Strategy's Yield Machine & SEC Unlocking DeFi Front Ends

Transcript

It's quite novel and unique financial engineering and it's working. Obviously this strategy works but can be stretched too far and then it breaks. And so you have to monitor the characteristics [music] of when that stretch would be stretched too far. Stretch is an instrument for people who believe that Bitcoin will stay around. They just don't want to be exposed for Bitcoin's [music] 30, 40, 60, 80 vol. So they will say, "Okay, I'm fine stripping most of the volatility and then I'll take this [music] juicy yield." It pays on 11 and 1/2% dividend and I think that's basically the headline of it there. Just the willpower to do this even in a bit of a quote-unquote bear market. You

know, this is what makes strategy the premier BTC data probably all of the others in the world. But I think it's important for everyone to think about like wouldn't buy it at 4, you would definitely [music] buy it at 50. But where is that breakpoint? You shouldn't just say, "I'll buy it." The only way that I would be comfortable holding it longer is >> [music] >> As always, note that none of the information discussed constitutes investment advice or any offer,

recommendation, or solicitation by Blockworks Galaxy Bitwise or Anchorage or any of its affiliates to buy or sell any securities. Everyone, welcome back to Inflection Point. We have an interesting episode ahead of us. There's some stuff you wanted to talk about. Uh we were just discussing how last week's episode on ETFs, I mean, vaults are the new ETFs has been getting some traction and I kind of actually saw something today, Matt, that I wanted to bring up. I saw that in that episode we also talked about, you know, the maturation of vaults and the asset managers coming into the class and I saw that EigenLayer released uh AVS for reinsurance specifically for

vaults. So, I mean, people think of restaking as kind of like reinsurance anyway, so it's like a natural fit. Um it's called catalysis or catalysis. I'm not sure how to pronounce it. Um and I was thinking this kind of maybe fits in well with, you know, Bitwise going into into vaults and Bitwise also with the acquisition of Chorus One, then this gives Chorus One a way to earn extra yield on their staking as well as give protections to the institutional investors who may be a little bit more hesitant in the space about going into vaults with this kind of like protection on the downside as well.

Uh I don't know if you have any thoughts there if you saw that news. Well, I I I saw it briefly. I haven't dug into it. It is it is uh it is fresh. But it it speaks to something which we talked about, the necessary conditions for this maturation and I think uh that concept of insurance reinsurance is a big piece of it, right? That is that is what's going to happen that helps take this um take this onward. I don't know if anyone else dug into that news more aggressively than I did. No, I did I didn't dig into that news. I'm I'm actually though quite interested in reinsurance and insurance um um and from a DeFi perspective uh if anyone can pull off an insurance product or reinsurance product in DeFi, I think it

could have legs. Um I'm looking at a few companies but nothing has really um I mean, it's it's one of those ideas that's obvious and it's all about execution. Can someone execute on it? Yeah. >> Yeah. I just wanted to bring that up because we talked about it and then yeah, go ahead. Yeah, I mean, I would just add it's it's actually like a beautiful example of uh crypto blowing apart the stack of financial services that get lumped together in the traditional world and then slowly accumulating the necessary pieces uh where it's needed and people will be able to opt in, opt out. But I think it's a great example. Look, this space is going to mature dramatically.

Uh insurance, credit ratings, etc. are are all going to be part of it. So I I do think it's an indication we're moving on that track. Massive DeFi primitive. It's it's going to come. Okay, lovely. Um well, now let's let's bring it on to stretch. We were kind of um we were talking about this backstage before we started recording the pod and for the audience who's unaware, Stretch is there's this company called Strategy, formerly known as Michael MicroStrategy, and they're very famous for becoming the Bitcoin digital asset treasury of the world and they have numerous products.

They have common stock, their bonds, convertible bonds, and some preferred equities. But this one in particular, Stretch, SDRC is its ticker symbol, is their preferred equity that it it pays an 11 and 1/2% dividend and I think that's basically the headline of it there. And people want to know how can how can such an instrument pay such a high yield? And here on screen for the audio only viewers, I've put a graph, a daily chart of the Stretch price and we can see that it's been fairly stable around the $100 mark.

And that's because the way that this preferred instrument works is anytime the preferred equity trades below par and in this case $100, management has the ability to increase the dividend yield by, you know, up to 50 bips per month and mostly 25 is the standard. And anytime it goes above 100, then MicroStrategy essentially sells that the preferred instrument using an at-the-market offering to keep the price down and they use the funds from the sale of this preferred equity to fund the purchase of additional Bitcoin. Um

I think that's a decent enough primer to start with. Um Does anybody I want to put it out here to the floor. Um maybe Michael, you can start. Any any first thoughts here? Uh well, what I think makes STRC unusual and and genuinely novel, I think, is the variable rate mechanism. So Strategy has sole discretion to adjust the dividend rate every month and their, you know, stated intention is to adjust it to keep the stock trading at or near 100 par value, I believe. >> [snorts] >> Um they can't cut the rate by more than 25 basis points uh per period plus a SOFR-linked adjustment, I think. Um and they can't go below the prevailing like one-month SOFR rate, I think. Uh but

within those guardrails, they're basically running a monetary policy. Um and you know, it's a monetary policy operation uh on their own preferred stock. It's quite novel and unique financial engineering um and it's working. Um as you just said, Mark, you know, the stock is pinned at par, it trades like a stablecoin on equity rails. The rate went from 9% when they launched this to 11 and 1/2% today. So the market demand is there um and it actually demanded more than Saylor initially anticipated.

