P&L Talk Series with CoVenture’s Ali Hamed & Nikhil Kalghatgi

CoVenture operates a venture capital firm, a direct lending business, and CoVenture Crypto, a cryptocurrency asset management firm run by co-founders Ali Hamed and Nikhil Kalghatgi. CoVenture Crypto operates multiple strategies and is backed by a large, publicly traded financial institution.

Profit & Loss: How did CoVenture get started?

Ali Hamed: During my freshman year at Cornell, I launched a software startup, and after that I started doing Angel investing. I didn’t have the capacity to write anything larger than a $25,000 check at a time and would find that when I tried to invest in people, they’d say the money was great, but what they really needed was help building the product.

That made us think about how ridiculous the venture capital business model is – where you put $50 million into a fund and give out $1 million at a time to kids who can code and hope they can start a company – it just made no sense to us. So what we did instead was go out and find founders who have either built and sold companies in a given industry, or worked in a given industry, and said, ‘We’ll give you capital, but will also help you build the technology. Then, if it’s doing well, we’ll help you find your technology team and give follow on capital to you along the way.’

A few of our portfolio companies ended up being alternative lending platforms. They weren’t the types that you would think of like LendingClub or OnDeck, which found a new, unique way to originate loans, but weren’t inventing new types of loans. Instead, we were looking for technology companies that were using their technology to invent new types of credit.

P&L: How so?

AH: One example is that we have found new ways to lend to people in the digital economy. We’re looking for new, unique types of credit that have never existed before until these technology companies existed. Then we took a look at ourselves and said, ok, so we have a venture capital business and we have a lending business. What are we? And we decided that we were really good at focusing on asset classes built on the back of new technologies.

P&L: Enter cryptocurrencies?

AH: Yes, cryptocurrencies or crypto-assets or whatever you want to call them, really fell into the category of a new asset class built on the back of new technology. We have been personally invested in the crypto space for a long time, so when our investors came to us asking how to do it, we quickly realised that it’s still really hard for the common investor to have access to anything other than bitcoin. One great irony of bitcoin and the blockchain is that the first company we all think of is Coinbase. The blockchain was supposed to disintermediate the banking system, yet Coinbase is an intermediary that charges high fees.

P&L: So you felt stuck between new technology and old ways of doing things?

AH: It’s ironic how archaic our methods of security are for something that’s supposed to be a new age.

P&L: Nikhil, how did you get involved in the space?

Nikhil Kalghatgi: I started in military intelligence, and then decided there wasn’t much money in military intelligence and so started investing. Over time, I became the moonshot investor guy in venture capital. I am into frontier tech with deeply challenging engineering areas and they’ve ranged from hard sciences to space exploration, genetics and the stuff called ‘distributed ledgers’. In 2012, a former CEO of a fintech company explained to me the concept of a distributive ledger – and I was like, ‘distributed what?’ He showed me the concept on pen and paper and then founded Ripple, who’s market cap is around $35 billion today [February 25, 2018]. Soon afterwards, I began to learn a lot from the largest mining group outside of China. I had a front row seat to the miners, the exchanges and protocols, but being an investor is very different than being an operator. It wasn’t really until Ethereum came out that I became a believer – and trust me, talking about blockchain in 2012 – people thought you were a crazy person.

P&L: Bitcoin had a lot of bad PR when it came out.

NK: It still does have a lot of bad PR.

P&L: People point to the Internet as a parallel whenever you talk about blockchain technology. Do you find that a constructive comparison?

AH: The problem with the Internet analogy is that people immediately link it to the bubble. Then, once you link to the bubble, they immediately try to turn the conversation to price, and beyond that, people really stretch to make the analogy work. One example is that the individuals who capture the wealth of the dotcom era were the same people who captured the economics of every other great revolution. They were the capital providers, shareholders and entrepreneurs. One of the cool things about the blockchain era is that it’s the technologists and builders who are capturing the economics of the protocols they are contributing to, which is a big part of why you see a flood of intellectual capital running into the space, and perhaps the amount of time allocation and intellectual capital has outstripped even the amount of fiat that’s come in.

NK: It’s a helpful analogy, but it’s also hurtful. The first marketing challenge is the word ‘currency’ itself. It starts everybody off in the wrong mindset. On a practical level, I don’t think a government would be willing to debase itself any time soon, and even a payments application I think is not the first or easiest use-case when trying to explain blockchain technology. I’d like to suggest we call them crypto assets.

