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Capital Allocators – Inside the Institutional Investment Industry
[REPLAY] Ben Forman – Opportunities in DeFi (EP.256, Crypto for Institutions 2, EP.03)
01:13:40
Ben Forman is the Founder and Managing Partner of ParaFi Capital, a $1 billion investment and technology firm that focuses on decentralized finance across digital assets, venture equity, and quantitative strategies. Ben launched ParaFi in 2018 after a...
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- [00:00]
Ben Forman
Foreign.
- [00:05]
Ted Seides
Hello, I'm Ted Seides and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access Premium content@capitalallocators.com My guest on the third episode of Crypto for Institutions 2 is Ben Forman, the founder and managing partner of Parafi Capital, a $1 billion investment and technology firm that focuses on decentralized finance across digital assets, venture equity and quantitative strategies. Ben launched Parafi in 2018 after a decade in traditional finance roles across investment banking, credit investing and private equity at venerable institutions such as Rothschild, TPG and kk. Our conversation covers Ben's background, pivot to crypto and launch of Parafi into a bear market. We then discuss opportunities in the world of DeFi, including borrowing and lending, stablecoins, scaling, insurance, governance, and capital allocation. We close with Parfi's research and valuation approach, engagement with DEFI protocols, and seeding crypto managers. I hope you enjoy the show and if you do this week, if you're single and walking down the street street while listening to Capital Allocators and look up and see a beautiful woman or man coming your way, what better way to get the conversation going than saying excuse me, but you happen to know about Capital Allocators, they might respond that sounds amazing and start a really interesting conversation. Who knows, it could be the beginning of a beautiful relationship. Thanks so much for spreading the word. Please enjoy my conversation with Ben forman in the third episode of Crypto for Institutions 2. Ben, great to see you.
- [02:11]
Ben Forman
Yeah, thanks Ted.
- [02:12]
Ted Seides
Well, I'd love to go back to your traditional finance background into the non traditional world of crypto, but why don't we start how you initially got into finance?
- [02:22]
Ben Forman
Yeah so I grew up in Seattle, Washington and I had in my mind that I wanted to get a PhD in economics and become a teacher. So entering college I remember looking through the course list and seeing game theory on the list of classes in the economics department and I didn't know what game theory was, but it caught my eye because I loved games. I was a competitive chess player growing up. I loved poker and board games and puzzles were a core part of my childhood and my time with friends and family. So I googled game theory and I found out that it was the study of how and why people make decisions in competitive situations and it can be applied to diplomacy, war markets, business and a number of different other areas. And that fascinated me. So game theory, along with behavioral economics really became a primary focus of mine in college. And I loved understanding really the way people responded to incentives and then the cognitive biases that impacted them. And what I came to realize was there was no greater game theoretic experiment in the world than financial markets. It was the most complex and there was also the most on the line. And so I very quickly kind of put my plans to be a teacher on pause and wanted to enter in to the arena myself. So I graduated in 2008 and I was fortunate to get a job in investment banking. I started my career a few months after Bear Stearns went under and a few months before Lehman Brothers went under. And I would say I didn't really have any hard skills in finance and accounting. I wasn't able to navigate GAAP financial statements with any degree of fluency. And I really had to learn on the job. And I think necessity is the mother of all invention. So if you're forced to learn something and you're salary and your life depends on it, you'll probably learn it very well. So I spent the first 10 years of my career, from 2008 to 2018, really working across a number of different investment roles, everything from private equity to credit investing. So I touched a number of different parts of the capital structure. The majority of that time was spent at TPG and kkr. I think the thing I learned most during the first 10 years of my career was just how to rip apart financial statements. So really dig deep into unit economics of businesses, balance sheets, cash flows, income statements, really probe management team's claims around earnings or their business model. Along that journey, I was also able to work on a lot of corporate restructurings. So this was kind of coming out of the financial crisis. And I think when things get messy, when you have different creditors and management teams, when businesses have not been going well, you end up learning a lot. When things are going well, maybe you don't learn as much. So I was fortunate to work on some complex, hairy restructurings in my career. I never wanted to be just one type of investor. I didn't want to just do private equity my whole career or just do credit. I loved touching different parts of the capital structure and learning things from scratch. I think in part it was that curiosity that kind of led me into crypto.
- [05:54]
Ted Seides
All of that just naturally flows into crypto. So how did you get from that traditional corporate analysis and different forms of.
- [06:03]
Ben Forman
The capital stack to crypto in 2014? I was living in San Francisco. I had a roommate who was working at Google, who's a dear friend of mine to this day, and he had some of his co workers over for dinner and they were talking about Bitcoin. And I remember hearing the word bitcoin for the first time. Someone explained what it was. I was extremely skeptical. I thought it was somewhat of a silly idea. And my friend said, hey, you shouldn't come to a view on it until you've actually done your work. So I said, okay, what is doing your work entail? And he said, you should read the Satoshi white paper. I said, okay, I don't know who Satoshi is, but I'll read his white paper. So the Satoshi white paper is an eight page document that was written by a pseudonymous individual that describes the idea for bitcoin. I think it was written in 2008 and I had to read it a couple times to really digest what he was describing. But I found it interesting because I had worked in finance my whole career, but I had never really asked myself, what is money? Like it's such a fundamental question, right? Like what is money? Money is this like lubricant for all capital markets and for the entire financial services space. And digging into the question of what is money? I found to be an incredibly intellectually stimulating exercise and quickly realized that money is a technology that humans use to communicate value with one another. It's just a technology. So that to me was incredibly exciting. And I ended up buying Bitcoin in 2014, not at a great time. There was a bull market in 2013, and then in early 2014 the price started a two year decline. So my entry point wasn't phenomenal, but I bought some and started to pay attention. My story into crypto probably could have ended there with just bitcoin. But in 2015, mid-2015, Ethereum went to Mainnet. Ethereum launched. And Ethereum was different than bitcoin. It was this decentralized computer. And in the early days, I mean it was really a ghost town. There were maybe like a couple dozen misfit developers and other people in the ecosystem around it. But what caught my eye about Ethereum was a credit application that was being built on it. It was called Makerdao and it was a decentralized revolving credit facility. Or you could think about it as decentralized repo where you could post coins to a contract and borrow against them. Very similar to a margin loan on Schwab or Fidelity. And to the extent the value of your Collateral dropped, your collateral was liquidated and you borrowed in the form of a perpetual bond, so interest accrued to your balance. And this entire system was governed by math. There were no people involved, there were no forms to fill out, there was no underwriting process. It was globally distributed and it was incredibly efficient and elegant and simple and it just worked. And actually, to be fair, at the time it was in white paper format. It launched in late 2017 and to this day it works incredibly well. So that was exciting for me to see because being in the credit space and dealing in corporate restructurings and 300 page credit agreements and bond indentures, to be able to distill a bunch of legalese into code was exciting. So that was a kind of zero to one moment for me in terms of my understanding of other applications of blockchain. In 2016, I was at KKR and the firm had an innovation Council in house and there was one person responsible for autonomous driving and another person responsible for cloud computing. And so I raised my hand to be the blockchain crypto person at kkr. And so I