Welcome to our new AMA episode 13, today we have Sam Andrew, from Crypto Clarity who has been working for more than a decade in traditional finance and banking. He has been an Investment Banking analyst at Credit Suisse. He worked at BlueMountain Capital, a $22 billion hedge fund for 8+ years! Recently he joined FRNT, a crypto investment bank to build out the crypto investment fund, and now his research focuses on the business and investment case for crypto.
Here are the topics we discuss in this AMA:
This blog is based on our recent conversation with Sam Andrew from Crypto Clarity, who has been working for more than a decade in traditional finance and banking, has been an investment banking analyst for Credit Suisse, worked at Blue Mountain Capital, which is a $22 billion hedge fund for eight-plus years, recently joined FRNT, which is a crypto investment bank to build out the crypto investment fund, and now his research in crypto focuses on the business and investment case for crypto. And you have a Substack newsletter through his crypto clarity platform.
It was gradual at first and rapid in the end. There were two main drivers of this and two lenses under which I assessed where I was going, and what I was doing.
One was personally what brought me into crypto. And the second was professional. On the personal side, I started my career in investment banking. I did the investment banking analyst thing for a couple of years, and then I worked at Blue Mountain Capital, which was a $22 billion hedge fund.
I had several responsibilities there, and I was there for over eight years. But in that realm, that decade-plus of “TradFi”, I found that things had just plateaued a little bit and I was looking for something new, something innovative, something that would stimulate me.
I was also in search of a challenge, particularly something more entrepreneurial, something where I could reaccelerat the trajectory of my learning. And it was in 2017 that I had started to come across crypto. At the time it was almost impossible not to come across crypto.
I was deep in the world of financial markets and that's when the first time all of a sudden MSNBC that we'd be playing in the office every day was quoting Bitcoin prices and so forth. And probably a little bit before then, that bull market of 2017 is when I got introduced to Bitcoin and started reading the white paper and founding the stuff fascinating.
And then, Kind of thereafter was Ethereum. And for me, it was fascinating because it was the intersection of technology and markets and investing. I started to grasp the potential of this. So from a personal dynamic, I felt compelled to keep pulling on that thread.
And the second aspect, professionally what I discovered, is a big driver of your career trajectory is just what industry you're in, and I found the potential technological disruption from crypto to be not only fascinating, but potentially a huge opportunity for me to participate in.
As I got pulled in a little bit more, I started meeting all sorts of smart people that were motivated in what they were doing, what they were building. And so there was a real personal connection that came from it.
Sam Andrew: As I better understood the space, I found crypto to be, probably one of the most fertile investment grounds I had ever come across.
And the reason I found it to be so fertile is because, one, it's an inefficient market, and generally inefficient markets lend themselves to the greatest source of what's called an industry “Alpha” of investment returns. Secondly, it's also a very liquid market. And what's interesting there is, there's no other asset class in the world that is both inefficient but also liquid.
That dynamic, in and of itself made it interesting. Third, I found there to be real edge of understanding how some of these different protocols work and what they do in their potential use cases and how they could be valuable, to stand out from the investment herd.
And I thought if I could do that at an earlier stage, then you'd have an early mover advantage of understanding a nascent asset class and industry in its infancy. And so those were the personal and professional things that drove me to then commit all my time to crypto.
Pratik Wagh: So you wanted something that will keep you up at night. That's what you're saying.
Sam Andrew: (Laughing) In some situations I was already used to managing the stresses of, managing money and having positions and getting them moved around by the markets. But the crypto has, and the volatility of crypto, I should say in particular, has exacerbated all of that.
Pratik Wagh: So speaking of there is no other asset class, that has this combo that you mentioned was an interesting point, which was inefficient market, but also liquid at the same time. Can you quickly explain why crypto is an inefficient market?
Sam Andrew: Crypto is an inefficient market because information is not widely distributed. Not everyone knows how this stuff works. You've got to go find the information and then you have to analyze it. Whereas markets that are generally more efficient say, for example, equity markets tend to be more efficient markets, as the information is all easily accessible.
It's very standardized in the form of company filings every quarter. It's all audited and so the information is easily accessible. It's more how you interpret that information. Whereas in crypto, even just going to find this information, requires a lot more heavy lifting.
And that's why I mean information is not widely distributed. And so that inefficiency means that if you are willing to do the research and find the information, you can have a real edge in this.
Pratik Wagh: So let's say if some of your friends haven't, switched completely to crypto and they're maybe on the fence, what are their fears? How are they thinking about this current market, especially after what 2022 did for us? What are they thinking?
Are they thinking like, oh gosh, I'm happy I didn't, quite switch to crypto? Or are they now thinking, okay, maybe this is a good time because the froth has already gone and now we have an opportunity to build something fresh. How are the people that you already knew in traditional finance thinking about, let's say you being in crypto at this moment?
