A risk isn't what you think is going to happen.
Risk is what hurts if it happens.
That lightning strike only catches one tree on fire.
It's meaningless.
The risk is the buildup of dry brush in the forest that allows that one lightning strike
to spread tree to tree to tree to tree and burn the whole forest down.
Positioning is the only thing that matters.
I'd be very cautious about being too enthusiastic about TradFi getting their dirty little fingers
into Bitcoin.
I think it will inevitably bring leverage and danger to the process.
Do everything you can to eliminate the unrecoverable so that you can pursue the unimaginable.
David Dredge, great to see you.
You've come highly recommended from a good friend of the show, Peter Dunworth.
He says you're the man to talk about when it comes to risk.
So we're going to get into it today.
First of all, we should start by introducing you because first time on the show, I know you're not a diehard Bitcoiner, so people might not be aware of your work as much.
Do you want to start with just giving a bit of background?
Hi, Danny. Great to be on. Glad that our mutual friends hooked us up.
I'm sitting here in Singapore, you know, 6 p.m. on the Friday before Christmas.
I appreciate that.
I run a little business here that's focused on long volatility, long convexity that our investors use us as a explicit risk mitigating strategy, insurance, if you want to think about it that way, so that they go out and take more risk and go out and participate more aggressively in growth assets and stuff.
I'm a long, long time markets guy out here in Asia.
I originally got to Singapore just in time for the October 1987 crash and spent many, many years in banks, most famously, arguably sort of building what would be the emerging market trading businesses for Bankers Trust, sort of a leader in the derivative risk innovation world back in the early 90s through the 90s and through the Asian crisis and stuff.
So I have a lot of experience and still apply my skills in the world of financial derivatives and the complexity of derivative markets around the globe.
And have sat through and seen and participated in sort of a front row seat in every market dislocation that's come along since the October 87 crash.
And so I run a business that helps people manage risk so that they can grow wealth more efficiently.
So with that October 87 crash, what happened? Was that when the stock market crashed? Was it 50% or am I out of base there?
So the S&P, the U.S. stock market index, crashed 23% in one day.
They call it Black Monday.
Out here, we called it Blacker Tuesday because the next day out here, the Hang Seng Index in Hong Kong and what is now the AS51 index in Sydney, which was the ASX back then, crashed 50%.
So those two local stock indices crashed 50% in the day.
The best performing index in the world on that day was the Nikkei.
It was only down 15% because it had this wild thing that nobody else had ever done, a circuit breaker.
So when it went down 15%, it stopped.
Now all indices have one of those.
So were you working in risk management before that, or was it seeing the stock markets crash, you thought, I need to do something about this.
I need to be prepared for these kind of black swan events.
I was a very, very young man then, obviously.
And I was a trader.
So I was then working for Bank of America, and then I was an FX and interest rate trader and saw the just absolute devastation two weeks into my new role out here in Singapore.
And it dawned on me that the simple measures and methodologies around risk management in what was, you know, then and is now one of the most sophisticated, largest banking, risk-taking businesses in the world, that they didn't have any idea what risk was.
They didn't have any idea how to manage it.
And so I've been sort of trying to figure that out for the last 38 years.
and learned a lot along the way.
And over time,
have developed a reasonably good idea.
I'll simplify it.
You know,
risk isn't what you think is going to happen.
Risk is what hurts if it happens.
Risk is about,
as a good friend of mine,
Harry Christian wrote in his book,
a book he wrote,
he says,
risk isn't about predictability.
Risk is about vulnerability.
And so when you talk about risk,
I think one of the things that people
maybe commonly mistake for risk
is volatility. But volatility is what you want. Like an investment without volatility is absolutely
boring. Like there's no point in doing it. So how do you trade off the volatility and the
unpredictability, the risk on the other side of it? Yeah, exactly. And I say all the time
in my writing. So if your readers want to go and see, I put up a note that we, it's actually our
investor letter that goes out to our investors, a part of it. We put up on our website at
convex-strategies.com. And I refer to the traditional maths of the financial and economic
world, that which we all get taught in school and that which runs the way banks and pension funds
and insurance companies and wealth managers operate. I refer to that as sharp world. And
I'm not referring to it positively in that sense. I'm referring to it as derogatory as I can.
And at the sort of heart of that from an investment perspective is what's known as the Sharpe ratio. And so, as you said, in the Sharpe ratio, it's return over unit of risk, and they measure unit of risk as volatility of those returns. And that is absolute nonsense.
And obviously, upside volatility is good.
Downside volatility is bad.
Average volatility is meaningless.
And that thus leads to the dynamic that we're talking about here that's hard-coded into the financial system, into the regulatory construct of the financial system, that foregoing upside is risk-reducing.
And so they want you to enter into things that are low volatility, suppressed volatility, asymmetric volatility, and then apply leverage to it.
And they're going to claim that the leverage is not risk.
It's the volatility that is the risk.
And that, in essence, is what creates what we would call left-tailed or negatively skewed return dynamics, where you have foregone upside explicitly, think something very simple like a bond, where you don't participate in rising markets, you have a bounded potential return, the coupon, and you have probabilistically, based upon historical look back of defaults, reduced downside.
But every time something goes wrong, it turns out you didn't explicitly reduce downside.
You've still got it.
And that sort of is what gets built into banks most prominently that leads to systemic risk because they end up having not enough capital to support the risk they're taking because they're always measuring the risk with these very, very flawed metrics.
So how does Bitcoin fit into a volatility profile that you would look at?
because historically, it's obviously been incredibly volatile
to both up and downside.
Over the last year, it's really not.
I think we're probably down around $10,000 or something
since this time last year, roughly.
And it's not the year that anyone expected in Bitcoin.
I think people were expecting a ripping bull market.
And we saw a move to $126K.
We're back down to $87K or something as of time of recording.
How do you view it in terms of both historically
when it was very volatile and what it's maturing into today. Yeah. So I talk all the time that
a proper investment portfolio is the opposite of what Sharp World is telling people to do.