Um so you know, I think it's a very very interesting product um and I'd be interested to know if this is a product that David or Matt would buy um but uh the mechanism itself is functioning as designed at current. Yeah, I mean, I I I think one one important thing to think about when you think about this product is to think about the history. Uh it should be an infinite shark, right? 12% return, zero vol. Um to think about the history of MicroStrategy. MicroStrategy's mission is to buy Bitcoin.

And initially it was able to do that just by issuing common equity. Uh the common equity traded at a premium. It was able to issue equity at par, buy Bitcoin, and that was the focus of the strategy. Then that sort of came somewhat to an end and it pivoted to convertible bonds. And it was able to issue convertible bonds first with an interest rate and then with no interest and that became a multi-billion dollar market. They did a what, 8, 9 billion dollars. They were able to use that to buy Bitcoin. Now this newest innovation is they've taken the strength of their uh unencumbered balance sheet, right, which is still largely unencumbered by debt, and are using it to uh buy effective or

pay effectively dividends to issue preferred equity and they're using the capital they raised to buy Bitcoin. But they're all part and parcel of what the company is doing. It wants to buy Bitcoin. It has these various financial tools. This is just the latest one. I actually suspect, I don't know what it will be, but I suspect there will be other ones. I suspect that this is the Stretch era of MicroStrategy or Strategy and then there will be another era just like there was a convertible era and there was a traditional equity era. I wouldn't be surprised to see other ones uh in the future. They're going to use all tools available to them to acquire more Bitcoin. Maybe there'll be an M&A era. I'm not sure. From an investor's perspective, you have to think about

obviously this strategy works uh but can be stretched too far and then it breaks. And so you have to monitor the characteristics of when that uh stretch would be stretched too far and uh and would in fact break. But I think it's a a really interesting novel product. Um it's done exceptionally well. I've got reasons to be excited about it, reasons to be worried about it as well. I think Matt's point is spot on and I think you touched on the most important thing for stretch. The way I think about stretch is actually not too different from what Saylor has been. The way I think Saylor actually presents stretch in a pretty decent way at least in some of the talks I've seen. The folks from Strive as well, right? Strive is another

Bitcoin treasury company. Within all the treasury companies, Strive is probably the ones that most closely follows the MicroStrategy roadmap to the point that they have SATA, S A T A, which is an instrument similar to stretch. It has a higher yield, of course, because you can maybe see Strive as a smaller company. But the way these folks describe stretch is to kind of strip out Bitcoin's volatility. And I think this is interesting because stretch is an instrument for people who who believe that Bitcoin will stay around.

They They just don't want to be exposed for Bitcoin's 30, 40, 60, 80 vol profile, right? Which can be too much for some folks to to take in. So, they will say, "Okay, I'm fine taking a much lower volatility or stripping most of the volatility and then I'll take this juicy yield, right? Now I think it's 11.5% and I'll pass on the extra volatility to Strategy's shareholder. So, there is kind of a little bit of an amplification factor here in that Strategy shareholders, they are being exposed to, let's say, this amplified Bitcoin while stretch holders are

Again, you have to believe that Bitcoin will continue to stay around. But But But that's kind of what we we are saying. And And to Matt's point, maybe there's other folks who want to be in the other in other's vices from this volatility profile and maybe that could open room for other similar instruments. But that's how I think about stretch. I I think formally it's a perpetual preferred instrument, right? So So, at the very core, it's not that different from a preferred instrument, but it does have all these different characteristics in that it's perpetual, the rate is variable, so it has all these nice properties that and nice features that Mark has announced. I also

agree that it has been actually extremely stable trading at about $100, maybe with with pretty tight spreads. And And it's been probably the most the the main driving force of Bitcoin buying pressure probably over the past few weeks. It's been extremely successful. I I think that you made a really good point at at the end there. Even with you know, this depressed market action, depressed BTC price, Strategy is still able to go out there and raise funds and be able to continue to make, you know, common share accretive purchases.

Um and given the low liquidity and volumes just in a in a bear market, if that's what we want to call what we're in now, um these kind of like billion-dollar buys in one day start to have an out you know, an outsized impact on the market maybe in the short to medium term because obviously he's going to purchase this OTC. But the OTC desks need to then go and fill up again on their reserves. So, I I mean, the financial engineering and the just the willpower to do this even in the bits of a you know, of a quote-unquote bear market. I think, you know, this is what makes Strategy the premier BTC dot of probably all of the others in the world. And it's it's not just that but it the the

popularity of it. I'll pull up a slide here. This kind of shows you how popular this instrument is alone. Like stretch in terms of relative to its market cap is you know, is extremely popular and this is this is I mean, for the viewers at home, I'm showing a market cap average trading volume divided by market cap and highlighting that stretch is multiple times higher than every company in the market except one and that's Tesla, Meta, Nvidia, etc. Just kind of shows you how popular it is but it's it's mostly popular on retail. I believe the CEO said that 88% of their holders are retail and it kind of makes sense why Michael Saylor will say these analogies

like this is the iPhone moment for Strategy and this is the iPhone product and all you need is, you know, digital money, you know, digital car, digital this. It's like all of this is part of the marketing to retail and I think he's doing a well job in that. But then outside of retail, the 20% that that there's still some Oops. There's still some some attractiveness there as well cuz I mean, here I'm I'm showing a chart of some of the largest institutions that hold it and you know, they're I think they're number two on BlackRock's preferred income ETF because, you know, 11.5% Why why would it not be that high a weighting? But I think this broadly shows that

you know, crypto is getting institutionalized and financialized in in different ways that are starting to appear outside of the traditional crypto circles. 100% and I mean, the note I want to make here is that Anchorage also has announced during actually Strategy World, which is a recent uh conference that MicroStrategy has done. Anchorage has also an allocation to stretch from our our corporate resources. That 80/20% breakdown kind of makes sense to me, to be honest, Mark. I think institutions are still getting up to speed.