Sam Andrew: Okay, so I'd say most people in traditional finance or TradFi are not getting into crypto. They're at least not getting into crypto right now. There was some interest in 2022, and most of the interests I saw in 2022 were TradFi funds trying to short crypto.
Broadly speaking, TradFi is slowly engaging in crypto. And you can point to the Fidelitys that are now offering investments in BTC and ETH, there are some TradFi brokers that are building trading desks to trade these different assets. There are some banks that are being a bit more active in the space. Goldman would be a prime example that they've recently issued a bond on their own private blockchain.
TradFi is not coming in droves into crypto. And the reason for that is from an investment standpoint, one, other asset classes are at least for them from their perspective, I'd say more attractive. NASDAQ was down 30% last year. And all of a sudden there were a number of high flying names that were down 80%, just as much as crypto assets were. And so it's easier for them to wrap their heads around that than like, let me just go buy this crypto token currency, whatever, that I don't even totally understand.
The second thing, they're probably, they're not engaging as much is from a regulatory and custody standpoint. They've got real concerns, after the implosions we saw over the spring and summer of last year, culminating in the FTX implosion, that was a huge deal.
And now in the last few weeks you've seen the US government tighten some of the regulatory requirements. That's frightening people a little bit more, certainly dissuading people who are considering.
Third, they probably have a bit more career risk, to invest in crypto now. Given what 2022 was, people can lose their jobs over this stuff. From a personal standpoint, is it worthwhile? For a lot of these funds, it's not in their mandate. So that's the career risk as well, that we didn't raise this money to go invest in crypto. So if we do this and we lose money, we're going to look foolish.
Fourth, understanding, valuation is a little nebulous in crypto relative to other asset classes. And fifth, probably one of the biggest drivers is, the market's just not that big.
You've got a 900 billion market 300 that represents about 300 tokens. That's excluding stable coins and meme coins. But once you strip Ethereum and Bitcoin out of that, and say all the tokens that have less than 500 million market cap, that's a 200 billion market and about 200 tokens like that is minuscule relative to all other asset classes.
And so people are interested in this stuff, but it's not at a point where it can move the needle for much larger investment firms .
Pratik Wagh: One that I'm struggling to understand is the regulation aspect. I guess it's fair to say that regulations is scaring some of the institutions and people from getting into it.
Do you think on the flip side, they might also be sitting and thinking, well, it's good that regulations are actually coming into this space and targeting the companies that are not following best practices, rather than outright banning the crypto technology itself.
Rather than outright banning crypto like China did. Is it not encouraging? Is it not a positive thing, is it not a hint that they're believing in the crypto technology? Do you think the regulations are encouraging to anybody? Are there people sitting there saying maybe this is good?
Sam Andrew: Okay. The regulatory landscape, particularly in the US, is a pretty complicated one. I think on the whole, the crackdown that we've seen in the last call it year to date has been broadly speaking, not constructive for crypto.
Now there are maybe silver linings that you can tease out in that, one being, the SEC pursuing stablecoin as a security. The SEC's argument for USTerra, the UST stablecoin as to why that was a security. Those were things that were specifically related to UST and probably not broadly applicable to stablecoin, particularly asset backed stablecoin in general.
The second thing is the SEC going after staking as a service protocols. In this case, Kraken. The argument for that was, again, things specifically, related to Kraken's business model of how it was staking as opposed to staking writ large. So both of those could be seen as a silver lining that this is not the indemnification of staking as a service or stablecoin in general, but more specific cases of how that was being done.
The regulation that is impacting crypto the most is not actually regulations brought by the SEC. There's only so much the SEC can do. The SEC can't ban crypto outright. For any sort of ban like that, it would require legislation which has to go through Congress, which would be very difficult for that to happen right now.
But what is having the most impact is a policy that was, pushed by the Federal Reserve, the OCC, which regulates, National banks in the US and the FDIC, which insures all banks in the US and those three institutions, put together a joint statement that effectively says that, if you as a US bank are interacting with crypto businesses, you stand to lose some of your benefits of being a chartered bank, meaning you could lose access to the FDIC insurance or you could lose your access to the Federal Reserve backstop. Both those things are huge deals for banks.
So the FDIC insures deposits in your checkings account up to $250,000. So that means you have a lot more confidence in your local bank because the deposits are insured by the government. The other thing is the Federal Reserve backstop. The threat of losing that from a local bank, is enormous. The banks are not going to risk that anymore given the potential threats that this new policy has implemented. And that's why you've seen over the last, certainly a few weeks and now maybe months, banking relationships for crypto related companies have become very difficult. And that is a real problem.