So Sharp World is telling people volatility is risky, so avoid it. So literally, if you're in a
bank, you're regulated to avoid it. And then it's telling you that low volatility is safe,
So apply leverage to it. Well, the correct investment portfolio is the exact opposite. Own things that are thin-tailed, that have natural volatility, where you're getting rewarded with upside volatility for the downside volatility risk you're taking, and hedge with things that are fat-tailed, and particularly fat left-tailed, that have artificial suppressed volatility and attract leverage, which then limits the capital available when something goes wrong.
And Bitcoin over the last five, six, seven years has been a fantastic thin-tailed investment.
And so paired in a portfolio of other participating assets, it's been a very good compliment because it's rewarded you with upside for the downside risk you're taking.
You'll know way better than me. I say all the time, and I don't really know specifically, that Bitcoin's had six 25% drawdowns in the last three or four years and is up 250%. That's a good reward for the risk you're taking.
And then conveniently, in terms of the people that we work with, you know, in a diversified portfolio of risk-seeking participating assets, risk-managed with efficient risk-mitigating asymmetry negatively correlating, well, that worked really well in a year like 2022 because Bitcoin's worst year was a bad year for everything else.
And so the things that we would provide as hedges, and when we're providing hedges, we're really hedging that correlation, the correlation of risk across assets that makes your diversified portfolio, your diversification lets you down.
And so it's been a fantastic complement to people's diversified portfolios of risk-seeking assets. This year, in what's been a really good year for global equity markets, for gold, for various things, has been a mediocre year for Bitcoin, which had outperformed sort of all of them, ex-gold, up to a certain point.
And then in the recent months, it's had a pretty good pullback.
And it's been a pullback that obviously, you'll see it clearly than I do, has been somewhat idiosyncratic.
It hasn't been part of a correlated market dislocation.
You know, maybe you can say there's been some noise around some of the high-flying tech stock single names.
But at the index level, indices have been certainly not troubled particularly in recent months.
sort of, I don't know, when would you date the sort of origination of this sort of pullback in
Bitcoin sort of September? It was probably early October. Yeah, early October. Roughly. Yeah. And
so you had some noise around some of the other things, but that noise has kind of dissipated.
And meanwhile, Bitcoin still, you know, give or take, you know, not at its lows, but maybe
six or seven thousand dollars off its lows and you know i don't know exactly what drove that but
i would you know again i when i talked to our friend checkmate and we had discussed over time
about my thoughts about leverage and systems and how little leverage there actually was in bitcoin
in particular because the native exchanges that apply you know you know finance or bitmex or even
the one that went out of business?
FTX.
They cut the guy's position
when he runs out of margin.
It's not like the TradFi system
where they, you know,
they give you a call the next day
and say, you know,
when it's convenient,
send us more margin.
You know, particularly
if you're one of the big banks
who is blessed by the,
you know, monopolistic gift
of the governments
that underwrite them,
they can keep, you know,
running up under margin positions
forever until the system collapses.
but Bitcoin, the exchanges where the riskiest trading took place.
I mean, imagine if one of the top two largest exchanges in TradFi went out of business like FTX did.
I mean, talk about a systemic risk.
But in that one, it's just the people involved in FTX lose money.
That's the way it should be.
But what's kind of happened, and this is what Checkmate wanted to talk to me about at the time,
was this sort of proliferation of growth in the TradFi world.
obviously the ETFs, and then more significantly in terms of what I'm rumored to be a specialist in
or something I might understand, that the options on the ETFs and the evolution of that getting,
adding sort of that TradFi style of leverage into the system and the evolution, inevitable evolution
of the availability of these IBIT options, which dominate the volumes in that space,
into the world that I really do focus on, which is the structured product, the complex,
embedded, short volatility, yield-enhancing investment products, auto-callables and stuff
like that, that really drive the leverage in much of the equity, interest rate, FX markets that are
dominated by the TradFight world. And that's kind of, I think, probably why some sensitivity build up
everybody's familiar with the leverage from micro strategy and, and DATS, I think you guys call them,
you know, but you just got enough leverage build up in kind of a short time that you needed a
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so i'm just a simple bitcoiner david i uh i'm probably everything you hate about bitcoin is
in the sense where i don't i don't do any hedging i just i'm almost 100 into bitcoin and i just leave
it there and i wait that's all i do um and so when it comes to like the ibit options i know they're a
huge deal but i don't exactly know how it changes market structure and the impact it will have on
bitcoin the bitcoin market going forward like you say this is the thing you're an expert in so
how do you think large option markets coming to Bitcoin will impact it?
Well, you could think of options as leverage, right? So you obviously are well aware that if
you lever up your position in Bitcoin at an exchange, you're taking a lot more risk for
the amount of capital that you have. And you think you're going to get something for that.
But of course, when things go wrong, you get stopped out, which has been literally the beauty
or the thing that makes Bitcoin not risky is that the guy's position gets cut.
The exchange grabs his margin, his position gets cut.
So you could kind of, in a sense, only make as much money as the guy on the other side can lose
because the position gets extinguished.
But in the TradFi world, that margining isn't based upon a bunch of guys who are risking their own capital.
It's based upon regulated financial institutions that are using really, really bad mathematical,
risk and accounting rules.
And this margining thing masks and the way they operate
masks the risk in the tails.
And so when you start getting a world where option sellers,
volatility sellers can come in usually with somebody else money because they a fiduciary and they selling this optionality to harvest this image of enhanced returns Well almost without fail
they're not accounting for the tail risk on it. And so you start to get undercapitalized risk in
the system, which will start to make that underlying component negatively skewed. So you'll get the
movement where it pulls it the direction where the weakness, the fragility is in the system.
