader at PWC and a partner there. So I worked with many regulators over the years, many governments, many central banks. And then many of them speak big words, but actually the execution that obviously it doesn’t follow through, and here I have to say they’ve really done it.

It’s really impressive what’s happening in Dubai with VARA, with DIFC and the DFSA, what’s happening in Abu Dhabi with ADGM and also some of the smaller Emirates as well across the UAE like Ras Al Khaima for example, that is coming up right now with regulations on DAOs, on Decentralized Autonomous Organizations. But to put things in perspective as a crypto hedge fund, I’m in VARA, it’s an area called One Central. It’s a free zone here. Literally pretty much all my counterparties, Ian, are one minute walk away from me.

Ian:

That’s incredible.

Henri:

And when you think about building an ecosystem, the fact that I can have all my counterparties one-minute walk away from me, I see them down downstairs when I’m buying lunch, when I’m getting coffee, it really creates it. And they built this in less than two years. And I think there’s no doubt in my mind right now as you said, that the UAE has become now the global crypto hub for crypto native firms, VARA Dubai is doing a great job for, let’s say, traditional funds or asset managers who are getting into crypto. The IFCDFSA is a great job, ADGM when it comes to many things, including they just released a new law on DLT foundations. Abu Dhabi is playing a big role. So I think there’s a lot of activity.

I mean, what I just heard, that VARA alone has over 800 applications, forget 50% of those. If 10% of those go through, it becomes one of the biggest hub in the world by a multiple of three or four. So I think there’s a lot of activity going on. For sure what’s happening right now here in the UAE will be a business school case study and people will analyze this for the years to come, not only the vision, but also most importantly the execution. And I think that’s something that crypto community has appreciated and this is why you’re seeing an influx of not only crypto folks moving here, but crypto companies, including some of the large ones, moving their headquarters here, which is very telling.

Ian:

It is surprising that that is happening given the regulatory scrutiny that you described your companies going through, because I think what we’ve seen historically drive some of these migrations of crypto companies has been friendliness where friendliness meant low oversight. But you’re actually saying no, it’s incredibly high oversight. So what do you think? How has that changed?

Henri:

It’s a very good point because the impression I got, many people that are not in our crypto circles think, “Ah, these guys want to go where it’s low-touch offshore.” And I cannot emphasize this enough, if anybody tells you that getting licensed in Dubai is easy, you should hang up the phone on them. I can tell you firsthand how complicated it was. And I think it showcases actually the genuine interest from the crypto community of being above board, especially after what happened a year ago with FTX where these players want to provide their wallet to dresses. They want to provide the proof of reserves, they want to show their financials, they really want to open up and show what’s under the hood because we know that as a community, we are as strong as the weakest member of the group. And I think this is what’s driving a lot of the activity.

It’s been interesting because people often will confuse friendliness with being relaxed, and I think that’s very wrong. For example, I just came back from Abu Dhabi where Abu Dhabi is very pro crypto, but if you want to get licensed, it’s very strict and I can tell you that’s not a place where you want to do something wrong because it’s obviously very harsh enforcement as well. So actually when you’re where somewhere you feel welcome, where the rules are clear, and the rules are made in a way that they can adapt and innovate as the industry grows, but you know that if you don’t abide by the rules there’s actually very strong supervision. I think that’s a great place in the crypto community will grow. And this is why I remain very bullish on the future of the UAE as a regulated global crypto hub.

Ian:

Yeah. It’s very attractive to anybody who’s running a legitimate business, right? Here are the rules. Here’s how you can, you have to operate your business in this way. If you do this, everything’s going to be good. The ambiguity that we have in the US right now I think is driving some people nuts. It’s very difficult.

Henri:

As somebody who’s been in crypto for a long time as a lawyer, I genuinely believe in giving people a choice. I think whether … And what’s beautiful right now in the crypto world, people have the choice and you have the choice of moving your business where you want to move it. These rules are nobody’s forcing you to comply with, these firms are coming here getting licensed are doing so because they want to comply with. Did Dubai benefit from, you mentioned what’s happening in the US, by some of the ambiguity or, let’s say, confusion that’s been shared by other regulators? I think absolutely right.

Ian:

Yeah.

Henri:

And I think that’s what makes the world a beautiful place is that when somebody’s not doing a good job and other player can come in and really be a dominant player. So I think kudos to the authorities here. They’ve done something that I think many people believed was possible only two, three years ago.

Ian:

Yeah, it’s incredible. Shifting gears a little bit, I’m fascinated by people who are starting businesses in crypto and if I’ve got the timing right on NineBlocks, you raised your first fund sort of at the tail end of the bull run just about two years ago. And so talk about what it’s like to operate through the turbulence of 2022 and then kind of the doldrums that we’ve seen here in 2023. What has that meant for your business? And I imagine this has to be tough, but I’m also not an asset manager, so maybe it’s been terrific.

Henri:

No, absolutely. I think to better explain how the difficulties is better, it’s good to understand the background. NineBlocks was created because we really believed that with the vision of becoming the leading crypto asset management firm in the world where you can have basically all the governance, the regulation, the transparency, the compliance that you have in a Tier I traditional hedge fund, but have it in crypto. And as I mentioned before, I was not only hedge fund lawyer before I was in prime brokerage where my specialty was setting up hedge funds for clients. My first book was how to launch a hedge fund. So I’ve done this over and over many times. I have to say that launching, it’s an institutional-grade crypto hedge fund, took us two to three times more time than we thought and two to three times more money than we expected because it’s obviously if you want to comply with the highest standards, anything from independent directors to governance, to insurance to security.

And we decided that … We launched the business in 2021, so over two years ago. And then off a couple months later, FTX happened and it was very interesting, really the last 12 months, anybody in crypto tells you that it was easy is absolutely lying. It was very difficult. Probably the audience who listened to this podcast, they believe in crypto and they’ve been following it since. Where I found it was the most difficult was when you’re dealing with, let’s say, institutional allocators, the sovereign wealth funds of pensions, foundations, endowments, and the likes, and maybe I would say also some traditional family offices has been very difficult to get the message through, to getting this perception that people had of the industry. Despite that, we believe that actually our view as a firm was that this is the moment that you provide transparency and the players that will survive this will come out stronger.

And now we just crossed a hundred million dollar UM mark. We have over two years of track record now. We’re the first crypto hedge fund to get licensed. As we’re recording this, we just had the six months of consecutive inflows.

Ian:

Amazing.

Henri:

So it shows you that despite the hard times, it’s been very difficult to be fair, but I think this is why I really believe that as we’re turning corner and we know we’re getting through, the players who survive this will come out stronger. I think the big difficulty as well was the question of perception. I think there was two big things that people wanted to see, saw before they started looking at the space again. One was FTX. Of course now SBF is hopefully going to jail, but also I think the trials done and also the claims have been trading at pretty high. As we’re recording this, the FTX claims are selling at over 60 cents on a dollar.

So I think there’s been a lot of more positive momentum on the recovery rate of this insolvency, of this bankruptcy. And second, I would say is what was going to happen to Binance. So I think when I was talking to a lot of institutional allocators, they would often tell me, “Hey Henri, we want to see first what’s going to happen to Binance. How is that domino going to fall?” And there was a lot of actually interest in seeing how is that going to evolve and now that there’s matching settlement, yes, there’s one regulator, SEC that it’s still outstanding. But overall I think we can say that it’s been settled. There’s been definitely a lot of interest now, not a lot, but definitely we felt the change of the wind direction since the settlement has been announced. I think that’s very positive for the industry, especially as we go through the holiday, and we go through the ETF news and other elements that may act as catalysts over the coming weeks and months.

Ian:

I’m curious, as an asset manager, how do you set strategy in a downturn? You’ve been talking about, I think, the investors bringing funds in, but obviously your job is to make them all money. How do you approach the rocky market that we’ve had? I would imagine those are very different tactics than what maybe you initially planned to employ during bull run times when you were first getting started.

Henri:

Well, yes and no in the sense that obviously when we set up the fund, we have very clear indication of what our strategy is going to be. And I would argue that actually even despite the market downturn, we have to stick with our strategy. Of course, we always innovate and come up with new ways of generating alpha within that strategy. But it was very important that there’s no style drift as we call it. Our strategy and our fund, when we launched it, the first fund that we launched was a market neutral fund. What that means is that actually we don’t take any directional view on any type of crypto assets, but our goal is that regardless of whether you believe in Bitcoin, you don’t believe in it, whether Bitcoin goes up or other cryptocurrencies go up or down, we generate pure alpha based on the inefficiencies of the market.

For example, we do a lot of funding arbitrage between perpetual swaps and spot. We do base arbitrage, some other [inaudible 00:14:46] reversion and other strategies, but there’s always a real market neutral component to it. So it’s really taking advantage of the arbitrage opportunities, but again, with no directional risk. And I think that’s in the what really markets where our strategy really outperforms is really when there is a lot of liquidity, a lot of volumes, people are trading, that’s where it becomes obviously interesting. But even in down markets, as long as liquidity and people are trading, whether their assets are going up or down, we should be able to generate some interesting genuine alpha, real alpha. So I think that’s what we’ve been trying to do and I think we stuck by our strategy from day one and I think that’s what I would say investors like as well, the fact that you’ve been consistent and there’s been no style drift and you’ve been very transparent as well. I think that’s something that hopefully we believe the market will reward the transparency despite the difficult year that the crypto industry has had.

Ian:

Do you make bets on certain ecosystems? If you’re looking for liquidity, I would assume that Ethereum is probably the most interesting just because of the transaction volume in that space and the different number of services and platforms presents greater arbitrage opportunity. But there’s so many new chains coming online. How do you make a call? Solana as an example, looked like it might be dead following the FTX collapse, and yet I’m seeing the asset prices on the native token, so is now actually maybe trading higher than it was in November of last year pre FTX collapse. So how do you think about the different ecosystems?

Henri:

Yeah. So as any institutional grade manager, we have very strict guidelines. First of all, I think there’s different ways we look at the world when it comes to, for example, assets we trade on. There needs to be liquidity, there needs to be depth of markets. This is why the majority of crypto that we trade in a market neutral strategy, it’s the same for pretty much all market neutral managers. It’s Bitcoin E3M or definitely top five or 10 coins where there is a lot of liquidity. However, risk management is critical. Before making money, you have to make sure you don’t lose it and you actually manage your risk properly. And we look at this different kinds of risks that we are generally you need to be obsessed with, but there’s obviously market risk, what’s happening. There’s also what we call the counterpart risk. For example, we have very strict counterpart exposure met meters.

We tier exchanges, we have Tier I, Tier II exchanges. We monitor the counterpart risk on an ongoing basis to make sure that we are aware of anything that may happen at these exchanges and we monitor it dynamically as well. So I think some of these elements, there’s various elements that come into play when you are looking at managing a market neutral book, especially that unlike let’s say if you’re doing a buy and hold strategy where you buy the asset on exchange, you move to your custodian and you put it in cold storage for example. When you’re trading any market neutral, any trading strategy, you have counterparty risk to exchanges because that’s where your assets are sitting at all times and that’s where there’s always an exchange risk when you’re trading there. So I think counterparty risk becomes fundamental.

And I have to say that’s an area I’m very impressed by the crypto industry, I have to say. This is something I think we don’t talk a lot about it enough. I was fortunate or unfortunate that in 2008, I was a hedge fund lawyer and at the time I was helping hedge funds ironically against their claims against Lehman and the prime brokers and then I was UBS in prime brokerage helping set up these bankruptcy remote structures to help protect investor capital. And during the last year, I’ve seen really a complete 180 from some of the biggest counterparties when it comes to the access they’re giving, the transparency they’re giving, and really from a due diligence perspective, the openness that they have, which was not the case before. I have to say that I saw in the crypto industry really in three to six months, what in 2008 I saw from a traditional banking role in two to three years.

And I think this is something that, as a crypto industry, we don’t market ourselves as good as we should because I think there’s a lot of work that a lot of the big exchanges have done, which frankly I think we should be grateful for when it comes to transparency, governance, and the comfort that they provided to the ecosystem. I think an incident like FTX, I think it’s unlikely we’ll have the same type of fraud that would happen to FTX will happen again. There’ll be another incident in a couple of years. I don’t know what it’ll be, there’ll be something else, but I think this kind of fraud that we saw with FTX, I think, hopefully should not happen again. And I think the large platforms have done a pretty good job actually on the centralized side in trying to provide a better transparency to the investors and investing counterparties they trade with.

Ian:

That’s great to hear because I think in the wake of the FTX collapse, everybody was running around talking about public proof of reserve statements and then you got into this like, “Well, is it good enough to know you have the reserves if I can’t see the liabilities and how are we actually representing your operating budget of your exchange on chain in a way that’s cryptographically verifiable?” And then the whole thing, I think in at least the retail context kind of fizzled out. You don’t really see many people talking about this. There’s a couple exchanges, I had a guest on recently where they’re actively publishing both reserves and liabilities and there’s an audit function behind it. So it’s happening in a couple of places, but you’re saying as a business to business relationship, you’ve seen a meaningful increase in the transparency.

Henri:

I think the transparency and the openness that these large exchanges that have provided from pre and post FTX, it’s complete day and night. And I think this is something that is quite impressive. I think there’s also what is the right mechanism of transparency, whether there’s proof of reserves, like you said, there’s pros and cons to each approach. I don’t think time will tell. Different exchanges have taken different approaches to that, but I also think we need to be a bit humble sometime in the crypto community. I know many of us, we don’t like what Tradify does, what the banks do for example, but the reality is the banking, traditional banking sector, has gone through its load of crisis over the years and is actually pretty good processes that have been in place over the years to try to address a range of issues. For example, I’m a big fan of SOC 1, SOC 2 review mechanisms.

Even you can argue to certain extent financial audits. There’s a lot of agreed upon procedures that actually a lot of firms can use where a lot of the big consulting firms that big four will do. So I think there are a lot of these best practices. IASC is one of them. There’s these best practices that have been in place in Tradify for many years that I think the crypto, especially the centralized crypto ecosystem, where these big centralized players could benefit. And actually I’ve been quite pleasantly surprised to see over the last couple of months, many of the large players go through these certifications that are offered by these large consulting firms. Are these perfect? No. Are there a step in the right direction? Absolutely. I think this is something that actually we should also celebrate and welcome, not only by the way as a crypto ecosystem, but also for the regulators and the broader society as a whole.

Ian:

Yeah. I mean something like SOC 1, SOC 2, it’s an IT certification, but if we think about at the core of cryptocurrency at the technology layer, you’re managing private keys, right? It’s an IT level system and if you’re not doing the work to maintain the hygiene on your technology systems that underpin this, it just leaves open a hugely vulnerable asset, right? Digital money, you’ve got to be really good at your technology operations process.

Henri:

Absolutely.

Ian:

I’m curious-

Henri:

And transparency as well, by the way, what you guys got chain houses for example is a good idea. When I teach, I train a lot of regulators and I still do, and I do the same with central bankers and other financial services professionals and I think there’s a big … When I tell everybody, all my audiences, if you’re a criminal and you’re using Bitcoin, you’re an idiot. It’s the probably worst thing to use if you’re a criminal. I mean good old cash is still the best way if you want to hide your traces, especially smaller sizes. And I think that often people underestimate how powerful tools like what you guys have at Chainalysis, and others by the way, to be fair, have become. And in many ways you’re probably better off using the traditional banking system with trust and lawyers and lawyer attorney privilege and different jurisdictions to hide your assets.

As many of the law enforcement listen in your audience knows, you don’t want to do an investigation that’s going to take 10 years. You want the one that’s going to take a couple months or one year that you can show it. It’s public, you get a promotion. That’s why I think crypto is a pretty good fast way to solve some of these cases, which I mean if you’re going to start doing requests to different law enforcement agencies around the world, they will take you months and years and you probably will not be there. So I think it’s very interesting how the public perception of crypto, especially when it comes to illegal activity or nefarious activity versus the reality, it’s often day and night.

Ian:

Yeah, yeah. It’s such an interesting mechanism. We’ve been able to map ransomware organizational structure by looking at how they distribute payments after a ransomware attack, right? Because they pay everybody in crypto and then they buy all the services that run the ransomware infrastructure and it’s led to some meaningful take-downs of some of these more bad actors. You couldn’t do that if people are handing off bags of cash, the records just aren’t there.

Henri:

I would argue even this right now, this is going to be I think one of the big debates we’ll have as a crypto community over the years. Right now that plays, in my opinion in crypto’s favor because it makes regulators more comfortable, governments more comfortable to a certain extent that there’s a bit of transparency. We can keep the bad actors away. However, I think in a couple of years as Stablecoins are getting more adopted, as cryptocurrencies are becoming mainstream, that’s going to be a flaw cryptocurrencies. Ironically, today, a SWIFT bank transfer is probably in many ways more private and confidential than a crypto transaction. If I pay you right now in Bitcoin or I give you Stablecoin, obviously my wallet, there’s ways you can reverse engineer. If I’m a business that runs on crypto, you can in theory reverse engineer my cashflow statement and that obviously brings up a whole different suite of issues from security to confidential information.

And I think this is why we’re going to need to have at one point a debate on the need of privacy and payments. Right now, many people will say that’s what we need more narrow. That’s what we need certain features of other coins like Zcash and others. But I think, that’s why I have to say as a university professor, I’ve been teaching crypto since 2015 at university, from an academic perspective, I’m very excited to see some of the recent research that has been taking place. There was some with Vitalik recently with what’s happening on ZK, call it Zero Knowledge proof ecosystem if you want. I’m very excited that some of the innovation that is going in that space. But for right now in 2023, 2024, I think it’s still a positive. It is great as firms like yours that are doing this job. At one point over the next decade, this will become an issue. We’re going to need to find ways to providing the comfort but without actually hampering our right to privacy. I think that’s going to be very, very interesting debate to see over the next couple years.

Ian:

It really is. We talk a lot about it on this show, which is this tension between transparency and privacy. And I think because of the original design of blockchain, we substituted anonymity for privacy. We said, well, you don’t know who’s behind this wallet address, so it doesn’t matter. Everything’s private by default, but obviously that wasn’t really true because it becomes, as you said, pretty easy to reconstruct past transactions if you’re collecting the data and then you can sort of follow everybody’s activity all around. And I would have to imagine in your business running a trading fund, you don’t want everyone seeing your trades, you don’t want people front running you, you don’t want … You need a level of privacy to that transactional history and future activity, right?

Henri:

I mean for a lot of market neutral hedge funds, we traded only with centralized exchanges and there’s obviously a lot of security elements behind. But I think you’re absolutely right. I think this element of the privacy and payments, especially when it comes to digital assets, will be a big debate. And by the way, I think this is not only when it comes to cryptocurrencies, I think it’s going to be one of the things we’re going to debate as a society. What you mentioned before, there’s anonymity and privacy. It works if there’s no off-ramp exchanges, we’re all operating in a Bitcoin world and there’s never need of KYC. Yeah, that’s true. You’ll never find out who it is, but the reality is there’s this fiat world that needs to interact with the crypto world, and that’s where I think it’s going to happen. I think what’s interesting now is the reason criminals are still able to use digital assets is ironically because of the slowness of the traditional world.

So for example, if there’s a love scam going on or pig butchering or whatever these things that somebody sends crypto by the time the person finds out that it was a scam, by the time I go to my law enforcement, by the time there’s a request for the exchange, by the time they go freeze that asset, that money is easily already gone and I know the speed is helping a lot of these frauds, for example. But I also believe this is going to be big debate when it comes to the CBDC area. I generally believe, maybe not this presidential election that we’re coming up in the US, but two or three presidential elections from now or prime minister, other elections in many countries, privacy and payments, especially when it comes to CBDCs will be critical topic of election. I think some parts of the world, parts of Asia, countries like China, even parts of the Middle East will go ahead.

We’ll have CBDCs that are mainstream. Other parts of the world, say Europe or the US, I think will be very difficult to have a CBDC that is actually a retail CBDC that is being used on a day-to-day basis because of the fears around privacy and government interference. So I think it’s going to be very interesting. We may have a bipolar world of those are using CBDC and where we’re sacrificing personal privacy for the collective interior, a lack of crime, lack of lower money laundering and better society versus the one where we don’t want to provide, we’re afraid that the interference that governments and access can have through our own personal privacy. I think that’s going to be a very, very interesting debate over the next couple of years.

Ian:

Yeah. There’s people who are fired up on both sides of that topic, I think. One thing I’m curious about, you mentioned counterparty risk a few minutes ago, and it seemed like during 2022, there was not only counterparty risk but concentration risk where we had a number of crypto lending firms offering these incredible retail rates. But on the backend in order to support that, they were all lending to what turned out to be a very small number of institutions, right? Three Arrows Capital being maybe the most well-known, and then Three Arrows in order to generate return was making some kind of outlandish bets as it turns out that went badly for them. And that led to a lot of the collapse that probably undermined at least some of FTX beyond the fraud they were committing obviously. I’m curious how you think about the ecosystem now. Is there less concentration risk or is there maybe more awareness and you’re able to manage around this concentration risk? How do you think about that?

Henri:

Yeah, it’s a good question. It’s something that we spend a lot of time thinking about. I think you’re right. There is still some players are very big in the crypto ecosystem, not to name names. But I think the problem when it comes to this concentration risk, and I think I have to say that the industry has, the ecosystem, has grown a lot in the last, not only the last couple of years, but in particular the last 12 months. For example today, if anything would’ve happened to Binance, there’s a number of players that would’ve easily been able to capture, if you want, that flow subsequently. So I think the industry is definitely more mature than it was a couple, not a long, a couple months ago, but definitely a couple years ago as well. I think what’s interesting now is the counterparty risk mitigation mechanisms have dramatically improved.

So today, for example, with most of the exchanges we trade with, there’s different mechanism with certain custodians were we able to actually mitigate the counterparty risk. For example, you leave your assets at a certain custodian and you’re able to actually trade on a separate exchange using the assets that you have in this particular custodian. And even one of the biggest, it’s public, we can mention Binance announced that they also are looking at doing something similar in having a known regulated custodian where people can leave their assets and trade on exchange, or this could be done by a bank, for example, and other third parties. Of course, then you have counterparty risk towards that custodian or that bank, but at least it mitigates some of the risks that people have, the perceived risks in particular, against some of these crypto exchanges. So I remain, I’m very pleasantly surprised again of the fast-moving innovation and offerings that have taken place, especially from the custody world.

I think one thing that doesn’t get enough credit is I think the custodians in the crypto space have done a tremendous job in the last 12 months in improving their offering and making it very practical. I would even argue that today there’s more custodians than there’s actually demand for it, ask managers for it. So I think the infrastructure now is very solid, whereas I remember 2018, ’17, we were talking about we need custody, we were not there yet. Whereas right now, I would argue that from a custody perspective, especially the industry is very, very well served, so I think there’s a lot of positive things. Are there some big players? Yes, but I would argue to a certain extent it’s also the case of Tradify. I mean you have a couple of players dominate the market, liquidity brings liquidity and so on and so forth for the same exact reasons that are also applicable in Tradify.

Ian:

Totally agree. We haven’t published it yet, but we actually had one of the co-founders of Anchorage Digital on the podcast, and so we talked all about the emergence of the custody ecosystem. They’re a federally chartered bank, which really starts to set them apart from the historical custody providers, much higher standard of scrutiny I think on their operations in order to have that authorization here in the US market, and I see that maturity happening across a lot of the other custodial providers in the ecosystem, which is great.

Henri:

And to be honest, I think many of them did it at their own accord, right? I mean a lot of them went and not only you mentioned obviously I encourage with his bank charter, but a lot actually a lot of these firms did it for also regulatory purposes. For example, to bring it back to Dubai for example, if VARA, for me, if a custodian is regulated by VARA, I know exactly what kind of reporting they’re giving, what kind of addresses they’re giving to the regulators. I mean it’s very Toro, it’d be difficult for them to do something that is not fraudulent frankly, at least with what they’re providing. But also I would say a lot of them made it out of best practices. I think the level of governance, processes, procedures that a lot of these custodians have worked on over the last 12 months has been very impressive. And again, as an ecosystem, I think we should do, not that we should tank them, but I think there’s obviously a whole world of crypto that defied decentralization that will take place.

I’m a big believer in that and I believe people should have a choice and the option to go on decentralized networks from trading to other activities, but also believe that actually the DeFi world will cohabitate for foreseeable future with a CeFi world and for that CeFi world, if you want traditional financial institutions to come in, a lot of the big institutional capital, you need to have decentralized players that are actually really operating at the international standards. And I’m happy to say that actually today I would believe that especially from a custody perspective, the industry has come a very long way.

Ian:

Yeah, it’s incredible to watch. I’m curious, we’ve talked quite a bit about the situation in Dubai, but you lived for a long time in Hong Kong. And they’ve gone through an interesting, at first were an early point of genesis I think for the crypto ecosystem, and then more recently it seemed like crypto sort of banned and we saw departure, I think of a large number of firms who then relocated maybe to Dubai or Singapore. But then in the last few months, that’s reversed course and Hong Kong’s open again. What’s your take on the situation there? Should we expect to talk to you again in the future? You’ll be maybe back in Hong Kong. What do you think?

Henri:

Often people don’t realize really the role that Hong Kong has played in the birth and the growth of the crypto ecosystem. There’s actually a cover here, a book, I can show it to you guys, but there’s a book that was written about us, it was Block Kong, about the 21 people who created the crypto ecosystem in Hong Kong. And really if you think about many of the companies that we have today, were really created there. Think about Binance, FTX, Sam launched it there. Tether was created in Hong Kong, actually still the legal entity that holds a tether is a Hong Kong entity, crypto.com was on Wyndham Street in Hong Kong, block.one bullish all created there and the list goes on and on and on of Hex Trust and many others that came out over the years, again, Sandbox, not Sandbox, and IMOCO. So there’s many players that really created Hong Kong and it was a mix at a time of I think this entrepreneurship vibe that was there with it being a hub and many elements that came at the same time that made Hong Kong a big powerhouse in crypto.

And if you were in crypto 2016, ’17 … I’ve been in crypto since 2013 and I organized my first crypto event in January 2014 at the Canadian Chamber of Commerce of Hong Kong. And really from that period ’til about to two, three years ago, Hong Kong was the place to be. There was obviously some challenges afterwards, especially COVID that made it very difficult. I’m very happy to see Hong Kong get a resurgence now when it comes to digital assets. For full transparency, for full disclosure, I served for about, I believe five years or six years on the advisory committee of the regulator Hong Kong. So I’ve seen this ups and downs and the changes happen there. I think the rules are very strict right now, which is I think very good. And I think there are certain players for which Hong Kong is a great hub. There’s certain players for which Singapore is a great hub. There’s certain players for which Dubai is a great hub, but I think definitely anybody who’s in crypto knows the outsize role that Asia plays in crypto and I think that’s not going to go away anytime soon.

Ian:

Yeah, yeah, it’s exciting. Hey, as we’re wrapping up, I wanted to play a rapid fire game and I know this is one of your special tricks. I don’t have a bell, there’s no bell involved here, but I found a post that you published in January of this year, so it’s almost 12 months old as we’re recording this, your top 10 predictions for 2023, I’d love to go through quickly and just score how you did. You know so much about the industry, you’ve been around so long. Let’s test your power as a future prediction by going back.

Henri:

So that point, that prediction has been going on since 2015. So since 2015, I’ve been writing every year my top 10 predictions of crypto for the year ahead. So I would love to see the trend. It’s funny you mentioned this today. I was speaking to my agent and he said, “Hey Henri, you got to write your 2024 one,” and I was like, “Oh shit, I forgot doing it.” It’s my weekend activity coming up this weekend or next to get that together.

Ian:

I’m impressed. You still write it and it’s not an LLM behind the scenes, right?

Henri:

I wish you could use LLMs, but the reality is for insights that are there point of view, fortunately or unfortunately, the LLMs are not there yet.

Ian:

I totally agree. So number one, best practices from Tradify to enter crypto industry, ironically. How do you think we did on that one?

Henri:

I think I was right. By the way, every year I get some predictions right or wrong. I think this is one I was right. I think a lot of best practices from SOC 1, SOC 2, type one, type two IAC, and many others have been now adopted by the crypto industry in the last 12 months. So I think that’s prediction that I’m very happy to see came through.

Ian:

Yeah. Thumbs up on that one, I agree. Number two, central banks accelerate their CBDC development.

Henri:

I think that as well. It’s interesting. I was looking at data recently, really I think now we have over 90% of central banks that are doing some kind of experimentation on both wholesale and retail CBDC, and I think that’s going to accelerate in 2024 as well. Countries that I’m very impressed with by the way, is UAE India. I think India made tremendous progress the last 12 months. I think that doesn’t get the media attention it deserves. Where I’m a bit, let’s say things have been gone slower on the CBDC side is some parts of Europe and other parts of the world, but fortunately, unfortunately, CBDC will become mainstream in our lives and cash will be of course be banned. And we’re the generation that’s going to see the third form of central bank money CBDC in our lifetime for sure.

Ian:

Interesting. I think I’m up for that one. No more cash. I hate carrying cash around. So digitize everything. Number three, Stablecoins are the new safe haven crypto assets.

Henri:

Absolutely. There’s another one I think and I believe is just the beginning. We have over 140 billion in assets now in Stablecoins and it really depends where your people are. So if you’re in the US and you live in New York and your family, your life is 99% in the US, doesn’t really impact you. Ask anybody in Turkey of your listeners and how the role that Stablecoins are playing, anybody in Latin America, I mean pretty much any business individual that I meet in Latin America across the continent who is doing international trade is using Stablecoins. There’s no question that people that are in Lebanon, people, parts of Africa, there’s genuine usage of Stablecoins right now. And I have to say it’s moving way faster than I anticipated. So yeah, I think that’s another one that I think I’m pleasantly, I’m very happy to see that actually is getting traction.

Ian:

Yeah, we did some analysis on this recently and what my team saw was 50 to 60% of all transactional activity on chain involves Stablecoins. So it’s not just people who are maybe trading out of Bitcoin or Ethereum avoiding some volatility, but they want to hold a digital asset. This is actually being used for transacting, sending value between people and it’s a huge portion of the crypto ecosystem right now.

Henri:

Absolutely. Many countries, a lot of people, Argentina, just basically living off Stable coins especially, you can lend it, you can get a proper yield and fortunately for those who are in countries where they have good central banks, good governance, maybe you don’t need it. But unfortunately there’s a big chunks of the world where people don’t trust their governments and unfortunately they’ve been doing a bad job. The list goes on and on and we can go on for hours naming them and I think at least people have an option. I really believe people should have a choice, an option, and I think that’s amazing the role that Stablecoins are playing.

Ian:

Yeah. So number four, Ethereum continues its dominance.

Henri:

Yeah. This one, I’m not sure I got it right, to be honest. I really believe that post FTX, there’ll be kind of a flight to safety on Layer 1s as well. I’m not sure that really happened. Of course, Ethereum has a great dominance from DeFi to even Stablecoins we just mentioned. But I have to say that I’ve been pleasantly surprised that many of the other Layer 1s that people thought were dead, actually are doing, I’ve seen quite a lot of activity from Solana, Algorand, and many others. They’ve been active in the last couple of months. I’ve been very, very impressed actually, and people, I think it was not only Ethereum, which is good for an ecosystem, there’s more Layer 1s and activity.

Ian:

Yeah. I think if you look at it from a dollars perspective, Bitcoin and Ethereum are about a trillion dollars of market cap in an ecosystem that’s maybe 1-3, 1-4 depending on the day. So certainly dominating that way, but I’m surprised people continue to launch new Layer 1s and Layer 2s, right? It feels like there’s another one coming out every few weeks. So there’s still a lot of dynamism in that layer of the technology stack.

Henri:

And also you think about on that, if you go some of these and there’s very strong communities as well, think about coins like Cardano, think about Chainlink, Polkadot, and the list goes on and on. They’re very, very strong communities that people are very big believers in it. I think that’s great for the ecosystem. It creates a community. I think that’s fantastic. Think about Avalanche, think about what you’re seeing with Savannah, with others. So I think it’s very positive.

Ian:

All right, number five, regulatory tsunami is coming.

Henri:

Oh, I think the tsunami not only was coming, now it came as well. I think you know what I always said, if you’re a US policymaker or a politician and you were not anti crypto in the last year, I mean you’re an idiot. It’s a great thing. It’s bipartisan. Everybody loves … It was easy to bash crypto. I would even argue that some of the CEOs of crypto exchanges like we saw recently are very easy targets. Foreigners, they’re there. Bomb, I think so. I’m not surprised at all that there was a regulatory tsunami. Was that all bad? I think some regulators, without naming them, I think really went completely overboard and frankly from a legal perspective, I think a lot of these decisions will be turned around hopefully by the judiciary, but I think overall the industry will come out stronger after that regulatory tsunami.

Ian:

Yeah. Yeah, good regulations are good. That’s my takeaway there. Number six, DeFi’s rise to be catalyzed.

Henri:

This one, I mean I’m a massive believer in the world of DeFi. I really believe that one thing we often forget after FTX, of course, CeFi and everybody was afraid of another collapse. What’s been interesting is DeFi during the whole FTX saga did perfectly well, continued to operate perfectly well. I really believe there will be more excitement and more capital going to DeFi. It happened by the way, of course, the DeFi ecosystem has grown, although it dropped from its high, but it’s still continuing to grow. I was probably maybe too naive. I believe that it was going to grow faster, but I think this is one that I was not, let’s say, I’m not right, but I’m not wrong, but I was not perfectly right either. I think I’m probably somewhere in between.

Ian:

I think maybe what the rate limit around that ecosystem is right now is the point you were making about some of the operational cleanup that we saw on centralized platforms where they’re adopting some Tradify practices. I think that process is, it hasn’t happened yet in DeFi, and so institutional money is still hesitant to really touch some of these DeFi systems and that’s going to be the big unlock. I think the first player in DeFi that really goes down that path of building an institutional grade system probably has a massive opportunity in front of them. That’s maybe my prediction for ’24.

Henri:

From a trading perspective, some of the innovation in DeFi is absolutely mind-blowing. I’m really, I think from a technical perspective, academic perspective, trading perspective, what we’re seeing in DeFi is mind-blowing right now. But for that to become a bit more mainstream, we don’t need it to mainstream, but let’s say mainstream in the crypto community already. I think it went a bit slower than I expected it, but let’s see, maybe 2024 is the year that will change.

Ian:

There we go. There we go. We got one prediction for your 2024 list. Web3 continues its growth with gaming being the catalyst.

Henri:

Yes, yeah. That’s an interesting one as well. I think this one, I was a bit too bullish on it. I would say I’m a bit wrong. I’m a massive believer in the potential of gaming. I think people often underestimate how big the gaming industry is. It’s obviously bigger than TV and movie industry and sports put together. Industries like eSports, gaming I think have tremendous potential and I think they will be the bridge for the next billion users to come into crypto will be via gaming. I have no doubt about it, which I believe also will happen in the UE and the Middle East by the way. Countries like Saudi Arabia, PIF, the Sovereign Wealth Fund is investing 29 billion in gaming. The UE is doing tremendous investments in gaming and eSports. And this is why I’m even more bullish on the Middle East, by the way, in UAE and countries because of this interaction.

But I think where I was wrong by my prediction is I thought this was going to happen maybe in a bigger way in 2023 and it didn’t happen. I would argue potentially because of the bad press around crypto, I don’t think this really helped the gaming sector. If you’re a gaming company, you’re probably better off the last year staying away from crypto and then being and getting closer.

Ian:

Number eight, every Fortune 500 company announces its metaverse strategy.

Henri:

I think this one, I was probably wrong as well. When this happened, I’m a big believer I would say still of the Metaverse ecosystems. We’ve seen some countries really take big bold move here. I mean, again, not to brag on the UAE, but here in the UAE, many government ministries have to offer their services in the Metaverse. VARA was the first regulator to set up a presence in the metaverse, and I was happy to see countries even set up a presence there and so on, so forth. I think where I was a bit too optimistic, I believe that every country was going to have their own defined metaverse strategy, Web3 strategy. Again, I was wrong there, I think. So this is one that I missed. Where I think also, and I’m not surprised was again, there was a lot of bad connotation with crypto in the past year and you’re probably better off staying away from crypto in the last year. So I think that played a role in it as well. But I was definitely wrong on this one.

Ian:

I think maybe with the launch of the new Apple headset, the Vision Pro, maybe there’s a comeback on this one. But yeah, I would say that we definitely missed the mark for 2023. Number nine, self custody makes a comeback.

Henri:

This is a tricky one. Post FTX, I remember that, I think companies like Ledger were having record sales, and I really believe that for some time, self custody was going to make a comeback. I would say that I’m still a bit wrong on that because while there was a lot of fear in the early days, I think now people are getting more and more comfortable with these centralized players, and I think while self custody is great for people that are, I would say, knowledgeable on crypto and are comfortable with it as well. I always give an example, my mom, my mom would never be able to self custody. So I think where I was wrong, I think self custody will play a role, by the way, it’s called third-party custody. But I think that I probably overestimated or I was too ambitious on the role that was going to play. So I think this is another one I was wrong. I think people still prefer centralized custody in many cases.

Ian:

Yeah. The user experience is still too hard and the risks are too high. You might carry a few digital assets in MetaMask on your phone, but you’re definitely not putting your entire net worth there if you’re smart. Last one, number 10, NFTs become even more mainstream.

Henri:

Wow, I forgot about these. I should revisit them. So NFTs, I think at this point I was wrong as well in the sense that NFTs definitely became more mainstream. We saw with NDA top shots and a lot of the activities that was going on from luxury shops to others, I would say that they probably became very popular because of the wrong reasons. So obviously the hype around them and so on and so forth. Where I was probably wrong, if I remember correctly in the article I talk about how we’re going to be able to see them in day-to-day usage. I still don’t understand why my university diploma is not NFT, my driver’s license is not an NFT, my passport. I think unfortunately we’ve had a lot of NFT activity on artistic side maybe or some more funky stuff, but real proper use cases that are so much needed like some of the stuff I mentioned from land titles to any kind of government document, we’re still very far from having them on NFTs unfortunately. So I was wrong on that one as well.

Ian:

Yeah. So I’m trying to keep score here in the background and I think you actually did pretty well here, right? Predicting the future’s hard. I’m going to give you maybe a six and a half out 10, which is I would consider that to be outstanding, right?

Henri:

Exactly.

Ian:

That’s very well done.

Henri:

What I’d love to do is go back to my prediction from 2015. I should put them all together. I mean one pool for all of them. It shows you how much the ecosystem has grown over the years. That would be a good post actually.

Ian:

I would read that post. I’m there for that.

Henri:

Actually, it’s not a bad one. It’s pretty much nine years of year to year, but I think now you put me on the spot, I need to actually write my 2024 predictions as well as per the tradition. I’ll start it now.

Ian:

We’ll wrap up this conversation so you can get to work on 2024 predictions. Henri, this has been fantastic. Where’s the best place for people to find you online, follow all the content that you’re producing?

Henri:

Yeah. The best way, I’m pretty much on across all channels from LinkedIn to my YouTube page to Twitter, it’s Henri, H-E-N-R-I, the good old French Canadian Way, Arslanian, A-R-S-L-A-N-I-A-N, good old Armenian name. But I think the best way is via LinkedIn, Twitter, YouTube. I post a lot of educational content on YouTube. I have my own podcast called The Future of Money with Henri Arslanian, and I have obviously a lot of other content across other channels, so great to connect with anybody, happy can reach out to me on any of these platforms.

Ian:

Fantastic. We’ll link to all of that in the show notes so people can find you and definitely sign up for the podcast. It’s a fantastic list and you get some great guests on there.

Henri:

Awesome.

Ian:

Thank you.

Henri:

Thanks for having me, and thank you everybody for at the Chainalysis family for all the good work you guys have done for the growth of the ecosystem.

The post Crypto Hedge Funds with Henri Arslanian – Ep. 90 appeared first on Chainalysis.

Fan Tokens and SportsFi: Alexandre Dreyfus – Ep. 89

https://www.chainalysis.com/blog/fan-tokens-alexandre-dreyfus-ep-89/

Episode 89 of the Public Key podcast is here. Fan Tokens and SportsFi might be very new terms to those in the crypto industry. In this episode we have Alexandre Dreyfus (CEO, Socios.com + Chiliz) explain how the biggest sporting brands in the world are embracing blockchain technology and accelerating fan engagement through the newest phenomenon in crypto, Fan Tokens.

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 89.

Public Key Episode 89: Fan Tokens are newest way to engage fans of major sporting teams on the blockchain

Fan Tokens and SportsFi might be very new terms to some in the crypto industry, but probably not to the biggest soccer and football fans around the world.

In this episode, Ian Andrews (CMO, Chainalysis) learns everything about Fan Tokens from Alexandre Dreyfus (CEO, Socios.com + Chiliz) who are working with premier league soccer clubs, F1 racing teams, NFL and UFC partners.

Alex discusses the concept of Fan Tokens and their growth in the sports industry and how they allow fans to have a voice and vote on decisions related to their favorite sports teams. 

He also highlights the importance of regulation and compliance in the industry, as well as the challenges of security and user experience. He expresses optimism about the future of Fan Tokens and the potential for further innovation in the space, including challenging regulatory landscapes like in the USA.

Alex touches on how Fan Tokens differ from traditional NFTs and how his team is exploring a non-custodial platform in order to give users more autonomy. 

Quote of the episode

“And to give you some fun fact, Paris Saint-Germain fan token in August, 2021, so we are at peak bull markets, so it’s a bit unfair, but still there is Leo Messi that left Barcelona and joined PSG. During three days, the PSG token was trading a billion dollar a day on all the platforms and was more traded than Bitcoin in Brazil.” – Alexandre Dreyfus (CEO, Socios.com + Chiliz)

Minute-by-minute episode breakdown

  • (2:23) – Alexandre’s background in online gaming and poker and the emergence of regulation in the industry
  • (4:43) – Explanation of how Fan Tokens work and how they provide value to fans and teams
  • (13:20) – The goal of opening the ecosystem for developers to build on fan tokens
  • (15:40) – Fan Tokens vs. NFTs 
  • (19:24) – The global regulatory landscape and the need for compliance and education of regulators
  • (27:32) – The rewards and risk of launching non-custodial platforms for average users
  • (29:13) – Security concerns in the sports token industry 
  • (33:05) – The outlook for entering the US crypto market in the future 
  • (35:02) – Excitement about new SportFi features and decentralization

Related resources

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Speakers on today’s episode

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Ian:

Hey, everyone. Welcome to another episode of Public Key. This is your host, Ian Andrews. Today I’m joined by the CEO of Socios.com and Chiliz, Alex Dreyfus. Alex, welcome to the program.

