🎙 "The Bull Market is Intact for the Next 10 to 20 Years; We are in a Secular Shift:" Arca's Jeff Dorman

In this week’s episode, I interview Jeff Dorman, chief investment officer at Arca, an investment management firm focusing on digital assets. Jeff has been valuing assets for the past 20 years, from investment-grade bonds, to high-yield debt and equities, a...

We talk about the recent selloff; he thinks the big crash is over but that doesn’t mean we’ve seen the market bottom. Still, Jeff says this is a buying opportunity and he gives insights into which sectors will outperform and underperform.

We also talk about valuing cryptocurrencies and blockchain protocols. Jeff says some DeFi companies have fundamentals and multiples that are hard to come by in traditional finance. As an example he names SushiSwap, which is generating 1 billion in revenue and paying dividends.

Jeff says he can apply tried and true methodologies from debt and equity, but he’s most excited about finding new valuing techniques as crypto has its own characteristics, for example, the fact that a token can combine utility with financial ownership. To him, learning to analyze a space like DeFi before most have even heard of it where the real alpha come from.

Jeff’s clients are hedge funds and traditional investors, and he says they’re getting increasingly interested in decentralized finance —they find DeFi protocols are a lot easier to grasp than cryptocurrencies because they're more similar to tangible companies. He says asset managers will probably very soon start getting involved in yield farming and staking.

Jeff believes we’re heading to a 10 to 20-year secular bull market in crypto, where there will be a decoupling of sectors and where DeFi continues to grow.

The podcast was led by Camila Russo, and edited by Alp Gasimov. Transcript was edited by Owen Fernau and Dan Kahan.

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Camila Russo: Jeff is the Chief Investment Officer at Arca, an investment firm focusing on digital assets. And while his focus is in crypto now, he was formerly a TradFi guy with jobs at Lehman, Merrill, and Citadel. So really interesting, well-rounded perspective on the market. He has obviously been following the recent gyrations very closely. So first off, I usually start by asking my guests to give us their background and their story on how they got into crypto. But this time, I'll just start with the question that's on everyone's mind, which is, is this sell-off over? What do you think?

Jeff Dorman: Good question. Is this the bottom of prices? I have no idea. Is the sell-off over? I think yes. And what I mean by that is, you've mentioned my background a minute ago, I have a background in distressed and special situation investing. And generally, when you get into crisis-type modes and crisis-type trading, in the traditional world, it often lasts 18 months to two years.

You go back to 2008, for example, the first hiccup at Bear Stearns was in June of 2007. And the financial crisis really didn't end until about April of 2009. So it was a long, painful road down. What we find in digital assets is, a lot of times, this happens in two to three weeks, then it's over and we go right back up. Sometimes it can be longer, like 2018. But for the most part, these are usually quick.

“I think it's over in terms of the reasons and the flushing and everything that caused the selloff. But I don't know if the prices are at the bottom yet, and neither does anybody, and you shouldn't worry about that. You should just buy the things you're comfortable with.”

In terms of trying to find a price bottom, that’s really, really hard. But what you do as an investor is, you just find the assets that you believe in, the ones that you really, truly have a view for why they're going to be higher in 6 to 24 months, and you don't really worry too much about the price that you're buying it. So if you're buying at three different price points along the way down, so be it. Each time you buy in a downward environment like this you're going to feel like it's a terrible investment, but in six months from now, they're all going to be good. And that's the mindset you have to go into this.

I told a story on Twitter the other day. I personally sold Carl Icahn, one of the largest distressed investors ever. Back in 2009, he was buying MGM casino bonds, and his first purchase was at $0.80 in the dollar. And he bought at $0.80, $0.70, $0.60, $0.50, $0.40, $0.30 in the dollar, all in the same week. Those bonds ultimately matured at par. So he made a lot of money. But his first and subsequent purchases were all terrible. It takes a special kind of conviction to buy that way on the way down.

So I think it's over in terms of the reasons and the flushing and everything that caused the selloff. But I don't know if the prices are at the bottom yet, and neither does anybody, and you shouldn't worry about that. You should just buy the things you're comfortable with.

CR: So if you think the selloff is over, but prices aren't at the bottom, that means that we could have a few weeks of a rebound, but then another crash?

JD: Well, when I say the selloff is over, what I mean is the crashes. The crash was facilitated for a variety of reasons. And I think that is over. But in terms of prices going up and down, some people conflate that when the selling is done, it doesn't mean buyers are necessarily back. So I think they forced selling from the liquidations. We had $10 billion of liquidations last Wednesday. That is over. Most of the leverage has been flushed out.

The rationale that has been piling on from Elon Musk and Tesla deciding that Bitcoin is all of a sudden bad, to the news out of China late Friday night, local time in China, I think a lot of this news is now in front of us, and anyone who has been a force seller who has been thinking about selling, for the most part, has sold. The question now is, when do the buyers come back?

And what happens if you're a market maker, whether you're a human market maker or an algorithmic bot driven market maker, it's all the same thing, which is, at some point, you have to find where that market equilibrium is. Even though the selling might be done, maybe you have a little inventory that you got hit on and you're just continuing to take the market down until you find buyers. Or maybe you're a short seller, and you're just going to keep shorting on the way down until somebody stands in your way, and as soon as somebody stands in your way and starts buying, then you turn around and cover all your shorts.

“I think a lot of this news is now in front of us, and anyone who has been a force seller who has been thinking about selling, for the most part, has sold. The question now is, when do the buyers come back?”

So I think we're in the eye of the storm right now, where the selling pressure is done. But it might take days, it might take weeks, it might take hours or months for the real cavalry to arrive and start putting significant capital to work.Don't forget only two or three weeks ago, we heard a headline that A16 raised $2 billion. Who knows when that money is closing, and when that money is coming to work? Or there are significant hedge funds that have been raising money and getting institutional capital every month for the last nine months. That money is going to get put to work. It's just a matter of when.

I don't think institutional buying is done. I think it's just a matter of when it happens. And in the meantime, prices can be very choppy while markets try to find that equilibrium. So again, that's why I would say selling pressure, absolutely done; prices, hard to know. It could oscillate for a while.

TradFi to Crypto

CR: Perfect. Super interesting take. So now, I will go to my initial question of your story. Love to hear your background in all these great TradFi institutions and what got you from there to crypto?

