Transcript: Sam Bankman-Fried and Matt Levine on How to Make Money in Crypto

The price of major cryptocurrencies like Bitcoin and Ethereum have been moving sideways for awhile. But it doesn't seem like there's any slowdown in terms of money entering the space. Every day, some new fund is being launched or some legacy financial institution is diving into it. But what's all this money going to do? On this episode we speak with Sam Bankman-Fried, the CEO and co-founder of FTX, as well as Bloomberg Opinion columnist, Matt Levine, the money-making opportunities that people are exploiting, whether it's directional bets on coins or yield farming or arbitrage, and how much potential profit there is for the taking.  Transcripts have been lightly edited for clarity.

Points of interest in the pod:
What is FTX going to do with IEX? — 05:29
Why does money struggle to get into crypto? — 07:04
What does institutional money mean for crypto prices — 11:52
How people are making money in a maturing crypto market — 14:51
Sam Bankman-Fried explains yield-farming —21:17
What’s the deal with algorithmic stable coins?— 43:42
Why aren't they doing OTC options in crypto? — 47:13
How VCs find the next big thing — 50:2

Joe: (00:10)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.

Tracy: (00:16)
And I'm Tracy Alloway.

Joe: (00:17)
Tracy. The coins. Time to talk about the coins again.

Tracy: (00:21)
The coins. You mean like, you know, fiat coins, right?

Joe: (00:26)
No. The electronic digital coins that people are really into trading.

Tracy: (00:29)
Ah ok. You know what it feels like it's been a while, hasn't it?

Joe: (00:34)
Well, so this is the crazy thing. This is what makes crypto difficult for me, which is that if you like, and I've maybe you said this before, but if you step away for like a month and you focus on other stuff, like the price of corn or wheat or oil or something…

Tracy: (00:48)
Russia's invasion of Ukraine…

Joe: (00:50)
Yeah, and then you come back to crypto and it's like, the entire narrative has completely changed. There's all this new terminology, new tokens that you've never heard of. You can't step away from for a minute, let alone a month, and feel like you have any sort of hope of understanding what's going on.

Tracy: (01:05)
On. It does feel like it requires a certain intensity to make it in crypto.

Joe: (01:11)
And then after that month it's like, well, I'm already so behind. I don't wanna come back at next thing, you know, you're like three or four months behind, so we have to reverse it. We have to catch back up with what's been going on.

Tracy: (01:19)
Yeah. We need to reverse that. I mean, I am vaguely aware of some of the big picture stuff that has been happening. So I'm looking at the price of Bitcoin at the moment. It's just under $40,000. It is weird, and I think you wrote about this, it is kind of strange that in this environment, Bitcoin hasn't been doing better.

Joe: (01:37)
I know. So, you know, here's what I've been thinking about, which is that the prices of especially the big ones, you know, there's always tokens going to the moon, but the prices of like the big ones -- overall market cap, [it’s been a] rough year, kind of gone sideways in the last year, or more down. But the interest in the space continues to be unabated and it feels like every day someone is leaving a big bank, a big fund to do something new in crypto crypto, a hedge fund, crypto VC, interest in investing in the space does not seem to have abated it at all, even with the price of Bitcoin going sideways to down.

Tracy: (02:13)
No, absolutely. And also the other thing that's sort of happened is rather than crypto going off and being its own ecosystem, which if you think back to Bitcoin and its origins, that was really kind of the point of the whole thing, but it feels like crypto as a whole is becoming more and more integrated with the existing financial system or at least with Wall Street, and so, you know, you see people who are collecting NFTs and now they're talking about the bond market and interest rates, which is kind of funny. But you're right. We haven't spoken about it for a while and should definitely rectify that.

Joe: (02:45)
So I wanna know basically what all this new money entering this space is doing. And something I've been thinking about is that in 2018, you could make a fortune essentially just buying Bitcoin -- or maybe 2017, 2018 -- buying Bitcoin in the U.S. and selling it in Japan because the market was so inefficient that there were like multiple prices around the world. And you could make a ton of money doing that. These days, I suspect that the market is vastly more efficient than it was back then. On the flip side, I also get the impression that do, compared to TradFi, that the spreads are still a mile wide and that there's still big opportunities for all this money coming into this space. So let's have a conversation about how to make money in crypto.

Tracy: (03:29)
Let's do it.

Joe: (03:30)
All right. I'm really excited. We're gonna be bringing back, for his third time on the show, the one and only Sam Bankman-Fried, SBF, he's the co-founder of FTX. And we are also gonna be joined by Matt Levine, Bloomberg Opinion columnist. We had them both on last fall. Everyone liked hearing them discuss the state of the markets together. So we figured let's have them both back on. So Sam and Matt, thanks to both of you for coming back on Odd Lots!

SBF: (03:55)
Of course.

Matt Levine: (03:56)
Thanks for having me back.

Joe: (03:57)
Absolutely. So Sam, let's start with you. Actually, you guys have a big conference coming up at the end of April, the FTX Salt conference, Crypto Bahamas, the Bahamas being your new corporate home, which sounds pretty nice. Am I basically right? That there is sort of still this huge essential tidal wave of money coming into the space. Like how would you characterize it, very big picture, all the interest right now in crypto

SBF: (04:28)
There's a huge tidal wave of money trying to come into this space, is what I would say. Just sort of, you know, gobs and gobs of it, that that sort of been  desperately, you know, sort of like trying to find its way in over the last few years, every month, another sort of like nice little pile of that, you know, larger gob manages to make it in.

Tracy: (04:53)
So one thing I saw recently is that you took a stake in IEX, which I think a lot of people will recognize as the firm that was founded by Brad Katsuyama, who's the guy who was written about in Michael Lewis's book ‘Flash Boys,’ all about the evils of high frequency trading and stuff like that. What exactly is the thinking there? And, you know, I guess I understand some of maybe the ideological alignment or the stated ideological alignment there, but what exactly are you going to be doing together?