Alexandre:

Hi, Ian. Thanks for the invitation.

Ian:

Your background is fascinating. You started in the world of online gaming, online poker, if I’m not mistaken. And have since built your way into the cryptocurrency and specifically the world of fan tokens, which is a fascinating area that I think’s actually seen some great growth over the last couple of years. Tell us about your early career. How did you get into the world of online gaming?

Alexandre:

So I’m a Web 1.0 or Web 0.5 at first, actually I’m French, as you can hear with the accent, but I’ve been a geek, I mean since I’m six. I got my first computer when I learned how to write and read. And then in 1995, 1996, I created my first internet company. And since that time more or less, created several. And in 2004, moving into the online gambling, first sports betting and then online poker. Sports betting because of regulation, it’s actually a very interesting topic when you compare crypto and gambling.

But in Europe in 2003 there was a big case that a little more or less an online sports betting company to serve every users in every European countries, and that became the boom of regulated online sports betting. And so in 2004, moving into that space and then evolved into the online poker space, offshore, onshore, became regulated in several countries and eventually actually sold my business as the platform, especially to a US listed company that is still, I guess number one or number two in land-based casino industry in term of service provider. And so spend a lot of time as well in the US to understand how regulation works and lobbying and everything.

Ian:

Well, it’s an experience as an American that was so unusual to me, where when I was growing up, the timeframe you’re talking about, if you wanted to gamble, there were basically two places in the United States you could go. You go to Las Vegas or you could go to Atlantic City. And that was it. There was no idea of being able to walk down the street and go place a bet in a betting parlor. And I can remember the first time I went to London and I think the first time I went to Paris in the UK, Ladbrokes.

Alexandre:

Yeah. Ladbrokes.

Ian:

It’s like a retail outlet. You just walk down High Street and you walk in place a bet on whatever the Premier League game is happening that day. So your timing of creating this business was when that suddenly became international, where you could serve an entire European market, which must have just been incredible as it was moving online rather than this retail model.

Alexandre:

No, definitely. It’s interesting, every country is obviously different. In France actually, we never had this retail shop or barely had this retail shop. It was mainly UK as you said, Spain, Italy especially, a bit Germany who had a proper sports betting culture. And I’m a strong believer that the regulation of sports betting and the fact that it became regulated in most of countries help the sports to become bigger. And there is even an argument that I think I recalled 10, 15 years ago having read that the reason that the NFL was so successful, it’s because of fantasy in the US, and the fact that you were able to not bet, but kind of bet on that legally.

And that was very interesting. And I think sometimes even though, and it should be regulated and it should have limits and they are abuse and you have to be careful. Yet the fact that it became a digital product help to grow the, let’s say underlying asset, which is the game itself. So you being able to bet on the outcome of an event, make the event more interesting to watch and therefore has more value from a broadcaster perspective, et cetera.

Ian:

It’s absolutely true. I live in a city in the United States where our American football team has been terrible since I was young, almost unwatchable in many years. And if it weren’t for fantasy football, I wouldn’t pay attention to the NFL at all. Because you just don’t have that local franchise that you really care about. It’s an interesting connection too to the project you’re working on now. Talk about what a fan token is and why does anyone want one? Because I sense there’s maybe a similar concept around engagement here as there is with something like fantasy sports or betting.

Alexandre:

So five, almost six years ago, actually it’s going to be six years ago now, we created Chiliz and we created more or less Socios.com. The idea was very simple. 99% of sports fan are not in the stadium, not in the city, not even in the country of the team they’re supporting in general. And the question was what can you create that is both valuable for a fan and scalable for a team? So when you look at the revenue stream of a sports property, the main one is a sponsor, is TV rights, then it’s sponsoring, then it’s ticketing and match day, and then you have merchandising. This revenue stream of more or less have a ceiling. You cannot double them every year, you cannot increase, except in the US it’s okay, but in the rest of the world you cannot increase the price of the ticket.

People will go on strike. And so you need new revenue stream. What can you sell to fans all over the world? We think that recognition of being a fan, recognition of being a super fan and having a voice is actually valuable. So we created the concept of fan tokens, which in today’s world you could call that as a DAO in a way, you could call that as a membership program, as a social file, whatever you want to call it. The reality is, we created the concept of membership tokenized program let’s say, that allows you as a fan anywhere in the world to own a Paris Saint German, which is one of the top soccer team in the world or in Europe or FC Barcelona or Arsenal.

You own one of these fan token, as long as you own that in the wallet, you can vote on decision of the club. Sure, you’re not going to vote on what’s going to be the player or what’s going to be the business decision, but everything in the middle, which is fan related, is valuable to ask their fan for. And so we started with that idea. We signed two teams, Paris Saint German, Juventus in Europe in 2018. And fast-forward today, we are on more than 300 people, we have a hundred plus sports team more or less all over the world and in many sports.

Ian:

It’s amazing. I was looking on your website and it’s not just European football, you’ve got Formula 1 teams like Alfa Romeo and Aston Martin. You’ve even got some American sports teams like my local Washington Commanders and the New England Patriots. When you go to have a conversation with Paris Saint German, what did they say when you first approached them about creating this fan token? Does it make sense to them? Is it already lined up to their business model or are they like, “Alex, come on crypto, blockchains, why would anybody want to do this?”

Alexandre:

So first of all, in the us, as much as we have the Commanders and Patriots, and actually we had 88 teams in the US, we signed 27 NBA teams and 13 NFL teams, but we never launched any token due to the lack of guidance and clearance of regulation, let’s say in the US. So we were never able to recover our investment there. So we lost a lot of money when FTX collapsed, it killed the regulatory momentum that there was at some point last summer, I mean 18 months ago. And so we lost a lot of money there. And so for now we are not active anymore even on that side of the world. In term of when we approach in summer ’18, we approach thousands of let’s say European teams. Of course, we were already post peak end of ’17, early ’18, Bitcoin touched 19,000 I believe, or 20,000 and then it was already done back to 13,000 or 7K, I’m not sure.

And so we talked to people that looked at us like, “What is this? What are they talking about?” And I’m usually not afraid to sell that publicly. We talk to people that thought that, “Hey, let’s take the money these guys are offering us and they will go bankrupt anyway in two years. As long as they paid us upfront, it’s fine.” And we actually delivered, we actually way over delivered. And so eventually what became our biggest asset was the fact that we were not, I hope charlatans, we were not people trying to pitch a scheme that was not relevant. We really understood, we came from the sports space and the tech and the sports space. We didn’t come from the crypto space at all. At that time and still today, I don’t trade, I don’t own crypto myself except the one we launched. And we were very much aligned in the vision that these sports property need legitimate partner to help them guide them in the Web 3.0 space.

And I think we managed to build that company at least up to today. And then yeah, it’s the egg and the chicken. The more you sign, the more you sign and you create what we call a network effect, because every team, I mean the sports world is a very small world, so everybody talked to each other. So when they got to know that, “Oh yes, these guys are legit and they made the 500K for us or a million dollar or more.” People trusted us rightfully, hopefully, and that’s why we’re still working with all of these brands and we’re still investing and building the ecosystem around that.

Ian:

So if I’m at FC Barcelona, we have this conversation, I say, “Alex, you’re a great guy and you’re paying me upfront. So I like that business model, zero risk for me.” What happens next? How do you actually create the fan tokens? And I think you’re running your own blockchain, right?

Alexandre:

Yes.

Ian:

You’re not deploying on Ethereum or something else like that. But take us through what happens after we agree we want to start a project together.

Alexandre:

So it’s a long journey. So I’ll say we have almost three different tech product connected. One, we have the minting of the fan token. It’s kind of easy, it’s a smart contract, you code it, you mint it, great down, it’s free mind. So for example, FC Barcelona, they have 40 million fan token issued or minted, and there is a vesting schedule. It’s very similar to traditional, let’s say crypto asset, et cetera. Then you have the utility platform. The utility platform is called Socios.com. It’s not available in the US, but it’s called Socios.com where you can buy a custody. So it’s a custodial platform, hence regulatory framework around what we are doing. But you own your fan token of Barcelona, 110, 100. If you own your fan token there, that’s where all the voting and the gamification happens. So that’s where you can vote on the decision that the club is asking.

So we develop a whole platform for that. That’s where you can earn and redeem your VIP tickets, your money can’t buy experiences. You can even now have some auctions on some jersey and stuff like this. So the whole fan engagement experience is built in a very much Web 2.2, let’s say platform called Socios.com where all the fan tokens are available, they’re also tradable there. And that goes to the third layer, which is the blockchain. The blockchain originally was more or less a private chain called Chiliz Chain. I mean now we call it Chiliz Legacy Chain. Was a private Ethereum fork where only exchanges and socials were connected. And then it became since not a year, but six or nine months, it became like a permissionless chain. It’s still an Ethereum, but it’s a BSC fork, let’s say it’s an EVM chain. The idea was not to reinvent the wheel, the idea is not to change the world, the idea is not to be the fastest blockchain, but it’s to be the blockchain that is dedicated to the sports and entertainment space.

And now the chain is almost the main focus of what we’re trying to invest in, because for the last five years, most of the utility of these fan tokens were provided by us and the club. The club through us or through the club. And that was our strength, I believe for the first five years. That’s why we got 2.2 million users and we managed to grow the way we managed to grow. But we realized as well that there is a limitation in the fact that we need to give more power to developers, we need to open that ecosystem. We call that internally fan token everywhere. And I was in Korea two weeks ago. There, for example, Paris and German is very famous because there is a Korean player.

So my dream is that when you go to a Nike shop, which is the main sponsor of PSG, you will be able to get a 5% discount or whatever reward, benefits, gamification rewards because you have that PG token. But we can’t really scale that in every countries. Every countries has different partner, e-commerce platform, whatever. So we more or less wanted to really open the whole ecosystem so developers can build tools with the biggest IPs in the world. And most of chain are fighting to get valuable content. For us, it’s the other way around. We do believe we have valuable content, now we need to onboard developers and projects, even though I hate that word, to actually build the utility outside of us leading that.

Ian:

Yeah, it’s an amazing architecture. I mean it’s probably one of the most useful projects in the broad crypto blockchain ecosystem. I look at a lot of them. So the setup that you’ve got here is pretty amazing. I actually saw a tweet that I think you posted recently where someone had launched a DEX on top of the chain that you didn’t have anything to with, you weren’t sponsoring these folks, they just created it on their own.

Alexandre:

So we have Chiliz Labs, which is a different entity, which is funding and giving grants to developers. We had our first hackathons in Istanbul during ETH Devcon 10 days ago. It was cool to see because it was the first time for us. But yeah, we saw that DEX Sunday night, I received a message on Slack and then I looked at it. So I tweeted about it. I do say to people to be cautious because again, we’re not sure who’s behind and what they’re doing, but we’re going to review that.

But that’s what is interesting for us is, we spend so much efforts onboarding and being successful at onboarding the biggest brand in the world. And I believe we are good at that from a corporate perspective. We are good at getting big brands and giving trust to these brands. But now we need to rely on more people to develop features, utility, innovation on top of what we are doing. There are a lot of DEX, DeFi lending protocol coming on the cheese chain that’s going to spice up a little bit just for the sake of the argument, this cheese chain and the assets that are on the chain.

Ian:

Now as a user, if I’ve got my fan token or maybe multiple fan tokens, is there a secondary market? Can I decide I’m done with the team, I hate that they traded a player or they lost an important game and I want to sell my fan token off. Can I do that?

Alexandre:

Yeah, that’s what exploded. So we launched our first token, I guess early 2020, and the trading component, yes, training component came, I don’t know, mid 2020, not sure. And so these fan tokens are fungible asset, I would hate to use that word, but let’s say they’re cryptocurrencies because they’re fungible, except that for me, they are more asset than currencies because you are not buying anything with it. You are just getting benefits, not financial of course, but you’re getting utility benefits by holding these tokens and using them in the utility platforms. And these tokens are tradeable. They’re tradeable on Binance, they’re tradeable on OKX, they’re tradeable on every outside of US, every more or less, every single big exchanges Bybit, Bitget, in Brazil, Mercado Bitcoin, in Turkey, Paribus, in Korea, UPbit. So not all of them of course, but you have a basket of let’s say 10 to 15 that are more or less listed everywhere. And they’re traded significantly because that’s what it’s supposed to be.

And to give you some fun fact, Paris Saint German fan token in August, 2021, so we are at peak bull markets, so it’s a bit unfair, but still there is a Leo Messi that left Barcelona and joined PSG. During three days, the PSG token was trading a billion dollar a day on all the platforms and was more traded than Bitcoin in Brazil, for example.

Ian:

Wow.

Alexandre:

Was interesting, and it was a revenue stream of course for us, was a revenue stream for the club. And we had few example this. One thing that we are careful the way we say it, but it’s interesting, it’s as a category or as an asset class rather, fun tokens are actually way more traded than NFTs today. People don’t know that, people don’t really look at it. People think sometimes it’s gimmicky, yet it has at least in our eyes, way more utility than 99% of NFTs, that’s for sure. And it’s way more traded. Now, let’s be realistic. We are comparing apple and oranges, trading a fungible and trading a non fungible asset is really different in term of volume and everything. But it is interesting.

Ian:

It’s interesting that you said it’s a fungible asset. I would’ve assumed that it was built on the same spec as an NFT. Because I would assume there’s a limited supply of the fan tokens and they’re each unique and different, but you’re saying no that they’re actually not.

Alexandre:

No, there is a limited supply. So as I said, Barca has 40 million. Paris Saint German, it’s 20 million, UFC, I’m not sure. Formula 1 is probably 10 million, Formula 1 teams, it’s probably 10 million. This was calculated back in ’18 about how many… It was based out of the fund base. So we created a formula that based on the fan base and the potential fans that will come in the next 10, 20 years on the platform, we made a multi-tier ladder and that’s how we created that. And they are fungible because the irony of NFTs is NFTs are non-fungible, which it’s their trend, but it’s their flaw as well.

Because the fact that they’re non-fungible make them less tradable and therefore less liquid and therefore less valuable. We also seen that you can have a Bored Apes, I think Bored Apes, it’s like 10,000 NFTs or something like that. So I think the way we see NFTs as of today, it’s kind of a rich club thing where you have 8,000 people, 10,000 people. But from a mainstream point of view, when you have a brand that exists for a hundred years and has literally a hundred million fans or 200 million fans, not that you can reach them easily, but the reality is you need to build a product or an ecosystem that at some point maybe in 50 years will be able to reach that.

Ian:

Yeah. So you don’t want to create the artificial scarcity that exists in a lot of the NFT projects because you’re actually trying to reach everyone that’s got an interest in the fan club.

Alexandre:

Yeah. You do want scarcity because if there is no scarcity, there is no value. And especially in sports, there is a limited amount of seat in a stadium, there is a limited amount of jersey available. There is a limited amount of how you can watch this. So everything in sports is about limitation, it’s about giving a value out of it. And it’s the same in crypto, in funnel engagement, you create a product that is not available to anyone, that has their own limits of course, because you cannot scale.

For example, we do some cool stuff. For example, there is a football soccer team in Turkey, which is one of our biggest market where the fans were able to choose the number on the jersey, in the back of the jersey. So they signed a new player and the fans are the one who decided which number between the two numbers is going to be a flocked on the jersey. This kind of thing is it never happened before. And I like to say that even though it’s very arrogant from us, but I’m French, so I’m allowed to be. It’s we pushed football club, we pushed sports property to give more to their fans because of the investment we’ve made towards them. And that’s very valuable for everybody today.

Ian:

It’s pretty incredible to extend that level of engagement. It seems like something that is, it’s a new feature of being a fan if you actually get to participate in the governance of the club somehow.

Alexandre:

And there are some of the clubs we’re working with are actually listed company. You have Juventus, club is a listed company, and that’s what is interesting. There is an argument how many times you’ve heard and read, “Oh, that’s amazing. You could create a token and you own a piece of the club and because you own a piece of the club, you can vote.” Well, first of all, this is securities, number one. If you own a real piece of a club that’s securities, which is fine, but it’s a different topic. Now if you really do securities out of a football club, well it’s more or less an IPO and that already existed for the last 40 years. You can today buy a share of Manchester United on the New York Stock Exchange, but what a share of Manchester United gives you in term of right? Nothing. It give you the right to say, “Hey, I own a share.” But you cannot vote anything. You don’t have any special benefits as a fan.

So the irony of fan token is you will always have the traditional governance and ownership layer, obviously, which is everything would be regulated at some point, but this one is the securities one. And then you have a more lower governance slash engagement layer, which is I hope, fan tokens, where you do have a voice on a more scalable way towards the teams that you like. And this voice comes with some benefits, comes with disclaimers, comes with regulation, regulatory framework of course, depends on the country, but that’s what’s very interesting.

Ian:

We’ve touched on regulation a few times. Obviously, I tried to actually create an account on the platform, but I’m in the United States, so I wasn’t allowed to access it, which I was sad about. Outside of the situation in the US, what is the reception to what you’re building here? In Europe, is this sort of accepted or are you still out on the edges of how the regulation is set up today?

Alexandre:

So we are one of the, so-called crypto project that has really a global footprint. So we have six people full-time internally from regulatory and legal department. So it really depends. So for example, in Brazil, which is our second market, in Brazil, crypto and Bitcoin in general is pretty much legal. Exchanges are legal. There is a regulatory framework from an AML perspective of course, but you don’t need a license to operate in the country. But if you go back on the equivalent of I think CFTC more than SEC actually, but let’s say the equivalent of CFTC, SEC in Brazil is called CVM. You have the superintendent of the CVM who tweeted, it was very weird because we didn’t expect that. Who tweeted in September of this year, made a video of him, a selfie video talking about fan tokens and how they’re relevant in the country to help the teams to generate revenue and to help the fans to be closer to their team.

So that’s the ultimate kind of dream country where the regulator talk about the product itself, because in Brazil we work with the top 10 biggest teams and we are huge there. In most of countries actually, let’s say we take Europe, we call that registered. It’s not really a licensing mechanism, but it’s a registration in many countries in Europe where it’s needed, for example in Italy, in Spain, everywhere we have a team and I will take the example of Portugal. In Portugal we work with the biggest sports team, a team that is like by 60% of the country, it’s called Benfica. When we signed that deal, which I believe was in November ’21, it took us a year to actually eventually launch the token because we had to ask the permission of the Banco de Portugal to make sure that both the issuing of the token and the operating of the trading platform or the utility platform was okay under the regulatory framework.

And normally we actually apply to be registered as a platform there. And the Banco de Portugal actually responded after a lot of exchanges, that we don’t need to register, which is what in US you call that non-action letter. It exists only with CFTC, it doesn’t exist with SEC. And so we’ve done that in every single country. In Malaysia for example, when we launched a token of the biggest team as well, we actually asked the permission to the local regulator and we got the same thing. So in every country we either get regulated like in Italy, in Spain, in Lithuania and other place, either we ask permission to do regulator, either we do nothing because we cannot do anything.

Ian:

It’s got to be a huge overhead on the business to do that in every single country as you’re going around the world.

Alexandre:

Yes. So the thing is, I mean the answer is obviously yes. The difference from us and from most of so-called crypto entities is, because we come from the online gambling industry, when we build our business, our mindset was already to work as a regulated entity. So every tool we’ve built, everything we’ve ever done, always was, and I hope always was with a pre requirement that we’re going to be regulated one way or another and we need to act as a regulated entity. So we didn’t come with the naive utopia of Web 3,0 where everything should be decentralized and there is no regulation, blah, blah, blah. Not at all.

And that’s why sometimes, probably we didn’t succeed as much as some traditional decentralized company, not company, but project because we were too… For us, when you work with the teams in the IP, the brands we are working with, we cannot afford to fuck it up. Excuse my French. So there are some things that we were not able to do even though other could have done it. So we have to be very careful of that. But in the long term, it pays and that’s also why the teams and the sports property enjoy or at least feel confident to work with us, is because we take this very seriously.

Ian:

Yeah, I mean that’s the biggest headwind I think right now across the broader crypto and blockchain industry is that, the people on the outside, they’re interested, but they’re very concerned. Not everybody’s taken the same strides that you have when it comes to compliance and regulation, and they don’t see that maturity and it’s like, “Well, this is just a risk to my business for something that maybe doesn’t have a return.” And so…

Alexandre:

I just want to add something on this. Because we had, for example, a very famous soccer player, a football player, one of the top three guys who has, I don’t know, 400 million fans. And they ask themselves, “Hey, should we launch a token?” We didn’t want to launch a token for them because we don’t believe in social token and individual tokens. But one thing was interesting for that, I love the guy, what the agent said to us, “Hey, we don’t want to launch that token as well because if that token goes down 30% Adidas or Nike, who gives me 20 million a year suddenly is going to ask me a discount because the brand or the fan sentiment is down.” And so there is an argument that the difficulty for so-called Web 2.0 Or more, how do you call that? Brick and mortar businesses, how do you embrace crypto and blockchain without damaging your existing business? And that’s a very interesting point.

Ian:

It really is. I hadn’t thought about this, a personal token being an index on your value to society. How interested are your fans in you. As you get older later in your career, you lose a step on the pitch, suddenly your value starts trading down. That would be a very sad moment.

Alexandre:

But that’s actually, that’s the reason we don’t do individual tokens because people die, people retire. So there is no utility, there is too much risk of insider trading. It’s not like a corporation, so we like to work with brands, corporation who have a marketing department, a legal department, and whoever will die eventually in the team, the team will still survive anyway. So that’s the reason we focus on that actually.

Ian:

So if I’m coming to sign up and I want to buy my first fan token, let’s say I was not in the US, you have a know your customer program, I have to show my ID, and then you have a nanny money laundering transaction monitoring team. You’re kind of looking after everything in that secondary sales market?

Alexandre:

Yeah. So because we come from online gambling, especially online poker and sports betting, and because we also based, I’m based in Malta for the last 17 or 18 years, so here in Malta we have I think 13% of the GDP of the country is made by sports betting company. So most of Europe, top European betting company are actually based in Malta historically for the last 20 years. So we have a pool of talent in term of KYC, transaction monitoring and compliance and money laundering, et cetera, anti-money laundering. That is very valuable. And so for us, indeed, when you create an account, it depends of the country. If you’re in Turkey, in Brazil, in Mexico for example, or in Europe, you have a different set of rules. So we had to develop a platform that based off where you are will react one way or another based on the local regulation.

And sometimes it’s going to become a bit frustrating because for example, NFTs in Europe, you can buy NFTs, you can trade NFTs, and you don’t need KYC, you don’t need AML. And so you don’t even need theoretically, let’s say age verification, let’s say there is, but there is an argument that it’s easier to play dirty if you wanted to with NFTs than it is with traditional crypto assets that are fungible. And in our case, depends on the country. For example, in UK because of the new FCA rules, you cannot spend your first euro or your first pound if you haven’t been KYCed and if you haven’t answered, I don’t know, I think it’s six questions out of 24 that are randomly picked up. And I believe as well that you cannot deposit your first euro or pound before a 24 hours cool down period, which is a little bit crazy, but it is the rules, so we have to follow the rules.

In continental Europe, it’s a little bit different. In Turkey, it’s different, in Malaysia it’s different. For me, what’s going to be interesting and frustrating and challenging is, we need to start to educate regulators about two kind of views of crypto. One is the trading part, the other one is the utility part. And should I, if I’m a fan of Paris Saint German or Barcelona, I just want to spend 50 euro in order to acquire this token and to vote on the decision of the club and do stuff with tickets. Should I KYC myself fully? KYC for 50 euro knowing that you cannot trade it or it’s not a medium of exchange, you cannot redraw whatsoever at that point. So it’s literally a transaction that is one way. And should I give my full identity card and whatever other things that are requested? It’s challenging.

So the problem we’re going to face in the next two, three years is, every single thing that touch crypto will be put in the same basket that is trading, yet there will be more and more utility platform and tools that should not require that deep KYC at first. Don’t take me wrong, as soon as I spend more than 50 euro or 200 euro, or as soon as I can trade or withdraw. So the platform becomes a medium of exchange, yes, of course I need to be KYCed before that, but when I just want to consume the utility of the asset I just bought, for that, I believe we should build new rules. And nobody ever has done that for the time being.

Ian:

Yeah, I haven’t seen that. In fact, what I’ve seen a lot of the rules being rolled out over the last year have a threshold of zero as the value point anything greater than zero… Right?

Alexandre:

Which by the way doesn’t exist in gambling, which is a little bit ironic, because in most of sports betting and online casino and online poker ad and countries, you could see an ad right now of DraftKings and FanDuel in the US you can see an ad of Ladbrokes, you create your account, you put 200 pound, 500 pound, thousand euro immediately, and then you have 15 days, 30 days to validate your account, et cetera. So you can spend already, actually you can spend and lose if it’s the question, immediately. And it’s true in the US as well, by the way, I think so. In most of states at least.

And crypto went, because of the toxicity of the narrative and the risk that it carry, which is true, it went super to the other extreme. But I don’t think it fit the utility narrative and I hope one day it’ll change a little bit. And that’s where there is from a regulatory point of view, there is a question about non-custodial utility platform where eventually people does the custody of their own asset and therefore we, Socios or someone else, can just take care of the utility, which is obviously a non-regulated product. And that’s going to be interesting I think in next 18 months to see how we can mix that.

Ian:

It’s so hard to do noncustodial platforms though, right? For the average user, the average sports team fan, right? Get a wallet, manage the security around that wallet. That seems like a huge challenge, right?

Alexandre:

Listen, I’m the only guy probably that you to have interviewed that doesn’t have MetaMask. So me, I need easy stuff. I need a MPC wallet where I don’t want private keys. Again, I’m not in crypto to evangelize the world about decentralization, I’m in crypto for the sports space. So we looked, and Socios will launch next year, not in the US but in the rest of the world, we will have a non-custodial wallet and we’re going to try to focus on that. But the tech is done by third party where the security is what we call multi-party computing or something like that, NPC and where you can just have an email or you can just have your Twitter account or whatever to have access and to sign transaction. And that’s cool. There is still the fiat component at the beginning. How do you fund your account because this has to be KYC one way or another, but there are more and more tools in all fairness that makes this way more mainstream even for a guy like me. And that’s what we need to push.

Ian:

Yeah. What about security? I would have to imagine valuable tokens, less technically savvy user base maybe than a typical crypto exchange. Really big brands participating. You’ve got to be a fairly high value target if I’m putting myself in the shoes of a [inaudible 00:38:20].

Alexandre:

Don’t jinx it, please, don’t jinx it. I mean, I guess still, no, we were not really because we had this kind of private chain, but now that Chiliz Chain is a fully permissionless chain, it’s our biggest risk and that’s very stressful, obviously we are trying to alienate nobody, we love everybody. The amount of the assets or maybe in a way, at least for the time being, they’re very low. So maybe it’s not the best target for the time being, but hopefully one day it’ll be, it’s a good problem to have. Of course, we have to be careful. We have to be careful the way we handle it.

And it’s the scary part. Now that reality is not that we became what is the chain became more decentralized. It’s a risk from the governance point of view, it’s a risk that is on every asset on the chain. It’s not really the risk anymore as an issuer like we can be. The platform, obviously it’s a risk as well, but hopefully we will become more and more non-custodial as well. But yeah, that’s the non cool part of that business, is being a potential target of white or black hack. And that’s an issue.

Ian:

I would imagine that from your days in the online poker world, this had to be, you had to face similar challenges in that world?

Alexandre:

Yeah, definitely. So there was no crypto, there was only, so-called fiat money. So for that angle, the money actually in the online gaming, the problem was not money in, money out, was the fact, I will always remember that in my life, so 2005, 2006. So we had a sports book. We were doing a regulated sports book actually from the UK. We had a license in the UK, et cetera. And we cover, I don’t know, hundreds of sports and there is this Polish football matches, I think they were Polish, I don’t want to say something wrong. And 10 minutes before the beginning of the match, at that time the live beating didn’t exist. 10 minutes before the beginning of the match, you have a gang of 10, 12 people that deposit money with actually wallets. Actually back in the years there were wallets called Neteller or Moneybookers, which are digital wallets, not crypto, but digital wallet like PayPal, more or less equivalent of PayPal.

And they deposit the money there, they win because the match was rigged and then they withdraw the money 10 minutes after the match. So this is typically the kind of attacks that used to exist, and it still exists actually in the sports space. And so you had to have tools to monitor that “hey, if the guy made a deposit more than this, you have to block the withdrawal for 24 hours so you can make verification.” Then you have to check that the result that you enter or it’s an API that you enter for is the accurate one, was there a suspicion of rigging, et cetera.

So that was for the sports betting. In poker, it’s even worse. In poker, the danger was the fact that people use stolen credit card to deposit money in a poker room. Then they play on a table with some friends, they lose their money to their friends on the cash game table, the friends, we draw that money legitimately. And then you get 30 days later the cashback of the credit card company and you paid the other guys. So all of these tools and smell, I would say that you need to be educated about to protect yourself. It’s same but different. But eventually it’s always the same scheme.

Ian:

I’ll be honest, it sounds way harder than securing things in crypto. I mean,-

Alexandre:

That Is for sure. Yeah, for sure.

Ian:

Having a professional football team throw a match and having people wagering against that, knowing the result was coming, I mean that’s a hard thing to defend against. That’s not technical security, that’s some serious social engineering. What do you think about the US market? Do you anticipate being able to come back to the US at some point in the future? What’s your outlook here?

Alexandre:

Sorry, can you repeat?

Ian:

Yeah. What is your outlook on the American market? You think you’ll be able to come back to the US at some point?

Alexandre:

Yes, I guess so. I mean, US is interesting because you could probably argue that it’s one of the most innovative country in term of innovation, yet sports betting, regulated sports betting and regulated poker, regulated gambling was more or less the latest countries out of all the western countries in the world. And by 10 years or 15 years, if you look at UK or even a few others. Then in crypto you can see that there is a cleanup happening right now and probably it’s healthy one way or another. So I’m pretty bullish, not bullish, but I’m pretty confident that regulation and clear guidance and framework will happen post November next year.

And so 25 should be a year where you’ll have hopefully a clear guidance about what you can do. Because what you cannot do is pretty clear right now. It’s more or less everything, but what you can do is not clear. And so I think for us, by that time, hopefully we would have proven like we did in the past, that we are a good partner to work with sports property. As I said, we spent more or less 80 million working with some US sports team in order to prepare an upcoming regulation that unfortunately never came. So we lost a lot of money, and we are confident that at some point in the next two, three years, we will be able to reinvest one way or another. And if we can’t, that’s fine as well. The rest of the world is good enough.

Ian:

Well, that’s terrific. My customary closing question. As you look to the next year and a half, beyond the US market, everything else in your business, what’s getting you really excited? What do we have to look forward to on the roadmap?

Alexandre:

For us, it’s really about new, we call that SportFi. So you have GenFi, DeFi, SportFi, so it’s all the new SportFi features that third party or us one way or another, are going to be able to launch, promote or support. That’s the main thing I guess next year and a bit more decentralization actually. And as I said at the beginning is, I’m a Web 1.0 guy, we are a Web 2.2 company. I hope to be a Web 2.5, 2.6 by the end of next year as a company. And I think it’s just enjoying the ride, offering better product to the fans, offering better product to the teams. That’s really what we are pushing.

Ian:

Wow, that sounds exciting, Alex, thanks so much for joining us on the podcast. This has been fantastic.

Alexandre:

Thanks again.

The post Fan Tokens and SportsFi: Alexandre Dreyfus – Ep. 89 appeared first on Chainalysis.

Combatting Fraud in the Crypto and Fintech Industry: Podcast Ep. 85

https://www.chainalysis.com/blog/combatting-fraud-in-crypto-fintech-industry-ep-85/

Episode 85 of the Public Key podcast is here and we are happy that you love the refreshed look.  Fraud is the leading concern for many traditional and crypto companies navigating the non-face to face onboarding process and we speak with Tommy Nicholas  (CEO of Alloy), who has been helping companies combat fraud for over 8 years.

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 85.

Public Key Episode 85: Your fraud model is broken and here is why

When Tommy Nicholas (CEO of Alloy) wrote a blog titled, Your Fraud Model Is Broken, you had to know  Ian Andrews (CMO, Chainalysis) was going to have a fun and insightful conversation.

In this episode, Tommy discusses how early NFTs and Bitcoin transaction speed got him interested in the space, and years later his company Alloy is now servicing Fintechs, Crypto and TradFi companies managing their compliance, AML, credit, and fraud risk.

He explains the broken fraud model and the need for a shift in approach to focus on the person rather than just the transaction. He emphasizes the importance of transparency and accountability by regulators in the industry and the burdensome requirements placed on the private sector.

Tommy also breaks down Alloy’s Annual State of Compliance Benchmark Report 2023 and how automation and even AI can support compliance teams in any industry. 

Quote of the episode

“It’s widely believed, and it is true that the best way to stop fraud is at the front door. Like, just don’t open accounts for people … who are stealing other people’s identities, creating synthetic identities or just here to commit fraud in the first place.” – Tommy Nicholas  (CEO, Alloy)

Minute-by-minute episode breakdown

  • (2:10) – Alloy’s role in managing wide variety of risks for companies dealing with money
  • (5:08) – Alloy as an operating system for risk management instead of just another risk solution 
  • (7:23) – The frustration behind the blog “Your Fraud Model is Broken”
  • (14:33) – The burden and costs of money laundering controls on the private sector
  • (18:27) – The inefficiency of processing suspicious activity reports
  • (22:56) – Threat actors taking advantage of online onboarding
  • (30:03) – How Alloy got into the crypto industry and fraudulent practices they have identified
  • (33:13) – Involvement in the NFT community and the potential of digital collectibles

 

Related resources

Check out more resources provided by Chainalysis that perfectly complement this episode of the Public Key.

Speakers on today’s episode

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Chainalysis does not guarantee or warrant the accuracy, completeness, timeliness, suitability or validity of the information in any particular podcast and will not be responsible for any claim attributable to errors, omissions, or other inaccuracies of any part of such material. 

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Transcript

Ian:

Hey, everyone. Welcome back to another episode of Public Key. This is your host, Ian Andrews. Today I’m joined by the CEO of Alloy, Tommy Nicholas. Tommy, welcome to the program.

Tommy:

Hey Ian, thanks for having me. Excited to be here.

Ian:

I think your company is one of the firms that I never heard of until I got into this world of crypto compliance, and now I have an appreciation for the scale and importance of the role your technology plays across the fintech ecosystem. Maybe let’s assume the rest of the audience is kind of like me and maybe not as familiar. Where did Alloy come from, and catch us up to the present of what you all are doing today?

Tommy:

It’s actually funny that you mentioned crypto compliance because Alloy’s main role is not necessarily to work with crypto companies, it’s to work with all companies that deal with money of any kind, to manage risk for them without impacting their users. So compliance, AML risk, credit risk, and fraud risk in retail financial services. But how we actually started the business was from experiences that we had had working in ACH payment processing, not specifically for, but largely for money services businesses, which included crypto companies, and realizing that the systems behind the scenes that needed to make sure people were who they said they were, weren’t there to commit fraud, weren’t using, buying, for example, buying cryptocurrency to commit money laundering, weren’t looking for margin or credit that they couldn’t pay back, inclusive of floating payment times to be faster, that those systems were very hard to build for technical companies that needed to do… Issue bank accounts, transfer payments, sell crypto, whatever it was that touched money on the internet.

And we were surprised to find that while there were a lot of solutions in the space to address parts of the problem, there were no sort of infrastructural level solutions to what we would call decision-making or full risk management, and that’s what we set out to build. We’re really the operating system and the decision-making layer that integrates the entire ecosystem of, again, AML compliance, fraud, and credit providers, to stitch them together into a cohesive, automated, and effective decision-making apparatus for companies that need to make decisions about their customers in real time in financial services on the internet.

Ian:

That sounds awesome because I can just think about the landscape in my head and I can probably come up with half a dozen companies that do just one piece, like KYC. And really within know your customer, they’re really doing identity verification at the point of account opening, but that’s really just one slice of the problem that you’re trying to tackle at Alloy, right? That would be either a plugin to your solution or you could potentially roll up a bunch of point solutions that a company is maybe trying to assemble on their own, I’m guessing.

Tommy:

Yeah, you got it, man. So the jobs to be done are, you’re applying… Let’s just use applying. You’re applying for a credit card. The jobs to be done are to verify the customer is who they say they are, make sure that their intent is not to commit fraud, but also to assess their credit worthiness and whether they’re a money launderer. Across that, you’ve got to go assemble data and other things from third parties that can do the things I just described. When it comes to credit worthiness, it’d be like the credit bureaus and things like that. When it comes to identity verification, lots of different folks who could do that when it comes to fraud prevention, lots of different folks who could do that sanction screening, et cetera, et cetera. So we got to go get the information for them. Then we’ve got to put together a policy for how do we even say yes or no to each of these things?

Then we may have to have a person intervene to do some sort of manual intervention, or the customer may need to intervene. Hey, your credit was frozen. We need to tell you that so you can unfreeze your credit and we can restart the process. Hey, we couldn’t verify you. We need you to do a step-up authentication. We need to facilitate that process. So all of that is very complicated and we facilitate it.

Then there’s also the behind the scenes work of keeping an audit trail of that, keeping records of that, iterating it over time, back testing to see how you can make improvements, AB testing and split testing. So you can just think about everything that you might build to facilitate risk decision-making on the internet when it needs to be real time and touch your customer. Instead of having to build those systems, you just install one simple API and SDK, and we can control all of that for you regardless of how you decide to actually go about it in the future, regardless of the providers you decide to use, regardless of how your policy evolves over time, regardless of how many different ways you want to split, regardless of how you want to split on geography or customer type or whatever. And so we’re really, I almost think of us like a core or a processor or an operating system for the risk ecosystem, not a particular application or product within the risk ecosystem.

Ian:

I mean, to me it sounds very much like the first experience I had when someone showed me Stripe. It was like, oh my gosh, you’ve simplified what was a stack of paperwork and months to years of developer complexity to integrate something as simple as accepting credit cards down to a really simple API call, and you’ve made the entire experience pleasant. I feel like you’re tackling the next pillar in financial services complexity for companies that are trying to get into the space.

Tommy:

I used to resist that analogy because I misunderstood Stripe’s business, I actually think. Because I would’ve thought, I would say no, actually the Stripe of KYC would be more like one of our partners, like an underlying provider who does some part of that or whatever. But over time it’s become a very good analogy because ultimately what are they doing? They aggregate things a little bit more than we necessarily do. Because you don’t even need to go have anything to do with Visa, MasterCard or AMX, right? Whereas we wouldn’t necessarily keep you away. You still can have relationships with our underlying partners like the fraud providers and the authenticators and all of that. Other than that, the analogy holds because they’re going and saying, no need to go do all the crazy connection and certification, no need to figure out how to manage next steps. Oh, by the way, there’s a bunch of back office processes that if we don’t provide them, you’re going to have to build them. Reconciliation, audit trail, manual review, even eventually for them, fraud prevention, et cetera.

And if you really think about it, financial services is like ledgering payments and risk, and there’s core system for ledgering. So that’d be like the banking cores like FIS, Jack Henry, Pfizer. They just do the core functions of facilitating deposit holding and lending and a whole bunch of other things. There’s payments that’s like Stripe and all sorts of other payment processors. They are not Visa, AMX, et cetera. They are just the facilitators of the whole process. In the risk ecosystem, fraud, credit, and compliance risk, there really weren’t… That wasn’t really considered a category, but it’s like to me one-third of financial services. It’s like the money you hold, that’s the ledger, the way the money moves, that’s the payments, and then the risk of all of that. And so I think it was inevitable that as financial services moved online, that gap would become obvious and it’s very obvious to the market now. Even nine years ago, it wasn’t necessarily obvious that that category needed to exist, but it definitely does, and that’s what we do.

Ian:

Well, and I think it trends along with the digitization of everything, right? As we get more and more of the back office or infrastructure layer technology brought online, it allows us to iterate much more quickly in the retail user land experience and there’s much better products that come out of it.

Tommy:

You got it.

Ian:

Catching up on some of your marketing content, I, as a CMO, kind of enjoy putting a stake in the ground. So you published a blog this summer. Your Fraud Model is Broken was the title. Unpack that for us a little bit. What led you to pen this blog and what’s really the story here about why most people are approaching fraud the wrong way?

Tommy:

Well, the real reason that we penned that blog is actually my own frustration, and it’s pretty rare that we make a statement that really does come from me. We have a lot of smarter people than me thinking of things all the time, but I’ve spent a lot of time with our customers, with the technology in the space. I’ve been in the guts of the problem of predicting whether a customer is going to defraud you for a long time. And something that was really frustrating me was, we were having difficulty explaining a concept to folks who would come to us and say, “Okay, so we are issuing a credit card. We need somebody to figure out if our credit card transactions are fraudulent.” And I would constantly try to break this down for people. Just credit cards are just one example, but this is the one that really… I’d say, well, there’s two things that could happen where… There were actually really three things that could happen where the transactions could… Well, first of all, transactions can’t be fraudulent because transactions are not sentient, so the person is the fraudulent one, so let’s start with that.

And second of all, there’s three things that can happen. One, the customer was always going to commit fraud from the beginning, and they are who they say they are. The second is that they’re not… They signed up with somebody else’s identity in some way. There’s a bunch of different ways that could happen. That becomes super multifaceted. They stole an identity, they created one from scratch, they tricked somebody into using their identity for them, a million things that could happen. And the third is that the card was stolen and somebody else used it, but the person who originally got it was who they said they were. The transaction matters very little other than as a signal for whether the person always intended to commit fraud from the beginning, which is the first two types and the by far most prominent types of fraud online.

It’s so easy to sign up for the thing that you go figure out some way to sign up for it, use somebody else’s identity to commit fraud. And then even in the instance where the transaction can be determined to be not the kind of transaction the original cardholder would’ve normally done, and therefore something you should block, where the transaction in that sense is pretty important because you’re just… Different type of transaction than this customer usually makes. Well, you’re still trying to figure out whether the person changed from one person to another person.