Obviously, stretch is a very novel instrument. Bitcoin itself, I think it's something that a lot of institutions are learning how to engage with. So, I think it kind of makes sense to me that that is still a primarily retail-focused instrument, but we're starting to see institutional adoption kind of growing. Yeah, I I suspect that will shift a little bit over time. I think professional investors are just starting to learn about stretch. Retail investors have been aggressively yield-seeking, particularly crypto-adjacent retail investors have been aggressively yield-seeking since they came out of the womb. I think I think the the more professional investors are just now starting to learn

about this instrument, so maybe that will be 60/40 or something in another year. I wouldn't be shocked to see that. Can Can I ask the panel why do we think this strategy has not been successfully replicated by any other dot? And I don't just mean this strategy for stretch. I mean, even just tapping convert markets for other dots. What What What do we think the reason is? Cuz I got some views, but I would like to hear what you guys think. I mean, I think it's that MicroStrategy had this unique moment pre-Bitcoin ETF where it was the only equitized way to gain exposure to crypto and therefore

traded at a very high premium to NAV and that allowed it to build a debt-unencumbered balance sheet of Bitcoin. And once you have $50 of Bitcoin, you can do all these sorts of things. But if you're starting at zero and you don't have that equity mechanism to really build up that unencumbered Bitcoin balance, it's a lot harder. And I think as you look at the other dots, they just don't have the same size, scope, liquidity, and unencumbered balance sheet that MicroStrategy or Strategy does and that limits their ability to do these sorts of things. So, it's it's it's a lot of things, but mostly I think it's first-mover advantage. Can Can Matt, can

I just ask a follow-up there? Like I want to just tease out that one point cuz I think you're completely correct. But like is it the just the size of the balance sheet that if Bitmain was that size in terms of its balance sheet, it would be able to issue converts? Um and by like as a counterfactual, if Bitmain issued converts today, let's say, or preferred, do you think it just they wouldn't take off? I mean, Tom Lee's a smart guy, right? Like Yeah, it's a great question. Um I don't think they'd take off to the degree cuz the other thing that I didn't mention is that they filled this dramatic need. You know, the funny thing that about the chart that Mark was showing is that with the converts particularly, they had massive adoption

from convert funds. Like that was one of the primary driver because they were really excited about the vol that they were able to capture. But I think you could say that maybe they satisfied a big chunk of that market demand. And that would that would be the other piece because they But again, I think it all all boils down to being first. Unencumbered balance sheet, satisfy the market, first liquidity, etc. I I agree. I think there's an extra point to add here. Fully agree. Lending is and MicroStrategy got into Bitcoin at the right point of the cycle, so they built this big Bitcoin holdings that they can that they are now monetizing.

But for convertible markets, there's there's another thing you need. You actually need a very well-developed options chain. Because a lot of this convert this this this funds, what they're basically doing is they're actually arbitraging the volatility of the convert with the volatility of the stock. So strategy was actually kind of smart to kind of smart and was at the right time to not only build this big balance sheet, but also build stock liquidity, attract market makers, developed a full liquid options chain market that is basically necessary for converts. It's not necessarily

this is not necessarily for stretch, but definitely necessary for the other converts. What I would say, let's say Bitmain, they're probably on their way, but there's a lot of these things that you need to build and these things kind of come with time, right? You need stock liquidity, you need to attract market makers. Takes a while to develop a strong and and and liquid options market. And you cannot issue regular converts without that. What is the challenge for Bitmain just developing an options market? It's time.

Time, size, liquidity, takes a while to develop. Cuz there are Bitmain options right now, right? There's just not a lot of demand for it. Is that is that Yeah, I I haven't seen recently, but if you compare the liquidity of example MicroStrategy options, that MicroStrategy options are extremely liquid. They're actually some of the most liquid in the market sometimes. And I think maybe Bitmain still needs a little bit of time to to get there. But there's a path. There there definitely is one, I think. It will take some time. MSTR common stock is the most liquid in terms of volume to market cap in the entire S&P 500. And it's it's the mass point. It's the first mover advantage.

It was it being the only instrument. It was the appeal to retail and institutional. I think masters held by 40% retail now, but I feel like that's because of the S&P 500 inclusion is has been diluting the retail versus the institutional there. And it's it's the fact that it was already a public company that was already had another operating businesses and already had it was already used to all of the regulations that come with being a public company instead of becoming one through a SPAC or means of these other ones. And that kind of liquidity, like David was saying, takes time.

And you know, they basically they were the one who created invented this this idea that a creative dilution. And you know, they had and now Michael Saylor stepped down from CEO to be more of what I would say is a marketing role. And all of these things are very hard. I think they're difficult to replicate. I think the path towards that for maybe like a Bitmain is even longer than something. It it would for sure help if ETH went up. Yeah, >> [laughter] >> I mean I mean to give Tom Lee Tom Lee joined ETH was at 2500, you know, today it's at 2300.