And so that vol selling, I'm in the business of vol buying. So that's me, in a sense, taking on
non-recourse leverage, right? So I'm going to buy a put option. Let's say I'm going to buy a put
option on IBIT. So somebody in exchange for the premium I'm paying them has underwritten the
downside and I get all the upside. So if I buy a put and I go and buy I bet, if it goes up, I get
that benefit. If it goes down, the disbenefit goes to the guy who provided me the non-recourse
leverage. And for that, I pay him a fee. Now, in the long run of something that, you know, that is
driven by its ups and downs, which is, you know, interestingly, particularly fat-tailed things,
things that have low volatility, tight distributions will have fat tails, that the long-term compounding
paths will be driven by the extremes, the power law, right? So the moments of the distribution,
the average in a power law, you won't know until, you know, let's say we're at dinner,
Danny and the other you know there's me and you there's checkmating there's Pete and
etc and we're we're doing a survey of average wealth and we're going to try to guess the
average wealth but we won't know what the average wealth is until the last guy who happens to be
Jeff Bezos and he will be the average right he'll be 100% of the average because it's a power law
distribution not a normal distribution like we were trying to guess the average height right
nobody's height is going to be enough to fundamentally change the mean. But wealth is not
normally distributed. It's power law distributed. And so when you create these fat tails through the
suppression of volatility and the addition of leverage, the magnitude of the tail events
will dwarf the mean and variance inside what you thought was a much more narrow distribution.
And so the value of optionality grows in that because I want to get the infrequent low percentile but high magnitude outcomes.
Now, in a naturally volatile thing, it doesn't work.
You have much thinner tails.
And so you're fine to just kind of be in there doing it.
And so the guy who's selling that option who thinks, oh, good, I've collected this premium.
And, you know, my worst case is, you know, one standard deviation downside only to find out that the one standard deviation downside was a lie in a world that is accumulated leverage and has significant uncapitalized risk that will generate this fat left tail when it occurs.
So we obviously were talking a little bit before about how Bitcoin's volatility has dampened.
And one thing I've not fully got my head around with the options is assuming Bitcoin volatility comes back, which I think it will probably both to the up and the downside.
And it obviously trades 24-7 globally.
Do you think there's going to be a lot of people who aren't managing risk using these Ibit options who are going to get blown up because Bitcoin can be so volatile and it does trade 24-7?
Yeah, and even more so, and what did the TradFi world eventually really drives this accumulation of leverage and short volatility is these much more highly juiced structured product things.
So the autocallables, the example, and I mentioned it on that conversation with Checkmate, you know, the first major institutional long-dated autocallables started coming out.
And so one was issued on October 31st, and embedded in that is what they call a knock-in put, where the guy who's bought the note is getting a yield, but embedded in that without him really generally understanding it, he's short and at-the-money put that knocks in when the market's 25% down.
Now, I don't know exactly. I haven't dug through all the details of it, but just a quick calculation that I did. The IBIT adjusted Bitcoin rate for that 25% down knock-in was $82,000. So where did the market go to just coincidentally on that Friday night, November, what was that, 21st? It went to $82,000.
and then is that the market searching for max pain correct that's exactly what it is
it's exactly what it is and so that's you know again triggering that sensitivity the you know
whether it's the you know the the bank who's managing that risk hedging it and you know he's
he's trying to manage negative gamma and or somebody and you know you drive it there and
then once it knocks in the pressure's off and it recovers again at least in that short-term series
of outcomes. So as someone who follows markets loosely, but obviously nowhere near as the level
of view, is Max Payne just a meme? Because I see people say the market always wants to find the
pain. What does that actually mean? And does it happen? It definitely happens. And to some extent,
I've made a career out of it. Yeah, because again, this leverage means that you've got
uncapitalized risk. So if people are levering risk based upon bad mathematical metrics,
and again, in the financial industry, in the fiduciary industry, that's what everyone's doing.
They're using things like value at risk and regulatory reporting and accounting nonsense
and going out and taking risk, you know, massively asymmetric risk with other people's money.
And so you get these accumulated undercapitalized tails in the system, and then it's like a magnet, right? Once it starts going there, it's an unstoppable train.
Now, the analogy that I use all the time when I talk about endogenous risk, and so the way I would think of the world, Danny, is that all the risks that matter, a dredgeism that I say all the time, positioning is the only thing that matters because the risk that matters is all endogenous.
It's not about predicting the unpredictable lightning strike that's going to catch the forest on fire.
That lightning strike only catches one tree on fire.
It's meaningless.
The risk is the buildup of dry brush in the forest that allows that one lightning strike to spread tree to tree to tree to tree and burn the whole forest out.
And in the financial industry, that risk, that interconnectivity of dry brush is leverage.
And once that starts triggering a risk reduction, it causes this reflexivity where it just goes and finds where the most vulnerable part of the forest floor is. And that's where the fire is going to go and do the damage. And it's going to go and clean out those weak hands, that over levered or undercapitalized risk and cause the biggest pain. And that's the way, if you ask me, that's really how markets work.
so the other thing that I've kind of been trying to figure out on the iBit options is
if it's going to have a negative impact on Bitcoin price because it seems to me at least that
in Bitcoin's history it's largely been driven by people like just retail and obviously ETS were the
start of Wall Street really coming into this and with options which can be much larger on top of
that is this like Wall Street taking over the Bitcoin price chart instead of being retail and
What does that mean for it?
I think that's a great question.
I think in a sense, I think that is the question.
I've been known to say, and this goes back before there ever was a Bitcoin,
and what, you know, I guess I wouldn't have used the term TradFi,
but now that we're all used to it, I'll say TradFi,
but I would have said Sharp World.
TradFi destroys everything, right?
because it brings this leveraging dynamic driven by the regulated institutions who have no skin in the game.
So they're always happy to take on destructive risk that is allowed, in fact,
incentivized by their regulatory risk and accounting construct that creates the systemic risk that necessitates,
that brings financial crises and necessitates global bank bailouts every decade or so.
And sort of, you know, if you think about it, the great example, the easiest example, Danny,
I mean, think about, I mean, you're maybe too young, but, you know, even today,
what could be safer than U.S. houses?