And so the whole framing of trying to figure out whether these transactions are fraudulent makes actually no sense, almost literally no sense for the instance where the customer was always intending to defraud you in the first place. Because at most, the transaction’s details are an enhancement on the information that you really know or should know about the customer, which is really what you’re trying to figure out. And even in the instance where the transaction is probably the key point of information because trying to figure out using a transaction, whether the card changed hands, any information you can possibly know about how the person changed, it would be more impactful. And increasingly with digital devices, we have hints that that could have happened. And so-

Ian:

Yeah, this is what I was curious to dig in on is, what’s the solve here? So if instead of focusing exclusively at the transaction level, we need to focus on the person level, there’s a headline in the blog, people steal money. I’m on board with that. What’s the technical solution to enable companies to better prevent fraud? What should they be shifting in terms of their approach?

Tommy:

So just to even think about why is this not the dead most obvious thing anybody’s ever said? It’s actually just rewind and think about who had credit cards and bank accounts, just to use those two examples, even 10 years ago? It was people who had opened those accounts and to some extent in person. It’s very hard to commit fraud at scale in person. There’s lots of fraud committed in person. I just mean it’s hard to do it at the scale that you can do… Commit fraud on the internet in person. So there are people who’ve opened bank accounts in person, most of which weren’t fraudulent, and the products they were using were built for people who were operating things largely in person, like swiping at terminals and various stuff like that.

So the language that people have just used around fraud, particularly as it relates to payments, makes sense in the context of, well, most of the users of these products didn’t… Started off as strongly authenticated as you can possibly be because they walked into a branch and, yes, they may have always been intending to commit fraud, but we have credit bureaus and other things to try to figure that out and make it so you can only do that a maximum of one time.

And then, B, we know, knowing a lot about that person wouldn’t tell us a ton other than we want to know, what do they typically do so we can figure out if they do something else because that’s probably not them. And that’s the whole job to be done in that world. The thing that’s changed is two things. One is, these products are by and large increasingly not being originated in the sort of most ultra strongly authenticated meet space that you could possibly… That’s not where the people are getting these products. They’re getting products online, a highly manipulatable process. No matter how strongly you authenticate them, it’s a manipulable process that could be done at scale. So the professional fraudsters are coming after you because if they get you, they can get you at scale. And then the people are operating these products in various ways on devices, not just with physical cards.

So the technological solution is to start from, let’s assess the identity of the person and let’s use transactions as an input to assess both the intent of that person from day one and the intent of that person today because they may have changed as people. But we’re not going to just use transactional information because we’re not just a transactional system. We’re going to use identity information, the information we know about how they signed up, where they were, where they live, what devices they use, what their history is, and various things like that. And that’s going to give us a more robust picture.

Ian:

And does that start to change? Have you actually been able to observe a shift in occurrence of fraud or detection of fraud in your customers that have adjusted their approach and model?

Tommy:

What was frustrating for me in trying to make this point originally is, even the people who are asking us had already had success with a more entity in person specific approach to fraud because it’s sort of known that the best way to stop fraud, it’s widely believed, and it is true that the best way to stop fraud is at the front door. Just don’t open accounts for people who are stealing other people’s identities, creating synthetic identities, or are just here to commit fraud in the first place.

What was frustrating was the assumption that once you’ve done that, if you got it wrong on the other side, that that information isn’t the key information for figuring out if you got it wrong. You did open an account for somebody who intended to commit fraud. I still think there’s a general orientation in the industry that the only way you would figure that out is by, I don’t know, looking at time series data of transactions and trying to build a model of what a fraudulent transaction looks like. But we’ve proven over and over and over again that it’s the merging of those datasets that tells you what you miss during the authentication stage, and that’s really the point we’re trying to make to people here with that blog.

Ian:

Yeah, sorry. Take your time. We’ll edit it out.

Tommy:

Yeah, give me like 15 seconds. I thought I had some 

Ian:

Yeah, yeah, go ahead.

Tommy:

Fortunately I was done with that point anyway.

Ian:

Yeah, no, it is a perfect clean cut. No worries.

Tommy:

All right, great.

Ian:

You good?

Tommy:

Yep.

Ian:

All right, we’re back. So I’d love your organization’s produced some data on what’s actually going on in the industry. One of the interesting pieces of content we’ll link to in the show notes is your state of compliance benchmark report. One of the topics that I hear a lot from the compliance professionals that listen to this show is how much time and effort goes into suspicious activity reports. I mean, this is kind of a hallmark of the industry going back for years, and you put some numbers behind the scale of the number of SARS that are being produced by organization. I think 10,000 SARS on average for small- and medium-sized organizations who are dedicating one to 24 employees for reviewing and filing those suspicious activity reports, and that escalates for large organizations up to 50,000 SARS per year.

Tommy:

Yeah, that’s a lot.

Ian:

Which is staggering. You talk a lot about automation as being critical to solving this problem. Because I look at that and that’s just cost center of compliance inside of a business. You’re never going to get resourced, allocated correctly to the obvious demand and need that’s there. What’s the answer here? Because I feel like it ties into this conversation we’re just having about fixing the way people think about fraud.

Tommy:

They are related. I think just filling out a suspicious activity report, which is effectively a form, but it can be done via XML, but it’s effectively a form provided by FinCEN, which is money movement regulator for… I’m just trying to come up with a simple way to explain who they are… In order to track across… The theory is we’re going to track suspicious activity across all financial institutions in the US or globally, depending on how you’re looking at it, and we’re going to find trends and we’re going to catch bad guys and we’re going to do all this stuff.

Well, I think there’s two things. One is we would love to see, and I think the whole industry would love to see a little bit more accountability from regulators that that’s actually happening and it’s effective. And I think it is a little bit, but we’d love to… I think it would be good to show more of that or to share more information and data and actually allow more people to be helpful with the information they have from these SARS. Because filling out even one of these suspicious activity reports manually, I think it’s over a hundred questions. It’s a lot. It takes a long time and it’s not just filling out the information, but you have to come up with a narrative and you have to put a lot of stuff together.

I think the good news is that you can file… Oh, and so then you file a suspicious activity report and then there’s a bunch of other stuff that happens. You may have to file a continuing activity report if the customer you filed the suspicious activity about, Hey, this person might be money laundering. We’re not sure, file the report. They continue to do what they’re doing. You haven’t shut the account down because you’re not… It’s suspicious, not dispositive yet. You have to provide a continuing, and there’s even limitations on what you can even do if you suspect somebody of money laundering. Then you have to file a continuing activity report. Oh, you filled out one of these forms when you filled out one of the fields wrong. There’s feedback, there’s all this other stuff.

What we can do to help out, so it’s really, really hard. I think I covered that. What we can do to help out and what we do, but also this isn’t a pitch. It’s more of what the industry’s working on is like, well, how many of those hundred fields can we basically fill from a core system? How many of them are really about the identity of the person or the identity of the persons that are involved in all these transactions? Can we pre-fill this? A huge pain point is basically you fill out something wrong with the form and you get feedback. Can we automate that process inclusive of if FinCEN gives feedback in an asynchronous process that you couldn’t have known in advance because somehow they come up with some problem with what you wrote. Can we assist people in having really ready access to how they would construct the narrative?

That’s where automation comes in, and that is possible, and I think we are getting to more of a point where just deciding that the investigation showed money laundering and writing the narrative will be the bulk of the work that needs to be done. I think that can be done through our system if you’re combining the identity information and the transactional information in one place. I think we can help with that. And I also look forward to someday maybe even some of the narrative generation being computer assisted.

I think I’m a big skeptic of large language models as having a role in fraud prevention and compliance generally, but that’s one area I think they could be killer. I think it would be a great, safe, really good use of large language models to summarize a big set of information that a human’s already decided what happened with, but goddamn, they got to write a lot of stuff about it. I think like a GPT type, something like GPT-4 or another large language model could be appropriate for that. But I would say 98% of what needs to happen is actually just getting information from here and putting it there, and that’s a lot of what we’ve been working on automating for our customers.

Ian:

One of the critiques that I hear echoed a lot in the industry is the entire surveillance apparatus that has probably started in the seventies with the Bank Secrecy Act being passed in the United States and then was extended significantly post 9/11 with the Patriot Act is somehow like theater. It doesn’t actually serve a real purpose of protecting the United States from terrorists or protecting consumers. It’s just a huge expense and burden on everybody with very little real results. What’s your perspective on that, as somebody that sits in the industry and works with companies who are carrying that burden? It doesn’t feel realistic to me, but I’d love your opinion.

Tommy:

It’s not fully true at all, of course. And there’s a lot of money laundering that is prevented. There’s a lot of people who go to jail. There’s a lot, correctly, for having committed serious financial crime. But there’s two things I’ll say and I’ll first, I’ll defend the surveillance state, the deep state. Whatever term we use will be criticized by somebody, so I’ll criticize it… I’ll give credit to the surveillance state first, which is a lot of what’s happening is that they’re looking for big fish. They don’t want to chase down, they can’t chase down, or they’re not necessarily focused on chasing down every little thing that goes wrong and every bad thing that happens. They’re collecting this information so that when something really, really serious is happening, they can swoop in with insane precision and stop it and prosecute it successfully. Whether that’s with another nation state that they have to make the case to or whether that’s in the US judicial system.

That’s the biggest thing that I think people just lose is they’re just not interested in or capable of prosecuting and litigating every single case of money laundering that exists. They’re looking to stop big rings of it all at once so they don’t tip their hand because of resources, all this other stuff. So I think that’s… I’ll defend them there.

I’ll criticize them in like, well, how do we know that? Citizens have to be… It just is what it is. I know that people will come up with all sorts of reasons why, well, certainly you can’t know this or that. Citizens have a right to be and I think have to be informed about the effectiveness of their government, and especially a private sector that’s being asked this much. The burden of, I’m a guy who’s pro the government asking things of the private sector. That’s my general bent. What is asked of the private sector when it comes to money laundering controls in particular is a lot. It is large. It is a humongous cost burden, et cetera, et cetera, and it has humongous costs on consumers, too. Time, access, et cetera. Those costs need to be taken into consideration, and I think the absolute minimum the federal government in particular could be doing is providing more transparency on what is being done, what isn’t being done, what can be done, what’s being worked on.

I’m not saying, Hey, let me show you some cases that are in progress so we can screw them up and let some criminals off, but there needs to be more transparency and narrative provided because even industry professionals who work in AML will say, oh, it doesn’t catch any money laundering, right? You’ll even hear that from people who are as educated as they could possibly be on the topic. They’re wrong, but they’re not totally wrong, and then they’re also not wrong for thinking that, and I really think there should be change.

Ian:

Well, and even going back to the topic of SARS, I mean, I think it’s a burden on industry to produce those reports. Equally, governments consuming them, actually processing them and yielding some useful insight that allows us to catch a bad guy who’s running a terrorist financing ring. They’re overwhelmed with the amount of data that’s coming inbound, so it’s a problem on both sides. There’s such inefficiency there. They-

Tommy:

And if the government doesn’t provide transparency and feedback, it’s like if a team at a company doesn’t provide transparency and feedback. Sometimes it’s because they’re geniuses and they’re just crushing it, but sometimes it’s because they’re screwing everything up and they don’t know what they’re doing and they could use help. That is sometimes what is going on, and the American people will lose trust in institutions where they suspect that maybe they’re screwing everything up. It comes to light a decade later that they were, and they say, well, everything must be screwed up like that, and it’s certainly not the case.

I really think that this is an area where the narrative will always be, this is a waste of time. This is a waste of money, but we have to do it, and it could be this is the most important duty that we have as a private sector is to help with this. We feel really, really good that we helped, and it’d be the last thing I would ask the government. That should be how people feel about it and instead people should feel like the crime that’s… Largely the crime that’s being detected by filing SARS is the most non-controversially awful stuff in the world. It’s like child trafficking. We should all feel really, really good about stopping.

Ian:

That’s right. Yeah.

There’s nobody that’s in favor of enabling human trafficking. I mean, you’ve got a great slide in one of the compliance reports that talks about leading indicators for suspicious activity. Money laundering, tax evasion, identity theft, bribery and corruption, insider trading, human trafficking, terrorist financing. This is-

Tommy:

Pretty bad, pretty bad.

Ian:

… pretty bad stuff.

Tommy:

Not great, not great. Yeah, so we feel like we’re Sisyphus, did I say that right, pushing the rock up the hill. And we could feel like Captain America or whatever. It’s a miss by the federal government not to provide, I’ve said my piece, but the information that would make us feel that way, I think.

Ian:

Well, let’s shift gears a little bit. You touched on it earlier that one of the interesting things that’s happened over the last two decades is this transition from where you used to, if you wanted a bank account or a credit card, you walked into a bank branch in person with a bunch of identity documentation. Perhaps you already have a relationship with the bank in some capacity. But even if you’re a new customer, they go to great lengths to verify your identity. Now you can get a new credit card in under 15 minutes via an internet browser anywhere in the world. It’s a pretty straightforward, streamlined, simplified process. What has that done in your impression from a threat landscape perspective? Who are the threat actors that you see taking advantage of that shift in the customer onboarding model, and where’s the money being made if you’re the bad guys taking advantage of this?

Tommy:

Yeah, okay, so I think the easiest way to explain this is to just go ahead and say, let’s say that the online 15-minute credit card application actually went to exactly as many lengths to verify the identity as the in-person branch application. That is often not true. Let’s just say it is. Why is the threat landscape still changed dramatically? It’s just meet space versus bits. It’s just if it turns out that an exploit can be found even with all the intent, let’s say you even have to do a video call with somebody to move your head around and show your ID and all sorts of different stuff. It doesn’t matter what you do. It’s the fact that if an exploit was found, it could be automated at scale. That’s the real problem. And even if it couldn’t be automated at scale, maybe it could be Mechanical Turked at scale. You could recruit a bunch of people to exploit the whole that you find in this process at scale.

That might even include tricking people, which it often does, tricking people into opening accounts and then handing them over to you unknowingly and then committing fraud. So there’s always an exploit and now it can be committed at scale. That basically creates this unvirtuous cycle, which is exploit found, organization of some kind, whether that’s a state actor or a semi-state actor, or quite often just a group of people that are just motivated to do this and form a loose affiliation, maybe even on telegram, maybe in person, whatever it is, go exploit an exploit. And then they do it at a bigger scale. Then they do it at a bigger scale. Now they have a bunch of money, they invest in technology, they build AI to actually try to fool the exploit. Now they have more exploits they can… Now they have more money. Now they’re basically like a startup with a billion dollars of funding to do all this stuff.

A combination of, I would say, the exploits that came from pandemic relief and then the exploits that have come from the sort of broad digitization of financial services, inclusive of crypto hacks that is a subset of the broader digitization of financial services, have left some of these organizations very well funded. Some of them were well funded in the first place because they’re state sponsored actors, and states can sponsor quite a bit of funding in my experience. But some of them weren’t and they were just people on the street that are now wildly sophisticated, really, really, really tough actors, and they might also be in countries where we can’t necessarily go swoop in and stop them from happening. That’s what makes the threat landscape so complicated. I think what’s weird about the US that I still can’t totally figure out is some of those people are in the United States and they’re not being prosecuted.

I would like answers to that. There’s groups of people. This is kind of where the transparency comes in. If I just even felt like some of the groups of people that we know that are committing fraud in different geographies or whatever, were eventually going to be prosecuted and we’re just building our case and we’re just going to have to eat some pain for a little bit, that’d be great. I don’t even know if that’s true. I just don’t know if there’s just a non-intervention policy that’s come around to some certain types of credit card fraud. I don’t know what the deal is, and I would like to know what the deal is, and I would feel like if anyone would know what the deal was, it would be me. And we don’t necessarily. But then there’s also, I understand it’s very complicated to go invade a country to pull somebody out because committing fraud. There’s these two different things, but some of these groups are just fully in California committing fraud. Everyone knows who they are. Not sure what’s going on.

Ian:

That’s incredible. It is interesting, though, your point about how many of these fraud shops have actually become software businesses under themselves. I’ve spent a bit of time reading about some of these organizations where in some cases they’re building software frameworks that allow you to stand up, then an entirely fraudulent website that maybe is a trading platform for crypto or for stocks, and they give you an entire playbook to run to recruit people who think they’re using a legitimate service, and eventually fleeces them of large sums of money. We hear about this all the time under the banner of pig butchering scams. I didn’t appreciate quite how frequently that software is cloned, and so there’s been take-downs recently of a couple of these strains and it’s like hundreds or thousands of copies of that trading platform that they’ve found across a variety of domains, variety of different languages. And it goes to your point about the ability to scale. If you can automate anything when we’re out of Meetware and into ones and zeros.

Tommy:

The curveball that really threw me was when I started to notice that people were being manipulated by… Manipulated, and then sometimes they get in on it and kind of know what’s happening, but manipulated or pseudo manipulated by social media, telegram, et cetera. I don’t mean to imply at any level that Facebook, the website manipulated people into committing fraud. I just mean the connections people are able to form through these are turning into a weapon that I didn’t totally grok. And we first saw this, we saw this really bad in 2020 and 2021 of our customers being like, “Hey, I’m under a fraud attack.” Okay, we figured it out. It seems to be TikTok, and we like, with TikTok? And there’d be some TikTok who’s like, here’s how you defraud Bank X. And then maybe it didn’t say exactly that, but it was effectively that’s what they were doing.

Ian:

That’s amazing.

Tommy:

That sort of thing just shows you if there’s an exploit including manipulating other people to do the exploit for you, it’ll be found. And so 

Ian:

Not even being shared on the dark web. They wanted to get their view count up, so they’re pushing it on their TikTok platform.

Tommy:

No, we have this whole list of these. We have this big download of all the ones that, or a bunch of the ones that we’ve seen, so we can show people what it looks like when somebody’s… What to look for, what to actually see, and say, oh, that’s actually a scam. I wish I could send them to my friends, but they’re a little sensitive.

Ian:

Hey, different topic. We’re a crypto podcast, obviously. We’re 35 minutes into the conversation. We haven’t really talked about crypto at all, but you guys actually do quite a lot of work in the crypto industry. Touch on the scope of that and really how you got into crypto in the first place would be I think a fascinating story.

Tommy:

So what we do for crypto companies is fairly simple. If they’re dealing with money at any level, they have the same… They are concerned about chargebacks, so they’re worried about fraud. Money can be deposited and charged back, and now the customer has the crypto and platform doesn’t have the money, so they need to prevent that. Or they need to comply with AML regulations, and so we do the verification as it relates to that and the transaction monitoring, SAR filing, et cetera. So it’s really no different than any other money services business, and we do that with some pretty interesting companies and would love to… We always love to work with anyone doing interesting that touches money. We don’t do so much in the world of totally crypto to crypto. It’s still regulated in all these different ways. We’re just less involved in that. It’s usually when there’s some fiat component of it somewhere, either an on-ramp, an exchange, any sort of off-ramp, anything like that. Or even things like issuing a credit card on top of your crypto rewards, which we’ve worked with people on.

How I got into crypto, I mean actually it was back in working in the company that inspired us to start Alloy. We were doing ACH processing and we realized there was, Bitcoin was getting really hot in 2013. If you look at the price chart, doesn’t look hot to us now, but it felt hot at the time. It was like Bitcoin’s over $300 in the world. And there was sort of a bunch of other stuff, really interesting things happening. There was the, I don’t know what to call them, but the Ripple Stellar type, replace Swift pitches going around and doing a lot of interesting stuff. There was a lot of thoughts about how you might run compute on the blockchain, et cetera. And we were just doing a lot of payment processing for those companies and I got pretty interested in it.

Actually, my big aha moment about crypto that got me excited about it was actually a bit of a false moment, which was, there was a company called Change Tip. I don’t know if you remember Change Tip. It was the coolest thing ever. I still think it was the best, which is that you could tweet somebody, you could post on Reddit, you could post a bunch of different places, Hey, Change Tip you five, a coffee, and it would go send the person… It would either send the person $5 worth of Bitcoin or it would DM them, “You don’t have a Change Tip account. We’ve created a Bitcoin address for you and there’s $5 worth of Bitcoin in it.” And I got obsessed with that. I thought it was the coolest thing ever. They could only do it because transaction fees were zero, which is what I thought was going to happen with Bitcoin.

And I got super excited about it because I got pumped about what it would be like to be able to build a money thing where you could just do it permission-less dealing with money basically on the internet. And then I got excited about transaction speeds and fees, which within a couple of years I had been disabused of the notion that that’s what we were going to actually get from crypto in the short run. There was going to be a big academic and practical set of things that were going to need to happen before that was our reality and not speaking to whether I believe that has or hasn’t happened, just that it definitely wasn’t… By 2015, we knew that wasn’t what it was going to be like forIan:

I think you’re seeing a lot of people try and do that again with Lightning Network, right?

Tommy:

Lightning NetworkIan:

Where you’ve got the lower fee structures.

Tommy:

Yeah, starting something like Solana or doing all these different alternative blockchains, I think it could still happen. It may have even happened you could say. It definitely wasn’t happening in 2015. And, yeah.

Ian:

Have you ever added up all the tips that you handed out in Bitcoin at the time and benchmarked them back to-

Tommy:

We joke about it. I bought my co-founder a coffee that I think is up to a thousand dollars now. And he kept all his Bitcoin. I didn’t, but he kept all his Bitcoin, which not some crazy amount, but even these little amounts add up to just insane. It’s insane. Because we started, it was like Bitcoin was… By the time we were really interested in it, Bitcoin was fluctuating between $300, $1,000, $300, that kind of range, but when we started messing around, it was way below $300. So these $5 tips are, what is that, 100, 200, 300x. They’re out there. If you just Google, get on Twitter and look up Change Tip and Tommy RVA, which is my… I mean they’re just, I didn’t delete them. They exist. They’re out there.

Ian:

We’re going to have a listener who’s going to go out and pull all those out, and-

Tommy:

It’s there.

Ian:

… we’re going to get a summary of everything that you paid out in tips and what it would be worth today.

Tommy:

Sure. The more interesting project that it got me more into crypto and where I know a lot more about crypto is actually in 2017, Alloy was two years old and was a very small company and very stressful company to run at the time because we were very small and had very few customers and probably it seemed fairly likely that we wouldn’t make it just because it was so small. I’ve talked about this on a bunch of podcasts. It was a really hard time for us, and I’ll skip that unless you want me to go into it. But one of the things I started to do to just distract myself on the weekends, I had… This would sound obvious to a lot of founder people, but I guess I had stopped, I tried to stop working on the weekends because it had gotten too stressful to work 24/7 on something that was very uncertain. I went back to working on the weekends, unfortunately for my wife, although I’ve mostly stopped again now, shortly thereafter because things started going up into the right.

But there was this period in 2017 where there wasn’t a lot going on at work. We were still grinding our butts off and I needed something to focus on, on the weekends that was creative but wasn’t work, and I got really, really attracted to the… I know that this has become a little bit of a controversial thing, but stick with me and I promise that it wasn’t at the time. The rare Pepe Bitcoin counterparty wallet, what they called rare digital art at the time we would call NFTs, although the people who built the Rare Pepe project would strongly disagree with that classification. I got super into, not the Pepes themselves, but the idea of creating rare digital art. And I got so into it that I started messing around with solidity and basically built a standard and a framework for creating roughly the equivalent on Ethereum because I thought it was easier to program, and I did think and still think that was probably the future of programmable crypto.

And then actually ran, my buddy and I, who now actually works at Coinbase, ran a… Decided to start and run a festival for what we called Rare Digital Art at the time, the Rare Digital Art Festival. And we had the folks from Crypto Punks come. We had the rare Pepe folks come, CryptoKitties launched between the time we announced the festival and the festival happening. And we had this event in New York City. We didn’t know if anyone would come. We had about 400 people could come and there was-

Ian:

Wow.

Tommy:

… standing room only early 2018. But there was still no… I don’t think people were saying the term NFT yet. It was like two weeks after that NFTs became the thing.

Ian:

The thing.

Tommy:

The then NFTs weirdly died, kind of, and didn’t go anywhere and then came back in… During the pandemic. So where I’ve actually really cut my teeth a lot more on the ground and where I actually know the people who have done interesting work and have had just the most modest impact is actually in the NFT community of all things. And Ian:

And how are you feeling about things now? I mean, we’re sort of back in that same period that you just described where everybody was talking about NFTs for about a year there and now, save for maybe Bitcoin ordinals, the activity, at least in terms of trading volumes is way, way off the peak.

Tommy:

Yeah, it’s similar to how I felt about Bitcoin transaction fees, et cetera, which is that… And actually going back to Bitcoin, I got super excited about the transaction fees and the speed. I actually remain excited about whether I actually think this is a good thing or not. Like non-state money that’s plausibly censorship proof. That’s actually a really big idea and I think that’s the only idea that matters in Bitcoin, and I think that’s actually a humongous, transformational idea. Whether it’s for me or not is for another discussion, although I think I am interested in it, but I disabuse myself of a lot of those notions, but held on to this, it’s illegal to create a currency and yet this other currency exists because there’s no way to stop it. That’s fascinating. I think very important and powerful, and I think probably a force for good in the world probably. I have the same with NFTs, which I hate calling them NFTs. We’re going to call them NFTs because there’s nothing else to say. There’s no other word to call them. But I also, I still think 

Ian:

We can call them rare digital art if you want. Doesn’t matter to me.

Tommy:

I think rare digital art would’ve been better, but I’ll say NFTs. I got really excited about NFTs for all sorts of things, as representations of music and all these things that people have these ideas about. I’ve come back to the original idea that I never really should have… I should have stuck with the original idea in the first place, which is, it’s digital art and it’s digital trading cards. It’s the Joe who was really running a lot of the rare Pepe stuff. Always used to say the token is the art. It’s the ownership of the token that is the material thing. It’s a collectible, and collectibles are not to be diminished in their value. Collectibles are crazy important. Art is to a large extent, a collectible item if you can buy it and you can exchange it. And I still think a lot of the best… I still think there’s incredibly exciting collectibles that will be built, and I do think cryptocurrencies are specifically the only way to do that digitally.

I don’t think we’ll see another way. I wouldn’t be interested in another way. The fact that they’re plausibly decentralized, censorship-resistant, that I plausibly actually own it if I have it, is really, really unique and some of the NFTs I own and really value, I still love the Crypto Covens. I have a bunch of them. I think they’re the freaking best. I have some of the OG NFT stuff that’s best not to talk about. And I still really value them and I still think that they will be part of culture if cryptocurrency survives, assuming cryptocurrencies survive. I actually think they will be part of culture and there’ll be another revival, but I think we’ll get out of the sort of NFTs are your pass into a Taylor Swift concert, like weird era of NFTs are everything, and that drove me nuts. I think it’s just going to be the NFT is the NFT. The token is the art. Shout out to Joe. He’s the man.

Ian:

I like it. I like it. All right, last question as we wrap up. Bringing it back to your business at Alloy, where’s the whole market going? And maybe even broader than market, the entire industry of fraud and compliance. We touched on a lot of the effort that’s going in on both sides of industry and government. Any predictions about how we get more effective at stopping the really bad guys, but enabling businesses to do a better job serving their customers and satisfying all the various stakeholders along the way? Do we see that in the near term future for everybody or is that too optimistic on my part?

Tommy:

I’m a bad person to ask because I think I’m too close to the problem. It’s like if I zoom myself out and say, Tommy, get farther away from the problem and now answer the question, I do think I see things on the horizon. A lot of the digital IDs that are coming out, actually state, individual state, or nation state issued digital IDs, that’s going to be helpful. That’s going to make a step in the process more secure and more just frictionless. So that would be good. I think I’m just a lot less confident that there actually is the incentive apparatus to get some of the other things that I think need to happen done.

I’m not sure the… I’m not sure without visibility and accountability that some of the things that need to get done will necessarily get done, so I’m less of an optimist about that. I do think though, if I can say a good thing, the explosion of investment in technology to solve these problems, because they simply have to be solved in order to do business on the internet. And maybe they always existed, but they became exacerbated. That’s been a good thing. I mean, you just think about what you all do, just an incredibly good thing that required a lot of investment to get good at and that investment moving from investors into the private sector, into companies, that’s been a really good thing. And I think the fact that the market is very competitive for solutions to get better at this stuff will also benefit, be extremely beneficial.

I’m just a little, well, where I will say that I have some optimism. The European market and the European Union seem very focused on this in a way that… Or maybe I’ll say this a different way. The US and Europe are focused on these problems in two very different ways. So we will get innovation on two different spectrums. The European market sees fraud and money laundering largely as one thing. Financial crime. United States very focused on blocking and tackling on meat and potatoes money laundering, like the things that we talked about earlier, would love to stop other types of financial crime. Very focused on risk-based approach. You do it the way you think is best, so we will find a lot of ways that are best.

European markets tend to be more prescriptive. That has some benefits when you prescribe the right solution that has some detriments. There are some European markets that have prescribed really bad solutions and they’re going to need to figure that out. So that gives me some optimism. There’s a lot of money in the space, there’s a lot of innovation. Governments are regulating this from a lot of different angles, so we’ll see what works and what doesn’t.

I still just do get worried, though, when I think about what it’s going to take to kind of get the data, information, and transparency together to really unleash the true innovation of the crowd, to stop and spot patterns across the whole ecosystem, which I think could happen if governments were motivated. That seems unlikely in the short term. And I think we’re more going to see user experience improve because there’s a lot of innovation there. We’re going to see results on fraud prevention continue to chase after what the fraudsters are doing. Fraudsters are getting a lot of new tools in AI. Fraud prevention companies will have to fight back. So I see that more as a cat and mouse game. I think user experience is continuing to improve and I think the ultimate sort of dream of really collaborating to stop money laundering at scale is work I’m not even sure is in progress. I’m a little less optimistic.

Ian:

Well, thank you for the sobering assessment of the industry overall. Tommy, this has been an awesome conversation. Really enjoyed getting to meet you and learn about the business at Alloy. Thanks so much.

Tommy:

Hey, Ian, it’s been awesome, man. Talk to you soon.

Ian:

All right.

The post Combatting Fraud in the Crypto and Fintech Industry: Podcast Ep. 85 appeared first on Chainalysis.

KPMG in Canada and Chainalysis team up to help organizations combat illicit crypto transactions

https://www.chainalysis.com/blog/kpmg-in-canada-and-chainalysis-alliance/

With the ongoing threat of crypto fraud and criminals growing more sophisticated every day, organizations need ever-powerful solutions to help them investigate and recover stolen funds. KPMG in Canada and Chainalysis are teaming up to help meet that growing need by announcing a strategic agreement in which KPMG will join the Chainalysis Solution Provider program. 

The collaboration advances the certification of KPMG professionals as Chainalysis Certified Investigators, which enhances their ability to assist clients across public sector agencies and private sector businesses to detect and prevent illicit activity related to cryptoassets.  “Our clients look to us as trusted advisors in the cryptoasset space, and our relationship with Chainalysis is a commitment to helping those clients be more agile, innovative and compliance-focused in an ecosystem that’s constantly evolving. This collaboration will help to further solidify KPMG’s expertise in forensic investigations and cryptoassets and blockchain technology,” said Kunal Bhasin, partner and Cryptoassets and Blockchain co-leader at KPMG in Canada. 

The combination leverages the expertise of both firms to provide enhanced blockchain monitoring, support, governance and risk management to help organizations adhere to evolving cryptoasset regulations and advance their Anti-Money Laundering Compliance programs. KPMG is the first Canadian professional services firm to team up with Chainalysis on forensic investigation services.

“Cryptoasset exchanges, crypto-native companies, financial institutions, government and law enforcement agencies are increasingly looking for innovative ways to help them “follow the crypto” to investigate criminal activity. By teaming up with Chainalysis, KPMG clients can benefit from Chainalysis’ proprietary blockchain data monitoring technology, resulting in improved identification of potentially criminal activities and faster response times. Addressing and reporting criminal activities quickly can be challenging for organizations, but this collaboration helps address that. Together we’re providing clients with a comprehensive understanding of fraud and financial crime risks, and knowledge to help them make well-informed decisions quickly and effectively,” says Enzo Carlucci, National Forensic Leader at KPMG in Canada

“By teaming up with one of the Canada’s largest professional services firms, our clients can leverage the expertise of KPMG’s trusted forensics and cryptoasset advisory professionals to establish effective know your transaction (KYT) rules, stronger anti-money laundering protocols and robust investigation strategies. Layering KPMG’s extensive knowledge and experience in cryptoasset financial crimes over our platform’s industry-leading risk capabilities will help provide organizations with a more comprehensive approach to mitigating fraud risks in crypto transactions,” says Jonathan Levin, Chainalysis Cofounder and Chief Strategy Officer.

Cryptoasset fraud has grown over the last few years as crypto ownership has increased. Globally, cryptocurrency-based illicit transaction volume hit an all-time high of US$20.6 billion last year, according to the Chainalysis 2023 Crypto Crime Report. The Ontario Securities Commission Contact Centre has seen a 200 per cent increase in crypto-related complaints since 2020, and the Canadian Anti-Fraud Centre received 92,078 reports of fraud in 2022, with a reported $531 million in losses, up from $379 million in 2021 and $165 million in 2020.

About KPMG Canada 

KPMG LLP, a limited liability partnership, is a full-service Audit, Tax and Advisory firm owned and operated by Canadians. For over 150 years, our professionals have provided consulting, accounting, auditing, and tax services to Canadians, inspiring confidence, empowering change, and driving innovation. Guided by our core values of Integrity, Excellence, Courage, Together, For Better, KPMG employs more than 10,000 people in over 40 locations across Canada, serving private- and public-sector clients. KPMG is consistently ranked one of Canada’s top employers and one of the best places to work in the country. 

The firm is established under the laws of Ontario and is a member of KPMG’s global organization of independent member firms affiliated with KPMG International, a private English company limited by guarantee. Each KPMG firm is a legally distinct and separate entity and describes itself as such. For more information, see kpmg.com/ca 

About Chainalysis

Chainalysis is the blockchain data platform. We provide data, software, services, and research to government agencies, exchanges, financial institutions, and insurance and cybersecurity companies in over 70 countries. Our data powers investigation, compliance, and market intelligence software that has been used to solve some of the world’s most high-profile criminal cases and grow consumer access to cryptocurrency safely. Backed by Accel, Addition, Benchmark, Coatue, GIC, Paradigm, Ribbit, and other leading firms in venture capital, Chainalysis builds trust in blockchains to promote more financial freedom with less risk. Learn more at chainalysis.com, or connect on LinkedIn and Twitter.

The post KPMG in Canada and Chainalysis team up to help organizations combat illicit crypto transactions appeared first on Chainalysis.

GEO Report: Crypto Adoption in Sub-Saharan Africa: Ep. 83

https://www.chainalysis.com/blog/crypto-adoption-in-sub-saharan-africa-ep-83/

Episode 83 of the Public Key podcast is here and we are happy that you love the refreshed look.  Our 2023 GEO Report revealed that across the Sub-Saharan African region, centralized exchanges are the most-used platform type, facilitating over half of all transaction volume and in this episode we speak to an expert on the ground, Marius Reitz (General Manager Africa, Luno), to understand what’s driving this grass-root adoption. 

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 83.

Public Key Episode 83: The crypto African market – from bans to blockchain dependency 

Our 2023 GEO Report revealed that across the Sub-Saharan African region, centralized exchanges are the most-used platform type, facilitating over half of all transaction volume and in this episode, Ian Andrews (CMO, Chainalysis) speaks to an expert on the ground, Marius Reitz (General Manager Africa, Luno), to understand what’s driving this grass-root adoption. 

Marius shares his early journey into the crypto industry and discusses the challenges and opportunities in the African market. He highlights the importance of education and the need for regulatory clarity and collaboration between the crypto industry and regulators, in order for growth and stability in the market. 

He also identifies the rise of peer-to-peer trading, and the potential for real-world asset tokenization and how Luno’s products and services continue to evolve to meet the needs of its customers and expand its presence in the African market.

Quote of the episode

“In markets where governments do not impose regulatory bans, right? Such as the one in Nigeria, you typically tend to see the market flourish, grow more responsibly,  develop more responsibly and you see more interaction between the private sector and the public sector” – Marius Reitz (General Manager Africa, Luno)

Minute-by-minute episode breakdown

  • (2:09) – Marius’s chance encounter with cryptocurrency and decision to join Luno
  • (5:08) – The landscape of crypto in South Africa in 2016 and challenges in the industry 
  • (8:20) – The role of education in Luno’s operations and challenge and focus on providing safe access to the unbanked sector
  • (12:45) – Crypto use cases in Africa: unmet needs and access to global markets
  • (16:50) – Crypto regulatory climate in South Africa and relationship with traditional banking industry
  • (19:35) – Ease of buying and selling crypto in and the peer-to-peer market in Africa
  • (29:08) – Regulatory landscape and its impact on the African crypto industry
  • (33:24) – Decentralized exchange landscape and the appetite for Real World Assets in Africa 
  • (37:45) – Regulation to drive exponential growth expected in the African crypto market

 

Related resources

Check out more resources provided by Chainalysis that perfectly complement this episode of the Public Key.

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Speakers on today’s episode

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Our podcasts are for informational purposes only, and are not intended to provide legal, tax, financial, or investment advice. Listeners should consult their own advisors before making these types of decisions. Chainalysis has no responsibility or liability for any decision made or any other acts or omissions in connection with your use of this material.

Chainalysis does not guarantee or warrant the accuracy, completeness, timeliness, suitability or validity of the information in any particular podcast and will not be responsible for any claim attributable to errors, omissions, or other inaccuracies of any part of such material. 

Unless stated otherwise, reference to any specific product or entity does not constitute an endorsement or recommendation by Chainalysis. The views expressed by guests are their own and their appearance on the program does not imply an endorsement of them or any entity they represent. Views and opinions expressed by Chainalysis employees are those of the employees and do not necessarily reflect the views of the company. 

Past Episode Mentions

[CHAINALYSIS PODCAST EPISODE 32] Remittances Are Powering Crypto Markets In Sub-Saharan Africa

Episode 32 of Public Key, the Chainalysis podcast, is here! In this episode, we talk with Ray Youssef,  CEO of Paxful and he gives us his candid thoughts on how crypto is powering a new economy in Africa and providing an alternative payment system.

[CHAINALYSIS PODCAST EPISODE 37] Powering the Digital Asset Transformation in Nigeria and Beyond

Episode 37 of the Public Key podcast is here! In this episode, we talk with co-founders Michael Adeyeri (CEO & CTO) and Moyo Sodipo (COO & CPO) of Busha, one of the fastest-growing cryptocurrency exchanges in Nigeria, about challenging access to fiat and the gray area of crypto regulations in Nigeria.

Transcript

Ian:

Hey everyone, welcome back to another episode of Public Key. This is your host, Ian Andrews. Today I’m joined by Marius Reitz, who is General Manager Africa at Luno. Marius, welcome to the show.

Marius:

Hi, Ian. Yeah, thank you very much for having me today. I look forward to the conversation.

Ian:

Well, I think you absolutely qualify as being crypto OG, right? You’ve been at Luno for over eight years in a variety of different roles. You’re now running the show on the African continent, which I’m excited to talk to you about. But I’m always curious how people, particularly people of your vintage who have been in crypto for a long time, how did you first encounter cryptocurrency, and then what made you want to move into the space professionally?

Marius:

So, my crypto journey started in 2015. It was actually by chance, so I was still in my traditional accounting role, 8:00 to 5:00, and one of Luno’s co-founders, Peter Hanks, who was the CFO at the time, pinged me on LinkedIn. He was saying which was Luno’s first name, just went through a fundraise with Naspers, and Naspers is an African tech holding company with shares in Tencent. So, Naspers at the time just invested, I think 5 million dollars into in the end of 2015. So, obviously being a share trader myself, Naspers attracted my pension and I think I was due for a new challenge in . So, I worked in business rescue work, audit and accounting work. So, yeah, I think in general I was up for a new challenge. So, I took the interview, I had a couple of conversations, a couple of barbecues on the balcony of the small office.

And then I think ultimately, I think what convinced me to join the team was the global nature of the operations. There was opportunity for me at the time to work with Nigerian customers, Nigerian stakeholders. Similar at the time, Luno was active in Malaysia as well, Luno had just launched in Indonesia. So, there was a region operations across emerging markets, mainly Africa and Southeast Asia. So, that was quite appealing, I think, Luno being able to work across many different currencies, different cultures. But of course, I didn’t have that good understanding of the technology behind Bitcoin. So, for the first year, I still wore 100% finance hat, the debits and the credits. But I think due to the nature of startup companies, and I think we were… I think was employee number 13 or 14 at the time.

The hands-on nature of the business, I was helping out in customer support and compliance and a bit of marketing. But the real first encounter that I had with crypto users, crypto early adopters, was midway through 2016 when a colleague and I traveled to Nigeria. It was just six months after Luno launched its operations in Nigeria, and we hosted a Luno/Bitcoin meetup in Lagos in mid 2016. Now that was very, very early on, and we managed to fill the… It was called the co-creation app, which is a startup incubator co work space in Lagos, managed to fill that venue.

Ian:

Wow.

Marius:

And just the enthusiasm and the interest from the Nigerian public was just mind-blowing. And I think the key point there is that at firsthand experience the challenges that people, the mass market experience on a day-to-day basis in terms of having unmet needs or needs not being made by the traditional financial system. And I think from there I started getting more involved in other aspects of the business and started interacting more with customers as well.

Ian:

Now in 2016, what was the landscape of crypto like in South Africa? When you took the job, you left your accounting job, which is probably seen as very secure and conservative role, and you jump into this startup crypto company. Did your friends and family look at you like you were crazy?

Marius:

Yeah, I think there were many skeptics out there. And I did convince my dad to also invest in Bitcoin in 2016. So, I think-

Ian:

Wow.

Marius:

… no regrets from his side. But yeah, so I think the market was mainly retail, retail market, early adopters, trading volumes on exchange and then was low, I think only until the 2017 bull run from June 2017 that we see volumes on the exchange spike. And yeah, it was very, very slow-going in countries like Nigeria, like Malaysia. And I think the challenges were apparent. I think there was a complete lack of education, so we had to do a lot of educational work. We also started operational challenges at the time, so it was not as safe and well, we tried to make it as safe as possible, and that’s the nature of centralized exchange acting as intermediary. But it was not as easy as possible for our customers to transfer from their bank accounts to Luno to purchase crypto. So, that was one of the biggest challenges still at the time. Liquidity of course, and the marks not as liquid as they are today.

So, that was also a challenge for us. But yeah, I think it was not only smooth sailing, that’s for sure. And the journey has been reveled with roadblocks and challenges, and we take the long road, we follow an approach of hyper localization. We establish a local presence in each of the markets in which we operate. We have put local boots on the ground. And yeah, I think as a result of that, we wholeheartedly believe that that’s still the best model for us today to make it as safe and easy as possible for the public to dip their toes in crypto. I think as a result of that, we have had to manage quite a number of challenges over the last couple of years. Yeah.