If ETH were at 10,000, I bet that options chain would be jumping. So I think that is the other piece of it. But Matt, ETH has a higher beta than Bitcoin, right? And the for convert buyers, right? You're you are you are very interested in the volatility there. So you one would think that not just for Bitmain, but for Ford Industries or any other Solana Dats, the higher the underlying beta is of the core crypto, you would think it would be actually more attractive to convert holders and there'd be more of a market to sell converts into. I I just want to say one other thing. Okay, you got me there. No, no, I agree. I just think you need you need the the

bull market to bring in retail participation in those options. To get the liquidity to allow that that flywheel to develop as David was saying. But also I think Bitcoin has more upside beta. Cuz if you look at the Kager of ETH over the past 6 years, like it's it's where it was like 5 years ago like in terms of like compound compounded annual growth rate. Like I think it has a lot more of that and and it's vol is a lot more downside vol in recent years And you know, that this you know, yeah, the sharp ratio of you know, Bitcoin, they would you know, a lot of institutions have done this. What what adding 1 to 5% of Bitcoin will do to the sharp ratio of the entire portfolio on a

long enough time horizon, those same analysis don't look as nice with ETH unfortunately. But but if Just to just to be clear about what you just said, Mark. Like are you saying that Bitcoin goes up 20% this year that Ethereum is not going to go up by 30 or 40%? Okay, yeah, you're that's a good question. Let me let me clarify. When I put beta into my cap and model, I'm looking at a 3-year beta and typically. So if if and if we look at the past 3 years, if if Bitcoin's going to buy X, ETH isn't, the answer will be yes.

Right. It's so Mark's the statement is not a future statement. >> statement, a past observation. And and I think that's that sounds fair, right? Sounds good. Yeah. For sure. Yeah, I I'm just it's it's I'm not particularly satisfied with any of you guys' answers on this. I like I I like them all. They're all correct. They still just don't feel 100% like I understand why if it's so successful for strategy, it should this strategy should not be at least in a smaller part part of at least Bitmain's strategy, let alone others.

Now I David's point I think is the most persuasive to me, which is like you got to develop the convert market and if the buyers aren't there, that I'm sorry, you got to develop the options market and if the the market makers are not there and the institutions are not there, then it's going to be tough. But to me, the value prop of a Dat is not in selling common to just buy ETH or Bitcoin or or Solana. The value prop of a Dat is they have superior access to debt.

And so if you are long Bitcoin or if you are long Ethereum, um you have only two options outside of a Dat in order to get leveraged exposure to those assets. You can either get margin loans and then you have to risk getting margin called or you can buy a leveraged ETF, which historically does not outperform regular ETFs. And so you have this debt invention, which is absolutely incredible from a debt perspective in that you can get leveraged exposure to Bitcoin, Ethereum or well, not Ethereum cuz they haven't issued any debt, but let's just talk about MicroStrategy. You can get leveraged exposure to Bitcoin

over a 5 to 7-year horizon because the bonds that they issue are mature over a 5 to 7-year period, which is a feature that only corporates can can can have. Only publicly traded companies can issue public debt like that on those terms. And so if you're not using that public debt facility, what are you doing, right? I think the answer here, Michael, is yeah, I I mean, the first answer I would say is it is a lot harder to do what MicroStrategy did because you need to develop all these markets. But the other thing is that

non-BTC Dats can monetize their reserves in ways that a BTC Dat cannot, right? So Ethereum, Solana, they have staking markets. Depending on the asset you have like locked tokens that you can buy at a discount. You can probably deploy some of those assets into DeFi. So different ways for these guys to at least monetize the current reserve that they have, right? With Bitcoin you cannot do. So maybe that's their focus right now, right? These things like kind of there's there's a road map and we probably need to bring someone from ASBAT or Bitmain and have We should I I would just add though,

David, my response to that is you're 100% right, but all of those things you just described actually make issuing converts even more attractive and safe for these companies, right? If you can secure let let's just talk about a pref, right? If they issued a equivalent of a pref equivalent of what strategies issuing, they could actually get them at better terms potentially because they could be somewhat secured by the future cash flows of their validator business, right? 100%. The thing is the market the underlying market is not developed enough for them to issue those prefs, so they've they're probably focusing on these other ways to monetize their current reserve while these markets develop over time. I don't know. We'll see.

I mean, I would also add Bitmain in particular was trading at a premium to its NAV until the start of this year and even this year it's flirted above and below. I think the easy button is issuing common equity. If you can make a dollar and 50 cents by issuing a dollar of common equity, just like push that button until the button breaks. Right. You only have to do these more complex things when that button breaks. So I think I think that may be part of the explanation as well. That's what MicroStrategy did. They pushed that button as many times as they could and then they pushed the convert button and now they're doing the preferred equity button. As I mentioned, I think they're other buttons.