SBF: (05:29)
Yeah. And you know, obviously we'll have to see what happens because this is, you know, highly-regulatorily dependent space, but the core of it is like some digital assets are securities. Different people might give different quotes for exactly what fraction of them are, but  certainly some fraction of them are. Let's say that you want to offer trading in a digital asset security. What would you do? Right now, this is not a problem that people have really confident regulatory solutions for. It's something that there's certainly a lot of thought going into from the regulatory perspective. You know, at its core, we're experts in, you know, things to do with tokens and offering trading in tokens. IEX are, you know, experts in offering trading in securities. And more generally, they're also really good at being creative and sort of building out new market structures that might not be exactly the same as what they're sort of used to doing. And that's exactly what we need to do right now is to build out a new market structure that is consistent with our existing, you know, rules and regulations in coordination with the SEC and other regulators for digital asset securities. And that is our big deal with them.

Joe: (06:41)
Something, you said, Sam, in your first answer, I thought it was really interesting. You said there's all this money and it tries to get into this space, which I sort of took as to me, that there's like some constraint or that it's not easy as easy to just sort of jump crypto as perhaps people imagine. What is the constraint? Why is it that the money is just trying to get in?

SBF: (07:04)
Yeah, it's a really good question. And the answer is a little bit different for different pots of money, but the high level structure of it looks somewhat, you know, similar, which is basically you’re let's say a big bank, right? And all of your client are asking you, can you please get into the digital asset space? We want to invest, and we want [to] access token through you. And all of your traders are saying, ‘Hey, we wanna be trading crypto, you know, as part of the prop desk for the firm’ and, you know, random employees are coming up to you, the strategy person, or whatever, at this bank every and saying, ‘Hey, why aren't we doing the crypto thing yet?’ And so you go to compliance basically, and you say, ‘Hey, we'd really like to do the crypto thing. Like, I know last time we asked you sort of groaned, but like, could you give, you know, maybe give a little bit more than a groan, right?’

Like put some words to that groan, and they sort of like groan really loudly and they say, ‘can you tell me what regulatory framework are we gonna be under?’ You know, compliance comes back and says, well, okay, like you wanna have this conversation? Sure. We'll have it. Talk to me about why you think we are allowed to do this. And at its heart, people are sort of like, oh boy, well, why are we allowed to do this? Well, people push back and say like, well, what regulation are we breaking? And compliance is like you don’t understand, we are the first ones who are gonna get sued. If there's anyone who's gonna get sued here by a regulator, we can't point to a regulation we're breaking here. We need to know what regulatory framework we are a part of, what licenses are necessary to play different roles in this space. And if the answer is, as it is right now, basically like we're working on it, as a country, like as a global society we're working on it, that's not a great answer. And that's like roughly where the money gets trapped.

Matt: (08:58)
Sorry. When you say money, is that like, I mean, what you're describing sounds like the sort of regulatory environment that a bank lives in. I'm less convinced it’s like what an asset manager lives in. Like, do you mean mostly banks or like sort of everyone in TradFi?

SBF: (09:14)
Well, yeah, it's a good question. It certainly isn't everyone in TradFi and in particular, the closer that you get to something that looks like proprietarily owned and controlled money, the more you are able to do something here. And so when you look at, for instance, a prop trading firm that is trading, I mean on one extreme, you know, take one that's trading entirely for its own book. So doesn't even have customers, doesn't have LPs, doesn't have anything, right. From their perspective. This is a lot cleaner, right? From their perspective, the answer is a lot closer to like, oh, well, you know, here's our deal. Like we trade things. That's what we do. We're gonna trade this other asset class. And they often see themselves as like, look, we're not showing this to customers or anything. We're not sort of in the line of fire here.

So that is the area that we've seen sort of most come in early to this space. But if you sort of take a step back, actually even a lot of other money managers end up in the more concerned bucket, shall we say, take a look at like a giant ETF company, right? Like that's an example of like an asset manager a lot of assets are in ETFs and other sort of similar funds. How many ETFs currently have cryptocurrencies in them? Well, the answer is like two or something like that. And again, you're getting back to questions of, well, what are these? Are these commodities? Are these securities? Under which statute are we putting them into the fund, do we need to register them? They're having active conversations with regulators about this. And there's obviously been a lot of back and forth about attempts to have a Bitcoin ETF, which have only sort of come together so far.  There are now Bitcoin futures ETFs, which are something, but there certainly, this is not a solved problem.

Even if you sort of like aligned the specific, you know, registration requirements around a publicly listed ETF, and you look at sort of like private mutual funds for high net worth individuals. Most of those are sort of sitting there thinking like, are we gonna get in trouble somehow for this? Compliance is somewhat, you know, uncertain and nervous about it. And so I think there, you know, you're still in a pretty messy situation all things considered.

Matt: (11:23)
The thing you're describing sounds like incredibly bullish for the prices of crypto assets. Because basically you're saying there's a tidal wave of trillions of dollars of institutional money that they all wanna put 10% into crypto and they can't, but they'll figure it out. And then like crypto assets will explode, like, is that the right way to read it? Or is there like, I mean, like the counter narrative would be, you know, the sort of prop traders and like retail speculators have gotten so far ahead of that trend that like prices already reflect that demand. How do you think about it?

SBF: (11:52)
... I do think this is the thing that makes me the [most] bullish about like crypto asset pricing is just the amount of money that isn't able to access it today or able to, that isn't accessing it today, you know, one way or another, but directly could be, and very well might start doing so over the next few years. That is I think the most bullish trend going on in the space. And on the flip side, there's this question of, well, has that already been priced? And that could only be the narrative in some sense for like so many years in a row before, at some point you, you have to start saying, well, isn't that why people were buying last year and holding, you know, in anticipation of this?