JD: Sure. So I started my career about 20 years ago as an investment banker at Lehman Brothers. Back 20 years ago, getting a job in investment banking was actually like a cool and hard thing to do. Now, obviously, most people would prefer to go into software development or go to Apple or Google than to go to a JP Morgan or Goldman Sachs.

But back then, that was a prestigious job if you were interested in finance and economics. I started as an investment banker, then moved into capital markets where I was helping to underwrite debt and equity issuances. And then I went into bond trading where I traded investment grade bonds down to high yield and distressed. That was the first 10 years of my career at Lehman and Merrill. Then I went to the buy side after the financial crisis, and I worked for Citadel and a couple other smaller hedge funds as well.

So the first 15 years of my career was always value investing, fundamentals, CFA, studying, reading Graham and Dodd valuations, all the boring financial stuff. But it really gave me a pretty good, solid background understanding what drives value.

Ironically, the reason I left the hedge fund industry in 2013 was because all of those skills that I had worked on no longer mattered once the money printing started in 2008 and 2009. I found that understanding balance sheets and income statements and how capital markets work really doesn't matter anymore, because all people cared about was what the Fed was saying. And it became pretty uninteresting to me.

At that time, I went into FinTech with a friend of mine who started a company called Harvest Exchange. He wanted me to help work on it. It was catering to financial services, but it was basically a software company. And it was then that I started working with developers for the first time. They were all using GitHub and open source code. They were all raving about the sharing economy. A lot of them were mining for Bitcoin and Litecoin and Ethereum at the time.

“But it was really understanding when I learned about Ethereum, and I learned about smart contracts, and I saw how much more potential there was for digital assets to really replace a lot of legacy systems that just never really made sense in the first place.”

And I started personally investing in Bitcoin because it made sense to me from a macro standpoint, this idea that you can't just print money forever. At some point, inflation really does happen. But more importantly, I was doing that while working with developers who understood it for completely different reasons.

And like most people, my trek into Bitcoin was I heard about it in 2013, I laughed at it, I dismissed it, I thought it was stupid. 2015, I took it a little more seriously, started reading more. 2016, I made my first purchase. And then two years later was when I first actually heard about all these other things that were happening outside of Bitcoin, and that's what really got me interested in this professionally rather than just as a toy investment. Bitcoin was great. Bitcoin was an on-ramp. Bitcoin was exciting, to learn about blockchain and how to actually transact. And I still think Bitcoin is a great investment as a part of your portfolio, not as the entire digital asset portfolio.

But it was really understanding when I learned about Ethereum, and I learned about smart contracts, and I saw how much more potential there was for digital assets to really replace a lot of legacy systems that just never really made sense in the first place. That's when we started Arca. I think we officially founded in early 2018, and that's when we officially formed Arca to help other investors understand what we knew, which is that you don't necessarily have to be a software developer to understand the digital asset ecosystem. You could also take a financial approach to this asset class and understand revenues and cash flows and how markets work and how prices trade based on events and catalysts and fundamentals.

There really weren't very many people attacking it from that way at the time. There were a lot of VCs who were predicting the future 10 years out, and there were a lot of ALGO and quantum traders that were trading volatility. There really weren't a lot of people who were saying hey, what we did in the debt and equity markets, looking at fundamentals, can it be applied to this asset class as well?

Two Sides of Arca

CR: So a bit more on what Arca does: you structure active funds for institutions? Can you talk about what funds you're providing, like who your clients are?

JD: Yeah, from a structural standpoint, we are designed to look like a boring asset manager. And that's by design. You know, we are catering to institutional investors who require a certain level of fiduciary and regulatory and compliance knowledge that we all have from our TradFi days. But inside, the different types of funds that we're offering are designed to offer different exposure to different pockets of this ecosystem.

So we have two sides of Arca. We have the Arca of funds businesses, which is what I run as the Chief Investment Officer. And here we have different hedge funds and private vehicles, where we're investing in the ecosystem that already exists. Our core flagship fund is a digital assets hedge fund, which is a long-biased, fundamentally-driven, catalyst-driven investing vehicle. We also have the Bitcoin passive vehicle for those who just want to own Bitcoin and nothing else. And we have a couple other niche strategies that are yet to be announced that we've been running with internal capital, things that have more to do with the NFT ecosystem, and generating yields within DeF,i and in other areas as well. So we'll be rolling out other funds on that side.

And then the other side of our business is Arca Labs. This is where we are using blockchain as a wrapper, or as an infrastructure, to create traditional products. So the best analogy there would be, the ETF is just a structure, but what you put in the ETF is what matters. You can put healthcare stocks in there. You can put bonds in there. You can put gold in there. We did the same thing using blockchain, we created a structure called Blockchain Transferred Funds, or BTFs, intentionally designed to sound like ETFs, where it is the same type of a structure. It's a 1940x regulated product, but you can put anything inside of it.

The first one we created was ArCoin, where you put government bonds inside the trust. And the ArCoin token, which is an ERC token, is how you actually transfer and trade the vehicle. But over time, we'll have new additions to this BTF structure as well.

“The ETF is just a structure, but what you put in the ETF is what matters. You can put healthcare stocks in there. You can put bonds in there. You can put gold in there. We did the same thing using blockchain, we created a structure called Blockchain Transferred Funds, or BTFs.”

CR: Interesting. I wasn't aware of these tokenized funds. Are they traded on decentralized exchanges? Or do you have to be an accredited investor to buy that?

JD: You don't have to be an accredited investor to buy the BTF structures. But these are registered securities. So this is the same problem as those who still use the tZERO term security tokens. The infrastructure is not nearly as well built out for that as it is for the traditional tokens that are in more of a regulatory gray area. So like others in the space, from tZERO to TokenSoft and others, we're continuing to work on the infrastructure and build out a more robust security token landscape. Right now, most of it is trading peer-to-peer or directly through our website. But over time, we are working with partnerships and other areas to ultimately give investors more access to these products.

Lasting Impact

CR: Okay, cool. And then I really want to hear your take on the drivers of this sell off. Like you mentioned, you look at the market from a fundamentals perspective. So did the things that were driving the different price action make a lasting impact in crypto?