spent two years really canvassing the space. The world was a lot smaller back then. Coinbase was a Series B company. The entire crypto market cap was maybe 10 billion, so less than 1/100 of the size that it is today. And I was really more focused on understanding Bitcoin as a payment technology at the time. There was a feeling that people were going to use Bitcoin to pay for things to buy a cup of coffee. One of KKR's largest positions at the time was called First Data. Today it's called fiserv. And it was a legacy payment player that was charging merchants a few percent to accept credit cards. And so there was concern around disintermediation from blockchain. So I dug into that world, dug into a number of other areas in the space, and towards the end of my time at kkr, I made the decision to leave. And I think if you would've told me maybe six months, a year before I left kkr, hey, you're going to leave KKR and start a crypto fund, I would have said, you are out of your mind. But I think two things really clicked for me. So one is this was an entirely new asset class. It's very rare to live through the inception of a new asset class. It's maybe a once every decade or couple decade thing. And you don't always get to pick when there's opportunity. You kind of have to just identify it and Then the second thing is I've always optimized in my career for learning. And in the blockchain space, you get to learn about so many different exciting areas, everything from economics to cryptography to game theory to financial market structure. So I figured, look, if this didn't work, at the very least I'd learn a lot and I wouldn't get bored and I'd be able to carry my learning to the next experience. So that was really that. It was a tough decision because I loved my job at kkr, but I ended up leaving and never really looked back.
- [12:16]
Ted Seides
So what happened when you went to launch Parafi?
- [12:20]
Ben Forman
The timing in the short term wasn't great. It was really at the beginning of a pretty precipitous bear market. I'd taken a long term view and I had really high conviction that blockchain would be a thing long term. But in the short term, the markets were down fairly dramatically in the back half of 2018. This was kind of the hangover following the ICO boom. It was very difficult to scale our business to raise capital, to get institutions to actually care. I think majority of institutions wrote off the asset class. I kind of think back to the early days as being both challenging and exciting. I remember. So Henry Kravis was a day one investor in Parafi and is still a mentor of mine. And I remember getting lunch with him, say like a year into starting Parafi and we really weren't scaling. We were sub 20 million of a. Our performance was great on a relative basis, but not great on an absolute basis. And I came to him for advice. And I remember him saying, look, when I started private equity or When I started KKR in the 1970s, the term private equity didn't exist. They were called bootstrap funds. And the concept of buying businesses with debt was kind of foreign. It was really a new asset class. And he went around and talked to allocators. They really didn't even understand what he was talking about. And their eyes would kind of roll into the back of their head or they'd fall asleep during meetings. He said, look, if you have conviction, you need to stick with it. And so that always really stuck with me. Given the opportunity associated with a new asset class, it just takes time for people to get their arms around it. So it was certainly challenging. At the same time, it was exciting because in the early days, when I think back to some of the best investments we made, they were in 2018 and 2019. You just couldn't see the returns. They were invisible. We chose to make the investments. And we got over that time really smart. On defi, we were very close to the metal, using a lot of the largest applications today when they were kind of V1 products, we were the first capital messing around with them. And so we learned quite a bit.
- [14:46]
Ted Seides
In those first couple years before these last two years when crypto really took off. Next legs. What was it like running a fund? Having left KKR with a modest amount.
- [14:59]
Ben Forman
Of assets under management, it was a humbling experience. I felt as though I was as intellectually stimulated as I'd ever been because it was so interesting to dig into the unit economics of the defi applications and understand how they worked and talk to founders. But it was also challenging because you wanted to build a business that was sustainable and could stand on its own two feet. And to do that, to scale an asset management firm, you need to raise capital. So it was challenging.
- [15:33]
Ted Seides
I'd love to take a step back and just talk about your thoughts on defi. What has been your thinking in terms of the potential use cases and what's happening in Defi?
- [15:45]
Ben Forman
I like to start with the why, because I think if you lose track of why defi should exist, why it needs to exist, you're going too far. So just taking a step back as I think about the financial system today from first principles, if we were to restart global financial markets, would we design them the same way that they exist today? If we're starting from a blank sheet of paper, I think everyone would agree. We probably wouldn't. Most of the laws were written in the 1930s and 40s. Most of the code for things like Swift were written in the 1970s and 80s to send money internationally. You're paying 8 to 10%. Equities are settling T plus 2, bonds are settling T plus 3. Distressed bank loans are settling T plus 20. The only part of banks that have grown in headcount are back office and compliance. And SpaceX has lowered the cost of launching a satellite by 100x. But we're still paying $3 to take money out of an ATM. The financial system really has not evolved in the same way that other sectors of the economy have. If you kind of think about finance today, finance really describes a collection of verbs that you can do that kind of ing verbs of finance. It's lending, spending, borrowing, hedging, insuring, indexing. It's all these things you can do in the financial system. The reality is those activities today tend to be intermediated, so they're done through banks, broker dealers, custodians, they tend to be permissioned, so not everyone can access them. You can only access them if you have an account. These custodians and intermediaries are opaque, so you don't know what counterparty risk you're taking. You can't see the risk in these systems. They're rent seeking. So finance globally is 11 to 12% of GDP. And finance as an industry doesn't produce anything that's inherently valuable. It's just an industry that is a lubricant for other sectors like health care, education, et cetera, to actually like make the world a better place. So finance should be, I think, a lower percentage of GDP and not seek as much rent. And the final thing is financial services today are largely inaccessible. So 20% of the world is unbanked, another 70% is underbanked. And so what is interesting about DEFI is that we're moving from a world of intermediated finance to disintermediated finance. And instead of centralized authorities controlling these finance verbs, you have software doing it for you. So you have a network of software programs that mimic financial contracts using if then statements. And if you think about any financial contract, whether it's buying insurance or selling a call option, or entering into an interest rate swap or a loan agreement, it's really just a series of if then statements. If price is X, party A pays party B, C, dollars. And so this new network of decentralized finance is roughly a couple hundred billion dollar industry in terms of value that's locked in these networks. These systems are totally peer to peer, so there's no counterparty risk, they're permissionless to use and access. They're completely transparent and open source. So you can see every single transaction that's ever occurred on a decentralized exchange like Uniswap or a money market like compound. See every single loan, see every single borrower, every repayment. It's all visible. These networks are global, so they're the first ever global financial products. Every other financial product is launched within a specific country. These are the first global markets which should make markets more liquid, more efficient. And they're programmable, which. It's this idea of unlocking new types of financial primitives that simply weren't possible in traditional markets. That's really what DEFI is. And what's exciting about DEFI and what attracted me to it to begin with is it's working. This isn't something we're talking about that may work in five years or 10 years. This is here and now. I used a DeFi protocol this morning before coming here. We use them at Parafi every day and there are trillions of dollars of value flowing through these networks. Uniswap for example, just passed $1 trillion of trading volume since inception. It launched a few years ago. That's one of many, many examples. So just the fact that these systems work today are providing real value is very exciting.