I mean, in the end, it's messy. Like there's lots of reason that people would be, and I don't think that there's a very clean tally of this, and I think I'm still not bullish because of it, but I definitely do think this has already been prepositioned for a decent amount. Now there's a limit to how prepositioned it could be. Right. Because if you think about it, the scale of what could roll into crypto, if you think that a few trillion dollars of actual capital is what could happen, that's the entire market cap in crypto right now. If a few trillion dollars rolled into crypto, I'm guessing it would 10X in price, roughly speaking from where it is. And so if you think that the odds of that are at least 10%, that alone can sort of justify, and it’s sort of like an argument that it sort of probably hasn't been fully repositioned for by the world, which I think I like roughly believe in expected value terms. Although like in median terms, what are the odds crypto will go up or down versus like how much will go up or down? You know, I certainly don't think it's like anything close to a conclusive argument that like, it's, you know, very likely to go up.

Matt: (13:33)
You say crypto, I mean, my impression of like giant institutional interest is like the idea of having some portion of your portfolio in Bitcoin is very attractive. My impression is that there's a sort of like sharp fall off where, like, they're not sort of thinking about the difference between other blockchains and like how to, you know, yield farm and stuff like that. Like, is that your impression as well? Or do you think that a lot of the institutional money, you know, wants to actively trade lots of different cryptocurrencies?

SBF: (14:01)
Yeah. I don't think they've decided is the real answer. Right. Like, I think the real answer is that like, you know, if you asked them, they would say something like, I don't know, you know, if you ask 'em like, what do you mean by crypto? Like what crypto? I think their honest answer, like, I don't know, you know, the crypto thing, right? Like there's Bitcoin, like yeah. Or there more like, yeah, totally there more like, are you, you know, intending trade more? I don't know. Like we certainly wanna consider that, you know, down the road, like right now, our focus is on finding a way to get Bitcoin access and maybe Ethereum access to our users. Like, you know, but absolutely. You know, we consider, you know we'd be potentially interested in offering more. I think that's a sort of like messy, confused answer that you would hear in practice, which is just another example of like, you know, things are not very orderly right now in sort of like money looking at the space.

Tracy: (14:51)
Just on this point. And Joe kind of touched on it in the intro, I guess this is sort of an existential question, but it feels like the market is in the process of maturing. And it also seems like FTX’s whole purpose is to improve liquidity in crypto trading. And some of that should happen naturally as more money comes in, but some of it is you making a conscious effort to do so. But at the same time, it seems like a lot of the opportunity in crypto has historically been from illiquidity and frictions and fragmentation in the market. Is there a tension in there? Like does the attractiveness of the crypto world start to ebb away as the market actually matures?

SBF: (15:39)
It depends on how it matures. In theory, and this might not happen, but certainly I think if you could ask most of the traders in the market what they think, what they would say would be something like, well, yeah, we do think that P&L in basis points, you know, per trade, will sort of like go down over time, but we also think volume will go up. And that certainly has been what we've seen so far, where if you compare it today to 2017, right. 2017/2018, you know, I was busy trying to make money arbitraging Bitcoins here versus Japan. And those trades were good by many percent. But you know, there's a billion dollars a day of volume going on on each side, which is a whole lot if you're making many percent on it, but, you know, what do things look like today? Well, there's $100 or $200 billion a day of volume, that are trading in crypto. And so I think volumes are probably up like 50X or so since then, spreads on the other hand are down and they're down sort of a comparable, you know, ratio.

And so I think that so far, the sort of story of crypto has sort of been like spreads are coming in and at the same time volumes are going up such that actually the arbitrageurs are making about as much as they always did. Although it's maybe harder than it was before. And you can imagine the future that like that continues, that things continue to get more efficient, but that as part of, you know, the asset class getting more institutionalized, like, you know, volume and liquidity goes up a fair bit, which, you know, increases the sort of like scale of activity people can have. That being said -- and, and part of me does believe that, but not all of me -- because it is also the case that like, at least as of today, we are probably overindexed on, you know, volume relative to liquidity. And I think one way to look at that is just looking at ratio of daily trading volume to market cap. They're trading, you know, comparable amounts to how much U.S. stocks trade each day, but, you know, have the market cap of Amazon. But I would definitely guess on the margin that like, we are gonna see compression in that product.

Joe: (18:03)
People who haven't listened last April was the first time we had you on Sam, and we talked a lot about that trade where it's like really difficult sort of operationally to execute, but just these crazy spreads between the price of Bitcoin in the U.S. and Japan four or five years ago, and how you could just, you know, how simple that sort of opportunity was once you found a way to make that trade. As you've described volumes way up, spreads way down. You know, and you mentioned too that there's like a range of sophistication, so there are some entities that ‘I just want to have Bitcoin exposure. I want to have Ethereum exposure.’ And then there's other TradFi that's clearly way more sophisticated, like entities like Jump Trading are doing all kinds of wild stuff. And we had their head of crypto on the podcast last year, Kanav Kariya, but what, you know, like where are the current frictions as you see them? Or [what are] the arbitrageurs entering this market or seeing? Obviously, it's gonna be way more sophisticated than just buy U.S./sell Japan. Where are the existing inefficiencies sort of broadly in crypto right now?

SBF: (19:08)
Yeah. I mean, they're a little all over the place, although obviously way smaller. In particular, I think it's a lot less, well, you buy on this exchange and sell on that exchange. As you said, it's a lot less identifiable in some sense, is what it is. So what is it, if it's not that? You know, some of this is just traditional HFT stuff, you know, there's $150 billion a day of volume that traded, it's traded on a bunch of different order books. And when you say, how efficient is it, right? Like how much price might these order books be? Well, I don't know, take two Bitcoin or Bitcoin futures order books right now. They probably each have fees of a couple basis points and a spread of a basis point, or, you know, some fraction of a basis point or something like that. And, you know, given sort of like the funding rates and of the premiums of futures and things like that, and the time and cost to do one of these arbs, they can absolutely be a few bips, you know, out of line with each other.