Um so I think that may be part of it as well. Good point. And Bitmain's only only been around since last year. Strategy's been here since 2022, so Bitmain's not even a year old, actually. Yeah, exactly. Exactly. But I think you the real question is would you add it would you add it if you to your portfolio? Would you for I'll go first. I'll I'll I'll say my bit first. Um I think I would because they have enough cash to cover about 21 months of their preferred dividend obligations and obviously that number will decrease if stretch continues to get popular as it

is right now then the dividend obligations will go up but I feel like 21 months is enough to give you a one-year time horizon where you feel safe that they can cover at least one year's worth of the dividends and remember this is a monthly payout as well so you don't even necessarily need to hold it for the entire duration you can just hold it on the ex-dividend date and then maybe deal with some of the volatility that comes post ex-dividend and and secure what is what seems to be a reason a mismatch between the yield and the safety of that one-year time horizon. I the only way that I would be comfortable holding it longer is if strategy changes their

playbook and starts to earn yield on their treasury in some sort of non-price capping way. But yeah that's that's that's my take on it. Is now a good time to make the non-investment recommendation disclosure? Did we skip it this time? Um I'm I'm with you Mark. The way I think about it and again none of this is investment recommendation but the way I think about this is when I was talking about like this let's say low volatility exposure to Bitcoin and the amplified exposure to Bitcoin what is the ideal

amplification ratio? How far can we go? I think that's the answer that it's not clear to me right now what is the ideal ideal ratio here. I do feel like we're we're early we're in very comfortable stages and you look at MicroStrategy's balance sheet and they have even a fiat reserve right now so it does seem pretty pretty comfortable at Infinity I'm I'm I don't know how how that will look like so I guess the question is what is the right amplification ratio here? If you're comfortable I think it makes sense to hold it. I held this in the past so yeah I think it's Yeah I think I align with that. I'd just add if you're being intellectually honest the question to ask yourself is at what rate would you

hold it? Because if you're not being honest you you would say the risk-free rate and I don't think anyone on this podcast would hold it if it were paying the risk-free rate and then if it were paying 100% a month I would put all of my money into it. So I think the intellectually honest question is is 11 and a half percent a good risk-adjusted return for the obvious risks that are embedded in this? The risk of MicroStrategy issuing too much of this and getting over its skis the risk of Bitcoin falling and staying very low for a long period of time the risk of MicroStrategy changing its corporate structure. From my perspective it looks like a a pretty healthy rate for those sorts of risks as I underwrite those risks. But I think it's important

for everyone to think about like you wouldn't buy it at four you would definitely buy it at 50 but where is that breakpoint? You shouldn't just say I'll buy it. That's like that's like not the the rigorous version of it. It's where would you buy it and if you don't have a good answer for that then you don't understand the risk and you should probably avoid it. Yeah. I'm not giving investment advice on this one but I echo what Matt and and David said. I think it's a very attractive product. I definitely 10 out of 10 times I would bet on Michael Saylor.

I think he's brilliant and um I think he it in this market and especially in crypto and especially with the intersection of AI and crypto which um is being started to be talked about a little bit more. Michael Michael Saylor really has his thumb on the pulse. He really is seeing ahead in a lot of ways and I will always bet on guys like that. >> [snorts] >> Okay awesome. Don't worry there's there's a disclaimer at the beginning about investment advice so we're good.

Um any final thoughts guys? Yeah. Yeah I think I I think we said our bit. Next topic I wanted to to bring up actually David you you shared this in our group the SEC SEC's new DeFi broker exemption for like front ends. I I I I do like how forward this administration is going with crypto but to be honest this one was a bit of a surprise for me specifically because it was tokenized security so maybe David you could give a little bit background on the staff statement.

Um so the SEC published this guidance. I think I think it's guidance and it's very I I think it's specially interesting for DeFi and in my understanding what it's trying to address here is what to what extent a DeFi interface needs to register as a broker-dealer because at a high level a lot of these things and touched on this in the last episode at a high level a lot of DeFi activities might look like an equivalent in TradFi that requires some sort of license right? We talked about an asset manager and a vault curator right? These things are not

exactly the same. I think something similar to this apply here. A DeFi front end that doesn't hold custody assets a DeFi front end that is basically just a layer that the user is interacting with in order to use an underlying DeFi protocol probably doesn't need to be regulated like a broker-dealer is right? As long as you are satisfying certain conditions and these conditions seem very sensible to me. They're things like you should not be holding customer funds you should not be providing investment advice you should be like this neutral layer between a user and a DeFi protocol. If

that's what you're up to what I what I understand from this SEC guidance is that you do not need a broker-dealer license. This makes total sense to me it's something the industry has actually been pushing for. I think it was Andreessen Horowitz and and and one of the associations they pushed a paper on this sometime in mid last year and this is a discussion that has been going on I know in in policy circles so it's kind of interesting to see the SEC abiding to that. I think this is extremely sensible. I think that the requirements that they put they put in that would make these interfaces not having to register with

with as a broker-dealer I think they're they're very sensible. So so that's kind of my view very interesting very good for for DeFi front ends very good for crypto and for pushing DeFi integration into our everyday lives further. So so as the DeFi guy >> [clears throat] >> that I you know I focus all of my time on DeFi I thought this was absolutely massive. So I talk to front ends all the time. They're a huge part of my business. And I had been telling them for the better part of a year that if they connect users to tokenized securities they're going to get labeled a broker-dealer. That's what I've been

saying you know like just my my back of the envelope advice. Um so this guidance was massive because just by the very rules the broker-dealer rules previously to this one could make a very compelling argument that these interfaces these front ends were engaged in broker-dealer activities if they're connecting users to securities. With this guidance this opens a huge potential a huge opportunity especially because and I think this is very important it doesn't apply to CeFi right? Um and when I say CeFi I mean like Coinbase or Binance or like any

centralized exchange and I'll get into that second but but I think Mark it's important to tell like the users exactly what this um to expand on what David said exactly what this rule I think entails. So number one is you can't if a front end is going to comply with this rule the front end cannot custody user funds or touch private keys right? So that would that's great because Jupiter or Phantom these are all non-custodial right? Um you can't solicit specific trades or give investment advice. These guys don't do that anyway. I don't know a single front end in DeFi that does that so I think they're in the clear there.