Ian:

Yeah, tell me more about that. So, Luno’s in 40 countries around the world today, is that right? I recall that from the notes when I was researching. Where in the world do you see the most interesting market opportunities and conversely maybe some of the biggest challenges?

Marius:

Yeah, so we have customers across 40 markets globally. We are active across three continents, Africa, Azure Pacific, and then also Europe. We have just over 13 million customers globally at this moment, but the largest section of portion of our customer base being in emerging markets, so between SA, Nigeria, and Malaysia. And we view those three countries as our core markets. We have offices around the world, so Cape Town is our global operation’s hub. So, we have a team of just over 300, 350 team members based in Cape Town. I’m based in Johannesburg, so African HQ. And then we have our global HQ in London.

So, we also have a team on the ground there. And then local teams in Kuala Lumpur, Malaysia, Jakarta, Indonesia, and then also in Australia. So, I think we spread out across the world, but we have our base in South Africa, I think, probably around two thirds of our global workforce being based in Africa. And we follow similar model in most of these markets. And I think that is what we are good at. That is the skills and expertise that we’ve built up since launching in 2013. And by the way, we are celebrating our 10-year anniversary this year.

Ian:

Congratulations. That’s amazing.

Marius:

Thanks a lot. I think we were probably one of the first traditional crypto exchanges to exist back then. And I think we’re one of a handful of crypto exchanges that existed back then that still exist today, and I think of and Coinbase and those names. Yeah. So, it’s been ten eventful years, and yeah, we’re just grateful. I think that the one thing that’s very clear is that there’s still a growing demand for cryptocurrency and especially in emerging markets, and that is what gets us up in the morning.

Ian:

I’m curious about the perspective, given that you’re operating primarily in emerging markets, thinking about the role that Luno plays, I mean, obviously you’re providing custody and you’re facilitating transactions, but I’d have to imagine there’s a lot of education that goes into it as well, like explaining just the basics of how do you purchase cryptocurrency, how do you hold cryptocurrency, what are all the different cryptocurrencies? Is that the case?

Marius:

Definitely, definitely. And it’s not easy feat to educate people that know nothing about crypto. And I think that’s the role that we play. We see ourselves as an intermediary. We don’t try and convince people to invest in Bitcoin or to invest in any crypto asset. We provide people with information and the knowledge to do their own research, and then we provide the safe and easy to use platform and products for them to enter the space. So, it’s an ongoing process. We obviously have many efforts that run through marketing through the traditional channels in terms of social media. We also host in-person meetups. We also have education built into the app. So, we’ve contextualized many of our products and services from a crypto perspective as well. So, we educate the customer through that journey. But it’s been tricky because especially if you operate in emerging markets, because there are many challenges.

And if you look back to 2015, 16, the three or four African markets that were the continental leaders back then from a crypto adoption perspective, they’re still the leaders to this day. So, African, Nigeria, and Kenya. And then there’s a long tail of other smaller markets that also have increased volumes or transactional volumes, but only slightly. And I think the main challenge with expanding into as many markets as quickly as possible is firstly around education. You can’t create a crypto market out of nowhere and each of these markets replicate localized effort in terms of setting up local entities, local regulators, local bank accounts. And so, what we had to realize very quickly was that it actually, it slows you down and it can actually be very costly if your client market is the mass market in each of these countries. So, actually I think, so there’s different strategies in different markets.

Some of the new African markets, the focus is purely on the early adopter community, those with existing traditional investments, those with the banked segment of the market. In other markets, like , it’s also that, also focused on those with bank accounts and those that are included in the financial system. But we have a little bit more room because of scope of the operations, other established processes around education, the advanced stage of regulations that we can also now start to really focus on providing a safe for those in the unbanked sector. So, those that are not financially included.

Ian:

Yeah. In the past, we’ve had some terrific guests on the program, Ray Yusef of Paxful who has built with Bitcoin initiative seems to really go at the heart of the unbanked audience, like teaching basic financial literacy and then extending that to the opportunity provided by Bitcoin. We’ve also had the founders of Busha, one of the Nigerian exchanges on the program, and they told some really interesting stories about the challenges of international currency controls. And so, anyone trying to run a business that imports goods or raw materials from outside of Nigeria is incredibly challenged by the traditional financial system. And Bitcoin and stable coins have opened up a new financial services path for them. I’m curious your reaction to that, is that consistent with what you’re seeing in your business where access to global markets is a big driver for customers of Luno?

Marius:

Yeah, I think firstly, I think it’s have to say that African crypto firms and also crypto investors and others are probably some of the most resilient and creative people globally considering the extreme operational challenges that we experience. But despite that, the African continent still contributed billions and dollars in transactional volumes. I think in your report you state that it represents 2.3% of global volumes.

Ian:

Yeah.

Marius:

But we categorize the use cases in two categories, it’s those with unmet needs. And I think that sums up the category of crypto is that buys crypto as a hedge against political instability, as a hedge against local currency valuation. You mentioned import restrictions and issues with cross border payments, that’s absolutely also one of the drivers. And we’re seeing that especially play out in Kenya and Nigeria where there’s dollar shortages and individuals, but also small businesses simply cannot access dollars to continue trading and to continue earning a living. And so, I think there are definitely elements of that. It’s much more difficult for us to distinguish in the data to say, “This customer is using crypto for remittances versus arbitrage trading, for example, between different crypto platforms.” But we know that the rise in adoption in Africa over the last 10 years, it’s primarily driven out of need. And it’s been largely from a grassroots level perspective.

And I think it just, again, shows the creativity. We issued a white paper a couple of years ago, and one of the key findings that highlighted in there was that people in Africa tend to be more creative in finding ways to solve and to supply for their families. And so, when people face a hardship where they need to put food on the table, when they need to pay for school fees, where they need to pay for bonds, they tend to take on a little bit additional risk as well in trying to generate additional yield. And I think that’s also… You can argue that that’s out out of need, but I think there’s also an element, the need to generate higher yield and the need to let their money earn and more in return for them. So, yeah, I think that Nigeria, Kenya and South Africa is again, different demographic, different regions. And SA you see more sophisticated crypto traders, traders trading high volumes, high frequency, lower margins.

There’s a rising and growing arbitrage trading use case in SA as well. And that’s primarily there because of the price differences between the dollar price of crypto and global platforms like Coinbase,and the RAM value of crypto in SA. And that premium exists because of the existence of capital controls in SA. So, it’s not as easy to move funds cross border and to move funds back into SA compared to other markets where capital controls on that’s restricted. So, that premium exists and many of our traders, which is good for liquidity and also good for stability of the local market, trade arbitrage.

So, they move large volumes between local platforms and overseas platforms and in relatively small yield on those high volumes. So, yeah, I think it’s interesting to see within the same continent how different use cases have emerged and how our people’s need differs between different markets. But just the one thing on remittances, I think, as I said, it’s very difficult for us to distinguish between regular crypto payments to Bitcoin address and remittances. I think that probably the vast majority of the volume is still associated with Bitcoin as a store of value or bitcoin as a means to speculate or to trade. And yeah, so I think that’s contrary to popular belief, I think that’s still the predominant use case across Africa.

Ian:

The arbitrage trade is fascinating because that was some of the very early days of Bitcoin trading was the US to Japan market arbitrage that I know made people a lot of money back in the earlier days of Bitcoin. I’m curious about something you said a couple minutes ago about the regulatory climate in South Africa. With previous guests we’ve talked about some of the challenges in markets like Nigeria where I would categorize it broadly as unfriendly towards crypto. Talk about the situation in South Africa, I’m much less familiar with that.

Marius:

So, in South Africa, so firstly, I think in markets where governments do not impose regulatory bans, such as the one in Nigeria, you typically tend to see the market flourish, grow more responsibly, develop more responsibly, and you see more interaction between the private sector and the public sector. And I think that’s the role that we at Luno tried to play. We share learnings and experiences that we’ve gained and built up over the years with regulators in each of our markets. For example, Luno was the first crypto exchange to obtain a license through the securities commission in Malaysia in 2019. So, that really gave us good learnings to share locally in SA. But the relationship of the SA regulators have been right from the start. I recall, think back to 2016 when we did a pilot with the Reserve Bank and the FCA in the UK and one of the SA banks where we tested a remittance product.

So, we were included in the FCAs first cohort of companies in the sandbox. So, the interactions with the SA Reserve Bank started 2015, 2016 already. And they, from the start, I’ve acknowledged that they need to stay ahead of the market, that they can’t afford to ban crypto players from operating or ban the financial institutions from banking, cryptocurrency businesses. And I think that has done a lot to ensure stability in the crypto market. So, what we see in Nigeria, for example, and Kenya is completely different, people are… There’s still the same need for crypto, so the overall volumes in the market stays the same. You don’t see declining volumes or you don’t see a declining demand for crypto, but you see the crypto volume shift to avenues that are less transparent and more

In SA, vast majority of the crypto volumes have continued to flow through centralized exchanges that are registered with the local financial diligence agencies that have clear lines of communication with the central bank that are able to open up local bank accounts, which makes it a lot safer for our customers to buy and sell crypto in their local fiat currency. But long story short, I think all of those efforts have culminated in the financial sector conduct authority kicking off their So, all cryptocurrency asset service providers had to apply for a crypto specific financial service provider license between June and November this year. And we expect the first crypto FSP licenses to be awarded within the next couple of months. And I think it’s a watership moment for the SA crypto industry. We anticipate traditional financial institutions sitting on the sidelines to also enter the market. And as a fact, we know that many traditional firms have also applied for that license as well. So, I think it’s going to open up the market and really, hopefully inspire other African markets to follow suit.

Ian:

Yeah, it’s such a good point. I mean, this is consistent with all the research we’ve done here at chain analysis, which is bans don’t work. You can look at a market like China as a perfect example of this. The transaction activity that we can attribute into the Chinese, inside the country there has not declined at all since the ban a few years ago. And I think your point about do we want transparency in the market? Do we want well-run companies that follow the law, or do we want to have this black market operating on the side? That’s a very clear choice.

You create a ban, you’re going to end up with this black or gray market type operation, or you can have a reasonable licenser scheme that provides transparency and responsibility throughout the ecosystem. So, that’s really exciting. I’m curious about your relationship with the traditional banking industry. If I’m living in South Africa and I’ve got and I want to turn that into a tether or Bitcoin, how difficult is it for me to get money out of my traditional bank account and actually use it to buy crypto? Is it trivially easy for me to transfer to Luno, to my account at Luno, or is that a difficult operation for folks?

Marius:

No, so it’s very easy and we are fortunate enough to have banked with standard banks since 2013. So, our bank leadership also spans 10 years now. But it’s easy over the years, we’ve also evolved the buying of crypto. So, initially customers could only do normal bank transfer until obviously with the delays and the cost associated with normal bank transfers. And then a couple of years ago we’ve added card payment options as well. So, African customers can buy crypto with debit or credit card. And more recently we’ve also added instant Eastern EFT option. So, it’s very easy, you can instantly buy crypto with and when you want to withdraw your , we also process instant withdrawal. So, within two, three minutes, the funds can reflect back in your bank account. So, I think from an infrastructure perspective, South Africa… And again, it comes back to our point around bans and the unintended consequences of bans.

So, governments that impose bans expect bans to solve all the risks or to address the risks that they identify, in terms of money laundering, in terms of illicit financing and flows volatility. But in fact, it results in a more volatile crypto market results in much less visibility from a banking sector. And I have to say that have to commend Reserve Bank. Last year, around mid last year, they issued a guidance note to local South African banks where they cautioned them against the risks or the unintended consequences of de-risking the businesses from crypto and said that if you de-risk yourself on crypto, so if you close the bank account off a reputable and credible cryptocurrency firm, you reduce your ability to effectively monitor transactions because what is happening? And that’s if what we’re seeing in peer-to-peer markets in Africa.

So, the peer-to-peer business model absolutely gained a foothold in Africa and it’s great because it makes possible for Africans to still purchase crypto. But people still use their bank accounts to purchase crypto. Instead of sending the payment to centralized exchange with segregation of funds and controls and risk management, et cetera, that payment goes to another individual’s bank at another bank. So, the flows within the banking system remains exactly the same. The counterparties to those resections are just individuals that the banks do not necessarily have visibility on. So, yeah, and that’s the point that we’ve tried to convey Africa to regulators. And that’s the role we playing to this day. We had excellent workshops with regulators recently in other African markets where we really try and assist with the thinking, assist with the processes. And yeah, I’m confident that there’s a lot of potential, a lot of good potential for Africa. Yeah.

Ian:

Yeah, it’s really interesting as someone living in the United States, the peer-to-peer market is not something that I think many people talk about. The entry point for a typical American is a firm like Coinbase, publicly traded company in the United States, very well known, they run ads on TV. Or maybe one of the FinTech providers like PayPal or something like that where you can now purchase in the PayPal experience. So, talk a little bit more about how people get involved in that peer-to-peer setup. If I wanted to buy crypto from somebody in a peer-to-peer marketplace, where do I even start? What does that look like?

Marius:

So, you have two different models. So, you have the completely underground public model, and that is where people meet in chatrooms on private messaging apps, for example and they establish crypto groups and the communicate and then send DMs and agree on a price. And you have to then actually send fiat currency to a stranger and hope and trust that they will release the crypto to you. So, that’s the one form. Or the other form is entities, companies offering a crypto custodial service. So, they enable you to store your crypto on the platform, but the fear click happens peer to peer. So, it’s almost like an online marketplace in SA is a company called Gumtree where you can Facebook Marketplace for example.

Ian:

Yeah.

Marius:

So, those models have absolutely gained a foot out since the ban in Nigeria in 2021. But in Kenya, since 2016, Luno actually operated in Kenya. We had operations in Kenya, we had growing customer base until a similar ban was put in place in the end of 2015. And since 2016, the PATP model has actually been the defacto model way for Kenyans to access crypto and they know no other model. And that’s what I mentioned right at the start, the African landscape has grown very little. There’s been a massively growth in demand, but the infrastructure across Africa has remained relatively the same since 2016. You have no new centralized exchanges operating in any African markets. You have one or two new peer to peer platforms. But for most part, the infrastructure is completely the same and it’s a massive challenge and it’s one of the reasons why you’re only seeing 2.3% contribution to global volumes, it’s because of a lack of infrastructure. And yeah, that’s partly what we aspire to help solve those challenges and to make it easy and safer for people in Africa to access crypto.

Ian:

Yeah, that last point about safer, that’s what strikes me as someone that’s never used one of these peer-to-peer services. It seems ripe for scam activity where I’m advertising, “Send me money, I’ll send you Bitcoin,” and then I never send the Bitcoin. That seems like a fairly easy scam to run all over the place, right?

Marius:

Yeah. So, I think in the private messenger chatroom rooms, I think there’s a real risk there.

Ian:

Yeah.

Marius:

But the second model where centralized entities, the custodian, they won’t release crypto to the buyer unless the seller confirmed that they’ve made payment. So, there’s some measure of control, but there’s still some exploitation that’s taking place as well. So, yeah. Yeah.

Ian:

Yeah. I’m curious more broadly, when you think about the scams and other types of fraud happening, how do you approach that? I would imagine it’s challenging in certain markets where you have a relatively newer population of users who are learning about crypto for the first time. It seems like they’re going to be primed to chase the advertisement for the unreasonably high yield savings opportunity. I would imagine you all spend quite a bit of time thinking about how to protect users.

Marius:

No, definitely. And I think last year in South Africa, early this year, the industry got together and we worked with the advertising regulatory board, which is the white stock for public advertising. And Luno stated those efforts and we drafted crypto specific inclusion for their product advertising practice. And that’s been accepted, it’s been published, it’s been updated. And certain rules have been put in place, for example, you have to include risk warnings in your ad, and it provides rails and guidelines to broadcasters that started accepting advertising money from scammers in South Africa. And they have to do a lot of due diligence now before they accept any advertising money. So, I think that’s a good example of how the industry came together and we decided we need to address this issue. But from a Luno specific perspective, we try and attack this problem from any different perspective.

I think firstly from a technology side of things, and of course we use for that and , just the on chain visibility that we have through that I think has helped us to prevent customers from sending crypto to potential scams. I think one recent example in the SA is Mer Trading International, where through analysis we were able to identify that customers were sending crypto to this scam. At first we warned them and later on we actually blocked the payments. So, we knew it was confirmed scam, was internal analysis list of confirmed global scams. So, from technology perspective, we rely a lot on our service providers to do the monitoring. We also, obviously the issue of phishing and fake websites and impersonation is also quite real. And again, through a partnership with the service provider, we were able to remove more than 200 fake phishing links or fake Luno websites over the last 12 months and more than 1,000 fake social media profiles.

And so, we’re really trying to clean that up as much as possible. And then we have quite a big grant team as well, and they have relationships with local banks in SA, had in Nigeria as well. And we also then support the banks in investigating and also recovering payments made into our bank accounts that was a suspect. So, yeah, on many fronts, it’s a big issue. And it’s crippling and it actually… Scam activity was one of the main reasons why Luno had to exit markets like Zambia and markets like Uganda eventually because of absolute rising scams, making it very, very difficult to operate in those countries.

Ian:

Wow. And this was because you had people who were impersonating Luno or Luno executives and ripping people off?

Marius:

Yeah. So, that, and people pretending to be agents of Luno, Luno salespeople offering returns to the general public.

Ian:

Wow.

Marius:

People with topology people, people then started… Scammers started reporting Luno to law enforcement saying that, “Luno stole my funds,” or, “Luno lost my money,” in the hope that is a settlement payment or there’s a bribe or something. And so, it just became so crippling and it’s a real challenge. And then people always understand the cost of operating in any market if you don’t follow centralized exchange model, but more so in emerging markets where you have to build the infrastructure, the integrations between banks and the exchanges, we have to build that from scratch. Yeah. It’s a real challenge.

Ian:

I saw that even you were a victim of this where someone ripped off your LinkedIn profile and was running around offering crypto services using your photo and your background.

Marius:

Yeah, it’s one of those things. I think my wife obviously had a heart attack when she saw that. And she actually also got impersonated.

Ian:

Oh, God.

Marius:

But I think it’s part of the game. There will always be bad actors out there that try and deceive the public and trying to get the public to part ways with their hard-earned money. And we have a big responsibility as the industry, not only Luno, but all exchanges, whether peer to peer, centralized exchange, we all have a big responsibility to act as the first line of defense for our customers. So, it’s an area of the business where we continue to invest in terms of headcount, in terms of financial resources, and as I said, just using technology has been greatly useful for us in that regard.

Ian:

Yeah. I’m curious internationally, maybe zooming out from Africa a little bit, I know that Luno recently left the Singapore market, and I’m just curious if you can share the strategy and drivers behind that business decision.

Marius:

And in terms of Singapore, I think that was purely a business decision for us in evaluating our strategy and our global footprint. We still have operations in Malaysia, Indonesia, as I said, we fully licensed crypto exchange in Malaysia. We have a local office in as well, Malaysia in focus, our second-largest market globally for Luno. So, still fully investing in the region, southeast Asian region. It’s still an important continent for us or area for us.

Yeah, so, I think we’ve… So, first UK, we’ve always been pro-regulation. Always worked very closely with authorities in the UK to ensure compliance, whether this was enforced or not, so we follow a proactive approach there. So, adapting to working with regulators in the UK was nothing new for us, it’s part of our DNA. They recently announced UK regulations, the fund prime regulations. I think it’s an important step for the crypto industry and it supports Luno’s mission to ensure that all our customers invest responsibly. So, I think we are working very closely with the FC in the UK. We still operate in the market. We’ve not exited the market per se.

We’re still serving our existing customers in the most responsible way possible, and we will continue to be agile and adapt to regulation. 

Ian:

It’s one of the things that’s really interesting to me as we look at the evolution of the regulatory landscape and the relationship between crypto industry and traditional financial industry that’s driving entry into new markets. Because I think you’ve also just recently won regulatory approval in France, and I would assume that’s under the new Mika regime in Europe. And so, it seems like there’s a push and pull action happening. A lot of companies that I’ve spoken to recently have either exited the US market or are contemplating that decision because of the lack of regulatory regime here in the US and it seems like there’s a draw into the European market. Am I thinking about that correctly?

Marius:

Yes, I think so. I think there’s a clear theme globally now, and we see the regulators moving into two directions. So, I think the first theme of market is A and R regulations. And I have to say it’s been fairly consistent across most global markets, and that’s things like ML screening transactions, having the ability and expertise to report on to speech activity. And so, that would typically require registration with a local financial intelligence agency. And that’s one of the first steps we take when we consider moving into new market. Is it possible to register with the local financial intelligence center? And then second piece from market conduct perspective, there has to be regime from a conduct perspective that scrutinizes the operating models of crypto as service providers, shares that they have sufficient capital, they have the skills and the ability to actually safeguard customer funds, to safeguard customer information, and to ensure that they have good corporate governance.

And I think those, if you consider those things that I just mentioned now, I think those were probably some of the main reasons that led to  downfall as well, proper risk management or lack of proper risk management, the lack of good corporate governance. So, I think those two regulatory teams, we absolutely welcome. But from a centralized exchange perspective, I think there are many other challenges. Firstly, the cost to enter and localize your operations in an African market or any market for that matter with relatively low levels of adoption, it can be extremely costly. Secondly, liquidity, so in many cases in Africa, and I think that’s why we’ve seen limited growth in other markets outside these core countries, is they’re simply not sufficient liquidity locally. So, if you think of a use case like remittances, someone, the African diaspora, someone that resides in Malawi works in South Africa and they need to send money back home to their family.

They cannot spend their crypto in Malawi because vendors don’t accept crypto as a means of payment, and it’s not easy for them to convert the Bitcoin into local currency. So, the lack of liquidity in these markets also make it less appealing to global crypto businesses to set up operations there because it takes between three to four years to build up sufficient liquidity, so that you reach a point where you’re able to provide a fair quote to a customer when they want to buy crypto, the sufficient liquidity, not only on the buyer side, but also on the sell side. So, it must be as easy as selling Bitcoin as it was when you bought the coin initially. So, yeah, there are many challenges from that perspective, but mainly regulatory uncertainty that is making banks the defacto regulators in many African markets. So, the banks decide we get to play or we get to stay away. And secondly, a lack of liquidity locally, and also because of the fact that many African markets have exchange control regimes. So, it’s very difficult to send dollars in and to send dollars out as well.

Ian:

Yeah, it’s fascinating to watch the ebb and flow of into and out of other markets. Shifting gears a little bit, I’m curious, your take on . And this is something that I’m always interested in the perspective of the centralized exchange operator in the realm of this new layer of technology that I think in some ways is seen as complimentary to centralized exchanges. In other cases, I think people imagine becomes the future of all crypto exchange. It’s all facilitated by a smart contract living on chain rather than a company really operating there. What’s your take?

Marius:

Yeah, I think centralizing exchanges and decentralized patterns, I think they’re complimentary. Centralized exchanges make it possible for people to enter the crypto landscape using the fiat currency. I’m particularly excited about the potential for in Africa because you have a new generation of investors, investors that don’t necessarily hold traditional assets. It’s people that for the first time have been able to come online, get access to a smartphone with internet that don’t necessarily have traditional investments, traditional investment apps for many reasons. But for example, they cannot meet the minimum deposit requirements. So, crypto created absolutely new class of investors across the African market, and I think for the first time it’s going to give those investors holding crypto assets access, for example, to capital.

So, they can, through decentralized platforms and protocols, actually borrow funds against the crypto collateral to start out their local businesses in Africa. And I think that is probably the most exciting use case for me locally on the African continent. It’s the power of crypto at play real time. From a perspective, I think we obviously, as I said, we think that we are complimentary to many of the services offered by decentralized finance, lending, borrowing, staking, yield farming. We recently launched a Luno staking wallets as well. But I think we think that sensible long term approach, getting the basics done right, that’s our core mission at this moment. And we think that will give us as a business the base shot at upgrading the financial system, playing that role as people’s first experience with the crypto market. Yeah.

Ian:

I’m curious too, about real world asset tokenization. This is in the headlines of all the crypto trade publications that I read regularly. It seems to be one of the hotter areas. Are you seeing any moves in South Africa or maybe more broadly on the continent to tokenize corporate debt or government debt and actually put that on chain?

Marius:

Yeah, so I think again, markets where there are more regulatory clarity, I think you tend to see more conversations like this taking place. Pan Africa, absolutely zero that I’m aware of. But in South Africa specifically, there are many financial institutions that are exploring opportunities to tokenize corporate debt, for example, putting bonds on the blockchain, tokenizing bonds. So, yeah, so there are really interesting opportunities locally in SA, and I think probably relatively soon, traditional crypto exchanges will probably soon evolve the offering from pure cryptocurrency tokens to more real world assets as well. So, yeah, I think it’s an that’s going to open up significantly over the next 12 to 24 months in, you say.

Ian:

Yeah, it’s exciting. Well, this has been a fascinating conversation. I love to end the episode looking to the future. You’ve got eight years of experience in this industry, which is probably a lifetime for most people. I’m curious, what are you thinking about over the next year to two years as being most exciting in the crypto landscape and for Luno’s business?

Marius:

Yeah, I think firstly, I think we will start seeing exponential growth, I think not from a crypto price perspective, but the after effects of properly well run and regulated crypto market. Not talking about crypto assets itself as being regulated, I’m talking about regulation around the platforms, intermediaries that provide crypto related services. I think as we’ve seen in the US and each of these regions are on different maturity and different growth curves. We’ve seen financial institutions enter the market in the US two, three, four years ago. In SA, that’s about to happen. And I think that’s hugely exciting. It’s going to lead to a lot of inflows of capital into the crypto market locally. It’s going to lead to a more robust, stable crypto industry as well. And it’s going to lead to more partnerships between crypto firms and traditional firms to drive adoption. So, I think in the institutional opportunities in SA, I think, and as soon as regulations become clear and Kenya and Nigeria will be absolutely huge and will have a massive impact in the adoption curve of crypto locally.

For example, quite a large chunk of the SA population with disposable income use financial advisory firms to manage all the investments. At this moment, no financial advisory firm are able to render financial advice or intermediary services with regards to cryptocurrency. So, that opens, the regulatory regime, will open up and create a completely new channel or completely new set of potential investors into the market. I think we’ll continue to see Bitcoin has a store of value, or crypto is a store of value as the property, the most predominant use case. Although we’ve had exciting projects in South Africa over the last couple of months on the crypto as a payment channel payment network use case.

So, one of the largest grocery outlets in SAa couple of months ago announced that it’s not possible for you to buy groceries with Bitcoin, so at checkout you scan a QR code. Luno has also enabled that feature. So, Luno clients can spend their crypto. That’s just the very, very early stages of the spend use case. And I think it will develop as we see more critical mass of crypto holders that spend use case and payments use case will start to develop. For now, I think from a transactional perspective, it will probably still be limited to cross-border payments, remittances in emerging markets at large.

And then, yeah, I think I’m extremely positive about Luno’s prospects over the next 12 months to continue to evolve in a crypto app, to continue to build on our current suite of products staking crypto bundles, and to continue to upgrade our product in line with what our customers want. And then lastly, I’m very excited and passionate about the impact that crypto can have on people or people across the African market. And that’s mainly why I’m still in the crypto industry eight years later. So, I’m hugely excited about countries like Ghana and countries like Kenya, countries like Uganda, just to work with Luno and to put Luno in a position to be able to offer a safe and easy way for people in those markets to also access crypto. So, I think, yeah, I’m very, very, very excited about the prospects for crypto in the African market, and, yeah, I’ll be working day and night at Luno to make that a reality.

Ian:

Really exciting. Marius, this has been a fantastic conversation. Thanks so much for joining us on Public Key.

Marius:

Awesome. Thank you again. I really enjoyed the conversation.

 

The post GEO Report: Crypto Adoption in Sub-Saharan Africa: Ep. 83 appeared first on Chainalysis.

Decentralized Physical Infrastructure Networks Ep. 82

https://www.chainalysis.com/blog/decentralized-physical-infrastructure-networks-ep-82/

Episode 82 of the Public Key podcast is here and we are happy that you love the refreshed look.  When many think of crypto and blockchain their brains tend to go to investments and finance but what about the underpinning technology that allows decentralization of physical infrastructure networks or DePIN networks for short. We talk with the Co- Executive Directors of the Web3 Working Group, Amy James and Devon James, who have been playing in this space for almost a decade.

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 82.

Public Key Episode 82: Going deep into the “plumbing” infrastructure of web3

“Decentralization will not, absolutely not, be the reason for the average user to use Web3. The average user is not going to use Web3 until it’s as easy to use as Web2 and unlocks features that Web2 cannot provide.” 

This is a powerful quote from this episode’s conversation with Ian Andrews (CMO, Chainalysis) and the, Co-Executive Directors of the Web3 Working Group, Amy James and Devon James as they unravel the technical complexities of Decentralized Physical Infrastructure Networks (DePIN) and explain why they believe the next opportunity for wider adoption will not just be adoption in the financial space, but adoption in the technology space.

The duo also emphasizes the need for open protocols and standards to ensure interoperability and competition in the space, as well as the challenges of building in the Web3 space and the importance of educating policymakers and regulators about the potential for these technologies.

Quote of the episode

“Decentralization will not, absolutely not, be the reason for the average user to use Web3. The average user is not going to use Web3 until it’s as easy to use as Web2 and unlocks features that Web2 cannot provide.” – Amy James (Co- Executive Director, Web3 Working Group)

Minute-by-minute episode breakdown

  • (2:01) – What is the Web3 Working Group and the need for decentralized physical infrastructure networks (DePins) 
  • (6:08) – Discussing the Open Index Protocol and transitioning from manufacturing to software and Bitcoin
  • (11:20) – Advantages of the protocol and comparison to IPFS and use of BitTorrent and blockchain for indexing content
  • (16:45) – Difficulty in building web3 experiences beyond financial transactions
  • (20:50) – Decentralization won’t be the reason for average users to use Web3
  • (28:02) – Reasons for creating a not-for-profit advocacy group for Web3 and challenges of operating in the US market due to regulations
  • (34:08) – Educating regulators and policymakers on Web3 technology
  • (38:27) – Potential benefits and concerns of traditional finance players entering the crypto space

Related resources

Check out more resources provided by Chainalysis that perfectly complement this episode of the Public Key.

Speakers on today’s episode

  • Ian Andrews * Host * (Chief Marketing Officer, Chainalysis) 
  • Amy James (Co- Executive Director, Web3 Working Group)
  • Devon James (Co- Executive Director, Web3 Working Group)

 

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Our podcasts are for informational purposes only, and are not intended to provide legal, tax, financial, or investment advice. Listeners should consult their own advisors before making these types of decisions. Chainalysis has no responsibility or liability for any decision made or any other acts or omissions in connection with your use of this material.

Chainalysis does not guarantee or warrant the accuracy, completeness, timeliness, suitability or validity of the information in any particular podcast and will not be responsible for any claim attributable to errors, omissions, or other inaccuracies of any part of such material. 

Unless stated otherwise, reference to any specific product or entity does not constitute an endorsement or recommendation by Chainalysis. The views expressed by guests are their own and their appearance on the program does not imply an endorsement of them or any entity they represent. Views and opinions expressed by Chainalysis employees are those of the employees and do not necessarily reflect the views of the company. 

Past Episode Mentions

[CHAINALYSIS PODCAST EPISODE 28] Using Crypto To Connect Your Car To The Future

Episode 28 of Public Key, the Chainalysis podcast, is here! In this episode, we talk with Alex Rawitz (Co-Founder, DIMO) about using cryptocurrency, NFTs, and advanced vehicle telemetry to connect your car to the future and maintain important data.

Transcript

Ian:

Hello and welcome back to another episode of Public Key. This is your host, Ian Andrews. Today I have two guests, Amy and Devin James, who are the co-executive directors of the Web3 Working Group. It’s a lot of Ws. Welcome to this program, Amy and Devon.

Amy:

We’re really happy to be here with you today. Thank you so much for having us.

Devon:

Thank you. Yeah, we’ve joked about calling it W3 to the third or any number of things like that. I agree.

Ian:

It’s a tongue twister for me. There’s a hilarious video of me doing outtakes and it’s words like that that always trip me up. So setting aside the name, let’s jump into what is the Web3 Working Group and why did you two create the organization? Amy?

Amy:

Yeah, absolutely. So, Web3 Working Group was started to bring awareness to what’s become known now as the DePIN category, which stands for Decentralized Physical Infrastructure Networks. When we began, that acronym hadn’t caught on yet, and we are just given the mandate to bring publicity to, or awareness and advocacy for, infrastructure as a category and to have it be adjacent to the crypto industry, but distinct from it because crypto is often known for the financial applications of the technology. But there’s this whole other use case, which is the infrastructure use case, and I like to think of it as the plumbing for the web.

The way that we don’t think about the plumbing that brings water to our faucet in the morning, but we rely on it for our day-to-day activities, we rely on these infrastructure protocols for the things that we do every day, like be on this video call, like watch videos on YouTube. There’s these core infrastructure protocols that are necessary and things that we rely on day-to-day, and yet right now, most of them are closed source and controlled by a very small handful of companies and this technology, blockchain and other decentralized peer-to-peer technologies, have the power to push that power back out to the ends of the network, to re-decentralize the web in the way that it was always meant to be.

Devon:

Actually, I really especially like that analogy just because early on before utilities get standardized, they were a mess. Every local town would have its own version of different pipes and stuff like that and how could you have gas come from another town and stuff like that? And in order for them to really become utilities that you could just count on and multiple companies could operate on top of and stuff like that, they had to be standardized. And that’s exactly what we need when it comes to file storage and video transcoding and stuff like that that we’re using for this call. It’s exactly in order for that to really democratize and open up and have the right amount of competition.

Amy:

There’s an imperfection with the analogy, which is that a lot of utilities have become monopolies and that irony there is that these utilities, these web infrastructure protocol utilities are the solution to a lot of the big tech monopolies that we’re facing now.

Ian:

Yeah, I was going to say, I don’t have a lot of choice for my water and natural gas supplier into my house. There’s only one, which I think is probably the opposite of what you’re advocating for, which is that many companies can be providers, better consumer choice, better freedom, ultimately probably more consumer rights and control over the things that train these protocols, right?

Devon:

Well, you can see why the analogy breaks down because in the physical space, if one particular utility lays all the lines for something, they have ownership of that. So, the government had to actually grant them the right to have what they call a natural monopoly where it’s like they’re not going to be prosecuted for monopoly laws, and the premise was that it was going to open up competition, allow them to work with each other, it didn’t work, obviously, they all just collude with each other to give you very few choices.

On the tech side of things and the digital analog of that, it’s more you have to separate … The protocols are just the rails and then the application is how you use them all. You don’t need to have different infrastructure for each one, and by standardizing it, it actually opens up the opportunity for multiple different applications to run on top of the same set of data, the same … et cetera, and very much democratize the whole process.

Amy:

It’s a yes and no kind of thing because I don’t know how deep we want to get into the weeds on this analogy, but in the same way that we only have a few credit cards, we have Visa, we have MasterCard, we have Discover, some places. We’re probably not going to have an endless number of protocols for-

Devon:

For each individual bank.

Amy:

… for financial exchange. There will probably be a few that we settle on. And that will also be true for things like file storage and video, transcoding and GPU rentals. There will be a few protocols that rise to the top because they’ve optimized for different niche features that make them stand out, but then there will be-

Devon:

Thousands of applications on top of them.

Amy:

Thousands of applications. And because the way they function is by creating markets, they’re no longer functioning like monopolies in terms of the price setting and that’s important about it.

Ian:

We’ve been talking about protocols a little bit in the abstract here, but I think you two have been working for a long time on something called the Open Index Protocol. How does that fit into this story and what you’re trying to do now with the Web3 Working Group?

Amy:

So, Open Index Protocol is our origin story in terms of getting into this space. So back in 2010, we were in the manufacturing sector, we made accessories for Apple products and we were looking to get out of that business. I didn’t like being in manufacturing, I wanted to be getting into software. There’s just a lot of things that can go wrong when you’re working with physical products. And I also had gotten really into the manufacturer extraction distribution disposal cycle, and we were starting to live a zero waste lifestyle and we were just really interested in the environmental side of what we were doing and how that … having our business align with our ethics a little bit more. But we heard about Bitcoin through a friend and because the business, our manufacturing business, had bumped … Do you want to talk about how we bumped into payment processing? Should we go down that-

Devon:

Oh yeah, sure. Yeah, we initially were making iPad cases and stuff like that, that totally you needed to make that in China. And when Amy was talking about it, we got into the environmental side of things and wanted to change that model. We figured out we could build something locally. We built something, we called it the CashBox. It was like a bamboo box built around the Square payment system. And we thought this could be great for coffee shops and stuff like that, to enable them to take debit cards and all that stuff. And it turns out that was true, but Square went a different direction, built it in plastic in China, of course. Because we made it locally out of a nice material, it was incredibly expensive. It was like $1,500, $1,600. So, we started looking at can we subsidize that by selling businesses, the credit card processing itself, and then use that to pay for the actual hardware and give them the hardware for free?

Well, it turns out businesses really get stuck into their payment processor, so that really didn’t work. But by doing so, we learned more about payment processing and how the fraud involved and how hard it is and how slow it is. And we’d been pushed toward Bitcoin for a little while by a friend of ours, and at that point it was like, “Oh, I get it now. I get why this makes so much sense. It’s far superior money and it’s also a far superior payment technology.” So, we spent all of 2013 trying to think how we can use it in our hardware business, et cetera.

Amy:

So initially, yeah, we were looking at some creating some sort of modular miner because we understood that the miners … things were upgrading so quickly-

Devon:

There’s going to be a lot of turnover, fast.

Amy:

… with at the time that, there would be a lot of waste in the miner product. So, we thought could we make some sort of … because our background was in manufacturing. But I wanted to get out of that. And then Devon read the white paper and that was in December of 2013, something like that. And I used to joke he hasn’t had a full night of sleep since that. That still may be true because he was just so lit up by it. And before we’d been in manufacturing, we’d been in the entertainment industry. So, Devon had worked mostly in post-production and distribution, and so he really understood the problems there.

I’d been more on the creative side, writing and directing that kind of stuff, but I also … I had a sense of the problems there. Even though it was still so early, it just really felt dangerous that you were building your entire business on somebody else’s platform. And if you wanted to do anything risky, you know that phrase, you take the king’s coin, you sing the king’s tune, and that you would be putting yourself in a situation where you wouldn’t necessarily control your own distribution even though there was this move toward independent distribution, it was this weird juxtaposition. And reading the Bitcoin white paper, Devon immediately was like, “This can apply to media distribution. Let’s do that. And so almost immediately, we closed our manufacturing business-

Devon:

Well, we had to move to move super fast because I was afraid this was such an obvious idea, everyone was going to have it and if we don’t get out in front of everyone … So we had the idea for the name, the Decentralized Library of Alexandria, and it was meant to just store everything, including pop culture stuff. Because we had this theory that the media is being manipulated and it’s a bit of a monopoly. There’s only five companies that control it all. So, if you can disrupt that because news media and that kind of stuff always rides on the same rails as pop culture media, so if you start by disrupting the YouTube side and you let individual content creators actually have individuality and independence, you could take off with that and then that creates an alternative where you can actually have someone competing with the news and maybe get a little bit more truth and transparency out of it. Turned out we were way too early. I remember we raised a client in the spring-

Amy:

Way too early.

Devon:

… of 2015, where it was for media. You could publish any size movie and stuff like that, fully decentralized client and everything, and it didn’t have anything to prevent piracy. And I remember the night before, I was tossing and turning in bed, before we’re going to release it. I was tossing and turning in bed that like, “Oh my God, the Pirate Bay is going to discover this and they’re going to put up permanent versions of these movies and we’re going to be in so much trouble.”

The exact opposite happened. It took months for any individual to want to publish their own kind of thing. And so, we were a little bit too early. I think finally we’re at a point where there’s enough of the underlying building blocks in place and there’s enough awareness of this problem and need for it, and especially amongst content creators, need for it that I think something like that could really work well at this point, just 10 years later.

Amy:

So, just to thread the needle with Open index Protocol. It started as the Decentralized Library of Alexandria, but ultimately the protocol was renamed to Open Index Protocol because after a presentation, the decentralized web summit, sir Tim Berners-Lee told us, “Your technology is really interesting, but you need to name it something … you need to give it a protocol name.”

Devon:

Protocol, yeah. So, when the inventor of the web gives you that suggestion, you run with it. So after that, we actually leaned into-

Ian:

I’m curious-

Devon:

… having it work with other kinds of things other than media. We worked with the state of Wyoming and Medici Land Governance to do property records. We worked with the Middle East’s largest independent news platform to do decentralized news. Scientific records with Caltech, yeah.

Amy:

Scientific records with Caltech. We just had to find people who were interested in being on the cutting edge since we were so early. So, we found fun use cases to experiment with, which just gave us a lot of information about what would be needed to get this to mass adoption.

Ian:

And when we talk about the protocol, what are some of the advantages of it? And maybe go into a little bit of technical detail about how it’s actually built. Because I am thinking about things like the Interplanetary File System, IPFS, is maybe trying to do similar things, so I’m curious how they relate.

Devon:

So, if IPFS existed when we came out with it, we would’ve used it, but basically it was the common … You can think of the analogy of a library, where it has all the books on the shelves and then it also has a card catalog upfront to tell you where all the books are. And so, the way we saw it was that the books can be distributed on a peer-to-peer network like, at the time there was no IPFS, so we used BitTorrent. BitTorrent has these things called magnet links, which is not dependent on a hosted URL, it’s just an identifier within the network. And so, we would put those magnet links into a proof of work blockchain that had the ability to let you put text into it. It’s very limited amount of space. It was generally called flow or flooring coin, and then it became flow and now it’s called pin and it just had very limited block space. Block space is expensive, so we just thought of that as the index. That’s the card catalog reader.

And so, you could put not just the link to the decentralized version of the content itself, but also the descriptive information that you would use to find that. So, in the card catalog you would have the name and what subject it is and what category it’s under and maybe a little bit of a description and when it was published and who published it, stuff like that. So, that same kind of concept went into the proof of work blockchain data and that linked out to eventually we did adopt IPFS, it used IPFS as well. And that general premise held true, held through, or held true through the entire extent of developing it.