And so in theory, you can sort of do out the math, let's say that, you know, you made one basis point on each side, which would be a lot and, and would be like, you know, an impressive amount to make on this sort of volume on 50% of volume in crypto, taking the extreme of like you are the arbitrageur, you were the HFT firm, then, you know, how much is that a day? Well, a bip on, you know, $50 billion of volume is $5 million of profit a day, which is, you know, what? A billion and a half a year. And so that gets some sense for, and, and again, obviously I'm sort of like cutting a lot of corners. Like, I don't wanna sort imply that that's like, you know, that is the amount that could be made, but whatever, maybe that gives some sense for like what the available scale here is of arbitrage profit in the space. And it is like substantial. And so that's part of what they're doing. You know, what other things are there? Well, farming is actually probably, I hesitate to say that it's been the biggest source revenue, but it might be. Like, I wouldn't be shocked if you added up all the sophisticated firms together and said like over the last couple years, have they made more from farming or trading? The answer might be farming.

Matt: (21:17)
Can you give me an intuitive understanding of farming? I mean, like to me, farming is like you sell some structured puts and collect premium, but perhaps there's a more sophisticated understanding than that.

SBF: (21:28)
Let me give you sort of like a really toy model of it, which I actually think has a surprising amount of legitimacy for what farming could mean. You know, where do you start? You start with a company that builds a box and in practice this box, they probably dress it up to look like a life-changing, you know, world-altering protocol that's gonna replace all the big banks in 38 days or whatever. Maybe for now actually ignore what it does or pretend it does literally nothing. It's just a box. So what this protocol is, it's called ‘Protocol X,’ it's a box, and you take a token. You can take Ethereum, you can put it in the box and you take it out of the box. Alright so, you put it into the box and you get like, you know, an IOU for having put it in the box and then you can redeem that IOU back out for the token.

So far what we've described is the world's dumbest ETF or ADR or something like that. It doesn't do anything but let you put things in it if you so choose. And then this protocol issues a token, we'll call it whatever, ‘X token.’ And X token promises that anything cool that happens because of this box is going to ultimately be usable by, you know, governance vote of holders of the X tokens. They can vote on what to do with any proceeds or other cool things that happen from this box. And of course, so far, we haven't exactly given a compelling reason for why there ever would be any proceeds from this box, but I don't know, you know, maybe there will be, so that's sort of where you start.

And then you say, alright, well, you’ve got this box and you’ve got X token and the box protocol declares, or maybe votes by on-chain governance, or, you know, something like that, that what they're gonna do is they are going to take half of all the X tokens that were re-minted. Maybe two thirds will, two thirds will offer X tokens, and they're going to give them away for free to whoever uses the box. So anyone who goes, takes some money, puts in the box, each day they're gonna airdrop, you know, 1% of the X token pro rata amongst everyone who's put money in the box. That's for now, what X token does, it gets given away to the box people. And now what happens? Well, X token has some market cap, right? It's probably not zero. Let say it's, you know, a $20 million market...

Matt: (23:56)
Wait, wait, wait, from like first principles, it should be zero, but okay.

SBF: (23:59)
Uh, sure. Okay. Completely reasonable comments.

Matt: (24:04)
I mean, that's not quite true, but, like, when you describe it in this totally cynical way, it sounds like it should be zero, but go on.

SBF: (24:10)
Describe it this way, you might think, for instance, that in like five minutes with an internet connection, you could create such a box and such a token, and that it should reflect like, you know, it should be worth like $180 or something market cap for like that, you know, that effort that you put into it. In the world that we're in, if you do this, everyone's gonna be like, ‘Ooh, box token. Maybe it's cool. If you buy in box token,’ you know, that's gonna appear on Twitter and it’ll have a $20 million market cap. And of course, one thing that you could do is you could like make the float very low and whatever, you know, maybe there haven't been $20 million dollars that have flowed into it yet. Maybe that's sort of like, is it, you know, mark to market fully diluted valuation or something, but I acknowledge that it's not totally clear that this thing should have market cap, but empirically I claim it would have market cap.

Matt: (24:57)
I agree.

Joe: (24:59)
It shouldn't have any market cap in theory, but it practice, they always do. Okay.

SBF: (25:03)
That's right. So, and obviously already we're sort of hiding some of the magic impact, right? Like some of the magic is in like, how do you get that market cap to start with, but, you know, whatever we're gonna move on from that for a second. So, you know, X tokens [are] being given out each day, all these like sophisticated firms are like, huh, that's interesting. Like if the total amount of money in the box is a hundred million dollars, then it's going to yield $16 million this year in X tokens being given out for it. That's a 16% return. That's pretty good. We'll put a little bit more in, right? And maybe that happens until there are $200 million dollars in the box. So, you know, sophisticated traders and/or people on Crypto Twitter, or other sort of similar parties, go and put $200 million in the box collectively and they start getting these X tokens for it.

And now all of a sudden everyone's like, wow, people just decide to put $200 million in the box. This is a pretty cool box, right? Like this is a valuable box as demonstrated by all the money that people have apparently decided should be in the box. And who are we to say that they're wrong about that? Like, you know, this is, I mean boxes can be great. Look, I love boxes as much as the next guy. And so what happens now? All of a sudden people are kind of recalibrating like, well, $20 million, that's it? Like that market cap for this box? And it's been like 48 hours and it already is $200 million, including from like sophisticated players in it. They're like, come on, that's too low. And they look at these ratios, TVL, total value locked in the box, you know, as a ratio to market cap of the box’s token.