This is not technically regulation, it's more a policy, but people generalize it as regulation. And in my opinion, that's the largest problem. I actually just recently wrote a piece on this called Crypto Crackdown, that outlines, the handful of big regulatory actions that have happened, what it means, why it's important, what are the implications of it, of which I just teased some of those things out for you now.
Pratik Wagh: So for people to get into crypto, we need some use case, some real world use case. And one of the recent articles that you wrote was your crypto thesis for this year. You mentioned that crypto will accelerate commerce. You explained the whole context of how we started using waterways first. Then that led to innovation, which led to railways. Then steam powered ships, eventually road networks were built, and ultimately we got to this digitally connected world. Can you explain how crypto can play a role in accelerating commerce moving forward?
Sam Andrew: Sure. So you highlighted Pratik a few of the examples that I teased out in this, in this article I wrote. There's been a handful of technological innovations in the last 250 years.
Different geographies, different times. But the common thread amongst all them is that they accelerated commerce, right from the railroads, the steam engine, up until the end of last century, didn't mention the semiconductor, which led to computing power, global communications, internet, so forth.
And at each time, these things improved productivity. It improved productivity because all of a sudden, people were more connected. Even going back to railways moving people around, all of a sudden goods were starting to get moved around more frequently. And so that increased productivity and some of that productivity blended itself to other industries as well.
So you have this compounding effect of improving productivity and that improvement in productivity leads to economic expansion. Economic expansion is generally a good thing. Economic expansion leads to full employment. It leads to wealth creation, it leads to the rising living standards. So my hypothesis is that crypto, has attributes that will lend themselves to accelerating commerce, and it should play out similarly to some of these other technological disruptions and how they served to both accelerate commerce and widely benefit society in general.
I think of crypto as an infrastructure. And the attributes of the infrastructure that enable easier commerce is that one, it's permissionless. So anyone in the world can use this and you can't be banned from it.
Second, it's trustless. People who don't know each other can confidently interact in it, and it doesn't need a third party arbitrator. Third, it's auditable. So anyone can kind of see what transactions happened and ensure they're correct. And then the last two, the fourth and fifth, are emerging and working through, but one, it's low cost and it will become even lower cost to transact on blockchains.
And fifth, you have instantaneous settlements. And so all these things allow people to transact more seamlessly globally, online. And as we've seen through those historical examples that I gave, the easier it is to transact, the more people do it, and the more commerce accelerates. And that to me is one of the most powerful use cases for crypto: the acceleration of commerce.
Why DCF model doesn't work for ETH
Pratik Wagh: Coinbase announced that they're going the decentralized way by launching their own layer two chain called BASE chain, which is going to be a layer two on top of Ethereum chain. This is now the first ever public company to launch a permissionless blockchain that supports Ethereum. Hopefully it helps the Ethereum ecosystem because they will use Ethereum as the gas fees.
Based on these updates, do you think Ethereum is a good buy? Or what's the fair price of Ethereum? Because I came across one article in your newsletter, which talks about exactly this: the struggles and the pains of finding the true value for Ethereum. And in that article you mentioned why DCF, the model used in traditional finance quite doesn't do the job for valuing Ethereum. It works theoretically because Ethereum does have cash flows, but it doesn't work in practice because the discount rate or the beta is extremely hard to determine.
Can you briefly explain why DCF doesn't work to value Ethereum? And then what could be a better way, or is there even a better way to know if Ethereum is a good value?
Sam Andrew: Okay, so let's touch on DCF a little bit more and then we can zoom out and think more broadly, how to think about value in regards to crypto assets. For DCF specifically, there's two kind of structural challenges with applying a DCF to crypto assets. One is that most protocols are loss making. There are kind of traditional finance metrics or heuristics you can apply to them. They generate revenue and they have costs. The revenues are a product of gas fees, number of transactions, and usually they incur the costs through new token issuances.
And so what I mean by loss making is that the new token issuance is greater than the revenue they're generating. And that's generally a problem. And the second structural challenge that I alluded to is value accrual. Not necessarily all the value that gets created on the chain accrues to token holders.
And so because of those two dynamics, applying a DCF to many different blockchains doesn't work. One of the other issues is that the assumptions are hard to come by. We can use the Ethereum as an example. I know the current revenue and the costs, but projecting revenues for Ethereum is very difficult.
And the reason for that is, what its growth trajectory will look like, has a wide degree of outcomes. Because is this going to be a high volume, low fee chain? Or is it going to be a high value, low volume. By high value, I mean high gas price fees.
And which way that dynamic plays out is dependent on the development of layer twos and what kind of volume and what kind of price, what will be the volumes of layer twos. So projecting revenues for Ethereum is awfully difficult.