- [20:58]
Ted Seides
Well, that's a wonderfully articulated why I'd love to go through some of these ings as you refer to them and try to get a sense of in the actual protocol or what is working today and, and what maybe still needs to develop and we can start anywhere. But what about lending and borrowing to start?
- [21:18]
Ben Forman
So yeah, lending and borrowing is an interesting use case. So there are several like money market style platforms where lenders can show up, deposit tokens and earn a yield on them and they get paid a yield by borrowers. Borrowers may be deciding to borrow crypto because they have a low, a low tax basis. They don't want to sell to realize a taxable event. They may need working capital, they may want to go leverage long. And so these borrowers, they may post like say $2 of collateral for every $1 they borrow. So these money markets are kind of governed based on different loan to value ratios that can get changed by these networks. Secured lending is a category within DEFI that is actually probably the most mature in terms of finding product market fit and having real volumes run through these systems and very low if any principal defaults on the blue chip platforms. The one area that we're still figuring out is unsecured or undersecured borrowing. So in a world of blockchain where code is law and these instruments are all bearer assets and there aren't the same rights and remedies you'd have as a lender or borrower in a Chapter 11 bankruptcy, there's very little recourse. And so people have attempted to build reputation based systems or other systems to pull in Web2 data to give people kind of a Web3 credit card or Web3 credit. And we're just starting to scrape the surface of what's possible there.
- [22:58]
Ted Seides
Think about two different types of, let's say borrowing. One is in the world you started. So in any kind of corporate entity you have optimal capital structures, you have borrowing for investment cases. The other you could say is for trading, say leverage as you described it. It sounded to me like there's more borrowing against tokens for that trading side. And I'd love to get a sense of the risk that you see in the system down to project risk from borrowing for the purpose of just creating leverage.
- [23:34]
Ben Forman
So there's certainly a portion of the borrowing that takes place in Defi. That's for people that want to speculate. I think like speculation, it seems like a dirty word. It's part of every financial market in the world and it exists in DeFi. So period. I think that borrowing and having access to efficient credit markets is incredibly important for businesses, for companies. And what's interesting here and the potential I see here is because these networks are governed by software and they have very low marginal cost. There are no people behind these networks. They're truly daos that are just software programs. So in an equilibrium state, lenders should be able to earn more, borrowers should be able to pay less, and there's less rent seeking by these platforms. That's exciting to me. We're also entering a world of more tokenized real world assets. So today these networks involve people borrowing against tokens like Ethereum. What you're starting to see is tokenized physical gold or tokenized U.S. treasuries. Or you can imagine a state of the world where there's tokenized Amazon stock where you can borrow against those assets almost as like a repo. And one of the things that is interesting in the securities lending market is if you own stocks on your Fidelity or Schwab account, you are earning 0% on them. If you're a retail investor. And on the back end, to the extent people are shorting an asset that you own, Fidelity, Schwab, whoever your brokerage is, is making that spread. So really every asset should have some sort of organic embedded yield, even if it's one basis point or five basis points. And so these networks really allow you to earn that baseline yield, which is I think an important component to use.
- [25:30]
Ted Seides
That comparison in the stock world. We've had instances of say the shares outstanding of a company being some very, very high number because people can rehypothecate the same stock over and over and over again. How does that work in the crypto world? When you can imagine a token, a coin can be tagged and there could be limits on how many times you can relend the same coin.
- [25:57]
Ben Forman
There's really no limit on the number of times a token can get rehypothecated in Defi or on these digital networks. And we see there may be a certain token that's bridged to another blockchain or pledged as collateral on one blockchain borrowed against convert it into a preferred instrument. The number of permutations and experimentation that you're seeing is getting quite complex. And one could argue that complexity produces risk. And I think that's true. The positive thing is you can see it all on chain, so you can assess it and you can recognize it because it's all visible in the traditional financial system. I think a lot of risk exists, you just can't see it. We don't know how many times a specific asset is getting rehypothecated or how it's getting tranched up, or a lot of the time, like what assets even represent or what risk there is. One of the reasons that the financial Crisis occurred in 0809 is if you were to look at the 10Q of Lehman Brothers last filing before it went bankrupt, there's a big other line item on the balance sheet. You have to read into the footnotes. No one really knew what risk that large of a financial institution held on its balance sheet, not even the executives working there. And so I think the positive with DeFi is you can see it all. And if you can see it all and you can understand it better, if you can understand it better, you can anticipate it.
- [27:25]
Ted Seides
So certainly in theory you can see it all at the same time. There's lots and lots of transactions. I'm curious, in practice, in a decentralized system, who would be aggregating these risks to actually see what's going on?