You've got the world's strongest, most advanced economy, most wealthy economy,
most dynamic economy. You know, what's safer than the guy owning his own house? And yet the
TradFi system managed to blow that up in 2008, right? It found a way to tranche up and take
advantage of regulation that was, I'll argue, and like, trust me, you know, explicitly constructed
to try to subsidize homeownership. I mean, think about all the rules in banking and in tax treatment
and government mortgage guarantee organizations, Fannie and Freddie, and the risk-weighted asset capital preferential treatment on mortgages,
and then the rules around tranching and collateralization and building out mortgage portfolios and super senior tranches of subprime CDOs that get treated like a risk-weighted asset
because you've played this accounting game of buying insurance from a monoline insurer
who's a AAA-rated guy because he only insures AAA-rated mortgages.
And because he's AAA, he doesn't have to collateralize any of the insurance.
And the thing gets a zero-risk rating asset, and you can leverage it infinitely
and say it's no risk and pay yourself bonuses every year on the crude income.
Well, that whole thing destroyed the U.S. housing market,
They destroyed the global banking system, right?
You know, so I'd be very cautious about being too enthusiastic about TradFi getting their dirty little fingers into Bitcoin.
I think it will inevitably bring leverage and danger to the process.
Yeah, I think it's going to be really interesting because like as Bitcoin is often described as Bitcoin being the Trojan horse into the traditional financial system.
And that, you know, it's this like uncorruptible thing, which I believe it is.
but only time will tell if that's actually true.
So you've obviously been in markets a long time.
Were you around, like, working in the markets in 2008?
Yes, I was.
And did you spot this coming then?
Well, I was, at that time, I was still in the banking industry.
And so it was very easy to spot what was coming because I worked in a bank.
One of the things I say all the time,
so another analogy that I use all the time, Danny,
in terms of investment strategies and how you should manage your investments is the race car analogy.
In a multi, a 40-lap Formula One race, who wins the race?
Well, the guy with the best brakes, right?
Because the guy with the best brakes doesn't crash and he can drive faster.
And so when I'm talking to people about risk,
Most people, when they're thinking about risk, want to predict the future unknown course of the racetrack.
But the actual risk, the only thing you can control is your car.
So what you want in terms of risk management is a resilient, robust, dynamic car.
You want good brakes so that you can go out and test your car on how to drive it faster.
better aerodynamics, better tires, different steering, transmission, stronger engine, right?
Skills, right? So in a bank perspective, if I'm around a bunch of bankers or regulated financial
fiduciaries, everybody always says, Dave, what do you think the risk is? Do you think it's
geopolitics in North Asia? Or do you think it's recession in Europe? Or do you think, you know,
all these random exogenous things out there. And I say, no, the risk is your balance sheet.
Why are you looking out there? All the risk is right in front of you. And if you're sitting in
a room full of bankers and you say, well, your risks are almost certainly driven by the lack
of capital to the things that you've been told you can account for as riskless. So you've applied
a ton of leverage to them. And the interesting thing is, so is he, and so is the guy sitting
next to you and so does the guy sit next to him and so does the guy sit next to him because you're
all following the same rules and paying on the same incentive structure and so you know if you're
inside a bank and you understand what a bank does it's pretty easy to see where the risk is built up
because you're doing the same thing that everybody else is doing and you know where there's no capital
and again you know u.s mortgage structures that had been gamed to ad infinitum but you know not
just that all of the lack of capital around complex structure derivative type activities
was massively undercapitalized and you could see that kind of stuff coming.
And I'm sure you've seen the movie, The Big Short.
There was all kinds of guys inside saying, hey, this is a problem or, you know, margin
call or all of those saying, hey, this is a problem and getting told, you know, what
was the famous Chuck Princh quote?
You know, yeah, we know it's a problem, but, you know, as long as the music's playing, we'll keep dancing because that's how they get paid.
And they're not getting paid to grow the wealth of the bank over the multi-lap race.
They're getting paid based upon each lap.
So they're just trying to sort of match the average lap speed because they believe they start over each lap.
They're not trying to compound growth and compound wealth.
They're just trying to get through the year and collect money.
And so they're happy to, you know, in the old analogy, you know, pick pennies up in front of the steamroller.
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See, the thing that I find frustrating about this kind of thing is that, and this is talked about in Bitcoin a lot, in the sense that when money is broken, everyone has to be an investor plus a risk manager.
And if you're just like, I don't know, a doctor or a lawyer or a teacher or something, you shouldn't have to think about all this.
Does the sort of fiat currency world frustrate you?
Oh, it's so much.
It's my enemy.
And again, Sharp World is my enemy.
It's funny, you know, and people joke about this because, you know, your followers and listeners can go and track me down and hear me talk at things at podcasts and interviews and conferences and stuff.
And I am a very vocal and have been for 30 years outsmoking critic of Sharpe World of the regulatory construct of banks and a very outspoken critic of the practices of central banks and how they manage monetary policy and the sort of inflation the commitment to generating inflation particularly asset inflation and the wealth segregation that goes along with it Now on the other hand the practice of Sharp World is what provides the opportunity that my business lives off of So the cheap convexity that very highly efficient
asymmetry that allows our investors who, you know, tend maybe not to be just individuals,
but there are some wealthy individuals, but are institutional, to allow them to sort of delegate
that breaking, that risk management to us and then go out and just figure out how to drive faster
and do what I would, you know, crudely call the easy part and just go and own stuff that goes up
when things are good, goes up when fiat's being debased, that goes up when asset inflation,
which I'll argue, you know, sort of been the sort of singular growth policy since that 87 crash,
Since the first time Alan Greenspan cut interest rates because stock markets were falling, which started the first time in the October 87 crash and then basically evolved into the Greenspan put that was implemented all over the world and became inflation targeting central banks, beginning with the New Zealand Central Bank and then standardized around the world, where they every time asset prices fell, they cut interest rates and keep propping the asset prices up.
And they drove growth through the wealth effect of asset inflation, concentrating the wealth in more and more hands and concentrating, I don't know if you go and see the numbers, the consumption that drives the growth in places like the U.S. in particular in more and more, you know, fewer and fewer hands and the bigger and bigger and wealthy people.