JD: Yeah. So the obvious part of this is that this was a correction like every other. You know, as deep and as painful as it was, I'm certainly not making light of those who've lost a lot of money in the last two weeks, but this is obviously not the first time that we've seen corrections in this market. So I think the difference was maybe the speed of it, how we went from euphoria to complete panic in such a short period of time.

But it wasn't just driven by the last few days, which is when prices started to go down. It's really been about two months worth where there's been some signs. So from a macro standpoint, first you have to identify what some of the factors were that drove digital assets in the first place. So I can identify four obvious ones which is why there's been such strength over the last nine months.

The first is low rates, and a weakening dollar. That's still very much intact. The 10 year Treasury is still at 1.56% as of today, the dollar is at a year-to-date lows, so there's nothing that's changed fundamentally. But in the last two months, we've seen real inflationary data that has started to scare people about whether or not the Fed is going to start tapering and whether or not they're going to start raising rates. So even though we haven't seen it in the data yet, there has definitely been a sentiment shift with regard to what long-term inflation and rates is going to look like.

Second, there was a lot of talk about institutional money coming into the space and driving the interest of the last nine months. Still very much true. The institutions don't make sweeping changes based on price, it takes time for them to get into this market. But again, you could see some signs that that was starting to slow. The GBTC being negative discount to NAV and having no inflows into Greyscale products, that's a sign of institutional slowing. Coinbase stock coming around $350 and trading down to $225, that traditionally would be bought up by traditional investors, and they weren't. Another sign. So there were some signs. I don't think anything has changed. I think institutional money is still pouring in. We see it every day in our funds. There's no doubt that there's interest. But there's definitely some signs in the last few months that was slowing.

And then third was, we joked a few months ago, and one of our write-ups, we said, how many times can Bitcoin rally on the exact same news? Because it seems like we went up 10% every time Elon Musk and Tesla said something. Well, then the reverse has to be true as well. As soon as he decides that he's no longer interested, then that's going to lead to selling.

“I personally think that this is short lived. I think it's a great buying opportunity. But these things have ripple effects. When you have really high emotional extremes, it's generally a great time to make money. So when people are overly euphoric, usually a good time to take chips off the table. And when people are unusually bearish and think the world is ending, usually a great opportunity to buy, and I think we're in the latter right now. .”

So again, there were a lot of signs before China ultimately came out and talked about Bitcoin mining and banning it. So I think there was a lot of mosaic theory involved in what caused this. But like anything, it just fed on itself. For the first part of May, especially your listeners and funds like ourselves, we were outperforming Bitcoin by a mile. Bitcoin was trading down for very Bitcoin specific reasons. But DeFi was doing great. A lot of Layer 1 competitors to Ethereum were doing great, Layer 2s like MATIC, Polygon were doing great. It was only Wednesday of last week when all of a sudden, everything just converged to one correlation and everything traded down. And a lot of that was structural, more than fundamental.

So fundamentally, everything is doing great. You do this better than anyone. The fundamentals of the DeFi and Ethereum ecosystem are stronger than ever. There's real cash flow producing entities coming out of the DEXs, and out of the lenders and out of some of the asset management protocols.

In NFTs, in gaming, there's real cash flows in sports and social tokens. The fundamentals are great, the volumes are great, there's nothing going on that would indicate a fundamental reason to be selling. But structurally, there was a lot of leverage. And when that leverage builds up, and all of a sudden you have three or four negative catalysts, that's when you get those cascading liquidations, and you saw $10 billion of liquidations in one day on Wednesday. I think a billion of that was on DeFi protocols, and 9 or 10 billion of it was on centralized exchanges. And then that creates the fear, and the fear creates more selling, and then you have another tape bomb like he got out of China, and all of a sudden a bull market turns into, you know, I'm terrified.

And again, I personally think that this is short lived. I think it's a great buying opportunity. But these things have ripple effects. When you have really high emotional extremes, it's generally a great time to make money. So when people are overly euphoric, usually a good time to take chips off the table. And when people are unusually bearish and think the world is ending, usually a great opportunity to buy, and I think we're in the latter right now. You can see it in the Fear and Greed Index. You can see it in the futures curve. You can see it in lending rates. People are scared, and those who have money and are less emotionally attached are probably going to do better than others right now.

Opportunities From Regulation

CR: Okay, definitely want to ask you about what opportunities you're seeing in this environment where everyone is fearful. But just want to backtrack a second to the China news, which effectively made everything go to one correlation and then just sell off together. How substantial was this news? Like, will this have a lasting impact?

JD: Well, the first part of that is the correlation. So I'll just answer that quickly. That wasn't the crux of your question. As an investor, correlation is sometimes great, because this is an asset class where it's very uncorrelated on the way up. There's real idiosyncratic fundamental reasons for why certain tokens do better than others on the way up. But on the way down, it all crashes together.

So from a hedging standpoint, it's actually really easy to run a fund that way, right? You can use research to invest on the way up and you can use a variety of derivatives to hedge on the way down, because it all goes to correlation one. So I think a lot of people like to overly dramatize how correlated this asset class is. It's really not. 9 times out of 10, it's only during the crashes that it becomes really correlated.

With regard to the news out of China, I think the biggest takeaway is that I think it is real. Everyone we speak to is very concerned about what's coming. It's not necessarily the news itself. The news itself was actually fairly benign. It was just basically one sentence saying that we're going to crack down on mining. But who said it, and where it came from, I think is what really had people concerned.

“So I think a lot of people like to overly dramatize how correlated this asset class is. It's really not. 9 times out of 10, it's only during the crashes that it becomes really correlated.”

So I would say, it is definitely real. I think you should take it seriously as a form of regulation coming. But from a market standpoint, again, I'll put my TradFi hat on, most investors will tell you they can deal with any negative consequence. If you tell me that my number one investment in my fund has horrible negative news, but all the news is on the table, I can react to that and I can make decisions. In the same way, every time you hear a bank saying, oh, we just took a $7 billion dollar write down, generally, the stock often trades up because that news is now out there, and you can process it and model it and you can move forward.

It's only when the overhangs are there, that you don't know what's coming, but you know something is coming, where investors can't really do much about it. Because how do you prepare for something that is in perpetuity? You know, the whole idea of US regulation with the SEC and other regulatory bodies, this whole idea of China cracking down, it's like, okay, now we know something's coming, but we don't know when.