- [27:39]
Ben Forman
So it's a great question. There are certain data related services that are built to identify risks and track risks. So there are lots of different blockchain explorers that are built by community members that can flag risks in a network. There's also Twitter, which is wisdom of the crowds, a collection of people that are just constantly staring at blockchain related data and identifying anomalies and raising their hand and saying hey, this, this doesn't look right. And then there are smart contract auditors which are a little bit different, but they assess the overall architecture of these networks both from a code standpoint as well as from a game theory and behavioral standpoint to ensure that there aren't edge cases that can be exploited. So certainly it's not perfect today, but the risk management around these networks is improving very quickly.
- [28:37]
Ted Seides
You touched on this idea of security tokens with gold and Amazon stock. Where are we in terms of, call it traditional assets being either traded or lent against in the web three world.
- [28:54]
Ben Forman
So zooming out. Crypto today is about 20 basis points of all global assets. So it's a trillion and a half asset class global assets are roughly 600 trillion. And that number has gone from basically nothing to 20 basis points. If you really break down the trillion and a half, there are several different categories. There are things like bitcoin which are stores of value. There are operating systems or smart contract platforms, commonly known as layer ones, like Ethereum, like Solana, et cetera. There are applications built on top of those smart contract platforms, typically Daos or these different defi applications. And then the fourth category is real world assets that are ported over and tokenized and brought on chain. That last category, the biggest bucket within that category is stablecoins. So Stablecoins are about 200 billion of the 1 1/2 trillion dollars in the blockchain space. And these are in some cases dollars in bank accounts, backing tokens on the blockchain. And those tokens are redeemable one for one. There are also stablecoins that are not backed by real world assets. There may be backed by digital assets, over collateralized or backed by fictitious assets. And so that's the biggest category of stablecoins outside of stablecoins. There are stablecoins I would say are probably 90, 95% of all real world assets brought on chain. That number's moving lower over time.
- [30:33]
Ted Seides
So stablecoins and certainly algorithmic stablecoins have been in the news recently with Terra and Luna. I'd love to get your help understanding what portion of stablecoins are backed by assets. And therefore the one for one exchange.
- [30:49]
Ben Forman
Is, let's call it stable, sure, about 75%. So of the 200 billion, about 150 billion are fiat backed stablecoins. The largest one is Tether, the second largest one is usdc. And then there are a longer tail of others. Now the final 50 billion are two categories of credit based stablecoins and algorithmic stablecoins. So in the credit based stablecoin category you may have $3 of Ethereum or $2 of Bitcoin backing a $1 pegged stablecoin. There's no dollar in a bank account in the real world. It's money created through credit. So it's almost like M2 instead of M1. And that category has exhibited a significant amount of stability over time and is growing. And then the second non fiat backed category are these algorithmic stablecoins. That's where UST falls. There are dozens of these algorithmic stablecoins that have been launched over the years. Most of them have failed. Some of them have temporarily failed and revived. There's just quite a bit of experimentation there.
- [32:04]
Ted Seides
So I'd love to go through aspects of each of these three categories. So if the fiat money backed stablecoins is there leverage in that system?
- [32:13]
Ben Forman
So if you look at something like tether, they come out with some transparency reporting. The last I looked, about 80% of the assets backing USDT were in cash. The other 20% were in short term securities T bills, some commercial paper. And really the way I think about fiat backed stablecoins is they're almost akin to IOUs or credit issued by the institutions that are issuing the stablecoins. So if you own usdt, you're taking tether counterparty risk. How do you price that? What return do you need to earn to make that worth your while? If you own usdc, you're taking kind of circle counterparty risk and you're making a bet on their risk management. It's no different than having a checking deposit with JP Morgan or Bank of America. You're ultimately taking the risk of the issuer.
- [33:09]
Ted Seides
So I'd love to turn to any of your other favorite ings.
- [33:12]
Ben Forman
I'm excited about defi scaling and my hope is that and my sense is that people won't even use the term DeFi in five to 10 years. It will just be called finance because we don't call finance today centralized finance, it's just called finance. But I envision really defi as being the backend for all capital markets and financial activity. And the largest consumers of defi will be banks, will be fintech companies and will be institutions. It's very complex to interact with defi applications. And the reality is most people just don't care about finance or blockchains. So the most of the people that are using defi applications today are, it's a self selected group. But to scale defi and defi since inception there may have been roughly 4 to 4 or 5 million wallets. Unique wallets that have ever interacted with defi applications? Not that many. In order for that number to grow to 100 million to a billion and beyond, I think you need really two things. So you need abstraction, you need a layer on top of defi that abstracts away the complexity of using it. So the concept of people downloading self custodial wallets, writing down 12 word seed phrases, understanding gas prices, and then being able to make risk assessments around which defi applications are safe or which ones are not, that doesn't scale beyond 4 or 5 million people. You want a world where people are using defi without even knowing that they're using it. It's really invisible it's powering the backend because it's better, faster, cheaper. And so in order to get that, you need folks like Robinhood that are sitting on top of these defi applications, are using them on behalf of users, are risk managing and are kind of the gateway. So really defi scaling is in my mind a D to B2C distribution model, DAO to business to consumer. You need that kind of layer in between, not dissimilar from email. When you send an email, no one thinks about using smtp. You just use Gmail or Microsoft Outlook and it works. You need that application layer.
- [35:43]
Ted Seides
What's the second feature needed for scaling?
- [35:46]
Ben Forman
So it's what's being called permissioned defi. And it's very important and it actually could be one of the most important themes in crypto today. The idea of permission defi really comes from a problem and the problem is that many regulated institutions cannot interact with blockchain applications today due to compliance and regulatory reasons. You don't know who your counterparty is when you're interacting with a smart contract. And earlier this year the EU Parliament passed KYC AML measures that basically said whenever you're transferring crypto or whenever you're interacting on chain, you need to know who your counterparty is. And that's very problematic for institutions and is keeping a number of institutions, institutions who are otherwise interested in the space on the sidelines. And so that's really where permission defi comes into play. So I think just taking a step back, the defi that we use today is really this idea of permissionless defi. Anyone can show up to a website and connect their non custodial wallet and start partaking in finance without any login information, usernames, passwords, you can just start using things. And that has scaled very quickly, but it just doesn't scale beyond the few million people that are really using these networks today. For the reasons I mentioned, it's not institutional. So permission defi describes a new system where addresses are whitelisted by a centralized authority after they've gone through KYC aml. So just an example of this is imagine the big banks in the us, Goldman, JP Morgan, bank of America coming together and saying, hey, we want to build a trading venue on top of Ethereum. But the only people that can participate in it are those that have gone through KYC aml. And if they do make it through that process, they'll get an NFT in their wallet. If they're a qualified purchaser, they'll get a certain NFT if they're an accredited investor, they'll get another NFT. Depending on which country they're located in, US, non US, they're going to maybe a third NFT. And based on these identity verifications memorialized to these NFTs, they'll be allowed to use our architecture and our system. So it's permissioned, it's whitelisted, these are closed smart contracts, but they're still built on top of open networks.