You can't recommend execution routes. So like no best price or most reliable labels. I'm going to get back to this piece because like this is very confusing to me. This this is the thing that sort of stopped me in my tracks. Um but like I think what it means is like if you show one route you have to show users other routes and let the user decide what route right? Um you know and then the sorting and filtering must be you know objective neutral criteria right? It's got to be sorted by price or speed or alphabetical or something that is not almost like what you see

sometimes which is like you'll get higher like on Google search you know search ads right? Your your your your website will be listed higher than others if you pay Google, right? You have to you know, fees must be either flat or a fixed percentage and there's no P off, no kickbacks. I think that's important. I think there is that going on with front ends. Um That that's the one that I want to dig into. Like what So, this is how wallets make their money, payment for the flow and then they get to choose their aggregation in the back end.

They're not showing users what they're doing. And so is is tokenized security is a big enough market to What are you doing? Like just attracting users to come on to your other products where you actually make money from the payment for order flow or why as a front end, you know, how big of a hit is this? Let me let me just say I actually I know a lot about this this piece as someone who has has been very involved with P off and D off for for a while. Um Most front ends actually don't make a significant amount of money on P off. They make a significant significant amount of money on fees, right? So, like Phantom charges like 87 bips per trade, right? Axiom trades Axiom charges even more than that, right? So, majority of

their revenue is from fees. Um So, that's the wallets and wallets are at the top of the stack, right? They are the closest to the users so they control the order flow. Um Right. I touched on that some more. Touch on that some more. Like isn't that if they they're taking fees because they've maybe they're using Jupiter's pup where they can collect the API and the API automatically gives them a piece of the transaction fee. Is would wouldn't that be not allowed now? So, so let's just take MetaMask will integrate a smart order router called Matcha, right? Or Phantom will integrate Jupiter, right? Or or Titan or D flow or

another smart order router. These smart order routers are actually a very heavy competition with each other and they don't actually charge fees to most users unless you buy something called like Jupiter Ultra which is like a paid uh sort of, you know, it's a paid fee that it's a monthly fee that you pay to use some higher better Jupiter product according to Jupiter. But um for most of these smart order routers, they need order flow, right? And so they need to integrate with wallets which those wallets charge a fee to them like they charge a fee to the user upon executing the trade that the

use that the wallet pockets. Now, some of them also engage in private order flow P off deals. But those P off deals are not, as far as I know, the majority of their revenue. Um Now, Jupiter could also sell that flow. They're one tier below in the stack. So, it's Phantom and then it's Jupiter. They could also sell that flow and they could potentially monetize there. But here's the funny thing. Jupiter and Titan and these smart order routers are so efficient in routing on chain that they don't actually create a lot of MEV that can be actually monetized. So, the real

MEV that you see on D off is when people don't use these smart order routers. Um the real MEV that you see is actually in the meme coin space where there's not enough liquidity to route a user's order through multiple different pools. Um And with the advent of prop AMMs on Solana and now you're seeing it on base, there's no MEV there are very little MEV that can be captured by back running a a prop AMM. So, um I think to answer your question, Mark, I don't think this will be that prohibitive. But more importantly, um this is in the context to be clear about securities, right? This is not a

blanket rule that applies to non-securities. And in securities, this behavior like this is not should not be necessarily tolerated. Um Although, you can make an argument either way because there is P off obviously in equities markets right now. So, um what they're trying to do is provide disclosure. The rule is basically is saying if you do engage in this activity or if you route your own users' trades to an AMM that you control, you must disclose it.

So, I think that's pretty important. Is it fair to say that the rule or the statement applies to [snorts] folks who are not routing orders. There's nothing wrong with taking a fee. I think they explicitly mentioned it's a totally permissible activity to take either a percentage fee or a fixed fee. But if you are in the business of selling transactions, routing orders, arranging for financing, these are broker activities that should be regulated, especially I mean if you're a centralized company. So, in principle, it kind of makes sense to me. This Is that a good way to to parse this,

Michael? Yeah, but here's the what I'm confused about with the routing, right? So, how do these routers work? These companies like Jupiter and Titan, they spend a lot of time and a lot of money on these convex optimization algorithms, okay? And these convex optimization algorithms are meant are actually a very hard problem to solve which is to say they have n number of nodes within a graph and they need to find the fastest route or the best route, the most profitable route. And this is a challenging problem because in D off, anyone can create a liquidity pool. So, there's an ever-growing number of pools that you need to route through

the you need to route a user's order through the best series of pools and break up the order across those pools to minimize slippage. This is the service they sell. So, you can imagine a world in which there's hundreds [snorts] of different market makers selling tokenized securities on chain and each one of them have a different price. Are is the SEC actually saying that you can't route your users' orders through all of those market makers? Because if you were to say that, you're actually offering your users worse execution, not best execution. So, I'm not sure what the routing prohibition actually means.

And I think they're I think they are confused about what is actually going on in D off today because it's just simply providing the best like route, the best path, the best series of actions you can take to minimize your slippage and maximize your execution quality. >> [snorts] >> Isn't it a Isn't there a difference between providing your user a bunch of different routing options and let them choose their option and you choosing the option for them? Is that isn't that the the distinction?