AH: The useful part of the metaphor is that we’re at a really important inflection point when people stop talking about how it works and instead start talking about how it’s used.

NK: Exactly. I think the two categories of ‘how it’s used’ are: doing things better, cheaper, faster; or doing new things that have never been able to be done before. Between the two, the more interesting applications are the ones where you couldn’t do them without a blockchain.

AH: Yes, so the parallel on that would be pets.com – which was a lot less interesting than Facebook, because at pets.com, you’re basically selling stuff for pets online. Facebook could never have existed without the Internet, yet pets.com could have – it was just incrementally better because of the Internet. Facebook – no way.

So going and saying that you think the blockchain can make payments incrementally better is a lot less interesting than saying: here’s something that would have never existed before without the blockchain. That’s the thing that people are still waiting for.

P&L: That’s the other phrase that people love to throw around – that blockchain is a solution looking for a problem.

AH: Maybe or maybe not. There’s a company called Blockstack, which is the type of entity that could never have existed without the blockchain. Blockstack basically questions why all of our data is essentially warehoused? I blog on medium.com, if medium.com went out of business and I lose all my blogs, that’s incredible. How stupid is that? If Medium had used Blockstack’s protocol to build their application, I could’ve chosen to put my data wherever I wanted to put it – they would’ve just had a query for it. So now, instead of me licensing my own information, my own data for Medium, or basically licensing my online identity, which is literally licensed from Facebook – Facebook owns my online identity – why don’t I get to keep that data wherever I want to instead of on Facebook servers? That’s the type of thing that could never have existed before.

NK: Every file that you wouldn’t want to be replicated is the problem that you’re looking for. Every movie, every piece of art, every song, these are big challenges. Music rights management, media management is much more solvable when you can identify whether this is the exact thousand movies that were ever made and distributed. If I’m a young producer, I would love to get paid for the work that I’ve created, right? So that’s a real problem in the world for sure, and it’s not just piracy. I think it can actually create exclusive new content in that way.

P&L: When it comes to blockchain, people seem to be trying to figure out where they can get the most out of deploying this technology to make things quicker, cheaper, faster and more efficient on the operations side.

AH: It’s sad to me that everyone always talks about cheaper, faster, quicker rather than higher quality. If you can incentivise people to be contributors to a network, that network becomes higher quality – it doesn’t make it more efficient – but you can win by being much better.

P&L: A lot of the finance companies seem less concerned about high quality, because they’re looking to implement this as pure utility.

AH: Money getting somewhere faster is much better – that’s material. If Western Union figures out how to use the blockchain to get money from my family in the US to my family in Libya the same day instead of four days later, they will gain customers and that will create a meaningful shift for them. ‘Being better’ is more important than being marginally more efficient, or ‘less bad’.

P&L: When it comes to payments, how challenging do you think it is for an upstart to come in and unseat incumbents in the space, which have advantages in terms of connections, distribution and network?

NK: Payments is probably among the farthest out applications for cryptocurrencies today. The level of fidelity that one needs is extraordinary for most payments applications.

P&L: What are your views on the ICO space?

NK: I thought that ICOs were going to die – I thought the bubble popped in October, if not September. It was obviously a euphoric time last year. Since then, people have realised that there are some healthy regulations coming down the pipe for sure, however, the path to launch an ICO has never been easier. There’s so much infrastructure now for launching ICOs that didn’t exist a year ago that they are launching faster and in greater numbers.

However, not all ICOs are created equal. I’m seeing utility tokens are slower to launch and the bar is getting higher and higher for them to be created. That’s why you’re starting to see these mega-sized utility tokens. You’re starting to see existing companies launch larger ICOs. You’re starting to see security tokens in greater number, but they are raising less money on average. Even though the number of securities that are ICOs are increasing, I think ICO legislation will be healthy and curb most bad actors.

P&L: When you’re looking at an ICO, what are you actually looking for in terms of making a viable investment?

AH: If I was to come up with a checklist of things that I would look at, I’d ask if the team can actually do it. It’s probably similar to how you underwrite a startup. Do I actually believe that someone would want this token? Do I believe that there’s some sort of scarcity in the token? Do I believe there’s some sort of sustainable governance of the token? Do I understand how the rules are going to change and who’s in control of the rules if something happened to the team? There needs to be contingency planning if they’re raising serious amounts of capital. Does it seem like a reasonable amount to sell for a reasonable use of proceeds?