It's sort of a, it's funny, the same people who make fun of trickle-down economics from the Reagan era of that he was going to cut taxes and then the wealth would trickle down every because they get more jobs.
They seem very happy to implement trickle-down asset wealth because that's literally been the policy.
And that, of course, then leads to, again, back to the endogenous problems and the sort of fragility of systems.
It leads to this sort of geopolitical fragility and leads to economies that are really downstream from the markets.
So I say all the time, economics is downstream from markets.
But you don't have – markets don't fall because there's a recession.
There's a recession because markets fall.
So, I mean, you sound like a Bitcoiner, David.
That's for sure.
I'm not a disbeliever, that's for sure.
do you think there's a future like a near future you know give it 10 20 30 years whatever you want
to whatever number you want to pick where this kind of fiat sharp world doesn't exist anymore
and we move to like a hard money standard again um i'm not good at time in fact in a sense my job
is solving the problem of time uh i don't know when the lightning strike's going to come i just
know how much risk there is in the forest. And so I would say inevitably, yes, that this is
unsustainable. So solutions are going to have to be found. Exactly what those, you know, whether
the fire is going to start because of lightning or because kids are playing with matches or
which direction the wind's going to blow, I don't know. But there is a lot of fragility in the
system. I'll go back to this sort of basic core, the thing that I believe is at the very core of
the challenges, and that's the population demographic problem. And that problem, as I
would define it, isn't declining population, although that has obvious complications itself,
but by far the greater problem is declining working age population. And so this gets really
to the heart of Bitcoin, because the declining working age population, let's reclassify them,
declining taxpayer and saver population. And so I say this all the time that I find it as the
single biggest weakness in those who purport to make policy, economic policy, is how can they not
factor into everything they do this simple sentence that I say, so tell your listeners,
every time somebody says something to you, every time Rachel Reeves in the UK, you're in the UK,
right, Danny?
Now.
I am at the moment.
I actually live in Australia,
but I'm here right now.
Yeah.
Every time Rachel Reeves talks
or Governor Bailey talks
or Governor Bullock talks
or, you know,
Scott Besson talks
or Awaita-son talks in Japan,
at this sentence,
at the end of whatever they said,
and for every year going forward,
there will be fewer taxpayers.
And that will, in a significant way, clarify the nonsense that's coming out of their mouths.
Because how can you continue to borrow from the future to try to facilitate, maintain,
sustain growth today, knowing that in the future, there will be both fewer taxpayers
and fewer savers?
So there's fewer bond buyers in the future.
There are fewer sources of revenue for the governments in the future.
And now over on, I'll argue, and I noted this as my notes, I would argue that we've been under financial repression, that a big part of the subsequent implementation of BIS regulatory capital guidelines, what's known as Basel I, Basel II, and now Basel III, is in essence financial repression, right?
It's using the banking system to own a shit ton of government bonds.
And the government keeps issuing those bonds and then regulating banks and pension funds and insurance companies to own them.
And so this financial repression has had the intent of keeping interest rates below growth.
And when they did that back in post-World War II era, that allowed the debt that had accumulated during World War II to subside.
Difference back then was the governments were shrinking after the war, and the private sector had wiped out all of their debt in the Depression and the austerity years during the war.
And you had the, what I call the pig in the Python, the largest population cohort, the baby boomers, were just barely in the jaws of the Python.
And now, 80 years later, 70 years, 80 years later, you have all-time peak government debt, all-time peak private sector debt, and the pig is coming out the other end of the Python.
And they're no longer the largest taxpaying, largest saving bond-buying cohort.
And the cohorts behind them and every subsequent cohort is going to be smaller.
And this is what drives this problem and creates this sort of inflation feedback loop, because as you debase the savings of the now retirement cohort who saved in your bonds because they were quasi forced to through the regulatory construction around the fiduciary system,
They go into retirement with not enough wealth to offset the rising cost of living that you've imposed on them. And so that requires ever more subsidy from the government to cover their longevity, their unemployment, their Social Security, their retirement benefits, their medical benefits, etc., which requires more taxes from a smaller taxpaying cohort.
who are also burdened by the higher cost of living.
And so once you tax them more and they consume at a higher cost of living,
guess what?
They have less money left over to save.
And so eventually you have to financially repress more.
And central banks have to become the buyers of the bonds
and things that sometimes they call quantitative easing,
although last week they called it not quantitative easing
when they announced they were going to do it, right?
and you create this loop where it just keeps going.
So until you stop debasing the savings of your populace
as they move from savers and taxpayers to retirees
and, you know, where necessary, subsidized in their retirement
because their savings won't cover the higher cost
because you've debased the value of their savings
by forcing them to own bonds.
And, you know, they weren't smart enough to get on board Bitcoin
to finance their retirement.
It's a very difficult loop to get out of.
And so to your point, the long answer to the question, it's a complicated world.
You're going to have to figure out how to solve this problem, and you need to end that loop or you blow it up.
It's scary.
I was actually talking to someone on the show just recently who was talking about Social Security potentially going bankrupt by, I think, 2032 was the year that they gave.
and so if we do have like an aging demographic
more reliant on
social security retirement schemes around the world
and becoming more heavily reliant
on Medicare and
like the NHS here in the UK
it gets
messy really quick and
is the only way out of that essentially to print more
money and so when I ask like
does the fiat system die
is that because
of this they end up having to do a huge
print which then ends up in some kind of like
hyperinflation event? They don't have to, but that is what they have chosen to do, right? So,
again, I'll argue this really goes back to 2000, but, you know, accelerated post-GFC, accelerated
again post-COVID has, you know, really gone global. You could argue it started with my good
friends in Japan who, you know, added more fuel to that fire today with their own policy nonsense,
and they've chosen this.
And so if you stay in this loop,
we build a model.
I had some interns here for the summer
and we build a model,
what they call an agent-based model
on population demographic issues.
And it shows once you're in that loop
and your fertility rate's declining
and you start to get the imbalance
between retired turtles,
we call them in the model,
retired turtles and working turtles.