It's kind of like if you walk outside and someone says, a tornado is coming at some point in the next two years, but you don't know when. How often are you going to walk outside? You know it's coming, you just don't know when. It's terrifying. But if someone says, hey, there's a tornado two miles away, but it'll pass in 10 minutes. Okay, I can deal with that. I can go inside and hide for 10 minutes and come back out. So it's sort of the same thing with investing here. And I think that's why these moves are so terrifying, because there's not a whole lot you can do to prepare for something that is just hanging over you forever.

CR: Yeah. So it's like, there's some clarity, you know something is coming, but still not the clarity that the market needs to just get it out of the way?

JD: Yeah, correct.

CR: So in this environment, like you mentioned before, there are opportunities to make a lot of money when people are fearful. So what are the biggest opportunities you're seeing?

JD: Sure, I'll use an analogy to start. If you go back to march of 2020, when COVID first became a serious problem on everyone's minds, and then eventually when we had global lockdowns, Peloton and Zoom stock got killed just like every other stock. It was oh my God, pandemic, economy's in trouble, everything goes down. Peloton and Zoom went down too.

“Who will undeniably and disproportionately benefit from a coordinated government regulatory attack on miners and exchanges? Everything's trading down right now, but eventually, there will be green shoots and outperformers.”

Well, Peloton and Zoom then went up about 500% each over the next nine months. Because eventually people said, you know who's going to really benefit from a lockdown? Exercising at home and using video goals. But it took some time. It took about three weeks before that was the reaction.

In the same way, that's what we're looking for right now is, who will undeniably and disproportionately benefit from a coordinated government regulatory attack on miners and exchanges? Everything's trading down right now, but eventually, there will be green shoots and outperformers.

So let's take DeFi as the first and foremost, biggest winner of what happened. There were tons of liquidations. There were all kinds of transactions, and not a single protocol went down or broke. Just about every centralized exchange had problems in the last 72 hours. You had withdrawals being delayed. You had login issues. You had concern over jurisdiction. DeFi operated perfectly. The volumes were high. The protocols work. The systems were flawless, really, from a design standpoint. I think that's a huge win.

And you're going to continue to see it, probably mostly in the DEXs. I think Uniswap and Sushiswap for sure are probably some of the biggest beneficiaries of this, because volumes are going to be high and proof of concept, and everything worked great. And when you look at price going down but revenue going up, that's generally a time when you're supposed to be a buyer. If you look at price to earnings or price to sales, that's what that's for. It tells you that the instruments are not trading at the right price relative to the underlying revenues and cash flows. So, DeFi, huge winner.

Miners and other jurisdictions that maybe use cleaner energy, or maybe have a more friendly government, I don't know specifically yet who that might be. But I think that's something that would benefit. You can see censorship resistance storage, something like an Arweave, maybe, now that you have totalitarian governments coming in. Any system that helps you protect against that with secure archiving and storage may be helpful. Even self-storage wallets. If you think again about all the issues people were having sending assets around from exchange to exchange, the idea of self-custody storage should do well.

And truthfully, even Bitcoin should be a beneficiary of this in the sense that it's completely anti-fragile. The whole point of Bitcoin is to have hard money outside of government control. Well, the China news should give you a pretty good indication that that is necessary in the future of this world. So that's what we do. First, we try to be unemotional. Second, we try to always be prepared for the worst, whether that's holding cash and not using leverage, and all the other things that we talked about in the past. But mostly, it's identifying where those green shoots are going to happen. The correlated plunges are now over. Now you have to figure out who's going to outperform on the way back up

“And truthfully, even Bitcoin should be a beneficiary of this in the sense that it's completely anti-fragile. The whole point of Bitcoin is to have hard money outside of government control. Well, the China news should give you a pretty good indication that that is necessary in the future of this world.”

Green Narratives

CR: Yeah. I totally agree on DeFi showing its strength during the selloff. We did have a story on The Defiant on that the day after the selloff, on the miners benefiting from this. Do you also think Proof of Stake chains might benefit? They have kind of been leading the rebound, like the temporary rebound last week, maybe even with Elon Musk turning all green on Bitcoin, that also kind of helps. What are your thoughts there on Proof of Stake?

JD: Yeah, I mean, from a narrative standpoint, sure. From a fundamental standpoint, hard to know. I'll give an example. The largest ESG related ETF is called ESGU. It's from Barclays, I think. Let me give you the size here. It's $20 billion, the ESG ETF. Here are some of the holdings in the ESG ETF: BlackRock, JP Morgan, UBS, Goldman, tons of oil companies. You have Visa, MasterCard, you have Johnson and Johnson, Facebook, Google, Amazon, Disney. You have Exxon Mobil. These are not exactly green companies. These are companies that are giving off a perception of being green in some way because of what they say.

So I think, again, when you think about just investing, if this ESG narrative becomes so strong that people are saying, I can't touch Proof of Work because I'll be ostracized for doing so. Therefore, I'm going to go to Proof of Stake. I think from a narrative standpoint, certainly. I think more realistically, a lot of this is just how people are spinning a story, and I'm not sure it really changes people's behavior.

So like most people, I care about the environment, and I would do my part to help in that. But a lot of this, I think, is more spin than substance. And like anything, Proof of Work requires energy. But if you believe that that energy is being used for positive reasons, then it becomes worth it. It's no different than refrigeration or anything else that we use electricity for. So we'll see. I think Proof of Stake could certainly pick up. And you've seen it, right. You've seen some of the Proof of Stake chains start to pile on this narrative of them being clean. I'm not sure how much it holds from an investing standpoint. But I definitely think from a narrative standpoint, it's worth watching.

CR: I was laughing because I remembered I wrote this exact story for Bloomberg back in 2016. And I just looked it up, “Pay Close Attention to What's in Your Ethical Fund”. And yeah, look, “You better read the fine print if backing Exxon Mobil, British American Tobacco is your idea of doing good.”

JD: Yeah. And it's relative. It's like, okay, well, if I'm producing oil, we all know that oil is not environmentally sound. But if I'm doing it slightly more energy efficient or slightly better for the environment than someone else, then I can slip it into an ESG. There's a reason the SEC is cracking down on the use of the word ESG. And it's for that reason, right? Like, this is a real issue that most people are exploiting for their own economic benefit. And I have a feeling Proof of Stake will probably fall into that as well. That doesn't mean that individual Proof of Stake investments won't be great. It just means they won't be great purely because of this ESG narrative.