- [38:32]
Ted Seides
If we need this permissioned defi in order to scale, I'm curious what that implies for the large percentage of the world you mentioned earlier that are unbanked. Does that somehow the need for KYC type things for certain types of trading come in the way of those people entering a banking system through DeFi?
- [38:53]
Ben Forman
Potentially, I think there's always a trade off. We've decided on a global scale that like money laundering is a bad thing and we don't want criminals, terrorists interacting with the financial system. So there is a trade off between just being totally open and letting everyone interact with financial products and being inclusive. And it's interesting because sometimes when you think about this state of the world, many would say, well, what's the point? Isn't that the world we have today, the whole point of this is that it's permissionless. And the reason I'd push back is I would say that's one benefit of DEFI and blockchains is that they're censorship resistant, they're permissionless, anyone can use them. But there are a laundry list of other really important benefits as well that I would highlight. So one, you have instant settlement when you're using DeFi. So it's not T + 2 settlements for equities or T + 20 for bank loans. These are all bearer instruments. So there's no global working capital drag from all the unsettled trades in the world. It happens instantly. That's powerful. The second is that within permissioned defi there's still reduced platform risk. So we all saw what happened with the LME when they canceled nickel trades, or what happened with Robinhood and GameStop when they simply said you can't buy GameStop. And there is judgment risk or platform risk you're taking whenever you're interacting with any financial product today because you're doing it through a centralized authority. And in permission defi there's not that same degree of risk because you have the trust guarantees of interacting with a blockchain application. The next thing that comes to my mind is really that all the activity within permission defi is Completely transparent and open. It's not in dark pools. So everyone can see, tick by tick, data activity of all the participants in traditional finance. That data you have to pay exchanges for or they don't disclose it. And you think about the traditional financial system. You have 13F and 13G filings where you have hedge funds that say, hey, here's what I own. They report that quarterly. The beauty of permissioned defi and permissionless defi is you can see every single wallet's ownership in real time and how it changes, including insider activity. And so those are, I think, the types of things that really make markets more efficient. You can build all sorts of new bespoke structured products because really you're only limited by the human imagination. It's really the intersection of software and finance. So anything that can be thought of can be designed through code. So for all those reasons, I still think permission defi is incredibly interesting, incredibly powerful, and probably will be orders of magnitude larger than the defi that we know today.
- [41:57]
Ted Seides
All right, well, you mentioned a couple other ings earlier and you're always going to peek my ears up when you mention indexing. So I'm curious to hear where indexing comes into play in defi.
- [42:09]
Ben Forman
I think indexing is it's this idea of being able to buy a token that represents an asset management product. And so that could be an ETF, that could be a more actively managed product. And I think if you think about that category today, it's grown quite a bit, but it still has, I would say, limited product market fit. I mean if you think about the financial System, Vanguard Fidelity, BlackRock, State Street ETFs are pretty efficient. You can buy S&P 500 exposure for a few bips. So I think we'll continue to see growth in that area. There hasn't been as much demand for people that want to buy index funds in crypto. People want to pick tokens and catch the next 100x.
- [42:54]
Ted Seides
How about hedging?
- [42:55]
Ben Forman
So hedging is really interesting, I think about hedging in the same category as insurance. It's how do people buy financial products that protect them. And one of the things like we've seen in talking to institutions is that they want to use blockchain related products, but they're uncomfortable underwriting smart contract risk and software bugs and hacks. There's no FDIC insurance in crypto. So there are a few different insurance related protocols that are popping up. One is called Nexus Mutual. This is an Ethereum based insurance marketplace. It's regulated in the uk. And the way it works is you can show up to Nexus Mutual and you can buy a policy that ensures against a particular protocol having a bug. So one example is, let's say you're lending out stablecoins on AAVE, earning 5%. AAVE being a decentralized money market, and you're uncomfortable with the software risk of aave. You could buy an insurance policy on AAVE from Nexus mutual for say 50 basis points a year. Rough numbers. So Instead of making 5% uninsured, you're making 4.5%, effectively mitigating that risk. It's an interesting product. Within Nexus Mutual, there's this capital pool that pays out claims. There's roughly $400 million in the capital pool. There's roughly 20 million a year of annualized premiums being paid in. And it's an interesting experiment. It's gone on for a couple of years. It hasn't really scaled. Again, I think people are most of the capital in crypto today, it has been more risk seeking rather than focused on risk mitigation. So insurance is still kind of finding its legs.
- [44:53]
Ted Seides
One of the ings you didn't mention, but that comes up a lot, is governing. And we hear about daos as a governance mechanism on the blockchain. And it strikes me that it'd be pretty important within DEFI and would just love to hear how that kind of governing piece with DAOs when it's important in DeFi.
- [45:14]
Ben Forman
So DAOs are really just a new way to organize people and capital. It's really just a new step forward or new evolution of an LLC or corporation. Really everything in DEFI is a dao, whether it's a money market platform or a decentralized exchange or an insurance protocol. A DAO really refers to the equity, almost the equity piece of the capital structure that governs that piece of software. So one example back on the point on insurance, I was mentioning Nexus Mutual. So there's a token called the NXM token. And anyone that owns NXM has a direct claim on the money in the capital pool, which is roughly 400 million plus. They theoretically have a future claim on all the premiums paid in from people buying insurance policies, less the claims paid out. And with respect to what types of insurance policies should be provided. If the Dow should be paying anyone, any fundamental changes to the protocol need to be voted on by NXM token holders. So anyone that owns an NXM token is theoretically part of the dao, whether or not they want to participate in governance. Is a different story. I think most people within daos or who own a token tend to just be completely passive. There tend to be a small group of people that really care and then a long tail of people that really don't care. So everything in defi really fundamentally is a dao.