It is, but like what are users going to choose? They're going to choose the one with the best price, right? So, like if you go to Titan's interface, Titan's one of the top uh and top smart order routers on on Solana, um what you'll see is like a bunch of different routes. And the top one is the one that is offering at that very moment the best price. Yeah. So, like sure, I guess you could choose a worse price, but I mean, I guess what they're trying to protect against is you just showing one route and assuming this is the only thing out there even if there's better routes elsewhere.

Yeah. Yeah, it's also worth noting. I mean, it's it's it's a first effort. Yeah. Um right. And so that will probably improve and change and and and move over time. I do think that is what they're trying to protect against is just showing a single route. Right. >> And instead showing a spectrum. And of course, the vast majority of people will choose the best one, but some will favor brand and some will favor you know, that's the nature of choice. So, it seems it seems pretty smart to me. Like I'm wondering what what you think we're going to see from these front ends as a result. Like what is what what is the market going to look like now that we have this guidance?

I That's a great question, Matt. So, I think there's there's This has solved 50% of the problem for tokenized secure Well, 50% of the problem for trading tokenized securities on chain. The other 50% is market makers, do they need to be registered dealers in order to market make tokenized securities? If they do, then the primary market makers right now on chain that are providing liquidity for crypto, not securities, but for crypto, almost all of them need to register as dealers if they want to provide liquidity for these tokenized securities. And that it gets especially tricky when you're talking about AMMs.

DEXs can't register as a broker-dealer, right? Like I mean, the the labs company So, Uniswap Labs is not engaged in active in broker-dealer activities. Uniswap, one could argue, is, but they but they don't control Uniswap once it goes on chain, right? They might control the front end, and this is what these regulations apply to, but the actual underlying protocol um is is um an immutable smart contract on at least on Ethereum and at least in Uniswap's case. So, um we need to get clarity on market makers' participation in uh offering tokenized securities on

chain. If we get that, I think there's going to be an explosion of uh activity on tokenized securities. Big moves all around. Um when when does this actually Is this going to affect immediately? Um I think so. Um I think it does, right? I think it's a statement that they say this is our interpretation, and I think they put an expiry date. They're saying, "Hey, this will be withdrawn in 5 years from now." Like in uh yeah, I think it's from Yeah, I'm looking here at April 13th 2026.

This statement will be considered withdrawn effective 5 years from that date. So, yeah, I think in theory we're we're on. Yeah. Okay, lovely. Uh any last thoughts on this one? Um I would say one other thing, which is that um a16z um has their hands all over this, I think, which is is very positive for the industry. Same with DeFi Education Fund. Um they filed a joint proposal with the SEC laying out almost exactly this framework.

Um and it seems like the SEC adopted it. So, that is very in my mind even more bullish that the SEC is listening to the industry um and is being very responsive to the industry and is working with the industry on crafting um these policies. Yeah, I would I would also add that they're doing a risk-based assessment and not just a pattern matching assessment, right? The the the old way would just be to talk about what this does in the market and apply the same old rules without adjusting for the real risks that are different in this market versus the CeFi market. So, I think it's I think it's really commendable sort of first principles regulation uh that I love to see.

It also shows that you can move crypto market structure forward without waiting for Congress and the Clarity Act, right? Um so, I think that's an interesting side discussion. Uh well, speaking of which, so I saw last week that the FDIC, you know, they they don't major step in putting the GENESIS Act into law, like actually making enforceable rules. Um I I think that they talked about things like how quickly these stable coins need to be able to handle redemptions, T+2 business days, and custody standards requirements. Um to my own ignorance, I didn't realize that I thought the GENESIS Act already clarified all of this. I didn't know that these things

needed to then be turned into enforceable rules by the two separate agencies. And so, they've put this out, and they've given because the GENESIS Act was last year July, I think, somewhere around there. They've put this out, they've given like 60 days for comments, and in which seems like a tight window in my perspective. And then they have to make these enforceable rules, but then at the same time with the Clarity Act that you just mentioned, the Clarity Act might then change some of this stuff that the GENESIS Act um tried to enforce in the first place, particularly when it comes to well, stable coins, obviously. So, do you guys have any thoughts on this?

I I have some. Um so, yeah, no, that's that's a very important point, Mark, the one you highlighted. GENESIS Act was approved mid last year, but there is a rule-making process that comes after, and this process is long. This process can very well go until the end of the year. I think that's kind of our expectation, at least from our team here that I heard last time. So, this um uh this proposal is basically one example of that rule-making progress. Uh this is the reason why you're not seeing uh every single major bank issuing their stable coins. Like there is a uh a process here that needs to happen.