NK: If we take out the scenario of them being an early stage startup – maybe it’s a public company or a large company – and they have users and revenues, I think governance becomes number one by far, and the big concern you have is that you are holding a token, not equity. So, what are my risks? I don’t have any protective conditions. The one question you need to ask is: how does the company succeed and the token fail? Or what happens if the company isn’t doing great, can the token still be ok?’ All of those questions bucket into the separation of what happens between the company succeeding or failing and the token succeeding or failing.

AH: You also have to make sure that the tokens actually make the platform better, and if the tokens aren’t incentivising people to be good actors on a network or create more loyalty such that you would never actually want to move back to using dollars, I think that’s really important.

AH: I guess our firm generally thinks ICOs are interesting. We’re paying attention. Right now, I think that the best institutional managers are going to focus on the cryptos that have some sort of stability, some sort of staying power. It’s the reason we did the index that we did, because we’re not interested in taking LPs [Limited Partners] who trust us and put them with tokens managed by people who have no proven track record, no reason they’re going to use the capital, no proof that the governance is actually sustainable.

NK: I tend to spend much less time focused on ICOs and much more of my time focused on liquid cryptocurrencies and trading strategies.

P&L:  So what’s your investment philosophy?

NK: Liquidity is king. That’s everything. That’s why we set up the business. Here’s why: in 2008 when everybody was looking around the table and not really sure what was going to happen next – Goldman might not exist in three months – people looked around the table asking each other, ‘Hey, are you getting out? What price you getting out? What are you getting into?’ Within those questions is an assumption that you can get out. But in cryptoland, there may come a day when people have to ask the question, ‘Where were you when all the exchanges went down? Did you get out?’ It’s a much different type of question. That’s terrifying. If you have the most liquidity, you have the greatest chance of getting out.

P&L: There seem to be a lot of exchanges, how do you deal with fragmentation?

NK: The irony is that we’ve gone from a market where it was extremely thin liquidity to a scenario where there’s $25 billion in daily transaction volume. So now we’ve gotten to a territory where most banks will say, ‘Oh, we can actually make some money over there now’. While this transaction volume may look big, it’s fragmented geographically, across coins and fiat crosses.

P&L: How difficult is it to get out of a big crypto position?

NK: Depends on what you mean by big. A million US dollars of bitcoin, you can get out very easily in today’s environment. Ten million, you’d have to break up the transaction over a very short period. One hundred million USD equivalent of BTC, you might want to spread it over several days.

P&L: In the world of FX trading, it’s easy to get out of small positions, but when you need to get a larger amount done, it can be difficult because a lot of the market makers, traditionally the banks, have so many rules and regulations that they’ve curtailed their risk taking. So they’re not making markets the way they were, which is hurting liquidity.

AH: And they’re not doing it in crypto at all.

P&L:  So how do cryptocurrencies overcome their bad PR?

NK: I recently heard about an interesting exchange at a Tier 1 bank. Half the team in senior management didn’t want to touch cryptos, but then one of them asked, ‘Why is it that we’re holding cryptocurrency to a higher standard than every other commodity we ever traded? The same oil we trade might be also funding terrorism, yet it passes our KYC/AML’. I think that’s a question the banks and regulators need to answer.

P&L: Regulators keep trying to push more markets electronic, because then you get an audit trail. What are your views on auditability?

NK: I’m all for efficient and improved auditability. Cryptocurrency is far more auditable than cash. However, if I take the question of auditability to an extreme, we should also consider the ramifications of ‘over auditability’. We’ve never seen over auditability before. What if, for example, the Chinese government said they are going to regulate cryptocurrency and they’re going to have a state-sponsored coin, say Red Coin, and they can track any time one of their citizens spends something – anytime they touch a coin – they’ll know exactly what/where/when any Chinese citizen bought something and it would be tied to them as an individual. Now, what if some of those Red Coins made their way to American citizens, and now the Chinese government can track spending of Americans. How do you think the US government would feel about that? Now we’ve gotten to a scenario for the first-ever case of other governments being able to track spending of another country at a citizen level, which would be extremely valuable and sensitive information. Today banks are worried about KYC/AML, but the next challenge could become a point of national security.  

P&L: Why do you prefer cryptocurrencies over trading fiat currencies given that scenario?