DeFi Metrics

CR: Got it. I want to drill down on DeFi and how you're looking at investments in this space. From a fundamental standpoint, what kind of metrics do you look for and what trends are you seeing?

JD: Sure. So when you think about valuation, generally, it's still subjective, more than objective in the sense that even though there are ratios and metrics that we've used for 50 to 100 years on the equity side. Graham and Dodd wrote their securities handbook, I think, in 1920, with all kinds of valuation techniques, including discounted cash flows. Frank Fabozzi wrote the fixed income bible, I think, in 1950 or 1960. And it's 1,500 pages of bond math, how to value fixed income securities.

CR: And you read that?

JD: Actually, as an investment banker, it was required reading. Yeah, so I did read them. But these are valuation techniques that when they first came out, they were not very popular and nobody really believed them and over 50 to 100 years, they just became the norm. It's very similar to how we think about digital assets, which is, now we can take tried and true methodologies that came from the debt and equity world, but we can also apply new techniques that are maybe not necessarily agreed upon. And that doesn't mean they're wrong, it just means that people don't necessarily know if they're right.

“...now we can take tried and true methodologies that came from the debt and equity world, but we can also apply new techniques that are maybe not necessarily agreed upon. And that doesn't mean they're wrong, it just means that people don't necessarily know if they're right.”

So when we approach investing, the first thing we do is, again, take the things that we've already used forever that work. So DeFi protocols are great in terms of the revenue and the cash flows that come from them are really easy to understand. I mentioned Sushiswap earlier, Sushiswap right now is run rating about, I believe it's almost a billion dollars of revenue right now. And they are giving out 1/6 of that in terms of cash flow to xSUSHI stakeholders.

And the protocol after the plunge here is trading just around a billion or slightly more than a billion dollar market cap. I mean, that's as cheap as you're going to get, one times forward sales on a growth entity that is paying a dividend. You don't see a lot of that in traditional finance where you're paying a dividend, and you have massive growth, and you're trading at an insanely low multiple. So that's as cheap as you get from a fundamental standpoint.

“You don't see a lot of that in traditional finance where you're paying a dividend, and you have massive growth, and you're trading at an insanely low multiple.”

So we can look at things like that. We can use discounted cash flow analysis. We can use dividend yield models. We can look at relative value across the space. And ultimately, this looks like boring finance, when you do this, you're coming up with a comp sheet, and looking at what these entities look like. So that's the first part of it.

The second part of it is more opaque. And I'm going to borrow a phrase from my friend Jesse Proudman, who runs Strix Leviathan up in the Pacific Northwest, he came up with the term, “digital assets don't have no fundamental valuation, they just have opaque, fundamental valuation.” And what that means is they definitely have value, it's just worth something more to someone else than it might be to you. And this is that idea of utility over financial, right, the financial valuation we can do pretty easily with a spreadsheet, the utility is hard.

“...this is that idea of utility over financial, right, the financial valuation we can do pretty easily with a spreadsheet, the utility is hard.”

So for example, one of our partners here at Arca lives in Houston, he values United miles way more than Delta miles because he flies United a lot more out of Houston. If you live in Atlanta, it might be the opposite, you value Delta miles much more than United miles. But the reality is, they're both the same instrument, it's just a matter of what the valuation is to you. And we have to apply that same thing in DeFi.

So for instance, I once compared to a senior-sub relationship. In the traditional fixed income world, sometimes you have senior bonds and you have subordinated bonds. And what that means is it's your priority, if there's ever a liquidation or bankruptcy, if you're senior, you have a higher claim on the assets, than you do of your sub. So as a result, you get paid more if you take subordinated risk in terms of the yield you get than you do if you're at the top of the stack in the senior.

Well, you can apply the same thing to DeFi. If you're a passive investor, in some ways, you're like a senior bond holder, you're just taking the easy way out, you're not participating in the network, you're not taking additional risks, but you're earning some sort of price appreciation from owning the token. But if you're an active participant in DeFi, you're taking the subordinated risk, you're going for higher yields via staking or inflation or some sort of liquidity mining. But ultimately, you're taking more risk in the sense that you're putting your assets to work and there could be a hack, or there could be something where you lose those assets.

That senior-sub relationship is really fascinating. The difference is, it's the same instrument. If I own Sushi, but I'm not staking, but you own Sushi and you are, we both own the exact same thing. But it's worth more to you than it is to me because you're staking it. So as a result, you have again, this opaque fundamentals, where it's worth more to someone else than it might be to you depending on what you're doing with it.

“If I own Sushi, but I'm not staking, but you own Sushi and you are, we both own the exact same thing. But it's worth more to you than it is to me because you're staking it. So as a result, you have again, these opaque fundamentals, where it's worth more to someone else than it might be to you depending on what you're doing with it.”

So we have to start thinking through these other valuation techniques. They're not right or wrong, they're just new and untested. And I think that's why there's so much alpha to be had as an investor in the space, is that instead of reading Graham and Dodd and reading what Warren Buffett says, we get to be Graham and Dodd and Warren Buffett and come up with our own valuation techniques. And if we're right, we're going to kill it because we're seeing things differently than others are seeing.

“...that's why there's so much alpha to be had as an investor in the space, is that instead of reading Graham and Dodd and reading what Warren Buffett says, we get to be Graham and Dodd and Warren Buffett and come up with our own valuation techniques. And if we're right, we're going to kill it because we're seeing things differently than others are seeing.”

And that's why DeFi has been so incredible from an investing standpoint is, you're not guessing, it's not buying a layer one protocol and hoping that one day the entire world's economy is run on it. You're actually looking at applications that are live, that have real users, that have real cash flows, that have real metrics, but also have these interesting attributes where it's worth something different to different people. This idea of combining the utility with financial ownership has never been done before.

“This idea of combining the utility with financial ownership has never been done before.”

I often say and forgive anybody listening to this, who's ever heard me talk on another podcast, it's kind of like Amazon Prime and Amazon shares becoming one entity. If you get all the benefits from Amazon in terms of your Prime membership, your free shipping, your Whole Foods discounts, your movies, your music, but you also get the financial benefit of owning the shares in the form of the profits and the dividends, well, if that's all one instrument, and you get both, well, now you have the coolest thing ever, but at the same time, everyone's going to value it differently depending on how much they value music and movies and Whole Foods discounts.