A few things that we figured out over time was, things like removing say the word author, or title, or description and just swapping that out for something really, really low bit space like one, two, three and then put a copy of the metadata structure into the blockchain and reference that. That way, it’s expandable, multiple different applications that all are doing say books or doing music, they’re going to have very overlapping, very similar schema.

So, that was really the whole underlying premise behind it, is normalize all the things that can be normalized between competing applications, building on top of a particular type of media so that they can all get their needs met and they can add extra fields if they want to and stuff like that, but they can overlap where is useful. Everyone benefits from that.

The content creator is able to reach the largest audience possible. The consumer of content is able to actually have access to the most content possible. They don’t have to chase down, where is my favorite musician right now? Is it on Spotify, or Apple Music, or whatever else? The whole premise is put it all in one place and then force the applications to compete based on their user experience itself, not just what they have exclusive because competing over what’s exclusive is a really crummy incentive for either party involved. And so, we still haven’t seen that yet happen on the video, user generated content video space, or the music space, but we’re seeing it in other little realms within Web3, when an NFT is available on multiple applications, it reaches the largest market possible, et cetera. So, you can see proofs of that concept. I still look forward to when we really see it in the media space, I think it’s going to be enormously beneficial to the world.

Amy:

The other thing that we did that was way too early, but we’re also now starting to see catch on, is attaching the terms of that content right inside the record. So, inside the card catalog listing that says the name, the publish date, the title, it also says, “You can use this song in your video if you give me this percent or this amount of money,” or whatever it is that the artist may want to attach. Arweave has created this thing that they’re calling the universal data license, which is that same kind of concept, where it’s atomically attaching the terms of the content with the content itself. And what’s so exciting about that, is that it creates a market at the application layer because one of the things that we’ve seen that’s been holding back these protocols, is that there isn’t enough incentive for developers to create the applications for end users. There’s been-

Devon:

On top of an already existing protocol.

Amy:

… there’s been a lot of development at the protocol layer, but not from the protocol to the user because the incentives have been-

Devon:

There’s no business model for it.

Amy:

… lacking there, yeah, right. What’s the business model for a wallet?

Devon:

You can’t charge a fee obviously because no one’s going to use it.

Amy:

And that same kind of problem has existed just in the application space overall. Well, if there is a cut, let’s say that the app that serves the user, that piece of content gets 10% of that sale-

Devon:

Then they’re competing.

Amy:

… now all of a sudden there’s … exactly.

Devon:

And you leave it up to the actual content creator to determine what that is. So, it’s a two-sided market.

Ian:

It occurs to me that open protocols, I think have actually probably fueled the web. I can think about the email protocol, SMTP, generally open. There’s lots of examples, HCP another open protocol that obviously has blossomed into billions of websites. But what seems to lock in or give the tendency towards monopoly that we see in really big tech, is that they’ve managed to aggregate users on a global scale. So, you’ve got a few billion people use Facebook every day, I think. TikTok’s well on their way, similar scale.

Even some of the smaller platforms have large audiences measured in hundreds of millions, I think if you look at Snapchat or Twitter, X now, I guess. And it seems like we collectively in Web3 and crypto, have yet to cross that chasm of actually figuring out how to build an experience that users find useful and compelling, beyond some of the financial transactions that I think draw people into crypto initially. But when I look at things like Arweave, or any of the other decentralized social media platforms, they tend to fall well short. I’m just curious, maybe Amy, you can start a reaction. Is my impression here correct in terms of how you think about it and some of the advocacy that you all are doing?

Amy:

Completely agree. It’s been, for me discouraging, to be almost 10 years into this industry and still be what feels so early and also exciting at the same time because the opportunity is still ahead of us and the ground is more fertile than ever. When we got started and Devon said we released our first decentralized client in 2015, we were heckled at a conference for having something that was not a financial use case of the technology. That people are like, “The internet can never be censored. What are you talking about? That’s ridiculous.” And now it’s common knowledge. You go to Thanksgiving and your aunt is talking about how Facebook is listening to her or whatever it might be, right?

Ian:

Yeah.

Amy:

And so, these issues of rights on the internet and of personal sovereignty and all of the kinds of things that Web3 is about, have trickled out into the larger culture and that’s really powerful in terms of making that change. What will ultimately be the thing that takes us into that space, because it’s a chicken and egg problem, people want to be where other people are and people want to have access to the content that they want to access. And all of the content and all of the people are still inside of those Web2 walled gardens right now.

And so, what we need to do is build bridges, I sometimes like to think of them as Trojan horses, that will break those walls down and help to funnel people into Web3. The key here is that right now, there are some things that need to be overcome to make Web3 products accessible to your average user. The user that doesn’t want to have to be responsible for their own private keys in a way that it’s catastrophic if they lose them and there’s some other things like that. And that’s where standards, I think-

Devon:

Right,

Amy:

… are actually really important, yeah.

Devon:

I think your analogy to email is perfect for this because email only worked, like you pointed out, there’s multiple protocols involved in email POP3 and SMTP and IMAP, and they all do very similar things with a lot of overlap, but before email was really adopted as a standard, it has network effect. It’s the same thing as Facebook. You get on email because your friend uses email and wants to email you. It became a standard because applications started … They standardized how the whole experience would work and how they would be able to interact with multiple protocols that don’t all do the exact same thing, so that they can hide that complexity from the end user and give users a similar experience, whether you’re using one email application, or a web mail application, or any number of other kind of things.

So, one of the things that we’re looking at doing in the future is working on a project to build standards on top of protocols. Like if you’ve got multiple competing protocols like you mentioned IPFS, and we’ve obviously talked about Arweave, and there’s a handful of other ones where the concept is you get storage in exchange for some token. They basically do the same thing. One is maybe permanent, one is less permanent, one is contract based, one is more private, et cetera, et cetera, et cetera. But they do generally overlapping things. So, building a set of standards above that, where you hide that complexity and just say token input becomes storage output for file, and now Web2 developers, it’s easier for them to adopt it and have an application that’s built on say both … or say Filecoin and Arweave and for different functions you might want it to be permanent and other functions you want it to be temporary and other functions you want it to be private, et cetera. We’re only going to see that once standards are built on top of these protocols. So, that’s something we’re actually hoping to do in the next year.

Amy:

I would say there’s three things that we need to come to consensus about standards on. One is decentralized ID and that has made a ton of progress in the last 10 years. There’s actually a standard for it on the Worldwide Web Consortium standards track. The other is wallets and how that works and having the interoperability between them. And the last one would be what Devon’s talking about, the-

Devon:

Standards on top of DePIN.

Amy:

… I don’t know to call … The layers, everybody has different layer one-

 

Amy:

… layer two. But the layer above the protocols that allow you to interact with protocols with the kind of interoperability that we all say Web3 will have.

Devon:

And that can create the actual network effect that brings people on board.

Ian:

We recently had the head of product from Chainlink Labs on the program and they’re trying to create something called the CCIP, which I think is maybe what you’re talking about, a third layer across the layer one and layer two blockchains for interoperability. Not just a bridge trying to move tokens, but actually-

Devon:

Functionality.

Ian:

… any sort of data. Yeah, exactly.

So, data sharing arbitrarily. It could be tokens, but it could also be a pointer to a video like we were talking about earlier. I’m curious from a philosophy perspective, when you look across the landscape of potential users of Web3, which I would assume in theory is everybody, how do you react to the word decentralization?

Do people see that as a value point if they’re not like you all here, living in Web3? Because I feel like as an industry, we’re missing the point. We shout decentralization all over the place and I don’t think the average person puts a huge amount of value on that as the thing that they really need. No one wakes up in the morning, goes, “Gosh, I just wish there was more decentralization in the world.” Does that happen?

Amy:

I completely agree with you. Decentralization will not, absolutely not be, the reason for the average user to use Web3. The average user is not going to use Web3 until it’s as easy to use as Web2 and unlocks features that Web2 cannot provide in the story.

Devon:

It can be considered derived from decentralization, but it’s not the selling point.

Amy:

That’s right, that’s right.

Devon:

The concept itself isn’t. All the freedoms they get from it, those are great selling points, but you’re right, people don’t associate any of the challenges they have on Facebook with the fact that it’s centralized.

Ian:

Okay, good. I’m glad I’m not crazy on this point. Now, we’ve mentioned DePIN a couple times and that’s a totally new term to me. So decentralized physical-

Amy:

Infrastructure.

Ian:

… infrastructure.

Amy:

Networks.

Ian:

What is that? Yeah, infrastructure networks. Got it, thank you. So, tell me more.

Amy:

So the term was coined by Sami Kassab at Messari and it’s become his research beat now, and there have been other people who have proposed various terms in addition to that to cover this space. Decentralized digital resource networks I think is one of them, or virtual infrastructure networks, I think is another one, DeVIN. And I at one point was saying maybe we should call it decentralized public infrastructure networks, but then I was talking to somebody at one of the major studios and he was like, “No, we wouldn’t want to be public. Maybe the P can stand for private.” So, it was like, “Oh, okay, fair enough.” Maybe physical is the right word.

So, the idea here is that these are the infrastructure, like I was saying, the plumbing of the web. So this would be things … And so the categories can be broken down, some are more physical as in-

Devon:

Storage, hard drives, GPU.

Amy:

… sure, or let’s say even-

Devon:

Oh, IRG?

Amy:

… actual tangible things like the Internet of Things, or things like solar, real world kind of infrastructure that is being tracked with these systems.

Devon:

Or on the car networks, where the location of the car is being tracked around. So you could build an Uber application on top of that kind of protocol.

Amy:

Or even the mechanics of what’s going on with the car, the data inside your own car, you actually don’t have a … Weirdly that’s owned by the car company that sold it to you right now. And so, there’s a company called DIMO that’s switching that so that it’s owned by the user, that kind of thing. It’s things like Helium-

Ian:

We actually had one of the founders of DIMO on the podcast.

Amy:

Oh, awesome.

Ian:

Yeah, we have to go way back to the early episodes of the show, but so definitely familiar with DIMO. So, DIMO, Helium.

Amy:

Helium is an infrastructure network for a phone network, but then there’s also the more digital infrastructure applications. So, that would be things like file storage, video transcoding-

Devon:

Computer rentals, just alternative to AWS.

Amy:

… yeah, and then also protocols for AI training. There’s another one for a cash network I really like because they’re creating a marketplace for GPU rentals and with how popular AI is becoming and the constrained supply of access to GPUs, they’re really solving that problem because a lot of times when you’re training an AI model, you need access to GPUs for a very short period of time and yet, to buy your own hardware would be very expensive and also you might have trouble getting access to it. And so, a rental market makes a lot of sense because you can get it for the period of time that you need it without having to own it, maintain it, and all of that kind of thing. And so, it just opens up access to a lot more people.

Ian:

And the decentralized element of all these things, I imagine people are going, “Oh yeah, GPU rental, that’s kind of what a public cloud does.” Or a cell phone network like Helium. Well, that’s kind of what T-Mobile and AT&T do if you’re listening in the US. The big difference here is those infrastructure components are not all owned and operated by a single company. They’re everywhere.

Devon:

It’s a market-

Amy:

That’s exactly right.

Devon:

… where you have users are actually providing the hardware itself, so they’re able to … I mean, one of the best advantages to it is if you think about something like the really high-end gaming systems, that the majority of people that aren’t active gamers, they might play one day a year, one day a month, and then otherwise it’s just sitting on their shelf. It could be contributing to these networks and it’s going to need less cooling and infrastructure than it would need if you put it into a big warehouse that was already getting too overheated, so it can a part … It can be a node on a network that’s being used to train an AI, or process video, or any number of other things and get paid for doing that, and it has less environmental impact to do it, and it’s already deployed infrastructure. It’s already out there in the world.

I don’t remember if this is still true or not, but I remember seeing a couple of years ago, that if you put all the data centers in the world together, the storage data centers in the world together, they’re less than the amount of available hard drive space on all of end users’ computers. So, if you could financialize that and everyone made say five bucks a month from just turning over half their hard drive to the rest of the internet to use it as their cloud, there’s a higher degree of trust, higher degree of transparency, and you actually are financializing the hardware that you already purchased yourself.

Amy:

And it’s taking us back to that utility conversation we had at the very beginning because rather than these utilities being monopolies that are having their prices set-

Devon:

By a single company.

Amy:

… by the monopoly, by a single company, by Amazon Web Services, or what have you, you’re turning that into a market, a competition market, where everybody around the world is competing to provide that service to you.

Devon:

And you can see that working really well. With Akash for example, if you compare Akash to AWS, their average cost is half, so that’s enormous. You know what I mean? And it’s getting off the ground, so it works.

Ian:

So, what you’re telling me is if I can get my 11-year-old to stop playing so much Fortnite on his Xbox, I could also be participating in one of these networks?

Devon:

I would not be surprised if Microsoft gets into that really fast, with how into the AI space they already are.

Amy:

It would be amazing if they would set up all of the gaming consoles to have that ability.

Devon:

It’s really powerful GPUs that are idle a lot of the time, so it would be a really, really useful application of them.

Ian:

I don’t know how many hours of idle on my son’s Xbox.

Devon:

Sure, you have an 11-year-old that’s different.

Ian:

General point, yeah. So I have to ask, I mean, you two seem like you’re multi-time entrepreneurs. You’re obviously living out on the cutting edge of this technology space. What led you to create this not-for-profit advocacy group, rather than build a company in this space that’s actually delivering a technical solution?

Amy:

So, in full transparency, we were recruited into this role, the group of infrastructure … There was a group of infrastructure projects that were meeting on a regular basis, the founders, to just share notes and talk about things, and they were feeling like the infrastructure category wasn’t getting the attention that it deserved. It was really being drowned out by DeFi and NFTs and the casino aspect of things and that we needed somebody to stand up and say, “There’s this whole other aspect that is more important to most people’s day-to-day lives and also solves a lot of the problems that regulators are grappling with when it comes to big tech monopolies, when it comes to censorship, de platforming, demonetization, all of those kinds of things. The technical solutions are far superior to regulatory solutions, are far more enforceable and will do a better job of solving those problems.”

And we happened to just be the right fit for that role, I guess. I had a background in nonprofit arts and had done some work in politics, so had Devon in terms of advocacy. And when we were building Open Index Protocol, like we said, we were so early to this that we were just doing some of this advocacy on our own because we cared about it already.

We had been meeting with various regulators just to provide education and attending … There was that event about Section 230 when people were talking about potentially changing that, that Devon attended and there was just a bunch of things that we were doing and so …

Devon:

We had the show already, Amy, and started making-

Amy:

Oh, that’s right.

Devon:

… What Kind Of Internet Do You Want? Just because Open Index Protocol was meant to be a really open, broad thing that had a lot of different application, we needed to just educate about why is the internet broken as it is and what is it that makes it not work the way you want it to and why does it feel that way and how can Web3-type technologies fix that? And so, that’s what the underlying premise of What Kind Of Internet Do You Want? was. And I think we were doing that for a year or two before-

Amy:

We started in 2019.

Devon:

… so we just had the right combo of different things.

Ian:

Wow.

Amy:

We were just really early to these ideas and so, we were having to teach people that these problems existed before we could show them what the technical solutions were, sometimes. And so yeah, we were just good spokespeople for that and so, we’re still going to build other companies and other things in our future, for sure. But this just felt like the moment that this needed to exist, because-

Devon:

Especially because congress was finally tackling it.

Amy:

Exactly.

Devon:

It took them so long and they were finally starting to show some indications that they were going to take this on. And it was really important that someone speak up for the DePIN space specifically, just because if you treat everything that has a token as a financial product, you’re going to throw the baby out with the bathwater.

Amy:

That’s right.

Devon:

There’s a whole lot of different rules that are being proposed and have been proposed that would in fact make sense in the financial space. And if you try to apply them to something that in the past we’ve called a utility coin, where its purpose is to provide utility, it makes it untenable. And so, the danger there isn’t that the protocol would break or that it wouldn’t continue to be developed. It just won’t happen in the US, it won’t happen with US customers.

And we’re very fortunate because of just lucky happenstance with Section 230, that basically the entire internet was built here and an enormous tech sector was built here, and the rest of the world took a different approach, where it’s just unsafe to build that kind of a platform anywhere else in the world for liability concerns. There’s been an assumption that because of that, we can’t screw that up and the Web3 will just be an expansion of that and just continue on.

But if they treat it with too much hostility and the rest of the world that wants to compete for this space decides to be more open-minded about it, they’re going to attract founders and they already are. We’re already seeing a lot of startups that could have been built in the US, are instead being built outside of the US, in environments that are openly saying, we want to be more hospitable to this while the US is just wasting time, dragging their feet and even indicating that they don’t want to be attractive to this. And so, it was important for us to go and just try to educate them, teach them what is different about this and why do we want to maybe have some carve outs, or some exceptions and stuff like that, so that it’s actually safe to build those kind of protocols here in the country.

Amy:

That’s absolutely right. We experienced this personally. So, when we were raising money, or looking at raising money, to build an application for Open Index Protocol, the guidance was essentially to establish an entity offshore and to not raise from US investors. And when you’re building something with the express purpose of protecting freedom of speech online, both freedom of speech and freedom of association, those two things can live side by side using this technology, and yet you’re looking at raising all of your money from Chinese investors and establishing an offshore entity.

Just that contradiction didn’t sit well with us and we wanted to be part of making a path for entrepreneurs to be able to do it here legally in the US, in a very clear way. I like to say that there’s enough uncertainty in being an entrepreneur that you don’t need this sort of impending threat of the SEC coming after you five years later. It’s just too much. I think it’s a bridge too far for a lot of people.

Ian:

And this is happening in a very real way right now. I just had the CEO of CoinPayments, they’re a crypto payment processor, so not at all gambling in a casino. They’re working with merchants who want to accept payments from their customers in stable coins or other tokens. They work in 130 countries around the world, but the one that they’ve just recently shuttered is the United States.

Amy:

That’s so sad.

Ian:

And the CEO recently relocated and he’s a Canadian, but he relocated to the Cayman Islands, so completely out of the US and we had a very interesting conversation on this topic of what would convince you to come back and start servicing the US market? What would have to change from a regulatory landscape perspective? And he said, “It’s just too hard.” There’s massive opportunity in the rest of the world, at least for his business and the complexity of dealing with 50 states’ worth of differing regulations-

Devon:

Blue sky laws.

Ian:

… exactly. Plus the threat of the litigation from a financial regulator like the SEC or the CFTC, just makes the market opportunity … It doesn’t add up, and so they’ve exited. I’m curious, when you go to talk to regulators and policy makers, legislators here in the US, give me the high level of the case that you give to them. And I imagine a lot of these folks maybe have spent significant time getting familiar with the technology, but also a lot of them are probably very unfamiliar and words that we use every day sound like gibberish. But what does that talk track sound like and then what are you hearing in terms of common objections to that talk track, that we still have to overcome as an industry?

Amy:

I would say that there are two different archetypes for these folks. There’s the people who are really steeped in this. They already have a great technical understanding and they have a nuanced technical understanding, that these are things that are financial service-based technologies, but that there are also other use cases like these infrastructure use cases, that are essential and that the threat that we’re talking about of losing it is very real and very dangerous to the future of the US because the tech sector in the US is enormous. It’s larger than the GDPs of-

Devon:

Multiple European-

Amy:

… all the countries in Europe except for three of them. And there’s no huge amount of infrastructure that would have to move out of the country. It’s just people on their laptops that would have to move. And so, the threat is very real that that could happen.

So, those people are our champions. Those people understand this and are moving the ball down the field and are creating some excellent legislation that could make a huge difference, like Senator Lummis, like Patrick McHenry, like Tom Emmer, these people who are just great champions for helping to make this industry legal in the US.

Then there are the majority of people, who really don’t know that much about it, quite frankly. And oftentimes, who we’re talking to is a staffer who was recently tasked to spin themselves up on this topic. And what they have told us is that when they get that task and then they go to try to do the research, what they find is a lot of technical jargon, things that take them very far into the weeds very quickly, and that there weren’t a lot of just high level primers about this that they could get a quick understanding of something like … One of them said, “I went to go try to find out what stable coins were.” And there wasn’t just like, “This is what a stable coin is,” kind of thing that they could find.

And that totally makes sense to me, having been in this industry for as long as I have been. All of the acronyms, all of the jargon, all of the kind of industry talking to the industry, because for a long time, it was just a bunch of nerds who were talking to each other and trying to figure out how to build cool stuff and just nerding out.

And so, what we did, one of the first things that we did was we built a Web3 basics video series, which is just … It’s what you would imagine it’s wrong with Web2, what is Web3? What is blockchain?

Amy:

What is cryptography? What is all of these kinds of basic concepts that they need to understand in order to draft or vote to approve the kind of legislation that is needed here. So, that’s been our primary task, is just that first step of education, just getting people into the shallow end of the pool and helping them to have the kind of awareness that they need to know enough to make the right choices.

I think that the other thing is the, I guess I would call it disinformation, which is we saw really recently this letter, Senator Warren’s letter, that was signed by a lot of people around the Hamas funding issue, which I think you guys were the ones behind the research that showed that that was just completely ridiculous.

Devon:

Ridiculous, yeah. It was blown out by more than a 100X and it was a misunderstanding of wallets and exchanges and everything else. And yet they’re all running with it because it’s an emotional issue that they can attach to but I think honestly, a lot of them are just motivated by disliking crypto and being a little bit more servants to the banks. And the banks don’t want to have to compete on a level playing field. And so, they have blinders on, and so they’re willing to accept things that are not true just because they play well and it lets them say things that evoke empathy and stuff like that. And that’s really disingenuous and it’s unfortunate, it is-

Amy:

Well, you have to keep in-

Devon:

… not that popular, fortunately but-

Amy:

… you have to keep in mind the difference in the lobbying size, right?

Devon:

Yeah.

Amy:

I mean, the financial industry has a tremendous amount of lobbying money behind it. The crypto industry really hasn’t done much in that regard. And so, it’s really time now to step up and make sure that we’re … I think that the thing that anybody that caress about this can do is contact their legislator because hearing from an organization is one thing to get the facts, to get the information that they need, to get it in this very easily consumable way. But hearing from their constituents is what will motivate them to actually take that information in.

Devon:

But also that’s why we tend to always lean on the possibility of losing this industry just because, like Amy said, the amount of value that’s generated by just the FAANGs alone is absolutely enormous, and there’s a very real threat that we could lose the decentralized version of the FAANGs going forward. And if they’re not realizing that and comprehending that, they have the opportunity of making an enormous mistake. And it’s really unfortunate when you get … Some of them have actually responded like, “Yeah, I don’t really care if we lose it. It’s nothing but fraud and fake stories and stuff.” And they’re just disingenuous and don’t want to actually understand the details. So, that’s unfortunate.

But the vast majority of them that we make that argument with are like, “Wow, that’s really important. And it could be the future of our country. It could be obviously directly impactful on my constituents.” And so, even if we’re not throwing money at them to get reelected and the industry doesn’t have a big entity doing that kind of work yet, at least giving them the information that shows them that it could be affected to their own jobs helps to some degree.

Ian:

Yeah, I think busting some of those myths is so critical. I think people with accurate information make much better decisions than operating off rumor and conjecture. I’m curious, since you brought up the banking sector, it actually seems like right now the thing in crypto are most excited about, is this idea that we could see some really big traditional finance players come into the space.

Everybody’s talking right now about the price of Bitcoin is up 30% I think, in the last couple of weeks. It seems mostly driven by enthusiasm for someone like BlackRock getting their ETF approved. How do you think about that in the landscape you just laid out, where potentially the traditional finance is an adversary to the broader adoption of crypto? And maybe also, does that still go along with the ethos that attracted you to the space? This idea of big traditional financial services players wanting to participate? Is that okay? Should we take that in the space? What do you think?

Devon:

I think it is okay. I don’t know yet how it’s going to actually play out. The idea of being able to sell paper version of Bitcoin to everyone that wants to, is that really going to be a good thing or is it not necessarily? I don’t know. But at the same time, I think the only way adoption is going to happen is when the large existing institutions do adopt it. And it also demonstrates it is superior technology and they spent a long time writing papers and lying to themselves that it isn’t. And then the tenor of those papers changed when they dug deep enough into it to realize, “Wow, this is way better than any proprietary payment network we can come up with, even if it’s just something we’re using at the base layer and not publicly and stuff like that.”

So, it just is awareness that this is in fact superior technology and it wouldn’t help them at all to not use superior technology if they can benefit their bottom line by doing so. So, it makes sense that they would adopt it.

I don’t think it undermines the ethos at all, really. In the sense that there have been significant players in the world, family offices and sovereign wealth funds and stuff like that, that just haven’t been able to get involved in this. And so, I think most of the reason for the excitement and the speculation, is if there’s multi trillions of dollars waiting on the sidelines that have been convinced of how valuable this is and how important this is, but have been unable to participate in it and they’re about to come flooding in, then this market is just going to just go absolutely through the roof. And that’s enormous. And it’s also beneficial because a lot of that’ll go directly into Bitcoin initially. But as people start taking profits from Bitcoin, they want to move into what else is interesting in the space and it helps them discover what else can this amazing technology do? And then more of that capital flows into whatever the new emergent thing was.

Last cycle, it was DeFi and NFTs. I think Amy was just on Bloomberg two days ago or so and pointed out that we think DePIN, because it’s been the past couple of years of bear markets for builders, they’ve done a lot of building and they’ve got a lot of applications that are actually usable right now. There’s multiple competitors to say, Dropbox. That’s a very consumer-oriented application that you could use right now.

Livepeer has an application, what is it called? Zero … I don’t remember what it is, but it’s literally a video conferencing application that’s very easy to use. So, a lot of these are ready to go, ready to use. And so, some of that excitement and value is going to come off the top of Bitcoin and flow into these other ones, and we’re going to see a boom in those and really have the opportunity for wider adoption by web developers. So, not just adoption in the financial space, but adoption in the technology space.

We’re actually talking to a major studio and technology company about how they are very interested in … I want to say who, but I wouldn’t be cool, but one of the biggest in the world, is very interested in seeing all the different ways that they can integrate this across their entire stack. And that’s huge, and that happens more often during these bull runs. And this could easily be the biggest bull run we’ve ever seen if we get something like the iShares and other ETFs approved.

Amy:

I think the question of the ethos is interesting because we came into it at a time that was very … that libertarian, we don’t need government, kind of people. And it’s been interesting to see as the cycles have gone, the different communities that have come into the space. I think that the issue in terms of it retaining that heart that was there at the very beginning about user sovereignty, is important to remember and also to keep inside the technology. So, if the protocols are built in a certain way, that ethos can never go away

Devon:

Right, no matter who’s using it.

Amy:

If the protocols are built in other ways, it can. Right?

Devon:

Like CBDCs.

Amy:

Like CBDCs, permissioned, federated networks that are-

Devon:

Similar, but not really. Yeah, yeah, right.

Amy:

Yeah, there are certain kind of proof mechanisms that are more vulnerable to attack than others. And so, as long as the technologists themselves who are building this continue to make sure that those values are baked into the protocols, we will be okay.

Ian:

Yeah, amazing. That’s, I think, a terrific optimistic outlook on where things are going. Amy, Devon, this has been a great conversation. Where can people follow you and keep up with all the work that you’re doing at the Web3 Working Group?

Amy:

So, the handle for Web3 Working Group is Web3WG. You can find us there on all the platforms. We’re at web3wg.org as well. And I’m personally AmyofAlexandria and you?

Devon:

And I’m DevonRJames on Twitter and probably Instagram.

Ian:

Amazing. We’ll link to all that in the show notes. Thanks so much for your time today. Really enjoyed the conversation.

Devon:

So did we. Thank you.

Amy:

Yeah, it was great talking with you. Thanks so much.

The post Decentralized Physical Infrastructure Networks Ep. 82 appeared first on Chainalysis.

Decentralized Insurance: Brandon Brown Ep 81 – Chainalysis

https://www.chainalysis.com/blog/decentralized-insurance-brandon-brown-ep-81/

Episode 81 of the Public Key podcast is here and we are happy that you love the refreshed look.  With bridge hacks, phishing scams and malicious code draining wallets, how can the crypto industry protect themselves? Decentralized Insurance has entered the chat and in this episode, we speak with Brandon Brown (CEO & Co-Founder, FairSide) to discuss this emerging insurance alternative to protect consumers.

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 81.

Public Key Episode 81: Insurance alternatives to protect digital assets in crypto wallets 

Bridge hacks, phishing scams and malicious code draining wallets have forced consumer protection to be a top priority in the crypto and DeFi industry.

In this episode, Ian Andrews (CMO, Chainalysis) gets a deeper understanding of how decentralized insurance works with guest,  Brandon Brown (CEO & Co-Founder, FairSide), who are revolutionizing the insurance alternatives in the crypto space.

Brandon explains that decentralized insurance is still in its early stages and has yet to be fully defined and believes that the current models in the space are trying to reinvent the wheel, even though the traditional insurance model is robust and resilient.

He also discusses the challenges of navigating the regulatory landscape in the insurance industry and explains that FairSide operates as a cost-sharing network rather than a traditional insurance product. 

Quote of the episode

“Defi insurance, as we think of it, should harness the power of blockchain in order to make these things more transparent, make these things easier from an onboarding process, but I don’t think we’ve done that.” – Brandon Brown (CEO & Co-Founder, FairSide)

Minute-by-minute episode breakdown

  • (2:05) – Why Decentralized Insurance is yet to be defined and the importance of insuring valuable crypto assets
  • (6:12) – FairSide Network’s focus on wallet insurance for mass adoption
  • (14:19) – Insurance companies invest premium deposits, but DeFi carriers shouldn’t
  • (18:47) – Traditional insurance expense model vs blockchain efficiency 
  • (23:55) – Different approaches to governance in DeFi and wallet theft protection
  • (28:01) – Navigating the regulatory landscape in traditional and crypto insurance
  • (31:25) – Brandon discusses the roadmap and launch plans of Fairside
  • (33:27) – FairSide can go mainstream and expand beyond crypto

Related resources

Check out more resources provided by Chainalysis that perfectly complement this episode of the Public Key.

 

Speakers on today’s episode

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Our podcasts are for informational purposes only, and are not intended to provide legal, tax, financial, or investment advice. Listeners should consult their own advisors before making these types of decisions. Chainalysis has no responsibility or liability for any decision made or any other acts or omissions in connection with your use of this material.

Chainalysis does not guarantee or warrant the accuracy, completeness, timeliness, suitability or validity of the information in any particular podcast and will not be responsible for any claim attributable to errors, omissions, or other inaccuracies of any part of such material. 

Unless stated otherwise, reference to any specific product or entity does not constitute an endorsement or recommendation by Chainalysis. The views expressed by guests are their own and their appearance on the program does not imply an endorsement of them or any entity they represent. Views and opinions expressed by Chainalysis employees are those of the employees and do not necessarily reflect the views of the company.

Transcript

Ian:

Hey, everyone. Welcome to another episode of Public Key. This is your host, Ian Andrews. Today, I’m joined by the CEO and Co-Founder of FairSide Network, Brandon Brown. Brandon, welcome to the show.

Brandon:

Pleasure to be here. Thank you so much.

Ian:

Brandon, I have tons of questions for you. Let’s start with the big one, decentralized insurance. What is it and what drew you to work on this problem?

Brandon:

Well, if you really think about decentralized insurance, I believe that it’s yet to be defined. I think that when you look at current carriers or protocols in the space, I think the space will develop and look far different in five to 10 years. I think you’re going to get more of a replication of the traditional insurance system, where today I think you’re seeing different models mostly trying to reinvent the insurance wheel when, honestly, the insurance financial model was never a broken model. It’s very robust. It is far more resilient than the systems that we’re seeing in defi put out today. I think that over time you’re going to see that that replication come on chain and get the capital efficiencies that traditional insurance systems are seeing today. So I think it’s one of those issues that hasn’t quite been solved yet. Now-

Ian:

Well, I think you make a great point there, that insurance, property, casualty, life insurance, one of the greatest businesses in the world today-

Brandon:

Arguably.

Ian:

… in terms of profits. It’s incredibly robust. You don’t see many headlines about insurance companies failing. You just continually see returns of capital to shareholders. Specifically when you take insurance as a product and bring that into the world of cryptocurrency and specifically decentralized finance, what does that look like? Why as a consumer would I want an insurance product in the world of crypto?

Brandon:

Well, I think with any valuable asset that you hold, typically, people insure everything of value in their life. If you can lose it and you don’t mind, then no problem, but you see people ensuring … I’ve seen it in the traditional sector. People insure the smallest of assets rowboats, and you’re like, “Yeah,” but this is what people care about because people work hard and they want to retain their financial wherewithal. So insurance is that vehicle to allow people to do that.

I would argue that your crypto assets are soon, if not already, the most valuable assets that you hold today. So insuring them makes all the sense in the world, but you need the right vehicle in order to do that. I think that adoption rates, even stakeholder adoption, which is the underpinning of these networks, suffers from the adoption level due to underlying issues within the protocol, but also, the product doesn’t meet the needs of the individual consumers.

So we’re seeing products that require you to purchase cover for every single protocol that you interface with, manage the duration of time, pay a premium for each one of those different positions that you have. It’s become cumbersome and doesn’t solve the real issue. Defi insurance, as we think of it, should harness the power of blockchain in order to make these things more transparent, make these things easier from an onboarding process, but I don’t think we’ve done that. We’ve reinvented the insurance wheel, and that’s been the mistake so far, I believe, in this space.

Ian:

It’s interesting to think about this idea of … I certainly have some crypto assets. They sit in a MetaMask wallet. I’ve never thought about getting an insurance policy. So I would imagine for a lot of listeners, this is a fairly new concept, but you make a great point. If you own an NFT that is maybe worth a hundred thousand dollars or a few million dollars or you’re holding a large amount of Bitcoin or Ethereum, that’s something that the risk of loss is definitely greater than zero. We all read headlines about sim swapping thefts or seed phrase exposure, and all of a sudden everything’s gone. That seems to happen on the daily.

Then also, there’s the other side of it. I assume you’re protecting against things like protocol loss. So when we see one of these bridge hacks or some other manipulation that results in a failure of a protocol, these are all very real events that people are subject to with regularity it seems like in the ecosystem. That’s why I would want an insurance policy.

Brandon:

I think that from a consumer standpoint, we did quite a bit of market research starting in 2018 as to … Well, at that time it was basically how big is this market. We needed to understand how big the market was, are there consumers that have a to buy insurance, what cover types are they after. We did that all the way through … The last one was completed in March of 2023. So we’ve done four different surveys. The big telling factor right now is that today, people want protection for their wallet, and we look at it as the essential line of coverage.

The wallet itself is key infrastructure into crypto and the adoption of web3, that it’s secure and that it also can be protected from insurance products or insurance alternative products, and that’s really what defi insurance today really is. It’s a bunch of alternatives to this traditional system. So from that aspect, we have to have a large enough market to hit some critical mass to support any insurance alternative product or insurance products in the space.

Now, that’s where we start as our baseline is that we need to cover the wallet because we’re looking at poor adoption rates on defi and poor adoption rates on … When I say defi, defi coverage, not defi itself. That’s growing nicely, but the coverage being taken out on those is suffering for a multitude of different reasons. So when we look at things like the bridge hacks and these protocol failures, there’s a market for it and we can solve that and we have built products for it, but it won’t be our product launch. Our product launch will be the essential line is to bring in a mass adoption because when you focus all of your effort on defi insurance, like focusing on the protocol losses for users, you get into an area where you only have three million active users and they’re very risk on users trading yield for risk.

So now there’s a segment of that three million people that will purchase coverage, but will you be able to hit critical mass and will you be able to be a sustainable network with just the risk adverse that are in that group? It’s not known yet. So what we believe though is that if you can onboard through where you have the largest market thickness, which is in the wallet side, and you have the largest demand on the product. When we did surveys, it was overwhelming the number of people who wanted to purchase wallet insurance and cover their wallets.

So from that aspect, if you can onboard many users on the wallet side, it’s easier to offer them an endorsement or some layer on top of their FairSide membership that would then give them defi cover and give them another endorsement for exchange coverage or something like that, a more third party risk. That then becomes a sustainable model when you can start to layer these coverages on top of each other. That’s really where our focus is at is to start with the wallets and then move into the other areas.

Ian:

Now, I’ve got all sorts of questions about the business model of insurance, and I’ll probably ask some dumb questions here because I’m a consumer of insurance, not an expert in the industry like you are. So when I think about an insurance business, it seems like the most critical thing is the calculation of risk, this concept of actuarial tables. In a simple product like life insurance, it’s a prediction of life expectancy of a given individual with a whole bunch of risk factors I think calculated in like were you a smoker, are you overweight, and that allows you to establish likelihood of someone living or dying beyond a period that drives a premium cost.

You have enough of those policies. As long as you’re generally correct in your guess of life expectancy, the business model works. People pay in a premium. They get paid when a policy hits, a policy condition hits, it’s paid out, but the insurance company continues as a profit making business. How in the world do you calculate that risk of loss in something like crypto? I can’t even imagine where I would start to figure out the premium calculations and the risk of loss analysis. Maybe start there with the business. How do you do that?

Brandon:

We looked at it differently than others in the space. There’s models out there that people are using like prediction models and capital allocation. We don’t believe those are accurate to create any underwriting profit. We believe that you have to go with the actuarial modeling side of things, which is science-based. So we looked at things like phishing attack, social engineering, and those things happen today in traditional finance and data stolen all the time, cyber risk exists. So we started modeling the amount of losses that are happening in crypto against these known losses in crypto against some of these more traditional actuarial models and came up with a blended approach that really allowed us to create a starting point.

That’s really what your actuarial model is supposed to do is provide you this really robust but believable and starting point for any InsurTech startup. So with that starting point, we’ve been using actuarial data and using some of the reports that you guys put out. We have created a partnership with Chainalysis on different levels for wallet screening and all these other things to start to cut down on some of the potential losses that would happen in our network initially.

For us, it was to go with the science-based approach where people interface with wallets isn’t with the dark web and all these other things. We can cut a lot of that out through some of the services that you guys offer, but for us, it was to look at more of the traditional modeling and then blend that with known losses in crypto, ,as well as look at some of the reports that you guys are putting out and get some other data points from others as well.

Ian:

So that’s interesting. So you’re actually taking Chainalysis’ address screening, and you’re cutting off maybe what would be considered the riskiest part of the pool in the same way that certain insurance companies, if you’ve had two DUIs and totaled three cars, they’re just not going to write you a car insurance policy. You’re taking a similar approach and saying, “Hey, if a given wallet is known to interact with dark net markets regularly, you know what? That’s just going to be somebody we’re not going to allow to be covered in this case.” So you’re containing the risk profile to what would generally appear to be a less risky crowd in terms of some of the choices, behavioral choices they’re making.

Brandon:

Yes, some of that, and then we also look at a highly diversified model. So in a highly diversified model, we spread risk across much larger networks. So stakeholders have risk reduced positions as a stakeholder, and it creates sustainability within the system and using strong actuarial modeling, what it allows us to do is look at our frequency and severity of loss, and then if we need to adjust, premiums could go down. Your membership fee into the network could go down, but you have to an actuarial based model in order to get to the desired financial outcome you want in the future.

If you use these other types of premium allocation and wisdom of the crowd, there’s no scientific basis to produce an underwriting profit for the network of any kind, and that’s where we’ve really focused our attention is to really charge a higher premium than you intend to pay out in losses on an annual basis. That’s the basis of this model. When you marry these models with blockchain, you’re able to get these transparency, the efficiency, all the things that people are looking for in their insurance systems and cut down an extreme amount of expenses, which then can lead to far greater sustainability of the network.

Ian:

Now, one thing that I think most insurance companies, they have a very large pool of capital, all these premiums that are paid in. I think they create a large amount of profit for the business and their shareholders by investing that capital pool. Now, generally, I think it’s low risk asset like government debt or highly rated corporate bonds as the model, so low risk assets, but that money then goes to fuel a profit engine because they generally don’t have high demand for premium payouts if they’ve done a good job with those actuarial tables. Is FairSide taking an approach where you’re doing something like this as well, where you’re actually investing the premium deposits that go into the protocol or have you taken a different approach?

Brandon:

Well, the companies you described didn’t start that way. They started small and then they built to a position where they have assets in reserve and surplus that they’re able to then take those assets and then create investment income off of them, but they didn’t start that way. In the early systems, and everyone knows that that’s how an insurance system works, but in defi, as you see it today in defi carriers that are coming out and protocols that are offering cover, I think it’s important that they don’t invest those assets because when you see someone like the whole thesis is around the idea of creating an underwriting profit, well, people can do staking on their own early in a system.

The product itself needs to be sustainable and work, and those risk-based assets that are provided to that network need to be there early in the system to float any loss that the system has. If the frequency ends up being slightly higher than anticipated on an annual basis early in a year, then you need those risk-based assets to float the system until your premium allocations, your premium generation is then basically created in a way that the premium allocation, if it’s annualized, the losses end up being less than the amount of premium that you’ve collected, but you have to get to a point where you can do that, and that’s what risk-based assets in the system are meant to do is to continue because if you’ve done your actuarial modeling correctly, you will have an underwriting profit at the end of the year, especially when you’re talking about using blockchain technology, which increases that efficiency so much that you can reduce the amount of expenses that assistant like ours would have.

Ian:

This is a great point. So before we started recording, you were explaining to me the traditional expense model for a normal insurance company, and then you were making the point that with blockchain, your expense model is fractional to that. So maybe explain that in a little more detail for us.

Brandon:

So traditional insurance systems, they’re going to operate on expense loads. They have loss adjusters, they have underwriters, they have executives, they have agents and brokers to pay for distribution. So an expense model on a traditional carriers can run 30 to as high as 40%, 45% on some carriers. Now that means an insurance company that’s focusing on investment income is focusing on a one-to-one model, $1 in, $1 out in losses and expenses, so that means they have to have, this traditional system has to have a 60% loss ratio or lower if they’re operating at a 40% expense ratio in order to create that one-to-one so they can have the investment income.

In our system, focusing on the personal wallet theft side of things where you get more isolated risks and so it becomes very manageable, you’re able to operate at, if you were to get 1% market penetration of the 300 million crypto holders, 1% would generate a billion dollars in revenue. A billion dollars in revenue in a traditional system, they would be having an expense load between $300 and $400 million. So in our system, we could operate similarly on the same levels of revenue, but do that with two to three million dollars of expense load, which is far, far different because we’re focusing on the technology versus heavily driven manpower.

