How to think about risk in Blockchain, Private Equity, Public Markets

Last night a dinner discussion turned again to private equity markets, blockchain, stablecoins, and money. The argument went that public markets had less risk because they have stricter audits, governance. In private equity, you also have to find a buyer and negotiate a price and terms of your private equity stake. Stocks that are traded on public stock exchanges can often be sold within milliseconds; blockchain tokens and coins can be sold within seconds on Layer 2 blockchains, and within minutes on Layer 1 blockchains. Mutual funds trades are usually executed at the end of the day.

classification of different financial products

But aren’t they all private money products?!

Public money is cash, the coins and bills we can carry in a wallet. Maybe stamps. We use public money for transactions. A $1 bill will always be $1. Over time, its buying power diminishes because of inflation.

All of above products are actually private money! They are involve documents that acknowledge an agreement between parties, or an existence of a debt. Such documents are called IOUs, for “I Owe You”, issued by a private company (and not the government). You have IOUs issued by you bank for your checking accounts. You have IOUs when you buy a mutual fund, managed by a private entity. A true stablecoin (vs. algorithmical stablecoins) is an IOU.

Private money products have collateral.

Funny enough, most of these IOUs are backed by loans: Your checking account is backed by loans, money market mutual funds are backed by collateral like treasury bills or commercial paper. True stablecoins are likewise backed by collateral (hopefully). Some products, like public stocks, are backed by intellectual property and revenue. Some products’ only collateral is their brand. The worst kind of products use marketing terms where you assume certain types of collateral exist (like treasury bills or commercial paper) while the actual collateral might be very different.

All private money products are subject to bank runs.

When investors holding IOUs do not trust that there is actually sufficient collateral, or that the collateral is not “good” collateral (junk loans or junk mortgages .. remember 2008?). The most secure private money would be backed by public money (cash) as well as some process to communicate that there is sufficient cash. That is the reason we have “FDIC Insurance” (public money guarantee by the Federal Deposit Insurance Corporation, a federal government agency) as well as the National Credit Union Administration (the government-backed insurer of credit unions in the United States). Before that insurance, bank runs were incredibly common.

A different way to think about risk

When investing into startups through Convertible Notes (“CN”), you have the Note as a debt instrument, usually junior (aka “subordinated”) to pre-existing bank loans. But if the company runs out of cash, that CN is not always paid back. It shouldn’t happen, but it does.

The only collateral at startups is their intellectual property, inventory, and cash in the bank. Great execution according to the plan prevents running out of cash and creating a liquidity event. So the team’s ability to execute (and grow and learn) is in truth the only collateral. That’s why VCs often lead with evaluation of teams, not products, not revenue.

Whether it’s a stablecoin, a token, a venture fund, a mutual fund, or a REIT, you should ask yourself:

  1. What’s the collateral? Is it sufficient? Do I trust that it’s there? How “good” or volatile is it? How much control does the money product have over that collateral: What are factors out of the control of the manager/team/company that could diminish the value of the collateral?
  2. Who is providing the guarantee for redemption? Is there a back-stop? Is there another process or law that increases your believe that there will be some collateral? Are you sure you can execute on that law: will you actually sue the company, the board, the auditors if something is not as expected — and how high is the likelihood of wining that law suit?
  3. Risk/Return: Given the risks of 1. and 2., is the (expected) interest rate / rate of return adequate? (for you! a very personal assessment!)
  4. BONUS: How fatal would failure be? Can you actually assess the risk, or is the risk unknown? Do you have a large enough pool of similar money products for any risk percentage to be relevant, or is your pool of money products so concentrated that any failure would produce huge volatility? Remember: you don’t have 100,000 runs of a Monte Carlo analysis. You only have one of these runs.

Thoughts? Opinions? Comments? Corrections?