- [47:01]
Ted Seides
Sounds like in that NXM example that the DAO ends up being used as a form of capital allocation in the sense that you're deciding on what policies to write, you're deciding on how capital gets spent. So I'm curious how capital allocation works in daos.
- [47:21]
Ben Forman
I think about these daos and these applications almost as being toll booths on the Internet. Like if people interact with them, they take a small cut and that value accrues to a smart contract and accrues to a treasury. Very similar to if a company in the real world earns cash, it accumulates in their bank account. If a company wants to return that cash to their shareholders, they can either issue a dividend, they can use that cash to buy back stock, or they can decide to invest in growth and distribute that value to employees or people building, people helping their company. So it's very similar in the DAO space. So some of these earnings get funneled to token buybacks, which are akin to stock buybacks. Others are just distributed as a dividend to token holders. And then the last category is just sometimes in certain cases, these earnings just accrue to a treasury over time. And people can apply to daos and say, hey, I'm a developer, or we're a group of five developers. We want to perform and write this type of code or perform these services for the dao. We'd like to earn X amount of dollars for our services in the form of stablecoins that looks like you have in your treasury as well as tokens. And then what happens is token holders of this network come together, evaluate this proposal and vote on it. So a network like MakerDAO has something on the order of 50 different core units that are each responsible for the finance and accounting of the dao, the growth marketing strategy of the dao, the core engineering services, and they all have to apply to the DAO for compensation on a periodic schedule. There's roughly $40 million a year of expenses that are being paid out to over 100 different individuals contributing to that DAO. So it's very similar to a company in that sense, but there's no board of directors, no management team, and the workforce is very decentralized and distributed.
- [49:40]
Ted Seides
I'm curious as you get into that example where there is more complexity in a decentralized system, how do decisions get made?
- [49:49]
Ben Forman
It's very messy and it's very challenging. It's much slower to build a decentralized network than it is to build a centralized network company. I think about decentralization really on a spectrum. Even in the world of companies, when an entrepreneur founds a business and it's his or hers, they make every decision. It's on the furthest end of the spectrum. They have complete control. But as that business grows, they delegate more responsibility to others. There may be a board, there may be venture capitalists. Decision making is more decentralized, ownership is more decentralized. Through that process, things may move a little bit more slowly because you have to get more approvals. Communication isn't seamless, so there's a trade off. Centralization produces more speed. Decentralization tends to produce less speed. Same in the dao and the dao space and defi, et cetera. The more decentralized the network tends to be, the slower it moves. But everything's very much on a spectrum. We've seen a lot of challenges in building daos. I suspect that 98, 99% plus of the blockchain applications, the daos that exist today, are not going to be around long term. It's extremely challenging and in some ways governance and human involvement is almost a bug. It's not a feature. You want these systems and networks to stand on their own two feet, almost as public utilities. So one of the frameworks that we apply when we evaluate projects in the space, and sometimes this is more as a thought experiment, we said if no one touched the code of this network ever again, no one contributed to it, what would that future look like? Would it still continue to accrue cash flow, earnings, or is it reliant on people? Because if it's reliant on people, there tends to be more challenges with that and you're taking a different type of risk.
- [51:56]
Ted Seides
How do you think about the underwriting process and valuing tokens?
- [52:01]
Ben Forman
So yeah, tokens are really interesting because they're very much a new asset class. They're the fifth asset class in the world. Pre tokens, there were equities, fixed income, currencies and commodities. And really every asset could be put into one of those four categories. Interesting about tokens is they're really a brand new category. There are thousands of tokens now that exist. And what's interesting about this market is there's no GAAP financial statements, no 10ks or 10qs. No investor relations department to call and ask questions to. You can ask people in a Reddit forum or on Discord or talk to core developers, but because there's no person calling the shots, you have to talk to a lot of people to really understand what's going on. But this market is one where non standardized information, the information is very fragmented and it takes a lot of work to really get your arms around what these networks do, why a token accrues value, and really what a roadmap looks like and what the team around these projects looks like. So the way I look at our research process is we look at tokens not dissimilar from the way someone at KKR or tpg, the way we would evaluate a company. So we are understanding like, is there a solid use case and product here? What do the competitive moats look like? Is this company or product gaining market share, losing market share and why? What's the value capture and margins associated with the product that's being offered? Who's the team working around the product? Are they incentivized or not? Are they working on multiple things or not? So we look at like all the same types of things that you would look at if you were looking at a company. In addition, you look at the integrity of the smart contracts and code that's been written and you vet that. And then the other point that I think is sometimes lost is most of these tokens are claims on cash flows. We think about them that way. Most of these daos you can either look at a book value or look at fee capture and you could run a discounted cash flow, look at a price to earnings multiple and you can see all these metrics in real time. There's not quarterly reporting, but at least on Ethereum and it varies blockchain by blockchain, every 15 seconds you get a new 10Q with new information and so you can digest this in real time. And we're constantly reassessing our investment thesis. One big difference in this asset class is you don't only have to decide what to buy, you have to decide what to sell and when to sell. In venture, you typically just make a decision of what to buy and then you wait. You help a founder and then you wait. Yes, you can take off money in a secondary, but generally you don't control the decision of when to sell. In crypto you make a decision of what to buy, but then you can also decide to change your mind if your thesis doesn't play out.
- [55:21]
Ted Seides
So we've had this big sell off in the prices of tokens and crypto assets. And I'm curious, for those that are generating cash flows as you're looking at them, what are the range of multiples, if you're comparing it to equity multiples that you see in the defi space?