SBF: (26:43)
And they’re like ‘10X’ that's insane. 1X is the norm.’ And so then, you know, X token price goes way up. And now it's $130 million market cap token because of, you know, the bullishness of people's usage of the box. And now all of a sudden of course, the smart money's like, oh, wow, this thing's now yielding like 60% a year in X tokens. Of course I'll take my 60% yield, right? So they go and pour another $300 million in the box and you get a psych and then it goes to infinity. And then everyone makes money.

Matt: (27:13)
I think of myself as like a fairly cynical person. And that was so much more cynical than how I would've described farming. You're just like, well, I'm in the Ponzi business and it's pretty good.

Joe: (27:27)
At no point did any of this require any sort of like economic case, it’s just like other people put money in the box. And so I'm going to too, and then it's more valuable. So they're gonna put more money in, and at no point in the cycle, did it seem to like, describe any sort of like economic purpose?

SBF: (27:42)
So on the one hand, I think that’s a pretty reasonable response, but let me play around with this a little bit. Because that's one framing of this. And I think there's like a sort of depressing amount of validity…

Matt: (27:53)
Can you comment on like the sustainability of that? Because, you know, on the one hand you're like, well, a trillion dollars of institutional money is going to come into Bitcoin. And on the other hand you're like basically there are a lot of Ponzis that have done really well.

SBF: (28:06)
Right. So let me, okay, cool. I'll stay on the cynical route, think about like cynically, what could happen here? Well, okay. So you've got this boxes and it’s kind of dumb, but like what's the end game, right? This box is worth zero obviously. And like that, you know, you can't like keep this smart cap or something. But on the other hand, if everyone kind of now thinks that this box token is worth about a billion dollar market cap, that's what people are pricing it at and sort of has that market cap. Everyone's gonna mark to market. In fact, you can even finance this, right? You put X token in a borrow lending protocol and borrow dollars with it. If you think it's worth like less than two thirds of that, you could even just like put some in there, take the dollars out. Never, you know, give the dollars back. You just get liquidated eventually. And it is sort of like real monetizable stuff in some senses. And you know, at some point if the world never decides that we are wrong about this in like a coordinated way, right? Like you're kind of the guy calling and saying, no, this thing's actually worthless, but in what sense are you right?

Tracy: (29:15)
Can I just ask on this point, I mean, so are you saying that the value has to derive from everyone agreeing that it's worth something? And I know like on the one hand, that seems like a simple point about crypto, but on the other hand, throughout crypto's history, there have been these different arguments about how it actually gets value, you know, use cases for the underlying technology — for blockchain. Everyone's gonna start migrating stuff on blockchain, and then you're gonna have a real economic use attached to these assets. And that's where the value's gonna come from. But are you saying that it depends more on everyone just agreeing that these are worth something?

SBF: (29:53)
So really what I'd say is that it could come in theory from either. You can sort of get a market cap either because of cash flow and then Warren Buffett's like f*ck this. Like, I'm going to buy this if it's at too cheap of a price, because I'll just buy it and own it and get cashflow from it. And that's great. Or you could see something get market cap in the way that, I don't know, Doge coin or SHIB coin have, where people are just kinda like ‘ha ha’ and then they buy it. And if you're like, that's dumb, it has no cashflow flow. I'm gonna short sell it. You lose all your money. And, you know, those like, at least like over the last few years, those have both been ways that assets have gotten market cap. And I sort of like think that this starts to hint at like, at least some interesting angles on this, because it's not just cryptocurrencies that have had this dynamic, right? How about like, you know, AMC or Hertz or GameStop or meme stocks in general have like a very similar pattern to this and the sort of concept of maybe people will pay something for it even though it doesn't seem traditionally valuable, is not a crypto specific concept. Although it certainly has become like…

And you're trying to think like what crypto thing can I definitely do. What will my compliance department just sort of stammer if they try to object to like, what do they just not have a case on? The answer is well, CFTC-listed, cash-settled products where I never, ever, ever have to have the physical. Where I never have to actually have on me, any cryptocurrencies. And why is that important that you never have to have any cryptocurrencies on you? Well, it's because if you need to actually hold a cryptocurrency, you start thinking about things like Basel capital requirements, right? And other sort of fun notions like that. And it becomes a sh*t show really fast.

But if you do nothing but cash settled derivatives, you never have to touch physical. You don't have to figure out the security of it. You don't have to figure out the capital requirements. You don't have to figure out the regulation of doing that. And like CFTC structured products, which are cash settled, I mean, there's the exchange side that you can trade, but also there's a well-developed regulatory framework for OTC cash-settled derivatives contracts for institutional counterparties, starting with other institutional counterparties using Isdas. That sort of like is another well understood, really clean operational concept to do. And so it’s lamp posting as much as anything else, right? It's saying like, what is the one thing regulatorily that we feel comfortable doing in this space? Let's go do that.

Joe: (31:12)
No, I mean, with AMC and GameStop though, it’s like usually  the perception -- and I'm not judging -- but the perception is that it's sort of like a perversion of what the whole point of like the stock market is as opposed to like, this is gonna be the basis of this new asset class.

Matt: (31:31)
Yeah, I've written that sort of thing before. Like, I would've sort of drawn the causality the other way. Like I would have said that, you know, the rise of Bitcoin allowed for things like GameStop and AMC. But I also think that like, there's a difference between something like Bitcoin where people are like, well, this thing is a store of value and enough people accept that, that it becomes a store of value. And the box that you're describing where like, no one has an emotional attachment to the box -- in your description, and I think also empirically, like what they have is an APY number, right. What they have is they're like, ‘oh, this box is paying us a lot of money, so we're gonna stay in it.’ Right.? So with Bitcoin, you know, you can sort of say there's a sustainable value because of like, just sort of broad social acceptance. But I feel like with a lot of this farming stuff, like it is ‘Box X.’ Like no one knows the name from day to day. It's just like, this is the box that is yielding the most today. So I'm gonna put money in. And I'm sort of curious about the sustainability of that.