That's why you're going to see that a lot of these folks, no one calls their uh even like the regulated folks, like they don't call their stable coins uh GENESIS compliant. They call them GENESIS ready, right? Because there is no GENESIS compliant stable coin right now because the rule-making process has not finalized. The one point I want to highlight though is the Clarity Act. I think the window is getting tighter. I uh there I I I've talked to actually Kevin, our our policy guy. He's a great guy. Maybe you should bring him to the pod one day. He's very connected to DC. And it sounds like we're going to get to the markup stage at the Senate Banking Committee at the

end of the month. This is the strong expectation. There's a lot of back and forth happening here. Stablecoin rewards is a very central point, and I agree with you. Uh this is probably the main thing that the industry will be watching in terms of industry topics. I think this will be the main thing that we should be paying attention between now and the end of the month. Yeah, my uh good friend Tyler Williams uh who I worked with at Galaxy, he's in the Treasury Department now, um and he's writing a lot of these rules for the GENESIS Act. Um and uh yeah, it it's it's a creature of the Administrative Procedures Act, whereby uh when Congress passes a law, they typically write it in such a way that

some administrative agency, some regulatory agency then needs to take what Congress said and then apply it into a formal executable rules that regulators can actually apply. Um because Congress is not regulating banks, right? It's the Treasury. Um it's the FDIC. Um and so, that's the hard work that goes on once a law is passed. And then there's of course tons of litigation that always comes when uh a litigant argues that uh that the rule that was instantiated by the regulatory agency is actually inconsistent with the law, meaning the law that Congress

passed. And that's where you get into all the fun stuff. I think one of the interesting points about this is that uh the FDIC is explicitly saying that stablecoin reserve deposits are not eligible for pass-through FDIC insurance. So, think about what that means. Like your reserves sit in an FDIC-insured bank, but the stablecoin holder doesn't get that insurance? I think the insurance stays with the bank, not with you. Um so, like if you're holding a stablecoin and the insur- the issuer fails, you'd be an unsecured creditor? Um I think that's interesting. I'm I'm not entirely sure why if why they should treat stablecoins any differently

than dollars if they are held by an FDIC-insured institution. Cuz the banks don't want stablecoins to do well, like Well, yeah. >> [laughter] >> Well, yeah, I mean I yeah. I mean, that's the re- I mean, the the the the other argument is they're backed by the most liquid and uh and trusted financial instrument in the world, short-term treasuries, instead of uh fractional reserve banking. But the real the real reason they're restricting it. So, I don't I don't even think you really need it as long as the uh the stablecoins are in fact GENESIS uh compliant and aren't fraudulent, they should be backed one for one, and then

there's no need for that um that kind of insurance. But the reason they won't allow it is just uh the bank lobbying. I mean, it's just Right, but there but there's an inconsistency here, Matt, because like if you contrast it with tokenized deposits, the FDIC is saying deposit insurance applies regardless of the technology or the record-keeping used or whether it's on a blockchain or not. So, there seems to be like a little bit of an inconsistency there. Uh you know, a tokenized deposit on a blockchain gets the same exact FDIC coverage as your checking account. Um I don't know. But yeah, you're right. You're 100% right. Cuz banks can loan that money out, for sure. Yeah.

I I hate to take the other side on this discussion, but FDIC insurance should exist for things that operate under a fractional reserve system. And this is true for tokenized deposits. This is true for non-tokenized deposits. This is not true for stablecoins. Stablecoins are are issued by these trust charters. These things are supposed to be full reserve, actually kind of overcollateralized in That's fair. practical way. So, in a way they're they're very different beasts. >> Yep. That's a good point. Oh, I don't know I don't know if I completely agree with that. I just think from a consumer adoption perspective, they are used to FDIC insurance. They may they may would they may get greater adoption if they had {quote} insurance, even if it was

extraordinarily low cost, because they were not uh fractional lending. Um so, I do think that's an element, but I agree with you, David, of course. They don't really need it because they're backed by short-term treasuries. I also think though that, David, while you're 100% correct, from the average retail users' perspective, they're not going to understand this distinction. If their money is in a FDIC-insured institution and they happen to click stablecoins because they think it's cool or they heard their son talk about it, um you know, they don't have the coverage. It it's it's a little it's a little uh it's a little lost on I I would think most most people. Yeah, I agree. We'll see. Well, money market funds don't have FDIC insurance, right? So, like can

these things continue to have have taken off. but yeah, I agree. It's a different use case. So, yeah, got to got to We'll have to explain how these things work a little bit perhaps. Yeah, no, it's a great analogy. Like they should stablecoins should be considered thought of by the public as money market funds and this is uh this this education process just needs to take place. Yeah, I agree with both I agree with all of you all actually. It's They don't need it, but it would I think it would help a lot because Revolut here, they only got their banking license last year and before that they used to come up with a warning stating that they're not the UK's version of FDIC insured, right?

And a lot of my uh friends were afraid to use neo banks because they were like, "But it's not insured." Not knowing that it's it's fully backed and not being lent out or anything like that, but it was scary to them because it was a warning saying this and even though they don't know what it means, it's a scary warning. So, it it would have helped, but it's it's I think stablecoins will be fine without it. Um we're coming up on time here. So, any last thoughts from anybody? Um I have one thought just just a recommendation of an amazing piece I read this week. I don't know if you guys read uh Jeff Jeff Lyons the Hyperliquid founder profile on Colossus.

Uh it's a very very good profile. I would recommend everyone to look into it. Maybe we can put it in the show notes. And the reason why this is interesting is that it's going to show what a real true crypto product can do with a very amazing founder. He's probably one of the best founders of this more recent generation in in general, not only in crypto. It's very um we should be very proud of having someone of that uh prestige and and that caliber as one of the leading crypto founders. So, I'll definitely recommend folks to read that profile. It's very well written. It's uh it's not a short read, but it's a very easy read. And yeah, read that and let me know if you

get more excited about Hyperliquid. Okay, lovely. Wow, I hope you talk about your wife the same way you talk about Jeff. [laughter] That was That was a good recommendation. It's a great thing. You guys should Okay. All good. We'll definitely link it in the show notes. Um and that's it for today's episode. So, thanks for joining everyone and we'll see you next week.