- [55:38]
Ben Forman
We've seen things that have traded at 1 times earnings or 2 times earnings. We've also seen things that are trading at 100 times earnings plus and all of them have very differing growth rates. I think that it's helpful to be mindful of fundamental analysis in crypto, but you also don't want to rely on it too much for a specific reason, which is in crypto things are changing very quickly. You can have a protocol that's growing 10x year over year and then all of a sudden earnings fall off a cliff because of some dramatic shift in the landscape. Because of that volatility of earnings, you have to ascribe at a lower multiple. Because if you're looking out like five years, 10 years and saying how much cash flow will this protocol do? Well, we can make assumptions, but we know we're likely going to be wrong or our confidence intervals much lower. So you have to ascribe a higher discount rate to those cash flows very far out. Because of that uncertainty, I think daos probably trade at lower multiples than companies, at least in the near term. Now, offsetting that, these networks tend to not have any capex. There's no balance sheet. Some of them have very high cash flow conversion. Some of them are effectively 100% margin because they'll just clip a little fee of every transaction and they kind of run on their own. So there's a wide range and every one requires very individual underwriting. But that's how I look at it. As the markets traded down, I think what we've seen is in crypto, when the market trades down, everything trades down. And then when the market trades up, things tend to kind of diverge. So over short periods of time, you tend to have a lot of convergence or correlation. But over long periods of time, there's a tremendous amount of return dispersion in this asset class.
- [57:37]
Ted Seides
I'm curious, in your activities, you do call it venture equity investing. You're actively engaged in kind of arbitrage type trading. You buy tokens in the traditional markets. You often think of these as very different skill sets. There's a venture investor, there's arbitrage, hedge fund, quant hedge fund, or whatever it is. Is that the same or is it different as you are participating across the spectrum of kind of traditional activities in the crypto landscape, I think the lines.
- [58:07]
Ben Forman
Are blurred between tokens and companies. Sometimes we'll invest in a company and they'll end up issuing a token, sometimes we'll invest in a protocol. But a lot of value ends up accruing to a company that's really helping build products on top of a network. The actual exercise of understanding those two is very similar. The liquidity profiles can be very different, the risk return can be different. But I think the muscle groups that you're using in terms of evaluating teams, products, markets tend to overlap quite a bit on the credit side in terms of using these products, market neutral returns. That is helpful in the sense that we end up becoming users of the networks that we're investing in. And when you use something, you learn a lot, you understand it more deeply. It's a different type of investing, it's more quantitative, it's more technical, but it does help inform how we make decisions and how we build theses across the board.
- [59:08]
Ted Seides
So you mentioned at the onset, having used a Defi app this morning, how does all that come together?
- [59:15]
Ben Forman
So back in the early days of Parafi, one thing we forced ourselves to do whenever we invested in any token is we wanted to use the product that was actually behind it. And so we were tinkering around with Compound and Uniswap and some of these first generation defi protocols. And what we found by using these products is, well, we determined whether or not they actually worked. We understood then from first principles more how they worked and where they fell short. But then we identified that there were all these inefficiencies within Defi. You may be able to borrow a stablecoin on one application at 4% and then lend it out that same stablecoin on another at 6% and make a spread. And those spreads can be episodic in nature. They come and go, and maybe they only accommodate a certain amount of capital behind them. But there were all these pennies and nickels and dimes to pick up scattered across this new kind of economy. And that was very interesting to us. And so one of the things we do at Parafi is we have a strategy that's focused on capturing those tenths of a penny that are scattered across different blockchains. And we do it one to make money. We think it's an interesting market neutral strategy, but also it's an incredible mechanism to learn about the space, about what's working. Because again, when you're using these things every day, you really understand them at a deeper level.
- [60:50]
Ted Seides
What's an example of something that others commonly in the space thought to be true and you found wasn't by nature of using these applications?
- [61:01]
Ben Forman
I'll kind of give one example. I mean, there's so many ways to answer that question. I think a lot of time there's a quoted yield in yield farms where it's say, hey, if you deposit this token, you'll earn 100% APR. And what I think the market has done a bad job at historically is understanding the risk associated with that return. The capital tended to aggressively move towards the highest return. Almost agnostic to risk. When you really dig into these stated returns in yield farms, one, there isn't always the right disclosure around the risks that you're taking. But also a lot of time the return is coming in the form of a token that may not have liquidity and there may be lockups associated with it. It's really messy. And so just taking a return at face value and not thinking about all the other factors that go into it is, I think, something that the market wasn't doing well for a while and will hopefully start to do a better job of.
- [62:03]
Ted Seides
I'd love to get your sense on the fund landscape. I know part of your activities involve backing other crypto organizations. How did you come to that and what does it look like today?
- [62:15]
Ben Forman
So when I launched Parafi, there were maybe 150 to 200 crypto funds in the world. There were a handful that were over 100 million of AUM. Today there are roughly 2,000 crypto native funds globally that collectively represent, call it 50 to 75 billion of capital. And there are also a number of other crossover funds, traditional funds that are now investing in crypto. Perhaps there's been more money from crossover funds, traditional funds investing in crypto, than there actually has been from crypto native funds. But I am obsessed and love the art of building an asset management firm. I'm just very interested in it and all the different things that it takes. Culture, team building, processes, compliance. And what we kind of saw over the years is a number of these asset managers in crypto were incredible technologists, but had never managed capital. So they didn't know what a financial audit was. They weren't familiar with valuation policy or what a PPM even was. And so they just needed guidance. And I enjoy kind of helping and mentoring people that are launching funds in the space. And so we started to take very small minority GP stakes in a number of new emerging fund managers in crypto. It used to be that everyone just ran a crypto fund, like a generalist crypto fund. Now the landscape is segmented by geography and by theme and by strategy. So there's obviously quant and fundamental and quantamental and a number of different flavors in between, whether it's closed end venture or more trading oriented strategies. But then even a step further, there are now funds that are solely focused on investing in blockchain projects in Africa or focusing on backing teams building defi applications out of Asia. We're not going to be able to cover everything at Parafi. The world's way too broad within this space. And so we want to back other managers that are pursuing orthogonal ideas, themes, and we can learn from them, share ideas, and then we can kind of help them grow and scale along the way.
- [64:38]
Ted Seides
So if we circle back to Parafi and where you were at the beginning two years ago, roughly, you had battled through those first couple years and then hit this inflection in this last wave. And I'd love to get your sense of what that journey was like to go from battling it out on very small assets to where you are today.