And if the government is subsidizing the decline in overall productive resources relative to unproductive resources, and they end up having to do that to print money because the smaller productive resources can't cover the tax burden of doing that.
And then they themselves have less savings when they go into retirement. It becomes an impossible loop to solve. And the only solution for it, you know, I'm getting a little bit economic geeky with your crowd, but the only solution for it, the true solution for it is productivity gains, right?
You have to make the fewer workers more productive so that there's more productivity.
They have to have higher real wages, not persistently lower real wages.
You can't constantly debase their earnings, a la Janet Yellen, you know, joking about it in 1996 when the Fed was talking about going to inflation targeting.
And Alan Greenspan thought the inflation target should be zero.
and Janet Yellen thought it should be 2%
because workers wouldn't know
they were having their real earnings debased
and the benefit to the corporate,
to the employer would encourage him
to hire more workers
because he's kind of getting the 2%
that they're losing.
And that's literally,
that's in transcripts from the Fed.
I wrote about it one month.
Janet Yellen was my econ professor
in grad school.
It's so insidious though
because before I got into Bitcoin,
I didn't even necessarily think inflation was a bad thing.
I thought if we were at 2% inflation,
that was a sign of like a healthy economy.
And like these are the lessons you're taught.
And then as soon as you kind of see behind the curtain,
you realize everything was a bit of a lie.
So the productivity is an interesting one though,
because the obvious place where that could come from
is through like AI and robotics,
which is seemingly going to be a really big part
of the economy in the future.
Do you think that could actually save
the central banks around the world in the short term? I guess maybe. I don't know. I don't have a
lot of... I like AI as it functions as a simple tool, but I don't have a lot of respect for it.
AI or LLMs, the sort of current version of AI that's actually available for use is an LLM.
And an LLM is exactly like Sharp World, right?
I coined, so if your readers want to go, I wrote one of my notes that I titled The Polanyi Paradox.
Have you ever heard of Michael Polanyi?
No.
He was a philosopher, scientist in the mid-1900s.
and he coined, actually another guy, David Alter, a current economist, coined, referring to him,
the Polanyi paradox. So what Polanyi is known for is what's known as tacit knowledge. And the
Polanyi paradox is known as we humans can know more than we can tell because we have tacit
knowledge. So we can know how to ride a bike, but we can't necessarily write down the mathematical
formulas of physics to explain it to somebody, right? But we know, we know that jumping off,
you know, using a Nassim Taleb fragility analogy, that jumping off a one meter high fence 10 times
won't hurt us. But jumping off a 10 meter high fence one time probably will.
All right. That's tacit knowledge. It's skin in the game. Right. Well, I coined the reverse Polanyi paradox in this note about LLMs and the reverse Polanyi paradox about LLMs goes, AI can tell more than it can know.
right ai will answer every will answer every question it actually knows nothing right and
all it's doing is taking its entire corpus of it the data set and saying on average what's the next
word right it's just another normal probability distribution saying that in the course of
human data that I have access to, what's the middle of the distribution? And I'll put that
word next. And it's really remarkable how it does that and how quickly it does it and how fast it can
read stuff and order it that way. But again, taking science again, going to Claude Shannon.
Claude Shannon's the father of the modern day digital age. And he wrote when he was a PhD
student back in 1950-something, the mathematical theory of communication, and what's known as
Shannon's entropy, which is the math behind how information moves. It's bits and bytes. He coined
the word bits. And what Shannon would tell you is there's no information in the expected.
All learning and growth comes outside the expected outcome. And it's what we don't know
that matters. It's not what we do know that matters. So I have very little hope in the current
formation of AI. And I have a lot of doubt that the promises of generative AI will produce what
they claim it will produce because I struggle to understand how AI learns because the current AI
doesn't learn at all. It just expands its data set and gets a better probability of what the
next word is, but it still hasn't actually learned anything. And it only knows the average of what
everybody already knows. And one of the things I criticize central bankers with all the time,
because they also seem to be incapable of learning and that, you know, it's a Nassim
telebism without accountability, there can be no learning. If you're never punished for your
mistakes, there's a big difference between reading that sticking your head in the fire will burn
and sticking your head in the fire. So it sounds like you're kind of fading the eye part of AI.
You don't think it's actually intelligent. So there's probably, is there anything else out there
that could increase the productivity to a degree that could save the current financial system if
it's not going to be AI? Or is that it's like single shot? No, I think there's a whole bunch
of things out there. And almost all of those things are things that we haven't thought of.
And that's kind of the whole point. And so finding things, you know, Elon Musk.
Right, through some energy or.
Yeah.
You know, Elon Musk building, you know, energy and mining capability on Mars.
Nobody had on their bingo card 10 years ago.
And now this crazy guy said, what if we did this?
You know, and so it's always the, you know, and again, this is another investment thing.
And this goes sort of in line with, I was having dinner with my dear old friend, Pippa
Momgren.
Ever heard of Pippa Momgren?
I have, yeah.
a geopolitical economist strategy person,
and also an ex-banker's trust alum.
And, you know, we think we were all brainwashed the same way.
Nassim Taleb and me and Bippa all brainwashed the same way
in our banker's trust days when we were actually in the risk business.
And something I say you know the key to risk management or the key to life is to try to you know to do everything you can to eliminate the unrecoverable so that you can pursue the unimaginable
And that's how I advocate people manage their risk portfolios.
That's the brakes on the car so you can go out and explore, you know, the capacity to go faster.
And so cut off those wings.
Stop focusing on the average.
stop doing the simple, cut off the risk of the negative tail that you'll never recover from,
bankruptcy and insolvency in wealth management or death in life, and go and find the thing that
nobody else has ever thought of. And the human race has an unbelievable track record in solving
problems. It wasn't that long ago that people would have told you that we're going to run out
food because population is growing too much. Now we've got to solve the problem that, you know,
something that history books don't really have a record of is how to deal with population shrinking.