SBF: (32:30)
Yeah. So certainly some of them are unsustainable and some of them are, you know, many of them by number and exactly the way you'd think that they would. Right? Like the way these end is that eventually people decide that this is no longer today's cool box. This is yesterday's lame box and they go down a lot in price and then people sort of move on to box number two. And if everyone did a careful accounting of where they ended up, I don't know, you know, would they have made money? Would they not have? It's a little unclear, like some people would've, some people wouldn't have, it's sort of messy. And that's like, certainly how some of these quickly end up, but it's not how all of them do. And in particular, let's maybe revisit one of the earliest assumptions about this, right? The point where I said, this is a box that does nothing but be a box.

And that, like, I was being a little facetious, although I do think it's like an important way to understand part of what's going on, but it's not really the case that the biggest of these claim to be a box that is nothing but a box. They claim to be a bit more than that. And, you know, you can query how much you believe the story that their value at its heart is coming from them being more than just a box, but people certainly perceive them to be more than that. And, you know, examples of this, right? Well, let's say, you know, what are some of the most popular staking programs they're like, you know, historically Uniswap, Aave, Compound. These are the various boxes that have an actual product tied to them, that has like a narrative about why it might become the world's next big thing.

You know, maybe it's gonna be like the preeminent DEX, you know, maybe it's gonna be the preeminent borrow lending protocol on chain and this like, you know, weird box staking thing starts out as just this sort of like side show to the bigger story of we're gonna change the world with the protocol that we just built. Now, sometimes that sideshow becomes the main show itself. Because sometimes, you know, in the end, what really happens is that like the box plus yield nature of it becomes more popular than the original use case of it. But it makes it at least seem a bit less dumb and a bit less circular and a bit more like, you know, there's something real that many of these are drawing on and a real hope that it's gonna become itself a valuable protocol.

Joe: (34:57)
So obviously, okay. Maybe DeFi and crypto will become very important, but I'm still just sort of like curious, you know, just the sort of pure making money side of this. You estimated that sort of the arbitrage market for Bitcoin, maybe there's potentially one and a half billion dollars in profits out there for the taking, like how big is the farming industry? When you talk about like, besides trading, this is the other big way, how big is the putting money in a box industry getting, and I'm also curious, like, you know, one of the things that people in this space talk about is you can -- thanks to FTX specifically -- and thanks to the perpetual futures that it lists for so many coins, I could buy the coin, farm it, short the future on FTX, so that I don't even have to take a directional position on the coin itself and just sort of milk the farming yield. So can you just describe, like how big is this sort of like ecosystem and how sophisticated are the trades getting beyond just sort of like the naive or simple crude ‘put money in the box’ trade?

SBF: (36:00)
Well, let's do some rough ballparking. There's something [like] $200 billion of ‘TVL’ total value locked on chain. And now a lot of that is basically irrelevantly locked on chain and you can sort of ignore maybe a hundred, billion is sort of like the real number or something a little bit less than that. Yields are certainly down a fair bit. But I think we're looking at like, you know, mid to high single digit percents on average or something like that. And so, I don't know, you know, mid- to high-single digit billions of dollars a year of profit that are being made by farmers actually doesn't sound insane to me as a ballpark of this, which, that's a big number to the extent that this is real profit. It's, you know, we might be talking $5 billion a year that sort of like traders are making from farming.

So yeah, the numbers are not tiny. And they're plausibly bigger, probably bigger in aggregate than trading returns in crypto, I don't wanna like a hundred percent swear by that comparison, but I think it might be right. It is not out of line with like my sort of instincts and priors and, and bits and pieces of knowledge I have here. So it's a lot. One thing I think which is worth noting here, one parallel is, well, okay, let's say that you have a company, right. And this company delivers food. Right? What it does is it goes to restaurants and picks up food and takes it to houses and puts the food there. And  there's a few of these, right? What would be like how you would think this company would do during a pandemic? You  would think spectacular. Right? In fact, the pandemic was very trying period for some food delivery companies, because their unit economics were negative. Like they were running at a loss and it had been for years and the pandemic meant more business, which meant more loss for them.

So paradoxically, it was negative. And how did that happen? Well, what's the actual whole flow of funds there? If you take a step back, well, the company, why are they running at a loss? Well, VCs keep funding them, right? People keep putting money into the company here. And the company then has ‘stock price goes up’ because this metric business revenue, a metric that isn’t actually profit goes up and, you know, as long as sort of like that keeps happening, right. People keep putting more and more money into the box and the associated security, in this case, because it is tied to the sort of ultimate profit or something like that of this company, goes up and up and you know, it keeps spending more money than it's making on things that are causing it to make that money in the first place -- like negative unit economics or, or just tons of advertising or something like that.

And then it gets more and more business and because it gets more business, people are like ‘that's great, losing even more, more bigger numbers. Let's put more money in.’ The goal here being, collect all the money in your box. So you look a lot bigger than your competitors and they sort of give up and you win. And then in the end you get all the real business and basically it's just all an advertising budget, right? As much as anything else, this is all a way for like, you know, your box to get more notoriety and ultimately end up getting real business six years later because of that. That seems like standard operating procedure, frankly, for startups right now. And it's very similar to what we're talking about in some ways with these.

Tracy: (39:44)
Can I ask, I mean, what we're talking about here is basically circularity and the circularity of DeFi. And there's one other aspect of it that I've been thinking a lot about lately. And I'm trying to think how to phrase this, but it's pretty clear in crypto that you want to avoid dealing with fiat currencies as much as possible. So onboarding is tough or there are tax reasons to avoid doing that or whatever. So the way everyone gets around that is through stable coins, but stable coins are basically just trying to replicate the dollar for the most part. Right? So you're not really getting away from fiat. You're just replicating it in a way that fits into the crypto ecosystem. Is that a problem for crypto or like at some point conceptually should stable coins go away? I guess the question is like, what is the point of crypto if everything is eventually underpinned by the dollar anyway.