Ian:

Just thinking about that, I can imagine you’re not going to have an agent network. There’s not going to be a local office for FairSide that I come down and sit down with my agent and sign up for my wallet protection policy. So I can imagine all those costs going away, but what about the underwriting analysis? I would assume you still have some marketing costs, right?

Brandon:

Yes.

Ian:

Then you’ve got the people building the technology. Compare some of these other parts of the business.

Brandon:

So you have a fairly large marketing-

Brandon:

Let’s just check it real quick.

Ian:

All right. How’s this sound? Yeah, the echo goes away.

Brandon:

Sorry about that. So traditional insurance systems have a fairly large marketing budget. So that marketing budget in general could be commercials, could be radio ads, but part of that marketing budget is also distribution channels. So we believe that looking at distribution channels is a great go-to-market strategy in order to get to the people. So we intend to keep some of that in our system. One of the major ways in which we do that is we focus on the wallets, having FairSide replication of say the travel insurance experience where inside of a wallet where you hold all of your assets, there could be an easy onboarding opt-in option for getting cover for your wallet. So through that, we look at distribution channels as the wallet and we intend to share top line revenue with wallets, top decks. Similar to how an insurance company would distribute through agents and brokers, we want to distribute our cautionary network in the same way.

Ian:

Now, I have a bunch of questions because I was reading into the white paper this morning and you’re doing some pretty interesting stuff. So there is a token that you’re creating, FSD, and there’s a staking mechanism to support the network and there’s a level of rewards, but I think it also fuels the entire premium payment model and then payouts. Can you just talk us through what that architecture is, why that’s necessary to enable what you’ve built?

Brandon:

So at launch, we’re looking at a product first launch, token second. So when we do a very closed system where you have just early stakeholders in the network, the token doesn’t become as integral, but when you want to decentralize the system and you want a community to come together, basically, to create the social and economic good that traditional insurance will provide through our network, that’s where the token becomes an integral part of the system. In our model, we use, and you made the point earlier, very large capital pools like insurers have. We use a very large capital pool as one network staking system.

In that system, stakeholders can come into this network and they can bond their Ethereum to our network, and when they bond the Ethereum, we mint the FSD token. The FSD token then acts as semisynthetic to the system itself. Its price is represented on a few factors. One is the amount of Ethereum in the capital pool, but also, there are long-term drivers looking at adoption of the product, as well as the short-term driver would be the immediate need of the capital pool. Is it overfunded or underfunded? Those factors come into the token pricing model.

So as a stakeholder though, you hold the FSD in your wallet. The FSD then is able to basically represent your position within the network. When you do that, you’re using the large capital pool. As losses are paid in the system, we’re pulling Ethereum in order to pay claims within our network. So when you pull the Ethereum, there’s a marginal decrease in the value of each token you hold, but there is no permanent loss of that token because through strong actual modeling, the capital pool should continue to grow year over year with underwriting profit and the lack of expenses that the system has.

So if you start with X in the system, you’re going to have X plus your underwriting profit, which one of the main drivers is the amount of ETH in the capital pool, so the token price itself is increased. So there’s no liquidation factor that you see today in the systems. That’s where we have a non-permanent loss versus a permanent loss where staking in today’s system is a one-to-one staking mechanism where you stake the project pool and then you liquidate the stakeholders, and the stakeholders are only getting a very small portion of a premium, and so the risk reward ratio, it’s always one to point something. It’s never one over one. You know what I mean? You never get to a one to three or one to five or one to 10. Never happens in the system because the concentration of risk is so great in those systems, and concentration of risk is the capital efficiency killer of any strong capital efficient model.

So in our system, the FSD token is used in a few different ways. One, to represent the system as I explained, but two, holding FSD builds a conviction score in our system. When you build a conviction score, that represents your proportional amount of rewards that are paid as others leave the system because we have a mint and burn function on our curve. So when you burn the FSD in order to exit the position, it’s an unlocked position, so stakeholders can leave when they want, but you pay a tribute fee in order to leave. So when the tribute fee is paid, it is distributed to all token holders who remain in the network.

So this conviction score that is driving the amount of rewards that you receive, so it’s incentivizing long-term holders, believers in our network, and those that are really looking to create the social and economic benefit that insurance alternative products can provide to the space. Additionally, we use it for governance within the system. So in a decentralized system, governance is very important. So that conviction score that you’re using, we apply that to governance thresholds and allow users to help govern the network.

Ian:

This was one of the things that was really interesting when I was reading the white paper is it’s set up that the community is the one deciding when to pay out on a claim. I can imagine there’s all sorts of unusual incentives that that model creates. Talk a little bit about how you’ve envisioned that and how you expect it to work.

Brandon:

Well, ultimately, if you’re not looking at liquidation of a stakeholder, and there’s more benefit by acting fairly than unfairly because the marginal decrease in the token value, we expect by opening the governance system and allowing everyone to vote on claims that it can, and this is in defi losses, and we can talk a little bit more about the product launch, but in a defi loss, if you’re not liquidated and you have this open voting system that you don’t have to stake to vote, which can call into question the objectivity of the voting because you’re basically in this moral and financial dilemma in the current systems as to when I vote, if I vote fairly, then they can liquidate my assets and if I vote unfairly, they burn my stake. So you can’t really create a fair system in that way.

So what we’re looking at is if there’s more incentive for the user, for our stakeholders and our participants to act fairly through marginal decrease in value of tokens and at the end of any year we expect an underwriting profit, then it makes sense that the user is able to vote fairly within our system, and we don’t vote on individual losses. So to increase participation in the system, you only vote on the event. So I’ll use an example like a Cream Finance hack. Is Cream Finance something that we intended to pay out based on in sharing this loss, based on the type of loss it was? You vote once in the system. If the answer is affirmed, yes, then all other losses in the system aren’t necessary to vote individually on them. So if you are a participant in the Cream Finance hack and you’ve lost assets, then now, you’re just sent over to one of our partners, Halborn, who then verifies that you were part of that loss event, and then the system, we can expedite the payout for you.

So as a participant in governance, you’re voting one time, but you get paid every single time somebody has a loss because they pay an assessor’s bounty. So every time to open the claim, I paid this assessor bounty, I’ve only voted one time, and I may get paid 200 times in a defi loss because there could be a global loss where a lot of people are affected by that loss. So in defi, it works differently than in personal wallet theft protection. In personal wallet theft protection, we look at it differently because there is a higher likelihood of fraud in that system because you can spin up a secondary wallet, you can just claim to be phished. So now we work with NAXO, which is an elite group of cyber investigators, former special agents from the FBI, and these guys are top of their field, and we have an arrangement with them where we’ve had this formal agreement where they come in and basically assess all the losses for us on an individual basis, and they’re basically creating a trust score for the individual loss.

That trust score is then used by the governance committee to pay out the loss because if we can trust the individual that is making the claim, then we believe that we can trust that this claim is legitimate. So it expedites that system by using this disinterested third party that has a reputation online, and what they’re trying to do is just create fairness in the system as well with all of us. So it really expedites that system. Then on top of that, we use Chainalysis, reactor tools, and some other things as well in order to really dial that in and make sure that this isn’t a user that’s generating insurance fraud on our system.

Ian:

I hadn’t even started thinking about the variations of fraud here, but that seems like you’re going to be faced with probably a lot of people who are attempting to pull off something like that where they hack themselves, in fact.

Brandon:

You know if in the system if you do that, then you’re setting NAXO and Chainalysis loose on you. I wouldn’t want that as an individual. I have to be fairly sophisticated to do that, but we’ve also put in loss controls in the system and thresholds that keep us resilient. One of the things is to start off our system with offering coverage from one to 100 ETH in value. In doing that, we prevent very, very large losses or any one individual from having an overwhelming negative effect on our capital pool. We can scale that up as we get loss experience and we see how it goes, but it will satisfy the masses. That’s really been what we’ve been after from the beginning is to foster web3 adoption and to really deliver critical infrastructure to the space.

Ian:

Give me a sense of what it costs me to insure a personal wallet. You gave that range of amounts that I can insure, but let’s say I’ve got 10 ETH in my MetaMask. What does a policy cost?

Brandon:

So policy cost is 1.95%, and it’s not so much a policy as much as it is a membership into our network. So the network is based around cost sharing of others’ losses. So as stakeholders come into the network or contributors contribute to the network, they’re sharing in the losses of others for the reward system that’s put in place. So ultimately, 1.95% is the launch membership cost, but like I said earlier, with loss experience that we can toggle that up or down. Our experience and our frequency and severity numbers show us that we believe we can come down off of that number and we can even get as close to 1%, which I think would be very palatable, but through the market research, we found that 80% of people still want to buy our product at 1.95, and it’s not to have some huge underwriting profits. We just want to make sure that we remain resilient early in the system and that if our frequency or severity is the threat to any InsurTech startup really is going to be early when you don’t have the hundreds of millions of dollars of assets that you’ve built over time.

So that’s where we have to be as cautious as we can, but the nice thing is if you want to insure roughly two $10,000 of assets, cost you $195 for the year, and this is an annual membership into the network. Also, we don’t cover, I’m sorry, we don’t exclude wallet types or chain types. So we’re chain agnostic in the coverage that we offer. The only difference is that you will have to get paid back in ETH or DAI in our system earlier in the system, and then we will eventually migrate over to paying in the chain in which you lost the assets. You can elect the chain to get paid back in, but right now it’s ETH or DAI, and it still works for all wallet types.

Ian:

That actually seems incredibly reasonable to me, given that the risk of loss that I think a lot of people are exposed to in the ecosystem today. So shifting to slightly different topic, as I understand it today, the insurance industry is incredibly regulated. There’s state level regulators in the US, and prices are controlled, policy premiums are controlled on a lot of products. There’s federal backing for certain types of products like flood zone insurance. It’s an incredibly complex landscape, which I think has built a bit of a moat. That’s why there’s these really large companies that make lots and lots of money in insurance. What does that mean for you? Have you had to navigate the regulatory world in order to bring this product to market?

Brandon:

We did go and explore that route, but to your point, there is regulatory moats that have been created. This is a titan industry. You don’t just jump in. One thing that we did find through all of our research was that using a cost sharing network, one, it lends itself amazingly well to decentralization. So that was a starting point, but two, cost-sharing in the US is widely used as an insurance alternative for the healthcare industry. It was born out of Christian ministries, ultimately parishioners coming together to share the loss of others who couldn’t afford health insurance, and then it’s developed into an industry now, and it doesn’t fall within the purview of insurance commission.

So if you can model that same system with people all coming together, like-minded individuals sharing the loss of others that share the same beliefs, then we’re able to mimic that system and operate as an insurance alternative. When you overlay a modern actuarial model on top of that, you get a very resilient system.

Ian:

Interesting. So a cost-sharing network means that you’re not technically an insurance product and, therefore, you’re not under the insurance commissioner.

Brandon:

So it operates differently. There’s no central group. There’s no promise to pay. There’s no contractual obligation, which also causes a lot of the contention with inside of the insurance sector and the end user, the insured, where every time as … It’s not lost on the insured that every time a traditional insurer pays a claim, it’s to their own detriment, but in our system, we believe we can create more of a social and economic benefit to everyone in the system, those contributors to the network, as well as those members in the network where we can have this fully robust system where everyone wins and there are no losers.

Ian:

This is a really exciting model. So I’ve been to the website. I’ve clicked the join the wait list button. I’m now eagerly anticipating when I get to join. Talk to us as we wind down the conversation a little bit about the roadmap from here. When does this open up for general participation? When can I get my insurance policy on my personal wallet?

Brandon:

So membership will start, is anticipated right now in Q3. So we completed our final audit. We’re in a code freeze. We’re developing the DAP a little differently now because this has been multiple iterations of this product. Like I mentioned earlier, we have three different products built out. We’re launching with One to start. So we’ve really focused the DAP and redesign down to just the personal wallet theft protection and really focused heavily on the user experience. We believe that web2 experiences seem to be smoother and less clunky than a web3 experience as it stands today. So what we’ve done is really focused on that user experience, trying to make that a seamless process so that the users and members of FairSide network can sign up in minutes and not take a very long time in that process.

It’s still a permissionless system for us to get in, for the user to get into the system, and that takes around two minutes, which is a very reasonable amount of time. So for us, the idea of launching product first and our roadmap is Q3, then we launch staking, and this is a sophisticated model. It is going to take some time for us to dial in actuarial models so that they can be supported by the community and not the founders in a core group of governance level members, but I think we can get there relatively quick, definitely, hopefully, before Bitcoin goes to the moon, but it is a nice time to launch.

This is a great time to launch because if you launch in the height of a bull market, then there’s so much distraction in the system. The token also causes some issue of distraction when you have a very strong product. So for us, holding back on the token to a later date really allows the user to focus on the usability of our product and how important it is to the ecosystem. When you have a token involved, the token itself can distract people away from how good the product is when you have volatility within your token.

So really, the focus is product first, token second, and then start to develop into these other lines of coverage, the defi and the exchange and third party risk, but we also have models. Right now, we’re built to be high frequency, low severity, which is why we limit it to 100 ETH, but there are more catastrophic models when we start to look at how we want to cover protocols. So the protocol can get coverage because we believe that the user has one line of cover, but there’ll be a coordination of benefits. If you look at some of the defi protocols, it’s cost prohibitive for them to purchase a billion dollars in insurance coverage for all their staked assets, but if you have coordination of benefits through two different segments of FairSide where the protocol can purchase a layer of cover and then individuals purchase a layer of cover as well, then you get coordination of benefits and we’re able to fully support the ecosystem on all levels.

Ian:

Amazing. You’ve spent a long time before launching FairSide in the traditional insurance business. Do you envision a future where the products you’re building at FairSide become mainstream, part of that every insurance carrier has an option like this?

Brandon:

I definitely believe that we’ll go mainstream, and our focus is on bringing adoption to web3. So that’s one of the reasons we focused on our distribution points as being the wallets and indexes and top projects in the space because we need to get product and brand awareness out there, especially as first move around personal wallet protection, it becomes necessary that people have this awareness of what you’re doing because we’ve seen through the market research too that a vast majority of people don’t even know that insurance exists in the space on any level. So for us, it’s getting that awareness out there to the individual.

I definitely see it being mainstream at some point. FairSide, the way it’s been designed and built, we can tackle nearly any type of loss, and it doesn’t have to be just crypto. What we’ve developed can move into flood and into crop and into all these other forms of coverage. It is not isolated to crypto. We just intend on conquering crypto first, and then once we’ve hit some critical mass there, we can look at other product lines, but definitely, it’s a mainstream product.

Ian:

Amazing. Well, I’m really looking forward to the product launching later this year and being able to participate. Brandon, thanks so much for joining us on Public Key.

Brandon:

Yeah, I appreciate it. Thanks so much for having me.

The post Decentralized Insurance: Brandon Brown Ep 81 – Chainalysis appeared first on Chainalysis.

Web3 Adoption in Traditional Finance: Kemal El Moujahid Ep. 79

https://www.chainalysis.com/blog/web3-adoption-in-traditional-finance-kemal-el-moujahid-ep-79/

Episode 79 of the Public Key podcast is here and we are happy that you love the refreshed look.  Bringing real world assets on to the blockchain will need safe, reliable and accurate data points. In this episode Kemal El Moujahid (Chief Product Officer) at Chainlink, shows us how we can connect web2 and web3 applications in a seamless and secure way.

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 79.

Public Key Episode 79: Bringing real world assets on to the blockchain has never been easier

Real world asset tokenization is all the hype with traditional institutions looking to delve into the world of web3, but security, accuracy and reliability of data and price points, continue  to keep many on the sidelines.

In this episode, Ian Andrews (CMO, Chainalysis) gets to speak with Kemal El Moujahid (Chief Product Officer) of Chainlink, whose team is connecting smart contracts with Web2 systems. 

They delve into the benefits of Chainlink’s Cross Chain Interoperability Protocol (CCIP) and the potential for real-world assets and data to be integrated into the blockchain in a secure and trust-minimized way.

Kemal identifies the tension between speed and security in DeFi bridge transfers and the need for interoperability between chains, in order to unleash the real value of on-chain assets.

He also explains Chainlink’s role in providing connectivity and solving the limitations of smart contracts and how the future will be balancing real world assets with real world data and real world users. 

Quote of the episode

“But the fact that you could build something as a developer that could not be shut down, that could not cheat. You would write the code and it would run as is. So you get immediate, instant trust from everyone that your service will run as expected and that could carry massive amount of value” – Kemal El Moujahid (Chief Product Officer, Chainlink)

Minute-by-minute episode breakdown

  • (2:15) – Kemal’s journey from Google into the world Ethereum Virtual Machine (EVM) and smart contracts
  • (5:12) – Chainlink’s role in providing connectivity and solving the limitations of smart contracts
  • (8:58) – The importance of oracles in connecting smart contracts with Web2 systems
  • (11:25) – Introduction to Chainlink’s Cross Chain Interoperability Protocol (CCIP) 
  • (13:55) – The tension between speed and security in DeFi bridge transfers
  • (16:02) – CCIP’s approach to waiting for finality on the source chain
  • (21:45) – The connection between SWIFT and CCIP for modernizing the financial system
  • (28:45) – Introduction to Chainlink Functions and its role in connecting smart contracts with Web2 APIs
  • (32:27) – Real world assets, real world data, and real world users

Related resources

Check out more resources provided by Chainalysis that perfectly complement this episode of the Public Key.

 

Speakers on today’s episode

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Our podcasts are for informational purposes only, and are not intended to provide legal, tax, financial, or investment advice. Listeners should consult their own advisors before making these types of decisions. Chainalysis has no responsibility or liability for any decision made or any other acts or omissions in connection with your use of this material.

Chainalysis does not guarantee or warrant the accuracy, completeness, timeliness, suitability or validity of the information in any particular podcast and will not be responsible for any claim attributable to errors, omissions, or other inaccuracies of any part of such material. 

Unless stated otherwise, reference to any specific product or entity does not constitute an endorsement or recommendation by Chainalysis. The views expressed by guests are their own and their appearance on the program does not imply an endorsement of them or any entity they represent. Views and opinions expressed by Chainalysis employees are those of the employees and do not necessarily reflect the views of the company. 

Transcript

Ian:

Hey, everyone. Welcome back to another episode of Public Key. This is your host, Ian Andrews. Today I’m joined by Kemal El Moujahid. Apologies if I didn’t get the surname totally correct there, Kemal. You can correct me in a moment. Who’s Chief product Officer at Chainlink Labs. Kemal, welcome to the program.

Kemal:

Hey Ian. Thank you for having me.

Ian:

Kemal, I’m fascinated by your background. I know so many people right now that are rushing into the artificial intelligence space and you’ve actually gone the other direction. You spent a number of years prior to Chainlink leading the TensorFlow product team at Google but you’re now head of product at Chainlink. I had love to hear a little bit about your career journey and what led you into this world of crypto.

Kemal:

Yeah, sure. Well, so I think for me, the big “aha” moment … I think we all had our different moments with crypto, Web3. For me, the big moment was when the EVM came out. That really felt like something completely new and one of those big moments like … Well, internet was a big moment, right? You could get instant distribution for your content, your services. Mobile was a big moment, because as a developer, you could create something that could be in the hands of everyone with connectivity and sensors. AI, definitely a big moment, because now your apps are smart. But the fact that you could build something as a developer that could not be shut down, that could not cheat. You would write the code and it would run as is. So you get immediate, instant trust from everyone that your service will run as expected and that could carry massive amount of value.

Those three things put together felt something radically, radically new. And that was going to transform pretty much everything that we see around this. So that was the first big moment for me. And I’ve always been looking at this industry and wanting to learn more and to get in. I’ve been playing with smart contracts for a while and I think a couple of years ago it really felt … I could really see the acceleration of the adoption of the ecosystem and it went from this phase of very innovative, but trying to find its place in the world, to the phase where it starts being adopted more by traditional institutions and just before it goes mainstream. So that’s what got me in the space.

Ian:

Well, and you must have … based on what you just described, the rise of the EVM, the Ethereum Virtual Machine, and with it the creation of programmatic money or value transfers, that really started back in 2015, 2016. So you’re watching that happen while you’re busy at work in the world of TensorFlow. Were you writing code on the EVM? Were you building smart contracts? What was your level of activity before joining Chainlink into the crypto ecosystem?

Kemal:

Yeah, I was definitely playing with Solidity, seeing what the technology could do. I’ve had the privilege to witness a lot of those waves, AI before messaging, and it gave me a good feel of how mature a technology is for massive developer adoption. And so I was getting, trying those tools. I could see how sometimes they were very early and that’s what I meant by I sensed an acceleration a couple years ago of maturity of tooling. And I think It’s also when some … Chainlink became, very apparently to me, this missing piece.

Because every use case that I could think about that a real world use case that had real world value needed some connection with Web2 data or Web2 systems or AI systems. And we could … maybe we’ll talk more about some of those ideas. And so this incredibly exciting new primitive, those smart contracts, they were just not connected. So their power was really limited to the virtual machine and the idea that you could connect them with any Web2 system or you could connect them across many of those virtual machines that constitutes the various chain, became very, very obvious to me that that was the biggest unlock in that space.

Ian:

Yeah, it’s interesting. I think probably for a subset of listeners of this podcast, they’re intimately familiar with Chainlink, I imagine we’ve got more than a few of your customers, talking on the podcast. But I also feel like sometimes Chainlink flies a little bit below the radar, in that you’re an infrastructure technology, right? Can you give us the high level perspective on the portfolio that Chainlink has built?

Kemal:

Sure. So chainlink solves the connectivity problems. As I mentioned, those new primitives, those smart contracts, they have these incredible properties, but they’re limited in that they’re not connected to Web2 data or Web2 computation or Web2 system, that’s limitation number one. And limitation number two is they’re not connected with each other. Those chains are not natively compatible with each other. And so that prevents a lot of really interesting things. So there is this need for a connectivity layer, a connectivity standard, and this is what Chainlink provides. And we can go in more details about how we solve this, but at high level, this is what Chainlink does. It offers developers with a very simple way to build those apps that are composed by those … mix and matching those heterogeneous systems. And the first really big use case that really gave birth to DeFi Summer is taking a DeFi smart contract and connecting it with a price feed of a crypto asset.

And this is what Chainlink was originally and still very much known for, I would say probably outside of the industry, as the standard for delivering data for DeFi. But very quickly, the same technology, the same connectivity technology, started getting used for other use cases, randomness, to power gaming and NFTs. So as a consumer, you want to be interacting with something, which randomness is fair, it’s provably fair. And so that’s what Chainlink provides. Automation was another really important primitive. You want certain conditions to be executed at certain time at certain price points. Then you need chain link automation. And more recently, functions, which we launched it at ETHDenver. CCIP, which we launched in Paris, which is the Cross Chain Interoperability Protocol. Oracle. So Chainlink has expanded into this pretty massive platform and with three main primitive. Data, compute, and then cross chain, CCIP.

Ian:

Yeah, I think the thing that’s always struck me about Chainlink is it’s data combined with trust. That’s so powerful. It is not, “Oh yeah, I looked up the price of this asset three hours ago and it looked good in the thing that I looked at. And you can just trust me.” You’ve built a network that employs a lot of the same fundamental principles as the blockchain itself in order to deliver information that often originates in the real world or in a system disconnected from the runtime layer of the smart contract into that smart contract and able to extend the functionality or build more complex systems. Would you agree/disagree with that? That’s been my take as an outsider.

Kemal:

Yeah, so I think at the heart of the Chainlink platform is the notion of an oracle, right? An oracle is something that connects a smart contract with a Web2 system. Typically, it could be to get a data point but it could also be to execute something. You can imagine, I think we had someone at a hackathon that opened the Tesla via smart contract. So you can imagine that it actually enacts some action on the world. But then we’ve seen with function, people sending messages via Twilio. You can also process satellite imagery and detect whether there’s a forest somewhere and issue a carbon credit based on that information. So this idea can really be generalized, but at the heart of it, there’s this oracle. And what’s really specific about Chainlink is that those oracles are assembled in decentralized networks, decentralized Oracle networks.

And by using Chainlink as this platform is you’re not relying on one Oracle and you don’t have to trust one oracle to do the right thing or to not be down or to … You have this network that have to come to consensus. So in the case of a data point, you have your DeFi protocol, you’re securing billions of dollars of a position, and there’s the liquidation condition if the price of Ether in US dollar goes below a certain number, then you have to liquidate. You really want to make sure that this price point is good, is accurate. And this is where the fact that this network of oracle that will all go get different data points and come to consensus over the value of that data point gives you that really nice property of security and reliability. This is why Chainlink is really known as the standard in the industry for those properties.

Ian:

And from that basis, you’ve expanded quite a bit, and one of the things you mentioned just a moment ago was this CCIP that was announced earlier in the summer. I think It’s now live on main net. Cross Chain Interoperability Protocol, what is that? Why do we need it? What’s it going to do for people?

Kemal:

Yeah, so what’s happening is that we’re in an increasingly multi-chain world. There’re new chains popping up every day with new interesting properties because the space is exploring let’s get more throughput, let’s get lower latency, let’s get more flexibility, let’s get more programmability. Let’s have app change, let’s have subnets, let’s let you not have to share the bandwidth with other … which is a very natural phenomenon in expanding from the initial point of the industry. But as a consequence, you have this massively heterogeneous space, an increasingly heterogeneous space. And those different chains are just non-compatible. They’re not good at talking with each other, especially in a trust minimized, secure way. And this creates huge problems. So first liquidity is fragmented.

You have liquidity pockets in one chain, can’t be reused in another one. So you have some position in chain A, you want to use it as a collateral to borrow on chain B, you can’t do it efficiently. That’s problem number one. Problem number two is this is much, much bigger than just DeFi and Web3. If you look at TradFi, there are $900 trillion worth of assets that are just waiting to be tokenized. The tokenization trend is happening. It’s fueled by very, very strong factors, like putting an asset on chain just makes it much more … increases its utility and value tremendously. It reduces costs. So all TradFi institutions, they’re looking at how to put assets on chain. But the fact that those chains don’t talk with each other means that they’re going to move an asset on chain and it’s going to be trapped on one chain.

So why would you put an asset on a chain if it can’t move freely? So that’s also another really big problem for this industry to be fragmented. And the third one, which is maybe even a little higher level, is that if you look at the web, the web really grew because it was compos-able. Because as a developer, you could use what another developer that you don’t know from did somewhere and then you can just compose those things and build something even better. But if you have systems that are fragmented, you cannot compose things. As developer, I cannot mix and match the best of chain A with chain B. We were talking about AI before. As an AI developer, I can reuse a model that’s been built by people that I don’t even know, that I went and picked up on Hugging Face. So those are huge problems and this is why we set on to build CCIP.

And the way we went about it is it’s not just a technology problem, it’s creating a standard. What we want to do is we want to create something that everybody, uses and the more people uses it, the more powerful it becomes. Because the value of an interoperability protocol really lies in the size of the community that uses it. And so we set on to create a standard. And first property of the standard is security. We talk about security all the time because it’s the name of the game. That is what brought us to the position that we’re in. That’s what enabled all of our users and customers and clients to be successful. So that’s always going to be front and center. There have been a lot of hacks in the cross chain space and bridges. I think close to $2 billion stolen last year

Ian:

Yeah, easily. This was actually one of the topics I really wanted to dig in on with you because when I looked at CCIP, it seems to be an alternative to bridges that exist today, which have been notoriously the most vulnerable points across the crypto ecosystem. And I’m not deep enough in CCIP to really understand how it differs from a bridge or do you use it in conjunction with an existing bridge? So maybe we can go deeper on how does it solve some of the security issues that we’ve seen in the bridge layer of the architecture?

Kemal:

Sure. Well, it’s a radically different approach, and again, it goes back to this usage of these oracles and using them in networks, decentralized networks. So you have this very strong, reliable trust minimized glue, if you will, between two heterogeneous systems, which is very different than how bridges are traditionally designed. The other very big difference with CCIP is that we use defense in depth. We have different layers protection. We have the risk management network that sits on top of the actual infrastructure that passes the messaging. So you have multiple layers of checks that make sure that the information that had been passed from chain A and chain B is legitimate. And so I think, again, the design of the system, and this is something that our world-class research and security team has been working on for the past three to four years.

So this is also why we wanted to spend so much time testing it with our partners before we went live last July. So it is something that A, is deeply secure and something that we’ve brought the same infrastructure, the same decentralized oracle networks, that have processed a trillion dollars worth of value cumulatively is securing the same thing. And the second thing is I mentioned standards. We’re working with SWIFT, 12 of the largest banks in the world, we’ve announced something really cool with ANZ yesterday. Today with DTCC. This is what creating a standard means. We’re working with the largest DeFi protocols in the space to create, again, this interoperability language that everybody gets to use to solve the industry’s problem.

And the last thing is really flexibility. So this is more like the developer platform product person talking. We need to make this thing seamless to use, seamless to embed. Because at the end of the day, those innovations, they go through cycles. And the thing that really makes it go upward is when you can integrate them seamlessly with the existing infrastructure. So it never works to go to an existing player and say, “Hey, you’ve got to scrap everything because this thing is better.” It’s always, “Look, this thing brings you superpowers. This is how you integrate it into your existing stack.” And That’s also how CCIP has been designed. It’s super easy to use, it’s super flexible and matches all the use cases that we’ve observed.

Ian:

So just to maybe make it a little more practical for people, and then I want to come back to the SWIFT topic in a minute, because I think that’s important too. If I have my DAPP, let’s say it’s a DEX, running on Ethereum today, and I decide, hey, you know what? These layer two networks are getting really, really popular and I’d like to have my DEX also available on Polygon and Arbitrum, but I don’t want have to split the liquidity available in my DEX or I don’t want my users to be locked on only one chain and really have almost three separate universes. Maybe an option is to build my own bridge potentially but in a potentially simpler, and it sounds like much more secure path, would be to use CCIP. Is that the idea?

Kemal:

Yeah, absolutely. I would not advise a DAPP developer to build their own bridge. Very much like if you’re an app developer, do not rebuild your own cloud, just use a cloud.

Ian:

Use Amazon, make it easy. Yeah.

Kemal:

Yeah. Or Google. But focus on the thing that makes your DAPP the best. And we use proven infrastructure from players whose bread and butter it is to make this infrastructure reliable and scalable and secure, et cetera. But yeah, you’re right, that’s the idea and that’s actually the difference between multi-chain and cross chain, right? I think multi-chain means, well, I have all these chains and I need to be present on all these chains and so I’m going to create a DAPP on all these chains. So if you’re on chain A, you can use my DAPP, but then you go on chain B, it’s the same DAPP but it’s a completely different environment. So imagine if the Google Docs on Mac was very different than the Google Docs on PC and you couldn’t reuse the same docs. That doesn’t make sense, right?

Ian:

I remember those battle days, not with Google Docs, but Microsoft Office, where it was very, very different. So the analogy carries with it some pain I can appreciate there.

Kemal:

Exactly. It’s a good analogy. That’s why cross chain is a much better way to go about this. Those apps are cross chain, they live in the same environment and the liquidity is shared. And again, you don’t have a different Google Docs on Mac and a Google Docs on PC. I’m going to stick with that analogy. Sounds like 

Ian:

One of the questions I had about this. With bridges that exist in the ecosystem today or preceding CCIP, it seems like there’s a tension between speed of transfer and security. And I think this exists going layer one to layer two, or layer two back to layer one. When you want to withdraw, you’re locked up for some period of time. And I think depending on the technology and the implementation, it could be days, it could be a week. And I sense that a lot of the reason behind that time delay is to ensure that transaction on one side of the two networks that you’re trying to move between is completed with finality or … before you allow it to unlock on the other side. How does CCIP tackle that problem? Where do you decide between those two if it is a spectrum, in fact? Where do you set the limit?

Kemal:

So again, going back to our secure approach, we are very much on the side of the spectrum of waiting for finality on the source chain. So what this means is when finality is fast, then a transfer is going to be like a couple minutes. But when it’s slower, then it could take more time. But again, it goes back to this design choice of if You’re going to be using CAP, you really care about the security of either the asset you’re transferring or the governance decision that you’re sending over to another chain. So we’re very much on the side of security here.

Ian:

And you just touched on something that I think is actually pretty interesting here. I always think about bridges as being a mechanism to move assets cross chain, but in the blog, which We’ll link to, you point out that this could be like voting, for example. So if you have a community where your community members are operating or holding the governance asset on multiple different chains, you can collect votes on all those chains natively and aggregate them via CCIP back to the primary chain. Did I understand that correctly?

Kemal:

Absolutely, absolutely. And I think getting back to the notion of … We talked about internet of contracts when we launched CCIP, but if you look, it’s this notion of compos-ability. Chains, there are a lot of new chains, they’re all really good in one dimension. Some chains are storage optimized, some others are … They all make different design choices. And the idea is to let you as a developer mix and match and pick the best contract, smart contract or use case, on each chain and be able to assemble these. I think this is why, for me, it’s such a huge unlock for the industry because, one, it solves this very clear liquidity asset moving freely across multiple chain.

By the way, private and public chain, that’s another huge angle, especially for TradFi. So we have all this value that we are looking to help flow in the industry. And then the other angle is this developer compos-ability idea of you now get to not have to reinvent the wheel, you can just pick a really, I don’t know, a smart login, plugin somewhere on some chain. You can use a very scalable, low cost chain for a certain transaction for gaming, for example. You could be storing your asset on another chain and just settle at whatever is convenient for you. I think that really opens up the design space so much.

Ian:

Amazing. Now you’ve got a bunch of use cases in the blog online about CCIP but the one that stood out for me was the one that illustrated connection of the SWIFT banking network. And for people that don’t know, SWIFT is basically this intra bank network that allows for settlement of funds between all the large banking institutions I think are connected to SWIFT. It’s often referred to as legacy infrastructure and that it’s been around for a long time. But I think more politely it’s a backbone of the global financial system. And it looks like you’ve brought a number of global financial services firms into this. What are they doing? What’s their interest in being able to bridge here and how are they using CCIP?

Kemal:

Sure. So first, I think as I mentioned earlier, what’s fantastic for banks and TradFi players in general with distributed ledger technology is that they get to move from a world where they had a front office, a middle office, a back office with systems that then they have to use to settle their trades with other partners who were on different systems. And now, if they can just represent those assets on a private chain or a public chain, now executing a trade is as simple as one API call. And so it’s fast, it’s easy, it’s more cost-effective. It is just this giant leap forward and that’s why they’re so interested in this technology. By the way, once the asset can move so freely, then this is where its utility becomes increased so much.

Anyone can program that asset, you get distribution for that asset, so that asset fundamentally becomes more valuable. So there’s a cost saving operational efficiency angle to this and then there’s just a pure, my assets are now more valuable angle to this. So that’s why they’re so interested in this technology. But what they don’t want to do, and which is completely understandable, is to have to deal with the complexity of all the different chains out there and the fact that chain A is not compatible with chain B, et cetera. And this is where CCIP in particular is so appealing to them because CCIP provides this abstraction layer to the world of blockchain. And this is why we’re so excited as well to be working with SWIFT because SWIFT is that messaging system that’s already embedded in all the practice, all the IT system, that those banks are already using.

So this is where you could see putting both together is so powerful, right? Because banks are already using SWIFT as a messaging system. You connect SWIFT with CCIP, which is this abstraction layer, to chains, and now all those banks are able to essentially make that API call that I talked about with their existing infrastructure and that’s what’s so exciting and powerful about these POCs that we’ve been working on with SWIFT. And we’ve announced this successful transaction by ANZ, which is one of the largest banks in Australia. Super exciting. Today we talked about what DTCC has been able to accomplish, essentially minting and issuing a bond token, sorry, and compatible with CCIP. And distributing them to SWIFT’s designated test wallets.

Ian:

It’s a pretty incredible approach to modernization of the traditional financial system, bringing it forward into the world of Web3, which is exciting. One of the other pieces of technology, you mentioned it briefly earlier, and it was actually the spark why I was interested in having you come on the podcast, when you introduced something called Chainlink Functions. Now, prior to my joining Chainalysis, frequent listeners will know I was in the world of developer infrastructure and platforms. I was at a company called Pivotal, and as I was leaving Pivotal, functions as a service, platforms were all the rage. It was the new developer paradigm, it was going to replace containers and virtual machines as the execution layer. Companies like Amazon and Google had introduced entirely new compute layers to support that model of execution. Cloudflare has jumped into the space with Cloudflare Workers. So in that context, what is Chainlink Functions? What can a developer do with it?

Kemal:

Yeah, so Chainlink Functions solves the problem of connecting your smart contract with any Web2 API you’d like. In a trust minimized way. There’s a very naive way to do this would be, let’s have my smart contract make an API call. And then what happens is you have one single point of failure that can be compromised, that can be unreliable. And so you lose that property of my service is trust minimized. It is decentralized. What Function does for you is it creates this connection in a way that is secure and trust minimized. So you can offer your users this property of I have … it is a smart contract that is extended by Web2 infrastructure in a fully trust minimized way. So let me maybe just give a few examples. I think I mentioned a few things already. I mentioned the satellite image. So imagine you said, well, I want to issue carbon credits on chain and I want to essentially link it to an image at a given coordinate and know whether there’s a forest or not.

And that’s my ground truth, it’s a natural satellite taking the image, and then I process it with AI and I want to know whether there it’s a forest or not. And then I’ll issue a carbon credit on chain. That’s one example. Another example, which would be the parametric insurance contract. If it rained during … Sorry, if it didn’t rain during this period, then you’re owed a payment. You need to be able to make an API call somewhere. For example, Google Cloud Weather API to determine whether there was rain or not during this period. So all these examples, they require this connection, this Web2 API call. And that’s what Chainlink Function does and it does it in a very … Well, you mentioned, it’s serverless. It is very much the AWS Lambda model where you say, “Just give me your code and we’ll execute it.” You don’t know which machine it’s going to run on, et cetera, but it’ll execute, right.

Here, it’s the same idea. You’re writing a smart contract and you want to write a piece of code, you want a piece of code with connectivity, with the ability to make an API call, to run on those oracles and we run them for you. So that piece of code could be, “Go fetch the weather data.” It could be, “Go fetch my script on AWS that has an AI model behind it.” And we’ve seen developers do pretty incredible things with that. By the way, this was something that was used by 80% of our hackathon winners. We had something called AnyAPI before, which was a similar-ish idea, but was really hard to use. So really this was our developer community telling us, “Look, you’ve got to build this for us.” Those are actually pretty easy. As a product lead, you have 80% of your hackathon winners using something, you know you’ve got to build that thing. And so when we launched it in ETHDenver, people were incredibly excited with this. I had the pleasure of being a judge at the hackathon, I was seeing some incredible ideas.

And I’m really, really excited to get this product onto see people come up with those new ideas. And I think It’s going to massively, massively expand the space in terms of what you could come up with and how can … These are going to be things that consumers will deeply relate with. I’ll give you just one last example, there’s this 13 year old hacker whom I met at ETHDenver and maybe he’ll recognize himself if he listens to this podcast, whose idea was to say, “Okay, well I’m going to use the Peloton API and I’m going to commit a hundred bucks that I will hit the Peloton every day for next 30 days. And if I do, then I get my a hundred dollars back. If I don’t then it goes to charity or something like that.” And I thought this was a pretty incredible idea of self-commitment and actually having something that will … the smart contract will just ping the API and decide and either you lose your money or you get it back if you actually hit the Peloton every day.

Ian:

I love that. That is very close to home. I have a Peloton that is currently collecting a little bit of dust in the basement. I’ve been running more than I’ve been cycling these last few summer months. I’m curious, from a practical standpoint, what do I have to learn or know to use Chainlink Functions? Is it a different programming language? Is it dependent on the API I’m connecting to? Is it Solidity because it’s a smart contract? How do I approach it as a developer?

Kemal:

It’s super easy, it’s JavaScript. So if you know how to write like a Lambda function, it’s pure JavaScript. So you say … And you use the Fetch API to go get data from whichever endpoint you’re interested in and then you can transform the data back to make it suitable to what the return value that your smart contract is going to consume. So there’s your solidity code, which is you writing your smart contract and at some point just say, well, execute my function and then that is just JavaScript code.

Ian:

Yeah. And how does the connectivity work between my smart contract, which is Solidity deployed on the Ethereum network, where is that fetch request that I’ve written actually running? That’s on the Chainlink network?

Kemal:

That’s on the oracles, yes,

Ian:

Yeah. Okay.

Kemal:

So the oracles, so this is where the oracles are not just data pass-throughs anymore. They’re actually delivering distributed compute for you and they’re coming to consensus over the results that compute. And this is the general direction that the Chainlink platform is taking, right? Starting from you need the price of ETH in USD to now you get to ask for some compute to be executed with connectivity, to having cross chain interoperability, messaging and asset transfer.

Ian:

That seems incredibly powerful. To me it sounds a lot like the Cloudflare evolution as well where initially they were a CDN. Here’s static data that I can serve all around the world really fast out at the edge, to now I’ve got compute alongside that so I can have dynamic data, not just static data being served. And then obviously connectivity to everything. So the model coming from a Web2 infrastructure world seems very familiar. What’s the timeline? So you’ve announced it, you’ve taken it through a hackathon. It’s available today on testnet. When should we expect to see it on main net?

Kemal:

Soon.

Ian:

Come on, you’re not ready to give us a date right now?

Kemal:

Working on it. Working on it.

Ian:

Okay. Working on it. All right.

Kemal:

Yes, yes. This is something that I’m very excited about. I think this is going to open some really, really great use cases. And also, well another … We’ve talked about AI. When we released it on testnet, I did this demo with a friend, Lawrence Moroney, Who’s AI lead at Google and we had a smart contract generate art with DALL-E. So you start seeing how now with a smart contract you can essentially leverage LLMs as well and do some gen AI. So yes, we’re working on it and it’s coming soon.

Ian:

That’s exciting. I guess people are going to need to follow along maybe the SmartCon event that you have coming up in a few weeks in Barcelona to hear more about that. I want to shift topics a little bit from the technology and talk a bit about … It seems like you as a company have done an incredible job pulling some big name financial services institutions into the world of Web3, right? The announcement with DTCC this week and you talked about the work with ANZ bank in Australia. When you zoom out a little bit from those particular institutions, what’s your sense of traditional finance and their appetite to be in the world of Web3 and cryptocurrency. Is it hesitation, is it eagerness? Where would you rate that right now?