So that's where we are from a fundamental standpoint. And it's been our guiding principle since day one of Arca. And it's the best asset class I've ever been a part of, because you have this evolving, growing digital asset ecosystem, but not growing and evolving investors, meaning most of the people coming into this space are still just focused on Bitcoin or just focused on Ethereum and they don't even know this other world exists. So I think that we have, maybe a couple more years, a three to five year window here where we get to do all this cool, exciting investing, and nobody even knows we're doing it, let alone competing with us.

“...most of the people coming into this space are still just focused on Bitcoin or just focused on Ethereum and they don't even know this other world exists. So I think that we have, maybe a couple more years, a three to five year window here where we get to do all this cool, exciting investing, and nobody even knows we're doing it, let alone competing with us.”

DeFi Protocol Revenue

CR: So interesting. I want to drill down on one thing you said, revenue. I'm wondering if it's apples to apples to talk about revenue for these DeFi protocols. Because you have things like Sushi and Uniswap generating billions in fees a day, is that right or at least many millions in fees a day? But at the same time, it's actually not the protocol itself that is getting those fees as revenue, it's distributed across liquidity providers. So I'm wondering how accurate it is to label that as actual revenue?

JD: Sure. And actually, I'll give a shout out to the guys at Token Terminal. I don't know them personally, but they do a really good job of coming up with financial metrics for some of the space. There is this idea of protocol, revenue versus cash flows, right. And it's the same again, you can go back to traditional TradFi, you have revenues, you have EBITDA, you have profits, they're all slightly different variations of the same thing, which is the growth of a business.

But revenues can effectively be good or not good. If you have a company that pays out 99% of the revenues to employees, well, you as a shareholder, are probably not doing that great by having that revenue business. But if you have a business that pays out 80% of all revenues in the form of net income to dividends, that's a great stock to have.

So it's the same thing. You look at all of these things, but ultimately, your valuation techniques are going to be based on a variety of different factors. So when we look at revenue, yeah, there is a difference between Sushiswap’s revenue and Uniswap’s is revenue in the sense that Sushiswap directly pay is 1/6 of it out to token holders who are staking, whereas Uniswap is paying nothing out. So there's a cash flow differential between Uniswap and Sushiswap. But both of them have remarkable revenue growth. Both of them are operating in completely different ways. Uniswap is trying to be more high customer, low volume and Sushiswap is trying to be more like FTX where it's less customers, but high volume per customer. They're just growing in different ways. But the growth is real.

So when you're talking about valuation techniques, yeah, you do have to caveat exactly what technique you're using. Are you looking at just the cash flows and thus the yield? Sushi pays a 7% yield, Uniswap pays a 0% yield? Or would you prefer to look at the overall growth of the revenue? Because ultimately, you can eventually turn that revenue into a yield if you want to.

It's no different than investing in Amazon or Facebook in the early days. There was no accretion to profits, but they were growing so fast that any analyst could have said, you know what, they're growing so fast, eventually they're going to have free cash flow, and that free cash flow will be used for shareholders.

“So when you're talking about valuation techniques, yeah, you do have to caveat exactly what technique you're using. Are you looking at just the cash flows and thus the yield? Sushi pays a 7% yield, Uniswap pays a 0% yield? Or would you prefer to look at the overall growth of the revenue? Because ultimately, you can eventually turn that revenue into a yield if you want to. It's no different than investing in Amazon or Facebook in the early days.”

So there's this extrapolation of where these businesses are headed. You can make an argument if you're a Uniswap token holder, I don't want them paying a dividend right now, I want them to pour every dollar they have into growing the ecosystem through incentivizing customers and incentivizing liquidity providers. That might be the right choice. Ultimately, as much as we like to talk about decentralization, there really is a management decision here and a management decision is in some ways now given up to the token holders through governance. But in other ways, it's still fairly centralized with a core group of people. But you're getting to the same financial thesis, which is, is this company growing, is their revenue, is there going to be cash flow, and can I see that in the future regardless of whether or not it's happening right now?

Institutions Get DeFi

CR: Totally. I'm really curious to hear what you're hearing from institutions about DeFi. You're having these conversations with your clients, are they becoming interested? Are they playing around? What's the current status with institutions on DeFi?

JD: Sure. So, I talk to investors constantly. As much as I'm managing the risk of the fun, really, I have an unbelievable team that really does all of the decision making and running the fund. What I do is talk to investors about what we're doing and making sure they understand. And I have my pitches for Bitcoin and for Ethereum, and for other Layer 1s, and for sports and gaming and DeFi.

And I can tell you that you can see the aha moment every time you talk to some of these people who come in from the outside world, where they all think they know Bitcoin and Ethereum, but the reality is they don't really. You could argue that most people don't really understand Bitcoin and Ethereum, myself included. But when you get down to DeFi, or you get into something like even Chiliz, the Socios app that is focused on creating sports tokens. When you get into that kind of stuff, they just get it. They understand it more, because it's a tangible real business that has a real cash flow that they understand how that can be distributed.

“But when you get down to DeFi, or you get into something like even Chiliz, the Socios app that is focused on creating sports tokens. When you get into that kind of stuff, they just get it. They understand it more, because it's a tangible real business that has a real cash flow that they understand how that can be distributed.”

And in some ways, it's because of our own biases. If you come from the traditional world, that's what you're used to seeing, so that's what you're more familiar with investing in, but they definitely understand that much more than they understand Layer 1s and protocols. It's easier. It's a real business. You can say, hey, Nexus Mutual is an insurance mutual. Are you familiar with insurance mutuals? Yes. Do you understand how they make money? Yes. They collect premiums, and they invest the capital pool? And how do they pay out expenses?

They pay claims when there's a valid claim, pretty simple business model, easy to understand. The only real difference here is that you, as the token holder, are the mutual and you get to be the ones who vote on whether or not a claim is valid, and you're the ones who put up the capital pool to ensure the products. That's a much easier leap of faith for somebody, then, hey, Ethereum is basically like an economy, and the total GDP of Ethereum is X, and therefore every application in the world is going to be run on it one day. You can say that sounds promising, but it's hard to know if Ethereum at 2,600 or 26,000, or 260 is the right price. So I think traditional investors are definitely having an easier time understanding the tangible companies, the DeFi, the sports, the gaming, the NFTs, the things that are easier to see and touch than maybe some of the more traditional protocols.