SBF: (40:39)
There is an interesting question of like what happens to the price of Bitcoin and other digital assets in the face of stable coins, if they obviate the need to have an actual asset that is not tied to the dollar in the first place, right. If  just like dollarization takes over so to speak, like I think that's sort of an interesting question. I think when you look at well, is it bad to have a dollar-like asset in the system? I think, no, I think it's super powerful. And I think what I'd say is like I'll try and send a hundred thousand dollars to the guy sitting next to me or the woman sitting next to me and, and you know, you'll try a hundred thousand dollars, to the person sitting next to you and we’ll have a race and I'm gonna use USDC and you're gonna use USD, and I have a guess as to who's gonna win that race. I have a guess as to whose money is gonna get there first. And if we wanna do some, you know, race to someone who's sitting in Nigeria, boy, do I have a strong guess about, you know, whose money's gonna get there first and who's gonna have spent more doing it. And so I think that to some extent, a way you can see this…

Matt: (41:44)
Wait, can you unpack that a little? Like when you get the USDC to the guy in Nigeria and then he wants to buy a sandwich with it, what happens

SBF: (41:52)
Right. So right now there's a sense in which it doesn't accomplish all that much. If the next thing he has to do is figure out how to cash out USDC for a USD wire transfer anyway. Right. And then like, by the time he’s bought the sandwich, you know, your crypto transfer did nothing because it all bottomed out in the same place anyway. That being said, I think there's like two reasons that I don't fully buy that response. One of which is, you know, eventually you could imagine a world where the sandwich guy accepts USDC, right? And once a sandwich guy accepts it, then he actually never needs to go into fiat directly. He can just stay in cryptoland the whole time. And I think that it is in some ways actually just more efficient.

So that that's one answer to your question. But another answer to your question is, you know, there are services – FTX is one of them -- that can convert easily between dollars and fiat currencies and can act as, you know, point of sale converters there so that people could go to a sandwich store and pay with crypto but the sandwich store receives, you know, local, fiat currency. And there still does have to be a conversion involved. But now what we're saying is that like one, a few companies have to figure out how to do that conversion in large bulk size, you know, netting it all out, somewhat efficiently, which is a lot easier than if you are trying to live in a world where like [a] person had to figure out how to do this in order to send money to like their aunt back home. And you could still end up in a world where like, for almost everyone, this system is extremely easy. And like, there are a few points that deal with the converting back and forth, but like removes 80, 90% of, you know, difficult parts that would've needed to happen.

Joe: (43:42)
What's your take on the rise of either algorithmic or partially algorithmic partially backed stable coins. One of the most interesting phenomenon happening right now is the rise of Luna and UST and Luna has this Treasury Reserve consisting of a lot of Bitcoin, which seems a little dicey, but some people say any idea of like an algorithmically-backed stable coin is a perpetual motion machine. It's only a matter of time before it fails. Do you believe there can be like a truly sort of like decentralized stable coin? What do you make of these projects?

SBF: (44:17)
I think they're really cool. I do have some sympathy to the perpetual motion machine crowd here. They can serve some useful purposes, but if you do zoom out, right, and you say, this is a stable coin, backed by volatile assets, what's gonna happen in a big market move. Right? Like, you know how this plays out.

Joe: (44:34)
It certainly seems like it's only asking for trouble eventually, but a lot of people talk about it.

SBF: (44:38)
I think that's right. Now, again, you could say like, look, we want this on chain algorithmic coin for these reasons. And like the goal isn't for someone to sit there and hold it for five years, the goal is for it to be used brief for like transactions on chain and get created and redeemed on chain really frequently. And I think answers like that can make sense. I think there's also versions of ‘algorithmic stablecoins’ that do have risk in them, but that also have massively enhanced yield because they're taking that risk on in order to do a trade that makes money effectively, right? They're almost like money market funds in some sense, you know, that class of them. And that can make sense as well from sort of like an economic perspective. But I am skeptical of, you know, thinking that like a typical person is going to want to, for long periods of time hold a typical algorithmic stable coin that isn't paying interest because it's just like, you know, someone said, Hey, great. It's new things, kinda like a bank, put your money on it. But every four years it might go to zero. And that's the difference. It's not super compelling.

Matt: (45:44)
So we've covered straightforward HFT arbitrage type stuff, covered yield farming. If you asked how people are making money inequities, right. Like one of those things is true anyway, but then like a lot of it is options and structured products and kind of packaging stuff in weird ways. Where are we in that part of the ecosystem and crypto? I know there's things where like, people are doing like kind of DeFi structured products where like you can kind of put your money in a pot and sell options. How should I think about that as being part of the ecosystem?

SBF: (46:13)
Yeah, it's a good question. And I think the answer here is actually a little bit weird and surprising given everything else that's going on, which is, eh, not that much.

Matt: (46:25)
It's not that surprising when you like listen to the description of yield farming, but okay.

SBF: (46:30)
Right. I agree, I think thinking about it mechanically does clarify a little bit why options haven't taken off, but they really haven't. Volume in options is very small compared to volume in futures. You know, you look at most of these DeFi primitives that have taken off, most of them are way simpler than a typical options contract would be. By and large, I do think it's the case for right now in crypto, that like sort of more complex structured products are just not that big compared to the sort of like simplest, pseudo perpetual motion machine you could envision

Matt: (47:05)
Because you read all these stories about like Goldman doing OTC options trades. I mean, is that like kind of…

SBF: (47:13)
Oh, no volume. Yeah. I don't know for sure, but I strongly suspect that where that's coming from, you know, I don't think that that's coming from Goldman sitting there and saying, we're gonna go like do OTC options in crypto because that's where all the money is. Like, everyone's just printing money, doing OTC options in crypto. Why aren't they doing OTC options in crypto? What's the actual reason that that's a thing they're doing and advertising.

Matt: (47:39)
Can I guess?

