Insight
November 23, 2022
At Stone Ridge, we seek to add extraordinary individuals, but slowly. Recruiting requires candidates go through months of interviews and the completion and presentation of a challenging project. While I’m not sure we’ve ever been accused of sloth, when it comes to recruiting, we purposely put sand in the gears and test for endurance. The bar to join is exceptionally high and we’re not in a rush.
There are other filters. Our firm’s principles – Focus. Be Humble. Be Kind – don’t work for everyone. In fact, they repel many traditional Wall Street types. In a short-attention span culture that favors immediate results often based on shortcuts, Stone Ridge is a firm that values practice for its own sake. Practice is such a powerful thing that it doesn’t have the ability to discriminate what is good for you and what is not. If you practice negative habits that are not conducive to your growth, you will be really good at those negative habits. If you practice positive habits that are conducive to your growth, you will be become really good at those positive habits.
Whatever it is you practice is that which you become good at. That’s the immutable Law of Practice.
During the vast, vast majority of our practice time at Stone Ridge, we’re on our own personal plateaus where progress isn’t tangible. This pre-breakthrough practice time, arduous and unavoidable, doesn’t work for everyone. In particular, it repels the instant gratification types.
Viewed through this lens, perhaps it’s understandable, if not utterly obvious, why at NYDIG we have never done a single client trade – out of hundreds of thousands – on a crypto “exchange”. Perhaps it’s also understandable, if not utterly obvious, why we’ve only taken “right way risk” to Genesis.
When we started NYDIG, co-founder of Stone Ridge Robby Gutmann made a powerful observation. Like so many things in non-Bitcoin crypto that “borrow” well known tradfi terms out of naiveté or to deliberately mislead investors, Robby realized that a crypto “exchange” is nothing whatsoever like a tradfi exchange. Among many critical differences, a crypto “exchange” forces its customers to bear enormous credit risk. This comes primarily in two forms. First, the retail or institutional trader must send their money to the “exchange” and then, only second, hope to receive crypto in return at some point in the future. Will they? Maybe. But there is no central clearing mechanism. Even giant banks, Herstatt-style, occasionally fail to settle with each other. Why would a start-up crypto “exchange”, especially those run by children with no operational or credit experience, be any different? This always struck us as a giant, uncompensated risk so we stayed away. From all of them. Exactly zero1 client trades in the history of NYDIG have been on a “crypto” exchange.
Second, the retail or institutional trader almost always leaves the crypto they buy on the crypto “exchange” with the affiliated custodian of the “exchange”. This also struck us as bizarre and another giant, uncompensated risk. Why? Because the things one needs to be good at to run a successful matching engine are a set of things, and the things one needs to be good at to run a successful custodian are also a set of things. However, those things don’t overlap. At all. Zero. Indeed, in tradfi no custodian runs an exchange, and no exchange runs a custodian. They could, but they don’t. The different skill sets required are far too specialized. So, custodians affiliated with crypto “exchanges”, especially those run by children with no operational or credit experience, also always struck us a giant, uncompensated risk. We stayed away. From all of them.
Health warning: do not trade crypto on so-called crypto “exchanges”. Do not keep your crypto on any custodian affiliated with an exchange. Including FTX.
The term “right way risk” refers to a trading position in which your counterparty’s “jump to default” (i.e., going bankrupt overnight) does not hurt you. “Wrong way risk” is the opposite. Perhaps the simplest example of this concept is a loan (and please note that many derivative trades are actually so-called “financing trades”, which is a fancy way of saying “loans”).
Say you are the lender. You have wrong way risk because if your counterparty, the borrower, goes bankrupt overnight you will not be repaid. In contrast, say you are the borrower. You have right way risk. If your counterparty, the lender, goes bankrupt overnight you are fine as they do not owe you any money.
When you run an institutional trading business, as we do at NYDIG, there are many layers of risk to consider. We already discussed the risk of crypto “exchanges” and why that liquidity path has always been too risky for us. What about trading OTC? We trade OTC every day. However, to trade OTC successfully requires evaluation and constant re-evaluation of the operational, legal, credit, market, reputational, and regulatory risk of our counterparties.
Very few OTC counterparties ever passed our rigorous diligence process in the history of NYDIG, and from time-to-time NYDIG has been the largest counterparty to each of them. However, trading with an OTC counterparty requires another critically important risk decision: will you take wrong way risk to them?
We have been comfortable trading with Genesis the last four years. In fact, we have executed thousands of trades, and many billions of dollars with Genesis. Despite the scale of this trading relationship, we have never been comfortable taking wrong way risk to Genesis. Zero out of thousands of times. Zero out of billions of dollars. And we have no wrong way risk now.