“...that sounds promising, but it's hard to know if Ethereum at 2,600 or 26,000, or 260 is the right price. So I think traditional investors are definitely having an easier time understanding the tangible companies, the DeFi, the sports, the gaming, the NFTs, the things that are easier to see and touch than maybe some of the more traditional protocols.”

TradFi Soon to Start Yield Farming

CR: That's so interesting. So what do you think will be the first step as they start dipping their toes in DeFi? Will it be to buy ETH or the governance tokens? Or will they actually start yield farming? What are the first steps they’re taking?

JD: Sure. Well, first and foremost, it comes down to, do they even know this world exists. And that's where a lot of people think they're involved in DeFi because they own Ethereum, and don't even realize that things like Nexus and Sushi and Uni, and Aave and Compound even exist. So first is the education process.

Next is the access. Are they going to invest in it themselves? Are they going to go through a fund like ourselves? Are they going to do a passive vehicle like what Bitwise has? And then you get down to that senior sub relationship we talked about. Do they want to just be a passive investor? Or do they want to actually get their hands dirty and be an active participant?

The word institutional investor, in my opinion, is thrown out incorrectly a lot of times. Grayscale, for example, always talked about 80% of their investors were institutions. But what they meant by that was they were hedge funds, right. Most people think of institutional investors as like pensions, endowments, allocators of capital, not the asset managers themselves.

So I think the allocators of capital will probably be pretty slow to be participants in the DeFi ecosystem, but the asset managers will probably be pretty quick to this. They'll start to understand how to be involved in yield farming, how to stake, how to even potentially buy insurance on Nexus mutual. These are things that people have done for years, right, it’s no different than being a big bond investor and buying CDs against your position. So these are instruments that traditional investors will understand quickly and will be willing to use once they get through the operational hurdles, which is more difficult than the investing hurdles.

“...I think the allocators of capital will probably be pretty slow to be participants in the DeFi ecosystem, but the asset managers will probably be pretty quick to this. They'll start to understand how to be involved in yield farming, how to stake, how to even potentially buy insurance on Nexus mutual.”

Distinct Crypto Asset Classes

CR: So if we're still amid an overarching bull run, do you think this is the market cycle where hedge funds, and not crypto hedge funds, but maybe tech focused or larger hedge funds become involved in DeFi? Because I think when DeFi was growing during 2018, 2019, I think it was the space, and has been the space of crypto whales and speculators already in crypto. I think there have been few actual, larger funds, and hedge funds involved. And institutions, as you said, most don't know what this is. But is this next cycle where larger funds start coming to DeFi?

JD: Well, first of all, to the market cycle part of it, I think we are in a 10 to 20-year secular shift in terms of investing in technology. So I think the bull market is intact for the next 10 to 20 years, whether or not that means the next three months or six months or nine months relative to a different three months, six months, nine-month period, is harder to understand.

“ I think we are in a 10 to 20-year secular shift in terms of investing in technology. So I think the bull market is intact for the next 10 to 20 years.”

But I would say, I'm not a big Jim Cramer fan, but I think the only thing he says that I agree with is there's always a bull market somewhere. And his idea is that there is no such thing as everything up, everything down. And that wasn't true five years ago in digital assets: everything was tied to Bitcoin, everything had high correlations to Bitcoin, every trade was done as a Bitcoin pair. But it's not true anymore.

I mean, we have a full digital asset ecosystem right now with different token structures, with different sectors, with completely different drivers of success and failure. You know, in the same way that you'd say that it's unlikely that what would affect Apple's earnings would also affect your gold ETF. The same thing is true here. What affects Bitcoin shouldn't affect Ethereum. And what affects the theorem shouldn't affect Chiliz or HXRO or something completely different.

“I mean, we have a full digital asset ecosystem right now with different token structures, with different sectors, with completely different drivers of success and failure. You know, in the same way that you'd say that it's unlikely that what would affect Apple's earnings would also affect your gold ETF. The same thing is true here. What affects Bitcoin shouldn't affect Ethereum.”

So, I think, ultimately, this idea of this whole bull market or bear market or these cycles, starts to go away. And I think a lot of that comes with narrative. I hate the term altcoin, for example, it makes absolutely no sense. It's not Bitcoin, and everything else is an alternative. These are different sectors, these are different assets. These are different fundamental drivers. I hate the idea of Bitcoin dominance. I can't think of a dumber term. By definition, it has to go down. Bitcoin is the only Bitcoin. And there's hundreds of new tokens that are coming to market every year now, and probably a lot more coming in the future. It has to go down. That's not a real metric. It makes no sense.

And the same thing, the whole idea of bull markets and bear markets and market cycles. These are all things that historically were true in a very immature small asset class. They're not true as this asset class evolves and as different investors come into different pockets of it for different reasons. I can't think of another instrument besides Bitcoin that has more global reach other than maybe US Treasuries. I mean, think about all the different people that are invested in Bitcoin right now.

You've got corporations. You've got individual investors across different economies. You have banks. You have brokerages. You have macro funds. You have crypto native funds, long-short funds, pension funds. It’s touching more parts of the world than any other asset, again, other than US Treasuries. As a result, it physically can't just go up and down, like everything else when you have that many different people involved in it.

So I think that's where we're headed, is a much more mature asset class where you have pockets of strength and pockets of weakness, and it doesn't all move together. And shout out to the Messari guys, I love what they've done from a sector classification standpoint, just that taxonomy and changing people's opinions of what this asset class is, really matters. And it doesn't show up in a 10 day period like we just saw where the entire market trades down together. But when you look one year, two year, three years out, there's clear differences between the different sectors, how Layer 1s have traded relative to NFTs in gaming relative to DeFi and CeFi. And that will only continue to happen as more and more investors start to look at the whole space and not just Bitcoin and Ethereum.

Over and Underperformers

CR: So interesting. So if this is a 10, 20 year secular bull market, where cryptocurrencies are decoupling, which sectors do you think will outperform, say, in the next one to three years?