SBF: (47:40)
Yeah, go for it.

Matt: (47:41)
My guess is that someone at Goldman was like, let's put money into a box that's a Ponzi scheme. And some one else at Goldman was like, we are absolutely not going to put money in a box that’s a Ponzi scheme. And then someone at Goldman was like, what's our comparative advantage? Well, we have business with a bunch of hedge funds? We can price an option. Let's try to like, you know, rub some sticks together and drum up an OTC options business because then we'll have, you know, have customers for that. Whereas like the actual money making place is a little too insane for our kind of regulated, somewhat risk averse situation.

SBF: (48:19)
So that's absolutely a lot of it. But at the end you touched upon a key part of it, which is regulation, right? If you're a Goldman and you're trying to think like what crypto thing can I definitely do. What will my compliance department just sort of stammer if they try to object to like, what do they just not have a case on? The answer is well, CFTC-listed, cash-settled products where I never, ever, ever have to have the physical. Where I never have to actually have on me, any cryptocurrencies. And why is that important that you never have to have any cryptocurrencies on you? Well, it's because if you need to actually hold a cryptocurrency, you start thinking about things like Basel capital requirements, right? And other sort of fun notions like that. And it becomes a sh*t show really fast.

But if you do nothing but cash settled derivatives, you never have to touch physical. You don't have to figure out the security of it. You don't have to figure out the capital requirements. You don't have to figure out the regulation of doing that. And like CFTC structured products, which are cash settled, I mean, there's the exchange side that you can trade, but also there's a well-developed regulatory framework for OTC cash-settled derivatives contracts for institutional counterparties, starting with other institutional counterparties using Isdas. That sort of like is another well understood, really clean operational concept to do. And so it’s lamp posting as much as anything else, right? It's saying like, what is the one thing regulatorily that we feel comfortable doing in this space? Let's go do that.

Joe: (49:59)
On this topic of making money. The other obvious thing that's sort of like from the beginning of crypto, we talked about arbitrage and farming and all this is, obviously there's still smaller tokens all the time flying. And so I'm just curious, like what are the different approaches essentially that either institutional money or quasi-sort of like VC money is taken to essentially like find the next big thing? How do like people know?

SBF: (50:23)
I mean, at this point, I think I want to sort of zoom out a little bit. And say, well, let's even put crypto aside for a second. How do VCs find the next anything that they're gonna invest in, right? Like how do they find the next company they're gonna invest in? And I think my answer to that is like, when you break it down mechanically to what's happening, you get a bizarre process. Like you get something that does not look like the paragon of efficient markets that you might expect, where it's like, what’s mechanically happening? Well, they like see what all their friends are chattering about. And their friends keep talking about this company or this token or something, and they start FOMOing and then their LPs are like, yo, have you made us a lot of money off of this company or token yet?

And you're kinda like, the answer is no, we haven't invested in it, but you know, that's not a good answer given what question your LPs just asked. So instead you're like, oh boy, you're gonna be excited about what we have done and/or will do. And then you find a way to get into that token and/or company. And all the while you're like, how do we justify? Is this a good investment? Like all the models are made up, right? Like things are currently being valued off of 2025 Ebitda right. But it's not 2025 yet. It’s sort of like an interesting property of trying to value things off of 2025 Ebitda, right. You're valuing them off of a model built by a person who owns the thing that's being sold. So like, of course the numbers can go up between now and 2025. It's gonna go up an arbitrary amount and you can justify anything by just like, you know, back graph goes up and off and eventually like, holy sh*t, LPs boy, are you gonna be excited about the stuff that we're buying on your behalf. It's bizarre processes like that ultimately that are like shaping VC's investments in both traditional equities and in cryptocurrencies.

Joe: (52:13)
Well, there's tons more to talk about, but we're gonna have to pick it back up. Sam and Matt. Thank you both so much for coming on Odd Lots.

SBF: (52:20)
Of course.

Matt: (52:21)
As always it was fun.

Joe: (52:22)
Yeah, that was great. Thanks

Tracy: (52:23)
Thanks so much guys. That was, that was great. Yeah.

Joe: (52:44)
Tracy, I loved that. The highlight was definitely Sam's description of yield farming that even a sort of crypto cynic…

Tracy: (52:52)
As a magic box that you put money into and more money comes out?

Joe: (52:56)
And even Matt Levine was like, I would've never described it this way because I thought it would be too cynical.

Tracy: (53:01)
Yeah. I don't really know what to say about that. That was a little bit surprising. But it does, I mean, it does clear up a lot of questions that I had about DeFi. He sort of hinted at this idea of like the value either coming from actual economics and use cases versus everyone just agreeing. And I think honestly, one thing we've seen, one thing we've learned over the past 10 years is that everyone just agreeing something is valuable. Sometimes it works. Yeah. And I wouldn't necessarily say that it's gonna work for all the coins in existence, but the fact that it's been working for so long certainly has surprised many people myself included.

Joe: (53:41)
Yeah, no, that's the thing like, it's like, oh this is ridiculous. This is a perpetual motion machine. And yet here we are in 2022 and the industry’s still going.

Tracy: (53:48)
Yeah, the machine's still going.

Joe: (53:49)
Meanwhile, so the way DeFi works is you put in a money in a box that you think more people will put money into the box. And the way VC works is you hear what your friends in the industry are investing in based on 2027 numbers. And then you also wanna get on that. So it's really just FOMO all the way down.

Tracy: (54:08)
Well, so here's the other thing I would say. And Matt kind of touched on this too, but the idea of momentum trading is not, you know, that is not entirely unknown in finance. In fact it has been a very profitable strategy arguably since 2008 and the finance crisis. So I don't know how to feel about it. I feel weird

Joe: (54:31)
We all feel weird.

You can follow Sam Bankman-Fried on Twitter at @SBF_FTX and Matt Levine at @matt_levine.