Kemal:

Oh, I think the interest for distributed ledger technology is very high. And we touch upon those motivations. Because again, it’s this operation efficiency, asset utility. So I think that there’s a lot of activity in this space. And that’s why we’re so excited to be working with SWIFT and all those players. Because again, what they don’t want to have to deal with is the complexity of all the different chains and the fact that we offer an abstraction layer and an interoperative protocol, that we can essentially process any command they send to any chain, whether it’s private or public, is extremely exciting to them.

Ian:

It’s really powerful. Maybe to wrap up our discussion, one last question. Where do you see things going over the next 12 months? And maybe preview for us if there’s some big announcements coming at SmartCon, what’s on the horizon? You’ve obviously had a huge year with some big technology introductions, but I always like to look to the future and see what’s coming next.

Kemal:

Yeah, so look, we’re … The three big bets for us this year are oracles targeted derivatives market, CCIP and functions. And so we’re dead set on heads down, executing against those. They’re incredibly exciting. We’re seeing phenomenal feedback from our test users. And so this is really what’s top of mind for us this year. And yeah, you should definitely, definitely follow SmartCon. We are working very hard to make it a phenomenal event for the community and for the industry at large. And again, we’re very, very lucky to be working with phenomenal partners.

Now, if I take a step back, I think there are three things that are massively expanding the space that I think are going to accelerate in the next 12 months. The first one, we touched a bit upon that, is real world assets. Ultimately, you put more value in those systems and more exciting things will happen, right? I like to look at … There was the ChatGPT moment for AI. I’m thinking about what’s the ChatGPT moment for Web3. Maybe it’s going to be, “Oh, I just bought a house, I just bought a house. I just raised money in two minutes and bought a house with this app.” Maybe that’s the moment where everybody realizes, holy crap, that’s Web3? I can buy a house with Web3? And that comes from putting more assets on chain.

That’s accelerating and we talked about that. The second thing is real world data. For now, it’s been a lot of financial data and crypto prices data. But with something like Functions, I’m really keen to see what kind of data gets put on chain. It could be sports data. I don’t know if you follow the Rugby World Cup. I do follow it. Who won which game should be on chain for people to do exciting things about that. So it could be … We talked about satellite imagery. It could be any sort of data. Putting more data on chain will lead to more exciting use cases. And the last one is what I like to call real world users. What I mean by this is users who don’t know or care what a private key is and they just want to interact with this new world, via interfaces that they understand. And I think things like account abstraction, social login, social recovery, are going to be incredibly powerful to bring more people in the industry. And by the way, Chainlink is playing in all three of those.

Ian:

Not surprising.

Kemal:

So I think this is, if I take a step back, those are the three big trends I think that will massively unlock or bring this industry to the next level in the next 12 to 18 months. Let’s just give it 12 to 18 months.

Ian:

I love the outlook. I agree on all three points. Those are going to be massive movers for the ecosystem and best of luck to Team France in the Rugby World Cup. They opened with an amazing defeat at home over the New Zealand All Blacks, which I think people were very excited about.

Kemal:

I don’t want to jinx it. I don’t want to jinx it. I want to stay very, very cautious about this.

Ian:

Well, it’s going to be fun to watch the remainder of the tournament play out. Best of luck to your team in that tournament. Kemal, thanks so much for joining us today. It was a terrific conversation.

Kemal:

Thank you for having me.

The post Web3 Adoption in Traditional Finance: Kemal El Moujahid Ep. 79 appeared first on Chainalysis.

Convergence of Crypto and Institutional Trading – Ep. 78

https://www.chainalysis.com/blog/convergence-of-crypto-and-institutional-trading-ep-78/

Episode 78 of the Public Key podcast is here and we are happy that you love the refreshed look.  Institutional adoption has always been deemed as crypto’s much-needed catalyst. In this episode, we speak with Kyle Downey (CEO & Co-founder, Cloudwall) to discuss the risks we are not mitigating and keeping institutional traders on the sidelines of DeFi and crypto.

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 78.

Institutional crypto investment has long been the key to mass adoption in the cryptocurrency industry but with the chaos of 2022 and the demise of several large industry players, we have to start assessing what the real risks are in this space.

In this episode, Ian Andrews (CMO, Chainalysis) gets to speak with Kyle Downey (CEO & Co-founder, Cloudwall), whose team is building what they hope is the world’s most sophisticated digital asset risk platform named Serenity.

Kyle emphasizes the need for better infrastructure and risk management tools in the crypto space, particularly for institutional investorsWe also discuss  the challenges and opportunities in the DeFi space and the importance of finding a balance between privacy and transparency.

Ian and Kyle double down on the industry’s  need  to prioritize counterparty risk and also touch on what real-world asset tokenization will look like for portfolio managers.

Quote of the episode

“The [risk] tools for institutional traders are not suitable yet for the people who are going to be coming in 2024 and 2025. I do believe we’re behind the eight ball in terms of infrastructure investment in the space and that’s across the board,” – Kyle Downey (CEO & Co-founder, Cloudwall)

Minute-by-minute episode breakdown

  • (2:02) – Kyle Downey’s early foray into Bitcoin, Mt. Gox and crypto trading
  • (8:08) – Need for more investment in institutional-grade tools and systems for crypto
  • (13:20) – OTC markets, DeFi platforms and capital efficiency challenges with transparency on the blockchain
  • (17:06) – Momentum and interest in DLT and crypto within financial institutions
  • (22:25) – Potential impact of risk management platforms and limitations of risk systems in detecting fraud
  • (26:02) – Importance of addressing counterparty risk in the crypto industry
  • (31:45) – The role of risk management tools in attracting risk-averse investors
  • (36:13) – Open questions and challenges in regulating DeFi
  • (42:27) – Serenity’s upcoming release and portfolio analytics suite

Related resources

Check out more resources provided by Chainalysis that perfectly complement this episode of the Public Key.

  • Blog: Institutions in Central, Northern, and Western Europe Broaden Horizons with DeFi and Web3 Experimentation

Speakers on today’s episode

  • Ian Andrews Host (Chief Marketing Officer, Chainalysis)

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Our podcasts are for informational purposes only, and are not intended to provide legal, tax, financial, or investment advice. Listeners should consult their own advisors before making these types of decisions. Chainalysis has no responsibility or liability for any decision made or any other acts or omissions in connection with your use of this material.

Chainalysis does not guarantee or warrant the accuracy, completeness, timeliness, suitability or validity of the information in any particular podcast and will not be responsible for any claim attributable to errors, omissions, or other inaccuracies of any part of such material. 

Unless stated otherwise, reference to any specific product or entity does not constitute an endorsement or recommendation by Chainalysis. The views expressed by guests are their own and their appearance on the program does not imply an endorsement of them or any entity they represent. Views and opinions expressed by Chainalysis employees are those of the employees and do not necessarily reflect the views of the company.

Transcript

Ian:

Hey, everyone. Welcome to another episode of Public Key. This is your host, Ian Andrews. This week I have the founder and CEO of Cloudwall, Kyle Downey. Kyle, welcome to the show.

Kyle:

Thank you. Thanks for having me on the show, Ian. I’m really excited about this conversation.

Ian:

I am super excited to dive into the technology that your company’s building. I think it’s an area we really haven’t gotten into on the show, related to how institutional investors think about risk management across their crypto portfolio. But before we go there, I think I’m always interested in how people got into crypto. You worked at Morgan Stanley for nearly two decades. In your last role, you were managing director. Talk a little bit about your career there and what led you into the world of digital assets.

Kyle:

So it goes back a decade on the crypto side. So in the middle of the 17 years that I spent at Morgan Stanley, I spent seven years out in Asia, three years in Shanghai, and four years in Hong Kong. And that actually ends up dovetailing to the story of Cloudwall a little bit later on. But at the time in Hong Kong, I remember stumbling across a news article, South China Morning Post, I think, that was referencing a Bitcoin mine in Kowloon, so relatively near our home. And I remember thinking, what is Bitcoin and why are they mining it? I had not heard of this at all.

So this was a couple of years in already, in 2013. So I googled it and I started reading the white paper and I was utterly fascinated by it, by this idea. And then I started looking at what was going on in the trading side. And the thing that just came to me relatively early on was it seemed like people were using these internet technologies to rebuild a lot of things that were very familiar to me in my day job. And it was day traders and retail and all this, but they were building exchanges and they had free market data and it rhymed a lot with the institutional side.

And I started to wonder, is the day going to come where the things that I was doing at Morgan Stanley and what was going on in crypto were going to converge. So over that long period of time, that was always in the back of my head, when is that moment that that is really going to take off and what triggers it? Because at the time, this was not obvious. In 2013, this is the time of Mt. Gox. People may not know this, but Mt. Gox stood for Magic the Gathering Online Exchange. So people were trading Bitcoin on a trading card website. It really was a joke. Bitcoin was a joke before Dogecoin was a joke.

And then it really took off and suddenly it wasn’t a joke any longer, but it wasn’t really obvious that institutional traders would touch this thing at all. And you had a lot of those scandals around used on the dark web and Silk Road and all of that that were really dominating. But still from a technologist point of view, so at the time I was working on equities and equity derivatives and e-trading technology, which that was the latter part of my career and that kind of final role that I was in when I left MS.

So we were building market making and hedging and liquidity provision systems for MS traders, mostly equity derivatives, mostly options, actually, at the time. So when I was in Hong Kong facing off with an equity derivatives desk, and it just struck me despite all the weirdness of it, how similar it was to what was going on one floor below me from where I was sitting in IT. And so that was for a long while, just okay, this is cool, this is interesting. I was trading myself. I built some automated trading tools along the way. I was writing about it at one point.

Ian:

I’m curious what the reaction of your Morgan Stanley colleagues, like did you come into work and say, “Hey guys, have you heard about this Bitcoin thing?” Did anybody react?

Kyle:

Absolutely, but you get a real reaction when you resign to do it. But people knew because they saw my writing, they were aware I talked about it. I had a very senior quant sit me down and basically say, “This is utterly without value. What are you doing?”

And I had conversations with compliance along the way, because obviously when you’re working in a big bank, there are rules around outside personal trading. And so trying to do the right thing. Hey, I’m doing this, is this okay? And they were like, “Yeah, don’t worry about it. This has nothing to do with what we do.” And it was to the point where I asked several times, “Are you sure? I’m [inaudible 00:05:13] registered. Is this okay?” And the really interesting thing, of course, is that when it gets out that you’re interested in this sort of thing, people will come up to you like, “Hey, I’m reading this, too.”

Ian:

That was totally my experience as well, was when I took the job here at Chainalysis, all of a sudden people that I thought I knew well and had known for long periods of time came up to me and go, “Ian, you’re getting to work in crypto?” I’ve been trading Bitcoin since 2014.” Or, “I got into Ether in the ICO.” Or, “I’ve had mining rigs in my basement for the last five years.” And I had absolutely no idea. It was a very kind of underground movement within a circle of technology people that I knew who consciously chose to not mention it casually at work, which surprised me.

Kyle:

Yeah, exactly. Out on the trading floor, both quants and traders, there were multiple people who were doing it nights and weekends for fun, who got into it. I heard people at other hedge funds that were sort of running crypto accounts. And on the tech side, after I left, I found another managing director who had a whole fan cooled set of Dogecoin rigs in his basement at one point. And so he’s sort of like a mini Doge father.

And I was doing it, too. My daughter and I built an Ethereum GPU rig at one point in the early days of Ethereum that was running for a while until all the cards burned out. So people were doing it as just this hobbyist thing. And then around the, I would say acutely during the pandemic, but probably around 2019 or so, just things started popping up. This is the first announcements around GS setting up a trading desk, which they stopped and then they started again, and it was starting to come into the light and people were starting to take it a lot more seriously as a product for institutional trading.

And of course then the space races ahead again, and you have the summer of DeFi and that’s well beyond what most people on the institutional side had any tolerance for. The safe space was still Bitcoin and Ethereum and things like that. But I remember the survey that GS did of some of their family office clients and just being startled by the numbers, not just on the number who were actually already through mostly indirect vehicles invested in crypto, but the ones who had it on their roadmap for the next year, that they were already talking about it.

There was another survey, it was like of the analyst class, I think at one of the big banks, and again, showing the dynamic around the demographics, it was overall interest to the clients, but then how many of your just out of school analysts coming into the bank own crypto? And it was almost all of them. And so you have that too, that there’s this generational shift where there’s a lot more interest with the millennials and Gen Z that was starting to come into Wall Street because they were starting to take jobs.

But still, leaving in 2021, I got a lot of why are you doing this? My co-founder got it probably even more. You’re ruining your career. You’ve been here for 17 years now. You’re doing this crazy small thing. I had one very senior MD tell me flat out, “Yeah, I would’ve never guessed that you would do this sort of thing.” So I think for those of us who did that transition, it was easier than it was a couple years before, but there was still a lot of, are you sure you want to be associated with this? Is there reputational risk around it?

And a lot of that was outdated. And I mean, Chainalysis, you guys have done reports on this. A lot of the headlines don’t take into account the growth of the overall ecosystem, and they’re still quoting numbers of hacks and activity in the dark web and on chain and not recognizing that the percentage keeps going down over time. So in many ways, some of those people, those views are a bit outdated. They’re pointing to things that were real but not necessarily dominant anymore.

Yeah, and thus what ended up happening is I was planning a move probably around 2019 and just kind of late stages looking at it. And then the pandemic hit. And made a personal decision to not leave at that time. And so I just went heads down, because there was an amazing thing within four weeks of getting a 150 person department out of offices and into their homes and really just spent a lot of time and energy on that. And I stopped looking at crypto for the whole summer of DeFi and all the way until the restrictions on the pandemic in the summer of 2021 lifted.

And at that point I was on a family holiday in New Hampshire, where I grew up, and I started looking at it again. It’s like, I was really enjoying this. I’m kind of bored after hours. I’ll start looking at it. And it was, what the hell happened in the last 18 months? And I just felt this great sense of urgency that like, oh my gosh, it’s this thing that I’d kind of been watching for years, suddenly it’s moving really, really quickly. And I resigned in less than six weeks after that realization. I had a three month notice, and the company started in the fall of 2021.

Ian:

Amazing. You made a comment earlier about how when you first got into the space, you looked around and you saw that people were recreating a lot of the systems that already existed inside of institutions like Morgan Stanley. I’m curious, what’s your perspective now in the fall of 2023? Where are we on that progression of rebuilding the infrastructure that supports traditional finance, if you will, inside of the crypto ecosystem?

Kyle:

And there’s a degree of self-interest in this statement in that I’m-

Ian:

You’re absolutely building part of it.

Kyle:

So of course I’m going to come out and say we’re not spending enough on it, but we’re not spending enough on it. The tools for institutional traders are not suitable yet for the people who are going to be coming in 2024 and 2025. I do believe we’re behind the eight ball in terms of infrastructure investment in the space, and that’s across the board. And so that’s trading and custody and data.

I’ve had portfolio managers from large traditional hedge funds say to me flat out, not a single vendor and they work with series B and above large vendors, is institutional grade, not one. And so for those of us who came out of this space and have that standard, you see things happening and say like, this would be utterly unacceptable at a large institution. And I’m not talking about fraud or anything like that. I’m talking about just how you operate and the resilience and reliability of the systems and all that. We’re still really investing a fraction of what Wall Street is investing overall. So there’s that problem first.

The second thing is that I feel like in some cases we have reproduced things that we should not have reproduced in terms of creating centralized infrastructure, in terms of repeating mistakes, in terms of large opaque OTC markets with not very good automation around them. So we’ve created a lot of systemic risk in the space by not looking to some of the strengths of the technologies that this is built on and reimagining it.

So I think, I hope, that one of the values of people coming into this space who have that background but are also passionate about the opportunities and actually using this as a chance to reinvent, will do more than just say, “Let’s take NASDAQ, but put Bitcoin on it.” We can do better than that. And I think even the traditional exchanges, they know that too. They’re looking at ways to reimagine their businesses by incorporating this technology, and that I think we haven’t done enough of.

And a PM that I respect in the space, head of one of the early digital asset funds, one of the things she said is part of the problem has been the start and stop. The boom/bust cycle within crypto is people get into it, they start building, they start to build infrastructure, and then they get wiped out. And then we do it again. There needs to be a little bit more of a long-term commitment to actually invest in this. And I hope that the financial services industry as a whole sees it as an opportunity to redo systems from the seventies and earlier in a much, much better way.

Because ultimately, crypto is not the only application of this. I firmly believe there’s going to be widespread tokenization of traditional assets as well, and this is going to have huge implications for asset managers. So we have to solve this for everything, not just for crypto anyway. And if that is the case, we are massively underinvested right now in the space.

Ian:

When you bring up the large and opaque OTC markets, what’s the alternative to that? What’s the right way to do it? Is it all on some sort of DeFi type platform, where it’s all in the open?

Kyle:

So I think the ultimate destination is via DeFi protocols. I think the more general principle is that a lot of this has to be manifested on chain. The two big problems with that, the first is capital efficiency. So if people are doing large OTC options deals, they’re not going to over-collateralize that. There’s no point. The DeFi option protocols, they don’t have the capacity to absorb those really big deals and they just don’t make economic sense for someone, which is why the OTC market exists.

But the second issue is that that whole mechanism of having bilateral trades, it doesn’t work with a fully transparent blockchain. And so that’s the other issue right now. As you may know from some of my writing online, one of my side interests is privacy preserving technologies on blockchain, particularly ones that allow for selective disclosure, because there are certain financial use cases where full transparency doesn’t work and full obscurity doesn’t work. You need something in the middle.

And the OTC market is a great example of that. Like, you and your counterparty both need to see the details of the deal. You don’t want your competitors to see the details of the deal, but to assess overall systemic risk, you may wish to have high level summaries of what’s going on in the market visible to other parties, to auditors, to perhaps regulators. There are wonderful examples of this from early stages of my career. I worked on credit derivatives, back office technology with pre-financial crisis, what was being done to try to get a handle on the fixed income derivatives market, particularly CDS, where they wanted to have a central view of the net exposure across the street. Because it was going through fax machines. It was just not visible.

And so that’s a really good example, I think, of something that could be done better on blockchain, but maybe the technology is not entirely there yet. And so we’re in this kind of transitional phase where quite frankly, I’m like, have I been teleported back to 2004? You’re seriously negotiating this deal on telegram and then emailing a PDF summary of the deal terms, and then you have a bunch of operations people trying to make sure nobody made any mistakes. That we’re doing that in crypto in 2023 is horrifying to me. There are better ways to do that, but it’s kind of a case of [inaudible 00:18:35], there’s no good alternative to it right now that meets those requirements of confidentiality and capital efficiency.

Ian:

Yeah. Do you think firms like your previous employer, do they have the appetite to actually try and go rebuild some of the infrastructure around or on top of blockchain technology? And I know they have incredible technology budgets, like the spend at Morgan Stanley or JP Morgan is measured in billions of dollars annually. So there’s capacity, but it’s always seemed to me like we still run most payment systems on mainframes at the end of the day. So like you said, 1970s technology predominates when you dig deep enough under the covers.

Kyle:

So I mean obviously I can’t, particularly several years out, I can’t speak for where they are now. What I can say is for projects that JP and others have spoken about publicly, there is a lot of engagement and there’s a lot of interest both on the DLT side and the crypto side. The DLT side is easier to move ahead because it doesn’t have the regulatory constraints. And so to the extent that it doesn’t maybe move as quickly, it’s more like just typical budget prioritization, whatever.

So I’ve seen a lot of companies starting to move out of what I would call the innovation lab phase, where they were kind of stuck for a couple of years. It’s like blockchain was kind of alongside quantum computing. Like you would say, “Hey, we’re doing all this cool stuff. We’re doing blockchain, we’re doing quantum, we’re doing all this big data stuff. Please come work for us rather than going to work for Google.” That was the play for a while and blockchain was trapped in that.

But I think if you look at some of the original sins of financial IT systems, one of the big ones is reconciliation. It’s having multiple masters, multiple copies. I cannot tell you how many systems had these issues that I’ve seen over the years, where they just had copies of copies of copies of data, and then of course someone comes in and they’re an internal audit function, a regular whoever, and they’re like, “This number in this financial report, where did it come from?” It’s like, well, kind of awkward. It went through 15 different Sybase databases and a person touched it manually over here. And we’ve got all these scripts rubbed together that we’re fairly sure the number’s right.

This is architecturally not great, and people recognize this. They know this pushes toward central databases. Taking Goldman as an example, one of the great powers of [inaudible 00:21:31], their sort of master risk database was having it all in one place, that they could run those reports, they could run those analyses from a single, central reliable system. And so this is well before talk of DLT. A lot of the banks looked at that and built equivalent systems. BAML has one, JP has one, MS has, they all looked at that and said, “We want that. That is an improvement.”

And of course the opportunity with distributed ledgers is, well, why make copies at all? What if the copying mechanism is built into the protocol and then everyone has reference to a single source of truth? That fundamental concept of having that, and you tie it to settlement, that is huge for finance. This is a legitimately very big deal, and there’s lots of people who understand that. It’s not just the crazy people who left to go do crypto who get that. People internally get that, and they are building, and it does seem like there’s some momentum around it.

And so I almost see it going on two tracks. There’s what people are doing to renovate systems and leveraging the technology. And that may be private blockchains, that may be public, it may be hybrids, and then you have our clients are interested in trading crypto and thus we need to renovate systems to be able to handle these new assets as well. So we generally look more at the latter in Cloudwallet. It’s like how do you apply and get those same functions that an institutional asset manager or trader needs on this novel set of assets?

Ian:

Well, that’s incredibly encouraging to hear, that that momentum exists inside those organizations because it’s not an overnight change to any of the complex technology that runs big financial institutions. It’ll take years, if not decades, to fully plow into the architecture. But I think it’s a great segue. Let’s talk a little bit about what you’re building at Cloudwall. Maybe sketch the big picture for folks and then we can zoom into the details.

Kyle:

Sure. So my co-founder is Jia Yng Wee, and so we started in the fall of 2021 and the first stage of the startup was really kind of looking at the opportunity space. And so we looked at our background. She’s from capital markets operations. She was head of FX Asia operations and based in Shanghai when my family was there. So that was the personal connection. And when we were doing that look across the space, it’s like data, regulatory risk, KYC AML type problems, custody, execution. So my background was e-trading technology, and we looked at, it’s like actually there’s a lot of people doing pretty good things for algorithmic trading and smart order routers and things like that.

And just kind of running through the list of the institutional stack. And then it’s like, okay, and so who’s doing risk? Why is nobody doing risk? It is like this is fundamental to finance. Why is there no borrow or risk metrics or Moody’s Analytics? Where are all of these risk vendors from traditional finance in crypto?

And people asked me when we were fundraising, because of course when you come up to somebody and say, “There’s this complete area of white space, we’re going to build a company,” the first question they’ll ask you is, “Is it because you’re the only one stupid enough to go after it, that this white space exists, or have you actually identified a legitimate opportunity?”

And what we tell people is you have to look at the difference between a day trader and an institutional trader. Day traders think in terms of price. Institutional traders think in terms of risk. Who were making the running in the early days of Bitcoin and crypto overall? It was the day traders. This is just not the model that’s used for reasoning about investments.

So our thesis really was, well, the mix is changing in terms of people coming into crypto. It’s going to be people who think about risk first, not about price, who are coming into this space, and this gap will be filled sooner or later. So we pitched to build a risk management platform for digital assets, and that became the Serenity platform, which we spent over a year and a half building, currently out in production. The focus of the current platform is listed instruments, so CeFi, not DeFi, spot and derivatives. So spot futures, perpetuals, and options, with a focus on market risk.

But our view is that actually a portfolio manager in the space ultimately is going to have to have an integrated view of multiple dimensions of risk, that they’re going to have to be looking at their market risk, their liquidity risk, their operational/smart contract risk, their credit risk. And so there’s actually a lot that needs to be built to understand the risk of a crypto portfolio.

We also took the view very early on that tokenization was over a decade timeframe going to be a massive trend in asset management. So we always framed Serenity as a digital asset risk management system. It’s not a crypto risk management system. We have decided to enter the market with crypto hedge funds and crypto asset managers, but the system was designed and all of its data models do not assume that the underlier is crypto. The underlier might be a bond or a money market fund or an equity or a piece of real estate. That was very important from the early days, to recognize that for this to really work, you actually need to handle anything tokenized, not just crypto, but crypto is the big problem right now for the people who actually have risk on their books. And so that’s where we began.

Ian:

This is amazing because I think the big theme of 2022, as we saw multiple firms collapse, starting with the Terra Luna ecosystem and running all the way through until FTX and Alameda shut down at the end of the year, was nobody’s looking at counterparty risk. There was no visibility of the kind of intertwined nature of loans and leverage across the ecosystem. And I think it was then confounded a little bit by the fact that you had a lot of naive retail investors who didn’t actually understand where the return that they were getting was coming from, like what the nature of the underlying investments that some of the firms were making.

But I’m curious, had your firm maybe started back in 2019 pre-pandemic when you had the idea, could this have potentially averted some of those crises or at least made better informed decisions for the people that were honest operators? Because there was a layer of fraud happening here as well that I think maybe is out of scope.

Kyle:

We talked about this a lot, and I at one point made the point, one of the nice things about our risk tools is you can run them back in time. So I showed people what an FTX linked portfolio looked like a week before the CZ tweet and a week after the CZ tweet to make the point that risk systems do not catch fraud. There was zero. Nothing showed in there.

There were a couple of people who found interesting things on chain around the time of the CoinDesk report. That was probably the only way to really see that coming, unless you had insights, operational insights that you’d done proper due diligence on FTX, which some had done. And unfortunately Taylor Swift did better due diligence than some other people.

Ian:

Apparently so, yeah.

Kyle:

But some people did ask questions and get answers that they were not comfortable with, but a lot of this just, it wasn’t visible. And to the point earlier about the OTC market, a lot of those loans were bilateral. There was a lot of exposure with OTC derivatives as well, on the option side, that people could not see. And there was a true climate of fear post Terra Luna, Celsius, et cetera, about counterparty risk.

And we actually did a survey with acuity in the spring of ’23 and asked people to rank risks, and counterparty risk came up number one. That was the one where people were putting a lot of risk investment right after FTX, was trying to get a handle on it. And the issue with counterparty risk, going back to that earlier point and why I have that side interest in selective disclosure of information, is it’s a disclosure problem rather than a modeling problem. I know people got super excited about, oh, don’t worry, you can put all of your crypto on our exchange because we have proof of reserves.

And it’s like, okay, great, yes, you know that it’s there. There’s this general idea, there’s a difference between you have assets and you’re solvent. And it’s sort of like, hey, I will show you half of my balance sheet. How do you feel about your counterparty risk? It’s like, it’s not good enough. You actually need to represent financials on chain. You need to have secure ways of auditing those, putting attestations on chain. There’s a lot that just hasn’t been built to do that. And so as a risk vendor, I don’t want to overpromise. If we have the data and we have the models, we have the people who can build systems that will solve that. But the disclosure wasn’t there in 2019, 2020, 2021.

We could have been just as hammered out of all of that, having built Serenity earlier. Would you have gotten a sense through things like value at risk and stress testing and all the other tools we’ve built of what is the worst that could happen? Yeah, that would’ve helped. Maybe people would’ve positioned themselves a little bit better?

And just one last thing, I feel I have to restore the honor of those retail investors because I’m sorry, the guys at 3AC were not like these sort of, oh, we’ve never heard of finance before guys, and they were doing spectacularly stupid things with leverage. The institutional players were making some really poor decisions, particularly around leverage and counterparty risk there. But to be fair, for a lot of the players, a lot of the people we’re talking to right now, they just didn’t have the information. They didn’t know what was going on under the hood. But the rounds of amplification of leverage on staked ETH and things like that that those guys were doing with the Genesis trading desk, this was almost due to explode in their faces.

And that I would say is more about risk culture than risk tools. I think for people who’ve been in those spaces and have been through a couple of cycles, those scars usually lead them to be a little bit more careful. And in fairness to the 3AC guys, if you look at their professional histories, they started on Wall Street right after the great financial crisis. It always went up into the right for those guys. They never actually saw bad times until it was spectacularly bad. And that’s the importance of having history and experience in the space.

Ian:

I think that’s such a widespread problem. I mean, the industry has attracted a younger generation that just hasn’t seen that broadly. Obviously I’m sure we could find exceptions. But I’m curious. So okay, let’s take counterparty risk out of it. What are the things that if you were describing Serenity to a potential client, what does it do incredibly well? What am I getting by adopting the platform?

Kyle:

So there’s a couple of things. So our focus so far has been on market risk and the strength is definitely quantitative risk models that are sort of backward looking. So I would say we have the best implementation of those sorts of models out there right now, and we offer the ability to run multiple models and get different views on it. Some of the classic tools that like an equities trader would just expect to have in terms of being able to run a factor risk analysis on a Delta One portfolio, the ability to price and run risk slides on options and option strategies. Probably most importantly for crypto, the ability to stress test. One of the things that Serenity can do is you can replay the 2020 COVID crash on your portfolio today and actually get an attribution of the shock P&L to basically see where did the losses come from in the portfolio if that were to happen again tomorrow.

This is a space that is rife with hundred year events and black swans and all that. So a lot of people who do think very seriously about risk management in the space, they think in terms of scenario analysis, stress testing, which post-financial crisis, there’s a lot more focus on the traditional side on those methods as well. So we look a lot at what happens under the extremes, whether it’s with conditional VAR analysis or stress testing.

What we probably do less well is looking ahead into the future, more predictive risk. This is something that we’re looking at. This is where I think on chain really comes into its own. You really need that information to be more predictive in this space, and that’s something that in the future we’ll definitely be incorporating into the models, but we wanted to get solid traditional historical risk models in place and build all the infrastructure around it before we went out to the things that are truly novel in terms of risk models.

Ian:

One of the things that you and I talked about when we first met was my perception that most assets and markets in crypto have some amount of, I would say, manipulation that don’t exist maybe in the traditional equities market sense, just because there’s not the rules and the regulations and the oversight and the compliance. Trade surveillance is just really not a thing. I mean, there’s a couple of companies trying to do it obviously, but it’s not widely adopted. There’s nobody who’s looking or expecting trade surveillance, so companies who are attempting to try and use that technology or doing it of their own volition.

So does that quantitative modeling and back testing and stress testing, do those tactics still work in crypto? When I think about something like Dogecoin that is so sentiment driven, like an Elon Musk tweet is the biggest market moving activity, does it still apply? And you had a fantastic answer when we talked about this before. I’d love for you to dive into this here.

Kyle:

So specifically on Dogecoin, there’s been some academic research into risk factors already in the last couple of years, and one of them was doing analysis across crypto market that incorporated Doge, and they ended up saying, well, one of the factors in the model, we call it the Doge factor, because the only thing that explains Doge is Doge. Sorry. It is unique and it has elements of sentiment and crowd behavior and all of that that just don’t apply to the rest of the universe. And models often have to correct for that. If you have these truly idiosyncratic instruments, you want to make sure they’re not steering the model in the wrong direction.

So I do believe that eventually we will need, in the same way that we’ll need submodels for stable coins, which have some unique risk attributes, we probably should have risk models for [inaudible 00:38:33] coins that incorporate on chain data and sentiment data and social media and all of that. I actually don’t think it’s a joke. I actually think that there is a different financial behavior there, which whether you agree with it or not can potentially be modeled and understood. And so if you’re playing in that space, you probably do want to have a submodel that handles that use case.

The first point I’d like to challenge just a little bit more, because this is a common answer that I get when I talk to people. I say, “Hey, we’ve got a risk system.” And sometimes the answer is, “Well, everything in crypto is event driven. There’s no conclusions that you can draw from history. It is all, it springs from the forehead of CZ and a crash happens.” And this is not true. It is not true at all.

And there is at this point enough data, particularly if you’re looking at high resolution data, that you can actually use some of these models. There are some types of tokens they won’t work as well for. There are some that they’ll work better for. But just saying, well, there’s no point in doing this because there’s no information, I think at this point there’s enough evidence from academic research, from things that we’ve done, that there are things that you can do to better understand what could happen at the extremes.

It probably still will not perfectly capture it. And yes, there are events, there are manipulation in the space. I mean, the most recent Bitcoin flash crash, we were doing a deep dive over the weekend, actually, combination on chain and looking at some other things and just conversations with people within the industry, trying to piece apart what happened, what was the triggering event. People I think had a good explanation for what happened after the trigger, but a lot of doubts and speculation about what actually set it off. But you are going to have that.

But the reality is it’s not traditional finance is entirely without manipulation. I mean, LIBOR was not that long ago. And so the monitoring tools and the surveillance are maybe not as robust, and you have offshore exchanges that are kind of out of reach that are potentially sending price signals whether you’re on them or not.

So the trigger of the collapse appears to have been on OKX last week, but when you get these cascading liquidations, people just start seeing that happen on one exchange, they start doing it on other exchanges. So even if you have a well-behaved exchange, if you’ve got a big enough one that isn’t putting those protections and surveillance in place, it could still send price signals elsewhere in the market that people respond to. And so I think that’s going to be a problem for a while. But this is a really good example of there are tools that have been built, there’s history around what is needed. There’s history around good regulatory frameworks for it.

And it is important, and I think people often undervalue this one, the degree to which having trustworthy benchmark prices is important for big financial products. The reason we don’t have a spot ETF is fundamentally about trade surveillance. It’s not about Gary Gensler hating crypto. And so if that gets cracked and BlackRock has an interesting proposal for cracking that particular issue, that might open things up.

But regulators really care about people being able to trigger a [inaudible 00:42:23] contract by moving things a little bit. And so they’re a little uncomfortable with the fact that you can bump an oracle hard enough and you can suddenly get all of these wonderful consequences that are profitable. And so we definitely need more work there, but we at least know what needs to be built. It’s not something coming out of nowhere.

Ian:

Yeah, I’m really curious about, you’re almost two years in since launch, I think, and it’s obviously been a turbulent kind of market experience during that period, but I’m curious, what’s been the response from the customer side as they start to see your technology? Is it actually sparking more institutional adoption? I would have to say people probably look at Serenity and they’re like, oh, thank goodness this exists.

Kyle:

I think it’s a little bit early for that still. The fairly universal reaction has been this is really needed and I haven’t seen anything else like this, so that’s a good sign. But the asset managers are recovering as well. And you have the larger ones who are maybe more resourced who would go into it, but they’re looking at what’s been happening in the US on the regulatory side, particularly in the spring of ’23, and saying, well, maybe not this year. So they get it, but they’re not there yet.

The smaller guys were very badly damaged last year, and so whatever the interest may be a little bit slow coming into it, but we’ve seen a remarkable number of emerging managers come into the space post Terra Luna, post FTX. So the fund formation rate is actually quite healthy. People are coming in and they’re setting up, and the profiles that I’m seeing are people with pretty amazing traditional hedge fund backgrounds who’ve decided, hey, I’m going to leave Greenwich and I’m going to start a crypto fund. It’s a very different profile from the early days of crypto asset management.

So the challenge that they’re facing where we think we can help perhaps a bit over the longer term is getting assets under management. And that means going to more risk averse investors who are doing robust due diligence of the fund. And one of the questions they’re asking is, what is your risk management strategy? What tools are you using? What independent verification do you have of your strategies? And so really what we’re putting in front of potential clients is this is your answer. This is the thing that you can go to a more traditional family office that’s more risk averse and say like, look, we are coming with all this experience from, I don’t know, commodities or equities or whatever, TMT investment in Greenwich, and we’re bringing in institutional grade tools, and so we can reassure you that we have a handle on the risk here and thus we can take that larger check to build up AUMs.

So we are really hoping to help here. We want that segment. The industry is massively undersized at the moment relative to the interest. And I do think part of why it’s undersized is the people who could be allocating, who might have the capacity to do it, are reluctant due to the risk concerns, and we hope that we can address that and really bring more patient capital into the space so it can grow.

Ian:

I think there’s a lot of people cheering for that outcome, more capital into the space. You mentioned, we talked a little bit about DeFi earlier, and you talk about that is one of the big open questions from a regulatory perspective, even in the EU where MiCA is kind of driving the forefront of I think reasonable crypto regulation. They punted on DeFi as a topic until the next iteration of that framework. What’s your perspective? Where should DeFi regulation go?

Kyle:

It’s a really timely question with Tornado Cash, right?

Ian:

Yeah.

Kyle:

But there were, including from some multilateral organizations, some thinking from the regulators about how to handle this issue, which really boils down to when is coding a crime. And there’s a lot of people, including me, who are really uncomfortable with the idea that having written something and putting it on GitHub, that this brings in a lot of regulatory accountability.

But once you get to a point where you’re operating a platform and supporting it and there’s a real organization around it and you’re profiting from it, which is essentially the case in Tornado Cash that they’re trying to make, I do believe it’s a spectrum. And there comes a point where, yeah, it’s not as decentralized as you think. There truly are accountable people who you could ask to control these things. But I think the problem and the element of fear in the industry is it’s really unclear where that line lies.

And I’m a huge fan of some of the frameworks that have been put forward, like from Hester Pierce, where there’s this idea of almost a gradation where at a certain point in the early days of the project, you have a particular sandbox set up. Singapore has done this really well as well, the UK too. It’s a nice model of basically saying if something is small enough that it cannot do systemic damage and the relative impact within the market is not that big, we should allow a space for experiments to be conducted. But we should have a transition where when it gets to a certain size, a heavier weight set of rules apply.

And one of the struggles we’re facing, I would say more generally, not just around DeFi in crypto right now, is the one size fits all problem. Trying to apply securities law to something that has some securities like elements that definitely could prompt attention on the regulatory side, but has lots of other elements that are not securities-like and that doesn’t necessarily have a structure that’s conducive to doing the necessary disclosures and filings and trading on the regulated exchanges, et cetera. There has to be some middle ground.

And so I like that approach of dialing up the oversight based on the level of risk. I think there’s a good principle for risk management and risk mitigation, that it really should be proportional to the damage that could be done, rather than one size fits all. Now the problem with DeFi is there people are playing around on the KYC AML solutions with whitelisting, et cetera, I think there’s some really interesting and potentially more scalable ideas that could help solve that.

But talking to people in the market, that’s the one that stops them. It’s like, I’ve got a commercial bank account at Chase and they’re going to shut it down if they think I’m [inaudible 00:49:55] funds with North Korea, and if I cannot give a solid answer about who else is in that pool, they’re just going to assume that I’m doing something wrong. And they do have a responsibility. Like if those funds are transferred through the fund admin and they end up in a pool, someone has to be held to account if actually that is used in violation of some of these laws.

I’m not a big fan of the ways people have been doing it so far. I also don’t like the fact that a lot of these solutions tend to be one-offs. But I do think we will come to a point where there will be a broadly recognized token that sits in people’s wallets that contracts can recognize and say, oh, this person has been KYCed and they were signed off by this person. Thus, they’re allowed in. I don’t think whitelisting scales, I don’t think issuing your own ticket that you passed KYC AML scales. You really need the equivalent of what Vitalik calls a soulbound token for an organization that recognizes that.

And there’s a lot of interesting technical work going on right now that helps make that not totally break privacy concerns. I’m a big fan of healthy balances, not all the way to just totally ban it, but the free for all probably is not workable at scale either. So what can we do in the middle? And I think when you see that, you will see a lot more institutional interest in DeFi.

My personal take is that 10 years from now, it is going to be the dominant mode. You’re going to see a lot of peer-to-peer across the buy side through DeFi that never transits through a prime broker or a sell side institution. That is the true Napster moment for finance, once that starts happening. And that is potentially very appealing to a lot of people in the market for that to happen if it allows for greater efficiency, greater transparency, et cetera. So the tech isn’t quite there yet. The standards aren’t there yet. But it will happen.

Ian:

I think you’re hitting on the key point that comes up frequently on this podcast, which is this balance between anonymity and privacy. Because blockchain as first conceived with Bitcoin was a hundred percent transparent, we said, oh, well, privacy is like a derivative of the fact that it’s anonymous. And obviously through technology like Chainalysis and others, we’ve shown that the anonymity is not really there, but nobody actually wants anonymity. I mean, not legitimate actors. Criminals clearly do, but institutional participants, they want privacy. And I think retail also wants privacy.

But the anonymity I think is where we run into trouble here. And so we’re now having to rebuild that layer on top of the fully open and transparent protocol that gives us a reasonable amount of privacy that allows both my personal information to be protected, but an institutional trading strategy to be protected as well.

It’s great to say, oh, I’m legitimate and I’m trustworthy and I’m not North Korean hackers. Here’s my soulbound token proving it, even if you don’t know my actual identity. But now that token’s there and I can see your wallet, I’ve now unearthed potentially your entire trading strategy as well, which is probably undesirable. So I think there’s two steps there which are necessary to advance the pace.

Well, I want to wrap with, last question, what should guests who are interested in the tech and curious about what you’re building, what’s coming next? Where do you see this going for the company? I think you’ve got a big release coming up here in a couple of weeks.

Kyle:

So we aim to be super agile. This release is going to be, I believe, release number 27 since our initial launch, July 1st, 2022. So it’s constantly changing. There’s always new stuff coming for Serenity. So right after Labor Day, we’re adding Arbitrum and Optimism support. And the biggest thing that we’re adding, and both of these are driven by client requests, we try to be very, very responsive to that, is a whole portfolio analytics suite. So the ability to take any crypto portfolio and get your standard performance statistics, what they sometimes call a tear sheet, summary of how that portfolio has performed relative to benchmarks, as well as doing some more advanced performance attribution within the portfolio. This is something that we’re going to be adding to substantially in the fall.

But yeah, and lots of other small improvements on the performance side, the usability side, we have a number of people who spent many years working with institutional traders. We’re quite passionate about usability, so sometimes the improvements, they’re not really big new features, they’re just things that make it a little bit easier, a little bit faster to do that job. And so we have some things coming along those lines as well.

And then a lot more ahead. I mean, the vision is for really a multi-year project to get to where we think it needs to be, but trying to get there an iteration at a time, just constantly improving it, because it’s needed now. So we’re trying to get the best available with current technology out there as quickly as we can.

Ian:

Exciting. I’m certainly going to be watching along. Kyle, this conversation was terrific. Thanks so much for joining us.

Kyle:

All right, thank you for having me on the show.

The post Convergence of Crypto and Institutional Trading – Ep. 78 appeared first on Chainalysis.