JD: Sure. So, from a thematic standpoint, and this is how we invested at Arca, still bullish on digital money, which for us all intents and purposes is Bitcoin. We're still very bullish on DeFi as well as CeFi. You know, we think again, from a valuation standpoint, these are the easiest tokens to understand from a cash flow standpoint, and there's no doubt that volumes and interest is going to continue to grow which benefits all of DeFi and CeFi. Specifically within DeFi, we're much more bullish on insurance and DEXs and lending platforms than we are on things like asset management.

“Specifically within DeFi, we're much more bullish on insurance and DEXs and lending platforms than we are on things like asset management.”

We coined the phrase “Digitization of the fan experience,” meaning how do you connect fans to their favorite sports teams, their favorite athletes, their favorite celebrities? I think that's now being more broadly called social tokens. But this idea of everything from Chiliz to Rally to Audius to even what Spencer Dinwiddie did a year and a half ago with tokenizing his income. I think you'll see a lot more of that with these direct connections between fans and those that they support.

I think there's a reason to really get excited about different sectors starting to build in this economy, whether that's AR VR or communications broadband spectrum. In some ways, it's similar to the internet. If you wanted exposure to the internet, in the early days, you had to buy the infrastructure providers of the internet. I think Dell and EMC, for example, were the best stocks of the 80s and 90s. But it was 10 and 20 years later, when you started having non-internet based companies starting to use the internet for success.

And I think that's probably, I don't know if that's two or five years out, but I think you'll start to see traditional companies that have nothing to do with blockchain start to utilize digital assets in their capital structure to engage their customers, and to start utilizing blockchain in some way, shape or form. So we're definitely looking at consumer adoption apps, as well as the different sectors from telecom, to retail, starting to utilize these different instruments.

CR: Sounds like you mentioned a lot. So, different question, what will underperform?

JD: That is a good question. We have generally not been interested at all in privacy tokens. I don't think those have any merit from a standalone investment standpoint. I think it's a feature, not necessarily a standalone entity. So I'm not super bullish on that. I would say, within Web 3.0, we already mentioned something like Arweave, I think there's pockets like that, that will absolutely grow. But I think there's pockets of Web 3.0 that are going to be a lot harder to take off. Like you get this idea of just replacing Google Chrome with something like Brave or versus displacing Twitter with something that, I think EOS was working on or whatever. It's really hard to change consumer behaviors. And I think it's going to be a lot harder for any of these Web 3.0 ideas to really take off, just because the incumbents are so big and the customers are so sticky.

“...I think there's pockets of Web 3.0 that are going to be a lot harder to take off. Like you get this idea of just replacing Google Chrome with something like Brave or versus displacing Twitter with something that, I think EOS was working on or whatever. It's really hard to change consumer behaviors.”

CR: Fair enough. Okay. And then my original question is, are institutions coming to DeFi in the next couple of years? Institutions, and I am including hedge fund in this.

JD: As investors, for sure. As users, I think eventually, for sure. I mean, this yield environment and this idea of taking out the middleman is very appealing. I talked to one of the biggest funds in the world who is a huge structured product business. The amount of fees and middlemen that go into structured products is just insane. It takes three weeks to settle a trade. You're paying four times over for things that could be done in a blockchain for free and within 10 minutes.

“The amount of fees and middlemen that go into structured products is just insane. It takes three weeks to settle a trade. You're paying four times over for things that could be done in a blockchain for free and within 10 minutes.”

So they're interested, for sure. How soon they start to use it is going to be part regulatory, part operational workflow. Don't forget these big, highly regulated entities have huge compliance teams and huge legal teams that are going to fight like hell to keep the status quo just because it's easier rather than be innovative. And also, it's going to be due to the success of things like Nexus Mutual. There's a reason whether you believe in Chainlink or not, and there's a lot of people out there who are negative or positive on that. But there's a reason Chainlink took off when everyone was trying to figure out which Layer 1s were going to be successful. It's like, who cares which Layer 1 wins, an oracle has to win for any of the smart contract platforms to work.

In the same way, you could say who cares which DeFi platform works. Ultimately, insurance has to work because that's the only way you're getting any of the big institutional money. So I think things like that will matter. If these infrastructure plays that help traditional investors get into DeFi really work, there's no reason why they shouldn't be in here. So I think the short answer is yes, they're coming. I would imagine them to be passive investors before they are active participants though.

CR: Makes sense. Okay, and we need to be wrapping up. But I want to get your big picture view on DeFi. Where do you see it going? I always like to ask, is it replacing traditional finance? Is it playing nice with it? And will we have this hybrid system? What's your view on the future of finance?

JD: Sure. I mean, I think the future of everything is digital and finance is no different. I remember even when JPMorgan first announced their JP Morgan coin and they were like this is going to be great, now we're going to be able to send money back and forth between our branches seamlessly. And my first reaction was like, how the hell is that not already possible? And to me that wasn't innovative, that was just more damning with how slow the SWIFT and inner banking system really is.

So the internet changed the way we communicate. And the only thing that hasn't really changed is finance. So, yes, I think the digitization of finance is absolutely going to happen. I don't necessarily think it replaces traditional finance. In the same way that when robo advisors first came out, there was this uproar that, oh, here's Wealthfront and Betterment, and all of a sudden, Merrill Lynch and Morgan Stanley are screwed, and their financial advisory is dead. And it's like, no, they're not. They're just going to eventually adopt robo advising technology and use it with their platform. And that's exactly what happened.

Wealthfront and Betterment have both succeeded, but Morgan Stanley and Merrill and all the big financial advisors have also succeeded by introducing the technology. The same thing will happen. The banks and brokerages will start to use pieces of DeFi, but DeFi will exist too. And they aren't mutually exclusive.

“Wealthfront and Betterment have both succeeded, but Morgan Stanley and Merrill and all the big financial advisors have also succeeded by introducing the technology. The same thing will happen. The banks and brokerages will start to use pieces of DeFi, but DeFi will exist too. And they aren't mutually exclusive.”

So I think there's no doubt that DeFi is going to continue to grow, and there's pieces of DeFi that will attract people for more ideological reasons, than maybe for transactional reasons. But there's also the flip side, which is that many people will just feel more comfortable having a person whose hand they can shake and they can look in the eye. And both can exist and ultimately the technology will probably underpin both.

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