- [65:04]
Ben Forman
I almost feel like we're just in the middle of climbing the mountain and every once in a while you have to pause and look behind you. It's been one of making a lot of mistakes and learning from them. It's also been a very humbling experience overall because you realize you can make great decisions and you don't necessarily see the results of those decisions for a while. One of the things I've just learned as we look to back founders in this space is just the value of perseverance. Sometimes if you just stick with things a little bit longer, they end up working. It's been really exciting. I'm just so excited about what's happening in the space. I mean, the amount of talent that's building in applications, in Web3, the number of resumes we're getting from people on Wall street in the hedge fund world, or engineers at big tech companies that want to enter and spend their career in the blockchain space, I think is a really powerful leading indicator. But I think to build an enduring asset management firm, you need to be good during times of war and also during times of peace. And in a way, we're back in a time of war right now. So it's been exciting and I feel pretty fortunate just to be where we are with the team that we have.
- [66:17]
Ted Seides
What have you seen in the last couple months as the cycle has turned down again, both in terms of people's interest in coming into the space and then also in the technology underneath.
- [66:28]
Ben Forman
So look, I take the view that if you're investing capital really over a timeframe of quarters or even a year, it's really difficult to predict what's going to happen in this space. If you take a view of what will this world look like 10 years from now in the year 2032, it's very clear to me these networks are growing, they're working. There's never been more talent entering and building in this ecosystem. The technology has to a large extent been de risked. I think regulation is more of an opportunity at this point than a risk and price is going to bounce around. Price is rarely like a leading indicator for fundamental progress and traction. When I got into the space in 2014, there had been a bull market. In 2013, then there was a bear market. In 2014, 15 people kind of wrote off bitcoin and crypto at large. In 2016, people were excited about the blockchain space, but not Bitcoin. In 2017 there was a boom, the ICO boom. Then 2018, 2019, another bear market. A lot of stuff was built, but it was a bear market for price. Pandemic crypto took another Tumble. But in mid 2020 you had DeFi Summer 2021, NFTs, Metaverse, tons of talent came in and now in 2022 we're kind of back in a bear market. Now it's happened at a time when capital markets are also trading off. So I think that the best way to approach the space is really to think long term. And it's never been more clear to me that all the fundamentals are in place for a lot of growth.
- [68:13]
Ted Seides
Great. Ben. Well, I can't let you go without asking you a couple closing questions. So what is your favorite hobby or activity outside of work and family?
- [68:21]
Ben Forman
Chess. So I learned how to play chess from my dad when I was four years old. I played competitively growing up. I still play at chess clubs or in the park and I take lessons online. And I just love chess. It's the consummate game of strategy, skill, decision making. I'm trying to teach my 4 year old son, but he is not interested at all.
- [68:43]
Ted Seides
What's your biggest personal pet peeve?
- [68:45]
Ben Forman
So I think when people overrate talent and underrate the importance of hard work, I've seen a lot of extremely smart people like underperform. They aren't willing to work hard. And I think it's incredibly rare to find people that are willing to put in the Work to succeed. I think the best people at what they do work incredibly hard to get there. Whether it's like LeBron James or Michael Phelps or musicians, artists, investors, et cetera, they don't televise. LeBron James practicing 16 hours a day, focusing on his diet, meditating in the gym, in the weight room with trainers. You just see the games and he makes it seem easy. But hard work beats talent. When talent doesn't work hard is the way I look at it.
- [69:29]
Ted Seides
How about your biggest investment pet peeve?
- [69:32]
Ben Forman
I think for me it's dogma and it's having a very strong, rigid view without doing work. I remember when I learned about bitcoin, I was immediately dismissive and my friend said, wait a second, have you done any of your own diligence on bitcoin? And I was like, okay, no, it's a fair point. I can't have a view without actually having done my homework. In order to have a view, in order to have the right to have a view, you have to have done your work.
- [69:58]
Ted Seides
Which two people have had the biggest impact on your professional life?
- [70:02]
Ben Forman
Henry Kravis is one of them. He was a day one investor in Parafi and was a mentor to me and believed in me. I think when someone believes in you, it's very humbling and empowering. I think he believed in me. I'm not sure how much he believed in crypto at the time, but he respected the entrepreneurial journey and so that means a lot to me. The second. I've had a number of bosses over the years that have been extremely challenging to work for and extremely neurotic and have held me to a very high standard. It was painful to work for them at times, but I don't think I'd be where I am today if it wasn't for being in the trenches with them.
- [70:41]
Ted Seides
What's the biggest mistake you made and what'd you learn from it?
- [70:45]
Ben Forman
In fifth grade, I was playing in the Washington State Chess championship and it was a five game tournament. I'd won the first four games and I was in the fifth game playing for the title. And I was in a position that 99 out of 100 times I would win. But I let my guard down and I kind of rested on my laurels and I lost focus. I ended up losing. And it was an absolutely devastating experience because I had worked so hard to get to that point. I'll never forget it. My takeaway from it is you have to take a job end to end. You can't take something to the one yard line, you have to get it across the finish line, otherwise it doesn't count.
- [71:32]
Ted Seides
What teaching from your parents has most stayed with you?
- [71:35]
Ben Forman
It's really the importance of hard work. My parents always taught me that little by little does the trick. If you do the right thing over and over again and focus on practice and consistency, you'll get to where you want to go. So every big thing that's ever been built is the collection of lots of small things being done right over and over again. And my dad has said sometimes you need to swing the hammer 100 times to get the nail in. And that's always resonated with me.
- [72:06]
Ted Seides
All right, Ben, last one. What life lesson have you learned that you wish you knew a lot earlier in life?
- [72:11]
Ben Forman
So someone once said, no one's going to help you, but no one's going to stop you. That's some of the best career advice I've ever received. I was of the mind that the path to success was maybe staying on the paved road, and that involved the least amount of risk. But the reality is that sometimes staying in that safest path is actually the riskiest path of all. And so really, it's two things. It's don't rely on anyone else to create your success. You have to really push for it yourself. And the second thing is, if you can add value to a person or a company, do it. They're not going to stop you. They're not going to limit your responsibility because you're too young or you don't totally know what you're talking about. If you're doing a good job, people are going to be more than willing to give you responsibility. And so I think that's an empowering message because it says if you want something, you can create it. It's really on you and no one's going to stop you except for you.
- [73:14]
Ted Seides
Great. Ben, thanks so much for taking the time.
- [73:17]
Ben Forman
Yeah, thanks a lot.
- [73:19]
Ted Seides
Thanks for listening to the show. If you like what you heard, hop on our website@capitalallocators.com where you can access past shows, join our mailing list and sign up for premium content. Have a good one and see you next time.