Everything You Need To Know About the SEC vs. Ripple Lawsuit: Podcast Ep. 68

https://blog.chainalysis.com/reports/everything-about-sec-vs-ripple-lawsuit-ep-68/

Episode 68 of the Public Key podcast is here! The cryptocurrency industry got good news when Judge Analisa Torres ruled that Ripple did not violate securities law in selling its token (XRP) via public exchanges. But securities law and cryptocurrency specialist, Lewis Cohen (Co-Founder, DLx Law), explains why the industry shouldn’t start the celebrations just yet. 

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 68.

 

Public Key Episode 68: Analyzing the SEC vs. Ripple lawsuit and recent judge ruling 

The SEC vs Ripple has been a landmark case for the crypto industry and recently the Judge presiding over the case ruled that Ripple did not violate securities law in selling its XRP token via public exchanges. 

In this episode, Ian Andrews, brings on securities law and blockchain expert, Lewis Cohen, co-founder of DLX Law, who explains  this case is far from over and still has serious implications for the crypto industry. 

Lewis provides a background on securities laws and how they may apply to cryptocurrency, ICOs and NFTs and how decentralization is not the sole determining factor in whether a token is a security or not. 

He analyzes the judge’s ruling in the Ripple case, highlighting the distinction between institutional sales, programmatic sales, and other distributions, while explaining the impact on exchanges and the ongoing litigation of other major crypto trading  platforms.

Quote of the episode

“The fact that you can sell something in a fundraising scheme does not make that thing itself a security.”
– Lewis Cohen (Co-Founder, DLx Law)

Minute-by-minute episode breakdown

  • (2:35) – Introduction and background of Lewis Cohen and explanation asset backed securities 
  • (6:04) – The ICO boom and their similarity to traditional securities transactions 
  • (10:25) – Explanation of securities laws and the Howey test
  • (17:06) – Clarification on the relationship between decentralization and securities laws 
  • (27:12) – Overview of the SEC’s complaint against Ripple
  • (33:02) – Analysis of Judge Torres’ ruling on the Ripple case and explanation of institutional sales, programmatic sales and other distributions
  • (36:05) – Impact of the ruling on exchanges and future lawsuits
  • (41:37) – Explanation of the ongoing process and potential outcomes of the case

Related resources

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Speakers on today’s episode

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Transcript

Ian:

Hey everyone. Welcome back to another episode of Public Key. This is your host, Ian Andrews, very excited to be joined today by Lewis Cohen, who is the co-founder of DLX Law. Lewis, welcome to the podcast.

Lewis:

Hey, man, thanks for having me.

Ian:

Now, as people who are regular listeners to the show are well aware, I am the furthest thing from a securities lawyer, but I’ve been reading nonstop lately about the Ripple case, as I think probably everyone who’s in the orbit of the crypto ecosystem has. And I am mystified as to what the judge has actually ruled on. So I think today we’re going to spend the bulk of the time really trying to dig into that and see if we can get me to a feeling like I’m slightly competent on the topic. That would be a big win. But you’ve been in the space for a long, long time. I’d love to start with a little bit of your background and how you came to focus on this area of cryptocurrency, blockchain, and the impacts to securities laws.

Lewis:

Sure. Thanks. Yeah, I started my career in another offbeat area some years ago. Years ago. And that was in the world of asset-backed securities. And asset asset-backed securities at the time, especially as a young lawyer, I got involved, were very different from anything else that had come before, and a whole new set of rules, regulations, and ways of dealing had to address them because with asset-backed securities, you take basically a pile of mortgages, or credit card obligations, or things like that, you put them into a legal entity that really does not do anything, it just sits there. Some people call it a brain-dead entity, and then it sells some sort of interest in that.

And if you think about it, it looks a lot like a DAI, a multi-collateral vault, because in many ways that’s exactly what it is. And so we had to develop new sorts of rules, disclosures, and ways of dealing with this. And I worked extensively with the SEC during that period to figure out how to do that. There was a period of probably about the better part of 10 years before the SEC came up with disclosure rules, which ultimately became called regulation AEB, asset-backed.

So despite the fact that we see the chair of the SEC saying today, “Come in, and register, and everything works fine.” The reality is that in the past and other circumstances, the SEC have modified the rules to address different and unusual circumstances. There’s nothing wrong with that. Some things were made more tight, some things that didn’t apply were ignored. For example, when you had a securitization transaction, nobody said, “We need financial statements.” Because it wasn’t particularly relevant. Instead, they provided statistical data about the performance of the mortgages or other things. And I think that’s the direction we see and we’ll, I’m sure, talk a little bit more about in some of the legislation on both the House side and the Senate side, going, “Hey, let’s rethink what disclosures are needed. Let’s make sure the right disclosures are provided, but not set up rules that are sort of functionally impossible to comply with.”

So based on that background, when I first learned about this idea of, and sometimes we say blockchain and it gets a little bit of a skew look, “It’s crypto, man, it’s crypto. Don’t you know?” And I agree with that. But when I first learned about this, I said, “This feels a lot like what I’ve been doing for much of my career.” And I got very interested. And I was at a large law firm. And I said, “Hey, let’s dive right in. Let’s make this happen.” And it became clear to me, though, that large law firms didn’t really understand what was going on under the hood. I had the real privilege and honor to work with Consensus, the company, in some of their earliest projects. And so you’re there at the beating heart of really what’s going on in the Ethereum community and a lot of the different things, and learning, and understanding.

And I said, “Hm. This is different than things I’ve done before.” And ultimately we decided if we wanted to do this the right way, we need to start our own law firm, which my co-founder, Angela Angelovska-Wilson and I did in May of 2018. So our firm is about five years old now. And we help people almost exclusively working with crypto assets in one way or another. Some of those may be very large organizations that are traditional organizations, many that you guys at Chainalysis serve, but also others as well, much smaller startups, and others. And really what we believe is critical for anyone as a lawyer working in the space is you got to understand what’s going on under the hood. And that’s what we seek to do.

Ian:

Yeah. That’s really exciting. So I would imagine at the timeframe you’re coming into it, one of the hot topics must have been ICOs, initial coin offerings.

Lewis:

Yep.

Ian:

And my experience, and I’ve only been in the space about two and a half years, so I only lived that period, 2017, 2018, through headlines that I wasn’t really following. But my sense of it is that in some ways the challenges we’re having between the industry and the SEC are a little bit reflecting back on that period of the ICO boom. When I look at an ICO, I have a hard time not seeing it as being equivalent to a private tech company doing an initial private investor round, where, in that case you create documents often called a safe, and you have a bunch of accredited investors who put some money into that initial seed, startup capital pool, to help a group of folks with a good idea get off the ground. ICO, to me, functionally looks the same. Would you agree with that?

Lewis:

100%.

Lewis:

Yeah, 100%.

Ian:

Okay.

Lewis:

This is really, it’s a great, it’s a very insightful question, because it’s really where a lot of our confusion stems from. The prior chair of the SEC, Jay Clayton made a statement that, “Every ICO I’ve seen looks like a securities transaction.” I’d broadly agree with that. It sounds like you would as well.

Ian:

Absolutely.

Lewis:

If we can take just a slight step back, and talk about our securities laws and what the principles are, because I think it’s when you know what the principles are, it’s a lot easier to fit things into the framework. Obviously, prior to the stock market crash in 1929, and the depression that followed, we didn’t have federal regulation of securities. So like many other things, including barbershops, and money transmission, and a whole range of things, they were regulated at the state level. Each state could make its own securities laws and it regulated activity in the state in its own way. And those are commonly referred to as blue sky laws. You could sell anything but the blue sky, kind of thing.

Obviously, after the market crash, and people looked around and said, “Well, these are national markets, and they’re really important to our entire economy in the United States. We need federal regulation.” Fair enough. So Congress went ahead and drafted federal regulation. But if you’re going to regulate securities activity, what’s a security? … “Well, what are we regulating here?” So some things were obvious. Well, if you’re selling shares of stock in a company or corporation, that’s the security. That’s what we’re thinking of. Good to go. If you’re selling notes, or bonds, or debentures that are widely traded as an investment, those are securities. And so what Congress did is they enumerated various things. “Okay, we would all agree, here. That’s a security. Check. That’s a security. Check.”

And they went through about, give or take 10 or 12 different categories. But Congress back then, they’re just as smart as we are today. Maybe not smarter, maybe not less smart. I said, “People are people and they’re always going to find workarounds. So if we just define securities as things with certain types of names or categories, stock, bond, note, debenture, things like that, people are going to just, ‘Well, you know, Ian, I’m not going to sell you a stock, I’m going to sell you schmuck.’ Different, totally different. So we’re good to go, here.”

So Congress borrowed from state law this idea that there were arrangements called investment contracts, which didn’t necessarily fit into any of the other categories. But it’s a you know it when you see it. That’s what we’re driving at, here. That should be regulated. And so they stuck in that term. And rather unfortunately or maybe fortunately, they didn’t define the term investment contract because it was used commonly in state law, they incorporated into federal law. It didn’t define it. And so nobody quite knew what it meant. And so it took about another, give or take 10 years, for the Supreme Court to get around to saying, “Okay, here’s what we think you, Congress, meant when you use that term. We think it means an investment of money in a common enterprise with a reasonable expectation of profit primarily from the efforts of others.”

They originally said solely, but people realized solely, that’s not quite right, primarily, for our purposes primarily. So when those factors are present, and here’s really the important part again, a transaction will be considered a securities transaction. When we relate to each other in some way, and those factors are present, the law will … Even though you’re not calling it a securities transaction, I’m not calling it a securities transaction, if I’m investing in money in you, we have a common enterprise in some way. We’re both in it together. You’re not walking away and I never see you again. I have an expectation of profit. I’m not just buying some piece of art from you. I’m doing this to make money. And I’m expecting you to drive that forward. When those factors are present, we’re going to say, “That’s a securities transaction.”

That may be fine, and this really ties back into where your question started, if we are both sophisticated people who, I can make an investment in you, I’m what’s considered an accredited investor, you give me whatever information I need, and then we make that decision. You haven’t done a public offering of that. You’ve just talked to me. It’s a securities transaction, but it’s one that’s exempt, no registration is required.

The problem we saw in the ICO period is people were doing exactly that, but they were not doing it on a private basis. They’re putting it up on a website, you probably remember this, with a countdown clock and every bad thing you can pretty much do, “Hurry up and buy,” not a lot of information, what information is inaccurate? Sometimes they had pictures of God knows who on the website as you probably remember. And the whole thing was just absurd and ridiculous. So they were absolutely fundraising transactions because the people buying the tokens in those ICO transactions, they didn’t really want to use the token for whatever, a sensible purpose. In many cases, the protocol wasn’t even built. There was nothing you could use them for. What they wanted was to experience a profit based on whoever was the team, “Oh, look at this guy. It’s Prince Charles or whatever,” some absurd things they put up, and they wanted to make a profit. And so those were securities transactions. There were no exemptions. They were done publicly. There were no exemptions, and they were in violation of the law.

And so we saw the SEC appropriately come down on those like a ton of bricks, and mostly that got stopped, but I’m going to pause for breath, here, but that is where our problems kind of started, because you’re 100% right. Those fundraising transactions do, I think quite clearly fall within the scope of our federal securities laws, and are regulated, and either need to be exempt, appropriately exempt or registered with the SEC.

Ian:

And I think I want to pick up on something that you said, there, where you’re using the term the transaction, is a securities transaction. It doesn’t necessarily mean that the business is now a securities business or that something that the entity has created, the token in this case, is in and of itself a security. Am I thinking about that-

Lewis:

You’re thinking about-

 

Ian:

… reading too much into your commentary?

Lewis:

Yeah, no, you’re thinking about that 100% correct. And the judge really zeroes in on that, in that she focuses on the fact that the fact that you can sell something in a fundraising scheme does not make that thing itself a security. And it could be the most basic of commodities. The fact that there’s a commodity involved does not mean that the asset being sold, or what she refers to as the subject … Here, I was looking for a quote to give you. So she says, “But the subject of a contract transaction or scheme is not necessarily a security on its face. Could be, but it’s not necessarily.” She goes on to say that, “This Howey case and the cases that followed have held that a variety of tangible and intangible assets can serve as the subject of an investment contract.” And she gives some various examples. In each of these cases, the subject, which is the term you use, basically, of the investment contract was a standalone commodity, which is not in itself inherently an investment contract.

And so that’s really the key thing you have to examine, “So is there a scheme in which case that is substituting, it’s a disguise? I could have pitched it as an investment scheme where we were selling securities, but I obfuscated, I tried to trick you into thinking, ‘Nah, you’re not really that kind of thing.’ And I’m giving you something that you don’t want or need on its own. You just want to resell it later.” That should be covered by the securities laws, but the judge in the XRP case says, “When the transaction doesn’t meet the four prongs of Howey, you could sell the exact same thing.” And then this, I think, goes to what a lot of people is like, “Hang on, you’re protecting the institutional investors. You’re not protecting the retail investors.” We’ll talk about that. But that’s not her point. Her point is simply this, that you have to look at a particular transaction, not at the asset, unless the asset itself is a security.

Ian:

Well, and this is where I think a lot of people on Twitter suddenly start talking about oranges.

Lewis:

Exactly.

Ian:

And they’re like, “Oranges aren’t securities, even though you could invest in an orange grove and that could be a securities transaction.” I’m finally understanding why everyone’s been talking about oranges for the last few months.

Lewis:

Well, the catch I’d say, Ian, and this a little bit gets up my nose. People use this as a simplistic way of explaining it, and that’s fine, “Oranges are not securities.”

Ian:

Yeah.

Lewis:

But tokens are also not oranges. So I think it sells us short by underselling the argument in the other direction. You know, oranges are made-

Ian:

Yeah.

Lewis:

… by the good Lord upstairs. They’re in unlimited supply, and they’ve always been around, and you can find them in a lot of places. Tokens are made by, typically, one person deploying a smart contract on a network like Ethereum, and they’re in finite supply, and they’re specifically designed that when you apply demand, the price goes up. That’s not how oranges work. So they have very, very, very different characteristics. So I think in fairness, I wish people would stop saying, “Oranges are not securities.” Not because it’s not true, but it doesn’t get at the core issue. That doesn’t make tokens themselves securities, but it misleads, I think, the honest listener.

Ian:

That’s a great point. And I would actually like to chase that a little bit because then I think ICOs, clearly securities transactions, but I felt like you were going to lead us down the path of saying, “Even though you can have these security transactions, it doesn’t in any way influence a later decision about are any given crypto tokens, whether there was an ICO or not, a security?” But I feel like your last comment there is saying, “Well, in some cases it is a security and it’s not.” Can you give us maybe a framework that’s a little more sophisticated than the oranges that we can use to just reasonably apply as we’re navigating through the ecosystem?

Lewis:

Of course. Well, if we start with the base case. And for better or for worse, XRP is pretty good as a base case. But for the most part, Ether is not too far away. You have to look at the asset itself and the arrangement that it represents. So things that, particularly, in the early days, were characterized as utility tokens, which is not a term at all that I like, and you may have heard that term, but things that we’re … First and foremost, let’s just recall, the token itself is really just a number. What does it mean when you own, whether it’s Bitcoin, Ether, XRP, or anything else, is that you have knowledge of a private key which allows you to give an instruction to a network of computers and tells it to do something. So that’s first and foremost.

So is there anything that’s associated with that number that gives you rights or benefits against some identifiable group? And for most tokens, if you look at the CoinMarketCap, 50, or maybe even 100, or CoinGecko, we’re appropriate these days to say, when you look at that group, most of the tokens, holding aside stablecoins or Memecoins, do not provide any particular rights or benefits. But other coins do. Other coins have economics baked into them. For example, they may have a fee switch turned on. There may be a sharing, there may be a DAO that’s created in that if you own the token, the DAO periodically does a buy and burn on those tokens.

Now you have a very different sort of arrangement. If the DAO is seeking to run a business that would otherwise just look like a normal business except it’s completely decentralized, then you say to yourself, “Well, what’s going on here?” That doesn’t mean that it’s necessarily a security, but you have to look at it. Where the danger zone, I would say for folks predicting the DAO community are, is, is this really something managed by the community at large? And we can use the word decentralization. Interestingly, that word does not come up but once in the Ripple decision, that’s a very interesting thing, because people have been obsessed around this. But we can come back to that.

But when you think about DAOs, is it something where everybody’s really collectively deciding? And there are communities that are like that, where there’s really meaningful community engagement, but there are plenty of communities where it’s really a small number of folks who are driving the bus, and everybody else is along for the ride. Those are communities. If you’ve got real economics, you’re running a business, and there’s a small number of people or companies that are functionally making all the decisions and everyone’s relying on, now you have a different sort of arrangement.

So as a framework, ask yourself, “What is the token doing? And am I in part of an actively managed business?” XRP is not an actively … It’s just like you use it, you send it to somebody, they send it back to you, like Bitcoin. Doesn’t really do a lot. Even the Ether token itself is not, in and of itself a business or a venture, but other things are. So you think of more sophisticated products like Curve and Yearn or other things like that, that do, those are rate setting, that people are actively sitting there and managing the process. That’s a different thing. And so I would absolutely urge caution to your listeners again to make sure, I wouldn’t extrapolate from Judge Torres’ decision in Ripple Labs that any token you do, you’re good to go.

Ian:

Yeah, that seemed to be the internet’s reaction as soon as the ruling came out was, “Okay, everything now, not a security. Great. We’re in the clear, let’s go wild.” Decentralization has always been to me a bit of a red herring. I appreciate the idea of community driven action in the same way that I’m fascinated by things that happen on Kickstarter, but it doesn’t seem like decentralization in and of itself really has anything to do with securities law, but it’s been built up in the ecosystem as a shield, almost, that says, “Well, no, we’re decentralized, therefore securities laws don’t apply.” And I’ve never understood that logic. Could you maybe strawman the case on both sides of this argument for us?

Lewis:

Absolutely, and it’s a great question. It’s really a fundamental question. And look, decentralization is critically important, as you say, for a lot of different reasons, just for the ethos of the crypto ecosystem and many other things. So it’s certainly a very important concept. I think in fairness to community members, this really got its start when someone at the SEC, this gentleman, Bill Hinman, who was at the time in a very senior staff role as the director of the division of corporation finance, gave a speech, and this has now become a famous speech when Howey met Gary (Plastic), which was a case. And in that, Director Hinman was seeking to address a challenging issue in the community back in, I think that was in 2018 or ’19, I can’t even recall at this point. He was, “Well, what is the status of Ether?”

And Director Hinman didn’t want to say, “There’s nothing to see, here, nothing to worry about,” because basically Ether was sold and functionally in a crowd sale. So he didn’t want to say that, but he didn’t want to also get people all alarmed that the Ether token was a security. And so he came up with this term, “Right now, I see the Ether ecosystem as sufficiently decentralized.” And so people extrapolated from that. “Oh, I get it. If you’re sufficiently decentralized, then you’re okay. If you’re not sufficiently decentralized, might have a problem.”

And I think they took the wrong lesson away. The lesson is less about whether the ecosystem is decentralized, it’s what is the nature of the transaction? And I think in the article, which you may have in your show notes, Ineluctable Modality of Securities Law, we say, “Look, you have to ask yourself what is the nature of the token itself?” So if you are fundraising with the token, whether that’s because you’re the Ethereum Foundation or an initial person who received a big boatload of Ether tokens, if you are fundraising for a business and saying to people, “Hey, I’m going to drive this thing.” That’s going to be problematic.

The overlap with sufficient decentralization is it’s like the inverse of reliance on the efforts of others. The idea would be, “Well, if the community is so sufficiently decentralized that you’re not relying on anyone, then you can’t rely on a given seller, because by definition you’re not relying on anyone.” So it’s more like you’re looking at the same thing from the other side and say, “Hey, if no one is driving the bus, then I could buy from anyone and not think that I’m relying upon them.” But the key question, it’s not the inverse part, it’s the form of it. It’s like, “Is it reasonable to expect that you’re relying on someone?” And so for example, even with Bitcoin, we’ve seen investment contract transactions where people said, “Somehow or another they convinced them, like BitConnect, you’re going to do some crazy scheme with Bitcoin.” It’s not that Bitcoin isn’t decentralized, it’s people pitched the purchase based on something they’re going to do. So the key thing from a legal point of view is not so much the decentralization. That’s the absence, it’s the way cold is the absence of heat. It’s the same kind of concept, there.

Ian:

One of the things that I’ve had explained to me related to decentralization is that you could have something start as a centralized project, which I think almost everything I’ve observed in crypto actually does.

Lewis:

Yeah.

Ian:

Right?

Lewis:

Absolutely.

Ian:

It’s you and I get together and we say, “You know what would be awesome? If we applied an automated market maker, lending pools, we come up in and lose Crypto Emporium, and we launch. And then over time … ” So at the beginning, clearly, there’s an enterprise, “We’re going to go seek people to invest in our efforts. We’ll build this up.” But it’s some point in the future we could say, “You know what? There’s now a huge community of enthusiasts who are participating. There’s lots of great people with good ideas. We’ve written the technical architecture in such a way that other people can build on it regardless of what you and I think.” And at that point, it crosses into this realm of decentralization. And so at some point it definitely was a common enterprise and then it is no longer, and that somehow has an impact on the securities treatment of both transactions and the enterprise itself. Is that realistic or practical in-

Lewis:

I’d say-

Ian:

… any way?

Lewis:

… it a little differently. And I think again, Judge Torres did a amazing job in her opinion. The transactions between third parties who might be, you and me, our friend Jane starts a protocol with six of her buddies and she’s in the process of trying to decentralize. And each month that goes by Jane and her colleagues are a little bit less relevant, but it’s hard to say, “Have they really decentralized?” Hard to know, right?

Ian:

Yeah.

Lewis:

But then somewhere along the way, maybe she airdrops some tokens and they’re trading around. And you and I, who have nothing to do with Jane, we’ve never met her, don’t know her, never had any conversations with her, vaguest idea. Is she even living? I don’t know, maybe something terrible happened. We don’t know. You and I trade that token that Jane was the developer of and the centralized party, we don’t know the status of her scheme.

Between the two of us, we are not engaged in a securities transaction whether or not Jane is still driving the bus on that project, because between the two of us, we’re just trading something with each other. The critical thing that the SEC has tried to argue is that if Jane is driving the bus, then when we trade with each other, we are engaged in a securities transaction. The importance of that is that let’s say you are in the business, you’ve got a couple of different things going on over there, Ian, besides an amazing podcast. You’ve got a whole sneaker business. And you would, just like early on in Kicks, and you got all kinds of vintage … And you’re a dealer in sneakers. You make a market, you’ll buy them, you’ll sell them. You have a big inventory of sneakers in the back behind the nice artwork you got, there. So you’re a dealer in sneakers.

And then, also, somewhere along the way you became a dealer in tokens, same deal. You buy them, you sell them, and you have an inventory of them. When you deal in sneakers, you’re not engaging in securities transactions. The SEC wants to say, “Wow, hang on a second there, fella. When you’re dealing in tokens, you need to figure out if Jane’s scheme is ongoing and it’s relying on her or not.” You’re like, “I don’t know Jane. I don’t know what you’re talking about. Maybe she went and she’s on a long vacation. Maybe she just stopped. She got bored. I don’t know. Maybe she’s really actively involved. I do not know, and I cannot assess that. I cannot know whether, when I sell a token to Lewis as a dealer, I need to register as a broker dealer. I can’t make that assessment in the same way that I’m selling sneakers here.”

Now, this is different. Let’s say Jane comes to you with some of her tokens. “Ian, you seem to know a lot of people. How about I give you a bunch of my tokens, you sell them for me.” Very different set of facts. You are now distributing them. So are you an independent third party, unaffiliated? You’re just buying and selling tokens. Judge Torres recognizes that. And so she says, “It’s not relevant whether Jane’s scheme is decentralized or not decentralized when you and I trade in that token with each other, because you have strict liability. If you were dealing in securities, you would need to register with the SEC as a broker dealer and comply with a whole raft of regulations.” And they’re appropriate regulations. Nobody’s beefing about the regulations. But you need to know. So if you’re dealing in shares of stock, oh, you better talk to a lawyer because, man, you need to register.

Ian:

Yeah.

Lewis:

How do you know which tokens require you to register with the SEC and which do not? How do you make that assessment? That is the beef, really, that we’ve heard from the crypto community from day one, not about Jane. When Jane sells those tokens she would need to register those fundraising transactions until people do not rely on Jane. And that day might come. She’s got a big community and she happens to still be holding some tokens, but when people buy from her, they’re no longer relying on her or her company. At that point. Decentralization matters a lot, because they’re buying from her.

The question isn’t about the decentralization. It’s the, “Is it reasonable to rely on her?” If there’s a big community and a lot of people are doing a lot of stuff, then you might say, “It’s not reasonable to rely on what Jane is doing.” The question isn’t decentralization. The question is reliance on the efforts of others. That’s the Howey question. Decentralization is a way of saying, “Well, you don’t have to rely on Jane anymore because you don’t have to rely on anybody.” But when you and I trade, when coins are on a marketplace, Bittrex, Gemini, Binance, you name it, nobody knows whether that project is sufficiently decentralized, nor can they determine that. That’s the critical difference. Hopefully that …

Ian:

This is super helpful groundwork. So let’s jump into Ripple. This lawsuit’s been ongoing. I think SEC initially filed against Ripple way back in 2020 before the world shut down for the pandemic. Maybe start with a quick summary of what the SEC’s complaint against Ripple was, and then we can jump into the recent ruling from the judge.

Lewis:

Ripple had already had a brush with the law four years earlier or something around being a money transmitter. And so they went through this whole thing about whether, through their use of the XRP token, they needed to register, and they did. They eventually settled and they became a money transmitter, and they did all of that. Fine. They kept, because they generated this large amount of XRP tokens, and because a lot of people thought that it was a good product, and it would become successful, they bought it on a speculative basis. And so they said, “I got a feeling that people are going to use, this is going to be a great solution.” And maybe they’re right, maybe they’re wrong, not our point. People started buying it speculatively, that’s fine. People buy a lot of things speculatively.

And then Ripple. So then they said, “Well, a lot of people buying this speculatively. I thought I could raise money to keep driving forward my business by selling these tokens.” And so they sold quite a mod. I think it’s well over one and a half billion dollars worth of Ripple, I think is alleged, about 700 and 700 give or take between the institutional sales and the programmatic sales, give or take. And so the SEC looks at this, “Well, hold on a second, here, guys. Aren’t you the prime candidate of what we’re trying to stop, here? People are funding your business. And they’re doing so in a way that either is not exempt from the registration requirements in these transactions or providing the adequate disclosures. You are the poster child of what’s going wrong with this whole thing.”

And so the SEC, after presuming a long time of discussion and engagement decides, “We’re going to sue you and we’re going to allege that when you fundraised by selling your tokens, you violated the law. So that gave rise to this thing. Ironically enough, the lawsuit was, I think, on the next last day of Jay Clayton’s term as chair. And the Gensler, SEC inherited that and continue to move forward. But I think we can all readily understand where the beef was with Ripple Labs, and said, “Look, you’re raising a lot of money, here. Feels like,” just like you said, Ian, “that this feels like a tech company raising money, and yet you’re not making sure that you’re exempt, nor are you registering with the SEC. You got to pick one channel, guys, and you didn’t pick either. And so that’s our beef with you.”

Now, clearly, I think part of it was also thinking that this was going to be an easy case to win, and therefore having won that case, they were going to go on and then knock over some more bowling pins down the line. But that was the gist of the beef. And I think for many people we thought, “Yeah, there’s a beef there, there’s a beef to be had.”

Ian:

Yeah. And why did Ripple, and obviously you’re not representing Ripple, so speculation, here, not insider advice, but what is your assessment of why Ripple chose to argue against that case? Because that seems incredibly straightforward and something that I would say, “Well, gosh, we should probably settle and not do that again.” That would be my layperson’s assessment of the situation. But they clearly didn’t do that. They’ve been fighting this to great expense for now over three years and it’s ongoing.

Lewis:

Absolutely, and I’m glad you just reminded me because it should be either at the top or the bottom of the show. But as with every podcast I do, there’s no legal advice here. I’m not your lawyer. Get your own. So just to be very clear, no legal advice for anybody, here. These are just my own opinions and not those of anyone else’s. In terms of why Ripple apps choose to sue, there’s a lot at stake for them. The potential liability, it was quite large, and I think they felt genuinely that they had arguments to be made, and they wanted to assert those arguments.

And I think just as the SEC as an enforcement authority is every right to bring claims and actions that they, let’s assume in good faith feel are violating the law, people who are accused of violating the law have every right to defend themselves. And in this case, and I can’t, and I don’t want to speculate exactly why they didn’t settle, but this is very large situation, and they felt they had good grounds to win. They retained some amazing law firms to represent them, and they said, “Look, let’s just go at it.” And sometimes you got to just throw it down and see what happens.

Ian:

Well, and it seems like the strategy has paid off in their favor, at least to some degree. So unpack for us what Judge Torres’ ruling said, because I personally found it very confusing. She made two big statements, but walk us through what that was.

Lewis:

Sure. I think it really confused a lot of people. You’re far from being alone. And I think it was confusing both in terms of what she just practically said and then also confusing what the policy was. I think both of those flummoxed a lot of people. And you see a lot of internet chatter, “She got it exactly backwards,” a lot of different things. So let’s first talk about what she actually said. She broke down the transactions as the SEC put them forward into these, broadly speaking, three categories, the institutional sales, the programmatic sales, and what she refers as the other distributions. There were also some sales by the individual defendants, Garlinghouse and Larsen, we can talk about those at the very end.

So for the institutional sales, they fit, and the judge analyzed each of those separately as transactions. She’d never analyzed the XRP token after having concluded that it did not in and of itself embody a contract transaction or scheme for purposes of Howey. She says, “The token’s not the thing. We need to look at the transactions.” And so with the institutional transactions, people came in the front door, negotiated with Ripple Labs, Ripple Labs made direct undertakings to those persons, and said, “Hey, if you give me money, look at all the different things we’re going to do. This is really going to work out.” They commingled the monies that various purchasers had, so there’s a common enterprise through commingling what, in technical terms we call horizontal commonality.

And she said, “Clearly, the people buying the tokens, were not buying them like sneakers because they’re going to wear them, they were buying them in bulk so that they could resell them later at a profit.” So all of those elements were present. She does, “It’s really down the middle. Howey, boom. Did you register? Oh, you didn’t? Sorry, that’s a violation of the law. So you offered securities in the form of these transactions. You did not register with the SEC. Game over. You’re responsible.” However, that’s the less interesting part of her decision.

The second part obviously relates to the programmatic sales. And when it comes to programmatic sales, what XRP was doing was dribbling out small amounts of XRP in various marketplaces, and that there’s a critical thing, and I think this, as you said, Ian, earlier, was something that the internet had missed. She focused on the fact that there was a vibrant and active secondary market for XRP. At the time that this was going on, XRP was more or less the fourth largest traded token in the marketplace. There were a lot, a lot of people just trading with each other for whatever reason. We might think, “Man, what are you thinking over there, XRP trading people?” Fair enough. That’s not the point. They’re trading with each other. There’s a vibrant market for that. People are selling their supreme Kicks and doing all whatever, good idea, bad idea, not the point. They’re trading with each other.

What the judge concludes is, “Well, let’s look at the transactions in which XRP is selling them. They’re on a blind bid-ask basis. They’re just mixed into the flow of the other transactions that are already occurring.” When people bought or sold, but particularly here, bought the XRP tokens, they don’t know are they buying from Ian Andrews? Are they buying from Lewis Cohen? Are they buying from Ripple Labs the company? They don’t know, nor do they care. Nobody’s making representations to them. They’re not coming in, sitting down, engaging. There are none of the elements that are present in a Howey scheme, and therefore those transactions are not non-investment contract transactions.

So that’s what she says. As to the other distributions, that’s the area where I think many of us feel that she perhaps overshot the mark a little bit. So in the other distributions and your, I’m sure, community of viewers are aware, many, many projects use their tokens to remunerate their employees, sometimes contractors. And she says, “Well, they’re not putting capital into the business, so therefore no investment of money, therefore no investment contract transaction.” That’s a little … I don’t know about that. I think most of us would say, “We don’t know about that.”

Ian:

That’s a head scratch to me because-

Lewis:

That’s a head-

Ian:

… because-

Lewis:

I think that’s-

Ian:

As an employee of tech companies my entire career, my labor in exchange for equity via stock options in the business, again, just like-

Lewis:

You don’t have to be a fancy lawyer.

Ian:

… my ICO comment earlier.

Lewis:

Yeah, you don’t have to be a fancy lawyer. And again, of course when you get stock options, you’re getting a security, right, because the stock is a security.

Ian:

Yeah.

Lewis:

The problem with the XRP token, it’s not a security, but you’re bartering. Her argument is that, “You’re not making an investment of money, but you’re bartering,” right? So for example-

Ian:

Yeah.

Lewis:

You could imagine that you might have said, let’s just be optimistic, here, and said, “Well, I would’ve gotten $300,000 a year in cash, but if you give me tokens, I’ll do a $100,000 a year. Or just give me the money. Boom, fine.”

Ian:

Yeah.

Lewis:

You’re bartering $200,000 of value for tokens. That’s really no different than you’re getting $300,000 of cash and then using $200,000 to buy the tokens. There’s no economic difference in that whatsoever. So I don’t know. I’m right there with you, Ian. I’m not sure I got anything to say about that.

Ian:

The second piece that you talked about there, these programmatic sales, it seems like the industry impact on that ruling is going to be most directly felt by exchanges and one of the charges against them, I believe, is operating as an unregistered broker dealer for facilitating securities transactions via all these tokens. Does the ruling in the Ripple case ultimately cited as some precedent law in that case?

Lewis:

Well, I’m going to take the question just a little bit more broadly and say there are three allegations that are core allegations in three different lawsuits all filed around the same time. And all three are basically the same. Number one, exactly as you said, you’re acting as an unregistered broker dealer. So as we talked about before with the sneaker example, you’re acting as a market as a national securities exchange, which is different. So the broker dealer, you’re just offering to buy and sell in a exchange. You’re creating prices and creating a marketplace for bids, and asks, and prices. So that’s the second type of violation. And then there’s third, you’re acting as a clearing agent, meaning you’re settling trades. So you’re taking the cash from one buyer, the securities of another buyer, and crossing them to effect that all of those are three different but regulated activities.

And the SEC accuses all three of those entities of all three of those violations. All of those violations turn on what they are actually trading in, not being securities, excuse me, not being sneakers, but being securities. And so Judge Torres’ analysis here is absolutely central, just like you said, for all three of those cases. And also, potentially for Uniswap, for example, which effectively facilitates very similar activity. And she says, “Look, it’s not so much when two third parties are buying and selling, absent other facts. Those are not securities transactions. They’re securities transactions when someone … “

And again, for example, in my case of the tokens and Jane, I think, our heroine in our story, if she comes to you and asks you to distribute the tokens for her, that could well put you in the position of acting as her agent, in effect, on her behalf and selling those securities. And in the absence of there being a vibrant market, if the purchasers, for example, in a initial DEX offering or an initial exchange offering like a launchpad type situation, where there is no vibrant market, and basically everybody’s buying the token based on the only thing you have out there is not a market of buyers and sellers, but simply a project that’s saying, “Hey, buy this because its numbers going to go up.” I think you get a very different result.

So her decision really helps as to tokens that are already out there in trading. You had asked earlier about, “Well, how do you on ramp?” And that is, in many ways, the big question. And one of the bills in Congress, the House Market Structure Bill, attempts to address that by creating a on ramp way of allowing people to distribute tokens without necessarily violating the law, but in a practical way of doing that.

Ian:

Interesting. We won’t use the three that are actually in lawsuits, maybe, so we’re a little freer to speculate, here, but theoretical exchange collaborates with a new project. They want to distribute a token. The exchange has a bunch of existing customers who like to buy tokens for whatever reason, and they say, “We’re going to onboard token X, the new token of the day.” And they put out an email to all their customers, they advertise over Twitter, and draw a bunch of people in who buy token X. That’s going to get you in trouble.

Lewis:

Yeah, it is potentially going to get you into trouble, potentially. Right?

Ian:

Yeah. Okay.

Lewis:

And that’s where, and I have to say, I hadn’t used the whole cold as the absence of heat thing, but now I’m liking it. That’s why I love doing podcasts. You always come up with something new and different. That’s where decentralizations really becomes important. Right?

Ian:

Okay.

Lewis:

It’s not so much is the project, when you do that to decentralized? It’s is it reasonable to expect that the people buying on your exchange are relying on the efforts of that project? So if you’re not decentralized, then there’s a good chance that it is reasonable for them if you’re the main distributor of the token, and it’s not decentralized, that is, Jane’s really driving the bus, man, is she brilliant. MIT, that girl’s crazy. People are going to be relying on that. It’s not so much per se that you’re distributing the tokens, is, is it reasonable to rely on the efforts of others?

And again, in the case of Ripple, Judge Torres is looking at this and there’s a lot of people trading this stuff, they don’t know or care where it’s coming from. In the DEX offering or the exchange offering that you hypothesize, it’s probably quite likely, and in fact, in many cases, the exchange is actually disseminating the white paper and various things, and really facilitating that reliance. If you are facilitating the reliance on Jane, and Jane Labs, and that sort of thing, then you really are running a real risk, there, yes. So it really depends on what that relationship is, what are you trading, and where does it stand?

Ian:

Yeah, that’s very helpful. And it seems like there’s a slightly different scenario where there’s a token that’s already popular by its own right. It’s in the market. There’s lots of people that hold the token, they trade it frequently. And my theoretical exchange says, “Well, gosh, we want to facilitate some of these transactions, because we collect a fee on every one, and that’ll make us some money.” And we do the same marketing. We send out an email to all our customers and we advertise on Twitter and we say, “Token X is now available for trading on our platform.” That seems like it keeps me out of trouble.

Lewis:

Well, again, Judge Torres specifically doesn’t rule on that, right? She has a footnote-

Ian:

Okay.

Lewis:

… 16, and she’s not getting into the direct secondary sales. I think that’s an area where, if you’re running an exchange, you need to think long and hard about it. Do you feel comfortable that you are really sufficiently distant from anything going on, that you’re not promoting the scheme, you’re just facilitating third party transactions. If you’re comfortable that you’re facilitating third party transactions, then that’s a different set of circumstances. So decentralization is in the background, but really the question is, “How are you?” So if you’re going out there, and again, you could take the XRP as one end of the scale and maybe the launchpad as the other end of the scale. With the XRP token, she said, “Look, it doesn’t appear that people are relying in any way on the person selling. In the launchpad there is no market. You’re facilitating distribution. It’s not on your website. It’s on the exchanges website. But it’s the same thing. You probably have a lot of problems.”

Ian:

Yeah.

Lewis:

“Where in that thing that needs to be, everybody needs to … ” But it’s not that the token, the core thing here, it’s not that the token is a security. You’ve got to ask yourself, “Am I facilitating the distribution of an investment scheme?” And that is a different kind of question.

Ian:

Yeah, it’s very different than what I think most people are focused on right now, so I’m glad we got into that discussion. The important thing in the Ripple case is it’s not over. So this ruling is not the end of the case. Talk to us a little bit about, just from a process standpoint, what we should expect going forward now that this ruling’s been issued.

Lewis:

Well, that’s absolutely right. We said there are these three categories of sales, the institutional sales, she rules on, the programmatic sales, she rules on, the other distributions, she rules on. And then the individual sales by Garlinghouse and Larsen are functionally the same as the programmatic sales, so she rules on. So that leaves just one little thing, and that is did Garlinghouse and Larsen aid and abet in their individual capacity, the company in their illegal sales? So we know that the institutional sales violated a law. Her question is, “Garlinghouse and Larsen as executives, did they aid and abet that?” That’s a factual question. That’s held back. And that needs a trial. So we don’t have a final judgment because she hasn’t resolved all the questions.

Without a final judgment. Neither Ripple nor the SEC can appeal this decision as a matter of right. They don’t get to, like, “Okay, I’m going to appeal it and I’m out of here.” Because there’s no final judgment. That requires, and you’ve probably heard this term already, what’s called interlocutory appeal. That is, “Hey, hold on a second, pause the game because I’m going to go to the replay booth and try and figure out what’s going on over there. And then we’ll come back and keep playing, because it’s so important to the outcome of the game, we can’t wait until the game’s over to do the appeal. I got to figure it out now because that’s going to affect everything.” An interlocutory repeal depends on both the trial court judge, Judge Torres, granting that, and also the appellate court, in our case the second circuit, accepting it. So the SEC would have to ask, Judge Torres would have to grant, and the second circuit would have to grant.

As far as I’m aware, the SEC have not asked yet. So it’s a moot point. They could ask. If they do, Judge Torres would have to agree, “Yes, this is so important, I’m going to certify this for appeal.” The second circuit would have to agree, and then we would pause the trial, and move on to the appeal. If they don’t ask, or they’re denied by either the two courts that could deny it, “So sorry.” And then you’ll continue with the trial. But of course, there’s one more possibility. Mathematically they could settle with the two defendants.

At that point, all the issues are done and you don’t need a trial because you’ve settled, and then you have a final judgment. And then either side or both sides could appeal because Ripple lost, too. So they have an ability to appeal, or the SEC could appeal, or they both could appeal. So then in either way, the earliest I think anybody could see this getting resolved is probably about a year from now. And it could even be longer, depending on the trial and every which other thing. So it’s going to be a while any way you slice it.

Ian:

Yeah. Well, I’m going to get my popcorn, and keep watching, and I’m going to follow you on Twitter because you get deep into all these topics as they’re unfolding. Give us your Twitter handle-

Lewis:

Sure. It’s-

Ian:

… so that we can-

Lewis:

It’s NY crypto lawyer. So N-Y, I won’t spell crypto lawyer. You can hopefully figure it out. If you can’t spell crypto lawyer, probably just best let it be.

Ian:

That’s right. You don’t need to follow.

Lewis:

You don’t need to follow.

Ian:

That’s okay.

Lewis:

Because I’m following myself, man. I can’t spell that stuff. So in any event, Ian, it’s been so nice chatting with you. I’m so psyched. You have got a great show. And I hope everybody’s watching, not just this episode, but many more of the great episodes that you’ve done.

Ian:

Lewis, thanks so much. I feel incredibly more informed than where I was this morning when we started. It’s been terrific. Hope to have you back again soon as this and other cases progress, to unpack the- 

Lewis:

Be a pleasure.

The post Everything You Need To Know About the SEC vs. Ripple Lawsuit: Podcast Ep. 68 appeared first on Chainalysis.