The second thing is that, understanding a discount rate for Ethereum is also very difficult. And it's difficult because, well, one, what is the beta that you're determining in your discount rate? Beta to what? You can't have a beta to yourself. You can look at a beta to say traditional markets like S&P 500. Well over longer periods of times these things are not correlated. So I don't know what the beta is.
And then secondly, what's your expected return that goes into your discount rate? Well, it depends on the timeframe you're looking at. And depending on the timeframe you're looking at, it can either be a 100% or 0%, in which case both are not reasonable inputs. And so those are just giving you a bit of flavor as to how some of the assumptions that you put into a DCF are especially difficult for Ethereum.
Pratik Wagh: So for discount rate, we need to know the beta, we need to know the risk-free. What do you think is the risk free rate in crypto? Are we taking traditional finance risk free rate, or do we have a risk free rate in web 3.0 yet?
Sam Andrew: Both conceivably could work. The main thing with all this stuff is you want to be internally consistent. And so if you think of your discount rate based on traditional finance, then your risk free rate should be a US treasury.
And then the expected return should be the return in addition to whatever spread to the US treasury. Or you determine your discount rate in a purely crypto native environment, in which case, you're using a risk-free rate that should probably be some form of a DeFi yield or a staking yield.
There's some debate as to what you would use. A potentially yield you could get on a stablecoin could be your Risk Free Rate. If I look at the expected return over the last year versus the last five years in crypto, there's a massive difference in time sensitivity to what period you're looking at.
And then the third aspect of any kind of a crypto discount rate is well, what beta are you using? Like beta to what? Ethereum beta to Bitcoin? or Solana beta to Ethereum? The market has not evolved enough to determine a beta.
Pratik Wagh: Okay, so that's about the discount rate. Now coming back to valuations, how do we go about that?
Sam Andrew: Right. So taking a step back and thinking about value more broadly in crypto. A few things to note. One is that it's a burgeoning field. There's no one set way on how to think about valuing tokens. And that's what's so fascinating about this for me is you get to form the potentially the common discussion and the heuristics and how to think about value in crypto.
And the second important thing is that valuation heuristics are only useful if other people adopt them. I could develop the most theoretically sound way of valuing a token, but if nobody is else is adopting it, and if it doesn't become a rule of thumb then it's actually useless.
To think more broadly about what drives value for these protocols. It's demand for these blockchains. That's what drives the value and that manifests itself in gas fees and ultimately revenue. And the proponent of that are some of the use cases that we may see. Then from a valuation standpoint, there are two broad buckets to think about.
One is absolute and the second is relative. Absolute is what is this protocol worth. That's achieved through some combination of a DCF or thinking about yields or multiples, which are all related to one another. But that's how public equities are valued.
The other valuation bucket is relative. Credit is valued on a relative basis. There's no DCF of a company that's going to give you the value of the bond of that company. To think about relative value is more like, well, since this one instrument is worth X, then Y should be worth 20% of that. You often see that in crypto, people think of Ethereum as a reference asset. So if Ethereum is X market cap, then this other alt layer one should be 10% of that or 20% of that. And that's informed based on a whole bunch of different metrics across these different blockchains, usability, functionality, fees and so forth, and you can ascertain which one is worth.
And then you also have people valuing Crypto based on the relative total addressable market. You often see this with Bitcoin. The gold market is this big. And so Bitcoin, if it had X percent of the gold market, then that's how you get to an applied valuation.
And so what that gets to is that valuation is very much a triangulation of a bunch of different approaches. It's far more of an art than it is a science. Eventually, hopefully sooner rather than later, more common methodologies will emerge on how to value this asset class and tokens in particular. That's going to become increasingly important, specifically as the industry becomes a bit more sophisticated.
External capital from much larger allocators, call it TradFi allocators will then start to deploy more capital into crypto.
Pratik Wagh: I guess risk-free rate in crypto itself is an oxymoron.
Sam Andrew: (laughing) Yes, that is a very astute observation. .
Pratik Wagh: Sam, we need more people like you who have the background that needs these kind of conversations. I appreciate the research that you're putting out through your newsletter. I had a great conversation today. Where can people find you? Anything that you are working on recently that we should know about?
Sam Andrew: Sure, so you can find me on Twitter. My handle is @samuelmandrew. And then if you want to read my newsletter, it's Crypto Clarity. You can find that it's on substack. It's a labor of love. So I share pretty much all my insights for free.
The main thing I'm working on is I've recently joined, FRNT and we're excited about the crypto fund. We'll be launching shortly. If you go to frnt.io, there's plenty of information there on FRNT and in due course there'll be more information about the fund. I'm based in New York. Awesome. Cool, Pratik. Well, thanks so much for having me.
Pratik Wagh: Thanks, Sam. Take care.
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