NK: When financial liquid markets emerge, they don’t usually have that many quantitative data sources and as a result you have few, but very large, price inefficiencies. A value investor wins when there are a few, large price discrepancies – they can make the bet and wait for prices to adjust and then get out of their position. Algorithmic traders are usually laggards in liquid emerging markets. In a mature, liquid asset class, the obvious arbs are taken away and you have to make many smaller wins in order to have an edge. Cryptocurrency has been digital and quantitative from the start, and as a result, a savvy investor can find many large mispricings. While still early, this lends itself to highly quantitative investors that can make greater risk-reward returns than traditional FX, despite the relatively limited size and liquidity.

P&L: Of the many cryptos out there, do you think one will prevail? Do you think we have yet to see that one?

NK: First, I do not provide investment advice. I think there is different use cases for different cryptocurrencies and that one will be the market leader for each use case. For example, the four categories of cryptocurrencies are: store of value, payments, security tokens and utility tokens. For store of value, you’ve got bitcoin and I don’t think there’s a close challenger at this time. For payments you have a whole host of attempts out there, but I’m bearish for the near term. Security tokens, again, increasing in number, but I suspect regulation in America will cull them back before the regulated infrastructure launches. Utility tokens are by far the most diverse and as a result, one person’s trash is another one’s treasure and here’s why:

A common question is, ‘Why can’t one blockchain rule them all?’ Because they’re designed for different purposes. When they’re designed for different purposes, one’s weakness would be a strength for another use case (e.g., a low-cost provider may have cheaper ingredients, but is targeting a certain market segment vs a high-cost provider that may have a niche but profitable audience). Change ‘cost’ to any element of a blockchain like ‘speed,’ or ‘consensus mechanism’ and you quickly realise there are design trade-offs between utility token blockchains.

P&L: What do you think we’ll see this year in terms of bitcoin volatility?

NK: Compared to other asset classes, bitcoin volatility is very high. Compared to itself over time, bitcoin volatility has decreased every year significantly. If you took a poll once a quarter over the last year, you would have found people in this office saying bitcoin is the best, to Ethereum could take over, back to bitcoin maximalism again. The bear case is that institutional investors don’t come in and there is no at-scale proof point of blockchain technology. However, bitcoin is the reserve currency of crypto – when the sector performs poorly there has been a return to bitcoin, but what happens when bitcoin doesn’t win? That’s actually the hardest question of all – upon what circumstances does cryptocurrency hit an absolute minimum?

I don’t know the answer, but it’s probably not a security issue, as the industry has had lots of them, even a billion dollar security issue. I also think most cryptocurrencies will go to zero, similar to startup success ratios, without a loss of faith moment in the asset class.

P&L: So you think bitcoin has resiliency?

NK: I think that resilience is there.

P&L: But in bitcoin?

NK: Bitcoin crashed several times and came back stronger. It has the strongest network effects, has been around the longest and therefore has highest security, liquidity and is the best known brand in cryptocurrency. If we were to find that there’s a bug in Ethereum and every ERC20 token is now hackable, that’s a big deal – that’s a lot more than a billion – it could be tens of billions loss of value. Could that cause a loss of faith in bitcoin specifically? I think if people lost faith in Ethereum, if the hundreds of thousands of developers around the world lost faith, all of a sudden, I don’t think that would kill bitcoin or cryptocurrency in general.

P&L: Can you see a scenario when people lose faith in bitcoin?

NK: Sure, a majority of nations collectively deciding to outlaw a type of cryptocurrency could be an issue, but it’s not easy given the global, open and distributed nature of cryptocurrencies. I’ll extrapolate the question to cryptocurrencies in general and it gets much harder.

P&L: Do you ever worry that people could start to look at bitcoin and think: What do I use this for in terms of store of value? It’s not a store of value because the value changes rapidly. It’s not a currency because I don’t want to spend it. I don’t want to buy a sandwich with it today if I can buy a house with it tomorrow. Could that lead to a loss of faith?

NK: Bitcoin doesn’t really function as a traditional currency and the number of transactions is still relatively low. As a store of value, this is a five-to-ten-year long shift. However, store of value means you actually can store and access it. Go ahead and try and get $5 million worth of gold or currency legally out of the country. I would argue that a thumb drive can be a much better solution. In some parts of the world, trading volatility for transferability today is a very good trade off.

Julie Ros

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