And that shrinking, you know, sort of being hard-coded over the next two or three generations
because the birth rate decline, the fertility rate decline is already hard-coded in those that
were born behind the next few generations. And so we need to figure out how to cope with that and
coping with it by, and, you know, again, I wrote about this this summer. I think the note was
called preservation and, you know, linked to a paper that was done, commissioned by the G20 and
done under the oversight of the BIS in 1998 that said all this stuff. Said, you know, we should not
borrow from the future. We should focus on investment and productivity. We should, you know,
instead of going with what BIS, think about what the initial Basel I did, it provided the, you know,
sort of maximum subsidies, banking subsidies, the minimum capital required to own these assets and,
you know, pay yourself bonuses on the annual accounting revenue to government debt and mortgages.
Well, how much productivity comes out of government debt and mortgages? Shouldn't banks like they once
used to do, lend to businesses, to startups, to small businesses, to community businesses, to,
you know, guys that are out creating the actual productivity that allows growth. But we went the
opposite way. And now we're going to suffer through trying to solve that. So I think there
are all kinds of solutions that nobody's thought of. And maybe AI is that solution or certainly is
part of that solution because it is a fantastic tool. And, you know, what it can do, nobody really
knows. What it currently
does do isn't anywhere close
to what people are telling you it will do.
But maybe they get it there.
I don't know if this is recency biased, David,
but it feels like we're living
in the most interesting times for good
or for bad. Everything you've talked
about then, and then in the macro world,
it's, I mean, things are a mess.
But I'm
very conscious of your time, but before we close out,
I wouldn't mind just getting a little bit into the macro side
of things, because
QT in the US has now come to an end
and they're doing their not QE QE.
Rates are getting cut while inflation is still pretty high.
Fiscal dominance is a story that, like,
I'd never even heard the term fiscal dominance
until a few years ago,
and now it's kind of the thing that everyone's talking about.
How much of a mess are we in?
Like, you're always looking for risks in the market.
Like, what are the big risks that you're looking at right now?
Well, again, I see risk as leverage, as imbalances,
so I don't think about future events.
I can see where there's a lot of fragility, build-up brush, fingers of fragility to use, pair box, sand pile, self-organized criticality language.
You don't have to be too much of a rocket scientist to understand that still, going back where you got a real sniff of it in 2022.
There's a lot of uncapitalized risk leverage in government bonds.
So government bonds were piled onto regulated balance sheets.
Nobody with their own retirement money was buying 30-year bonds that yielded zero.
And yet, all of the major governments in the world hit their peak all-time bond issuance when they yielded zero.
So somebody was buying them.
In fact, somebody was buying more of them than ever in history.
Well, who was that? Regulated financial institutions. And so you get this dynamic like Silicon Valley Bank, a bank that a regulated, a heavily regulated bank goes out of business, goes insolvent, following the rules because it owned U.S. Treasury bonds.
So, again, my famous quote, which I quoted way before Silicon Valley Bank went out of business, banks don't go out of business taking risk. Banks go out of business levering that which they can account for as riskless.
Right. And so banks were told these bonds, U.S. treasuries, French government bonds, gilts, boons, JGBs, Australia were riskless.
And, you know, inside even non-developed countries, their domestic bonds are riskless.
Greek government bonds are riskless to everybody in the world because they're inside the eurozone.
Indonesian government bonds are riskless to Indonesian banks.
And banks aren't that, you know, banks are pretty creative. They'll figure out a way to use derivatives to leverage that up even more and still get it treated as a zero risk weighted asset, even though it's another round of leverage on top of their 30x leverage already.
So, you know, it's not hard to see. And then, you know, you get the stupidity like the liability driven investment strategies in the UK where pension funds are levering long dated duration gilts 5x and accounting that is risk reducing for their otherwise, you know, equity portfolio.
only to find out that they need to get bailed out
because all of their risk is the leverage and the gilts.
And so that still remains arguably one of the biggest risks in the system.
And you can see how the back end of everybody's bond curve
has behaved this year as all of the central banks have cut rates.
None of the long end rates have come down.
In fact, today, thanks to our friends at the Bank of Japan,
they're all going up aggressively. And so that's still a major problem, maybe the major problem in
the big global system, because that's where the systemic risk is. The systemic risk without fail
will be in the banking system, because that's where the bulk of the protected leverage is,
and that's where the sensitivity when things go wrong are. Having said that, one of the things
that has been proliferic in its growth in the last couple of years
has been the leverage going into the high-flying stocks,
the Mag7, the crypto, you know, micro strategy,
a great example of a high-flying stock
that inherent in its own construct is leveraged,
and then all around it in the financial engineering of TradFi
attracts more leverage. So, you know, let's take a levered micro strategy and embed it in a three
times levered ETF as though that makes sense to somebody or do auto callable these highly levered
vol selling strategies on micro strategy. And so the proliferation of that over the last several
years has been a big part, in my opinion, of the noise that we saw in iBit and fed through into
Bitcoin in October, November, and that we've seen in some of these names like MicroStrategy,
who's getting it from both sides. And eventually we might see in other high-flying
meme stocks. So those are things I think, you know, we saw quite a bit of volatility around them.
Some have recovered, some have not recovered, MicroStrategy being a great example.
AI related things, you know, that sort of cycle of internal trading.
I'll lend you money to buy my product and we'll both say that we've done this big deal and our stock prices will go up.
And then those will get embedded in three times levered autocallable structure, you know.
And so that stuff seems to me to have gotten pretty juiced and attracted quite a lot of leverage.
Japan itself, it just structurally is a very interesting place. And I've long said,
obviously, I hope I've made it clear, I don't know when or where lightning is going to strike.
I don't even know if lightning is going to be the thing that starts the fire. It's usually the thing
that you weren't anticipating that surprises you. But I've long said, and I don't necessarily agree
with them, but people are more familiar with what they call the Lehman crisis, thinking of Lehman
as the trigger of the GFC. When we get more time, I'll tell you what was the actual trigger. We can't
do that today. I've long said that the next trigger is going to be Japan, that Japan is the likely
spark because of the fragility in the Japanese market system economy after the longest period,
35 years of manipulating interest rates, manipulating the price that should balance between
borrowers and lenders, savers, investors, speculators, hedgers, importers, exporters.