We have enjoyed a terrific trading relationship with Genesis these past few years and I wish them the best of luck and success in navigating whatever they are working through. However it ends, though, will not impact NYDIG.
At NYDIG, we have gotten many (many, many) decisions wrong. We will continue to. As entrepreneurs, and as humans, that “problem” is unsolvable. However, our firm principles – Focus. Be Humble. Be Kind. – provide us with a reasonable framework and narrow guardrails for thinking deeply about risk.
The current thing, in crypto, seems to be “Proof of Reserves,” (PoR) though perhaps a day late and $8 billion a dollar short. Having said that, PoR seems like yet another item to add to the tragically tall pile of crypto terms that, Inigo Montoya-style, simply does not mean what you think it means. In contrast, let me be abundantly clear about what I mean on this topic:
NYDIG’s Fund and Custody client’s bitcoin is not, has never been, and will never be, co-mingled with the assets of any NYDIG entity, affiliate, or other client, used to operate or finance any NYDIG business, lent, borrowed, hypothecated, or rehypothecated.
Furthermore, our Fund’s bitcoin holdings are VERIFIED ON THE BITCOIN BLOCKCHAIN DAILY by the Fund’s administrator (U.S. Bank) and at least annually by the Fund’s auditor (EY). EY also audits and regularly tests our 100% cold storage custody controls. And NYDIG does not have, has never had, and will never have, a hot wallet. Too risky for my tastes.
This also means WE DO NOT HAVE RESERVES. Reserves are not a thing. So they don’t need proof. And proof means precisely nothing anyway. Do not get lulled into a false sense of security because your crypto “exchange”/custodian tells you they hold more crypto in aggregate than their clients have “deposited”. That’s irrelevant. Either your crypto is yours or it is not, period.
If you are client of NYDIG, your bitcoin is your bitcoin. Our custody solution is not as good as if our clients held their own keys in which there is zero risk of regulatory confiscation at the point of a gun. However, I do believe that the private property laws in our country (and only our country) still do count for something. I keep all my personal bitcoin at NYDIG (though I await better technology in the years ahead so I’m comfortable holding my own keys, the ultimate in personal sovereignty).
Some things need to be believed to be seen. Bitcoin was one of those things. Satoshi relentlessly iterated so that what he believed was ultimately seen. Working quietly out of view, he ignored the impulses of others to seek recognition. He didn’t believe that those out there in the limelight were getting the better end of the deal. He was too busy loving his work to do anything else.
New opportunities arrive ceaselessly, as long as we’re willing to learn. Business is a learning contest, and our ability to innovate depends on entering every conversation as if we have something to learn. Because we do. True listening requires a setting aside of oneself. When done expertly, the person across the table senses this. They open up and share their deepest creativity. Conversations are not promotional opportunities. In a real conversation, you’re in it together. And because business is a learning contest, it’s actually a listening contest.
Check yourself: when you are in a conversation, do you listen with the intent to understand, or do you listen with the intent to reply?
Folks who talk too much feel in control and the center of attention. Talking means they don’t have to hear anything they’re not interested in, including new ideas that might tweak their perspective or expand their world. One of my best friends is blind. He didn’t used to be, but now he is. So, instead of reading, he listens to books and emails. Through deliberate practice over many years, he can listen up to 750 words per minute. No wonder he’s one of the most creative and interesting people I’ve ever met.
My parents both passed some time ago and I think about each of them every day, but especially on Thanksgiving, my favorite holiday. In honor of my mom this Thanksgiving, I’d like to share something she told me just a few weeks before she passed. She said, “Whenever you talk to someone, be prepared to be amazed.” I am, and I’m never disappointed. Is it any wonder I’m endlessly grateful for my mom?
So tomorrow at Thanksgiving please put down that piece of plastic you are addicted to stroking. Technology is a wonderful thing, but only if you are in charge of it. Give your family your undivided attention. In conversation tomorrow, do not think about what you are going to say next. Just listen. Listening equals love. And be prepared to be amazed.
Happy Thanksgiving.
Ross L. Stevens
Founder & CEO, Stone Ridge Holdings Group
Founder & Executive Chairman, NYDIG
1 We did a trivially small set of test trades on select exchanges using NYDIG’s own balance sheet, not with client orders, several years ago as part of an empirical study of bid/offer spreads. Even in these cases we did not hold assets overnight at the exchanges specifically to mitigate credit risk.
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