They've decided instead of you, you know, hundreds of millions of participants coming
and finding an equilibrium balance where you're happy to participate, we're going to set it here.
And we're going to set it there and keep it there for 30 years. And now the market's decided they've had enough of that, and the transition away from that is proving challenging. And I think still has a reasonable possibility of being the kind of thing that triggers some of these problems.
because if Japanese investors who are the largest net international creditors in the world,
so Japan Inc. is the biggest foreign bond owner in every government bond market in the world.
And if they decide they need to bring money back to buy their own bonds that are circa 250% of GDP
and the Bank of Japan is in theory running down their bond holdings,
They're running down their bond holdings at a pace that will get them to some target in 100 years.
So they're not exactly selling off the bonds they bought.
They're just not buying them as fast.
You know, that kind of thing.
You know, and we had it today.
I guess, I don't know if you saw the European announcement about the $90 billion commitment to Ukraine.
So the EU, they're going to issue bonds out of nowhere. So there's been, to my knowledge, nobody voted for this. It's not been in any approved budget, but they're going to issue bonds, get 90 billion euro, give it to Ukraine over the next two years, collateralize it with the money they've frozen from Russia, and then force Russia to pay.
pay Ukraine that money in reparations, and then Ukraine will pay off the loan with the money that
they get from reparations. So they haven't strictly confiscated Russia's assets, but they've used them
as collateral for this loan to the Ukraine that they're going to fund issuing bonds. And so this
gets to, again, back to the government bond issue, something that I've written a lot about that I
refer to as the Hunger Games. So this Hunger Games competition of who will be the last guy that can
issue bonds to the last taxpayer and saver. And so this competition that now Germany has waived
their constitutional debt ceiling and started what they call the Made in Germany to bring capital
back to buy German bonds so they could build a military, which I saw the guy announcing he's
going to start drafting people involuntarily into the military if they don't start signing up
voluntarily. And now the EU, who, you know, doesn't have it, hasn't had an approved budget
in history, has just announced that they're going to spend another 90 billion that nobody's voted for
by issuing bonds. And the Japanese, you know, the every JGB on the curve has made a new,
you know, 40 year high in yields today or whatever, as that bond market gets nuked,
because Bank of Japan refuses to raise rates fast enough to stop the inflation.
And so if the Japanese ever decide they're going to bring money back to buy JGBs,
and the Germans decide they're going to bring money back,
Germans are the second largest foreign bondholder in most markets,
and the EU is now competing, where does that leave France?
So France, who relies heavily on Germany and Japan to fund their markets,
not to compete with them on bond selling.
And so these sorts of things are always percolating out there.
But meanwhile, you know, the core strategy of the guys who own the printing presses is to inflate assets.
And so what you can't do is sit out.
You can't say, oh, this thing is so messed up, I'm just going to sit on cash because the inflation will eat you alive.
And now Bitcoin has been an unbelievable good protector to date of that inflation, of the asset inflation, of the printing of money problem.
Hopefully it can continue to be.
Now, what we would advocate to all of our investors is you've got to own things that participate if it keeps going the way it has been going.
And owning that stuff has been very rewarding for the last 50 years.
Since QE started, since March of 2009, owning participating assets has been good.
And then you also need to own something that provides highly asymmetric, negatively correlating risk so that when you get GFCs or European credit crises or COVID or 2022 rate hikes to try to restore some stability,
You have something that's mitigating that drawdown and allowing you to stay in the market, not getting forced out of your Bitcoin or out of your gold or out of your NASDAQ or out of your Nikkei or whatever that may be.
And that combination of something that is, back to the race car analogy, that is accelerating on the good parts and aggressively decelerating on the bad parts, that's responding, reactive, is the way to deal with the uncertainty, the unknowability of the future path, is to have a car that's very resilient.
I love the race car analogy.
That's great.
I mean, the whole macro world seems a complete mess at the moment,
but I guess the good news for you is that you're going to be in a job for a while.
Yeah.
Well, you know, we always say, and I say it every day,
we and our investors hope we never make money, right?
You never want your insurance to make money, right?
But then your job is, once you've got the insurance,
is to go out and take advantage of it, to go out and drive the car fast,
you know, find the opportunity that knowing you've got, you know,
Good safety net allows you to go take.
What you need to avoid is the opposite of that,
which is what Sharperl is trying to force you into,
of saying, well, you know, let's do these covered calls.
Let's do a covered call strategy
where you have all of the downside volatility risk
and a capped upside.
Well, if you're going to take the downside volatility risk,
the reward should be the uncapped upside.
Why don't we turn that around and cut off the downside
and go get the upside?
So let's cut off the unrecoverable and pursue the unimaginable.
It's a very good motto, I think.
Yeah, I love that.
David, I'm very conscious that it's late there on the Friday before Christmas.
I massively appreciate the time.
I've really enjoyed this.
And I'd love to do it again at some point.
Maybe we should do a history lesson on layman and get into why Japan could be the start of this next fire.
But thank you so much.
Tell everyone where they can go to find your work and everything that you do.
Yeah, so I'm not active, but I at least note on LinkedIn and on X. On X, I'm at Convexity Dredge, and on LinkedIn, I'm just David Dredge. We note up there whenever our monthly updates go up on the website, and the website is convex-strategies.com, and there's, I don't know, at least 100 monthly updates talking about all this stuff, talking about the science, the math, the flaws, the way things work, and the way I think they should work, the mistakes that central banks make.
month after month after month, and then a whole bunch of, you know, podcasts and interviews or
presentations that somebody got to record over the last decade or so up there as well. So there's a
lot of information there. And I always say this, and, you know, when somebody thinks to check the
info mailbox at the website and share with me things that somebody's asked a question,
they'll be surprised how often I respond. I like talking about this stuff.
I love that.
Thank you so much for the time, David.
I hope you have a good Christmas,
and I will,
we've got to do it again.
I really enjoyed this.
We'll do it again soon.
Awesome.
Thanks, Danny.
Really appreciate it.