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The Politic Blog

Jakub Rehor (YC 95), Co-founder and CIO of LucyLabs CryptoFinance Firm

Jakub Rehor is Co-founder and Chief Investment Officer of Lucy Labs, Inc., a cryptocurrency merchant bank, and Founder and Portfolio Manager of Ubival LLC, a quantitative commodity trading advisor. Previously, Mr. Rehor was a portfolio manager and partner at Third Avenue Management, where he worked for almost nine years, and held research analyst positions with Putnam Investments, Sanford C. Bernstein, and McKinsey & Co. Mr. Rehor grew up in the Czech Republic and participated in the student resistance during the Velvet Revolution, building a nationwide computer network connecting student union cells around the country, and serving on President Václav Havel’s security detail during his inauguration in 1989. He graduated summa cum laude from Yale University with a BA in Economics.

Tell me about your background and how you got involved in the crypto space!

I run into people who get upset and angry every time they hear about cryptocurrency. It’s beyond irrational. A lot of this movement is being driven exactly because of the reaction it elicits. I’m one of the few people who’s open and public about my involvement. I first learned of Bitcoin in 2011, and I thought it was a neat concept and an interesting piece of software. I made my first investment in those days, back when Bitcoin’s price was $14, and I saw it drop to $2 very quickly. I thought that was the end, so I watched in amazement as the currency gained in adoption and grew to the beast that it’s become today.

I’ve been peripherally involved for a long time. I was on Wall Street for many years in asset management. I did quantitative investment as well, and a couple of years ago, a couple of friends and I figured out some arbitrage opportunities in the crypto market. These opportunities are well-known and well-exploited in traditional markets, but they’re still plentiful in crypto markets. So, we got together and started trading. The LucyLabs firm is mostly a trading firm looking for these anomalies.

Are you able to beat the market because it’s less driven by fundamentals? I.e., because there’s more volatility, and any informational advantage gives you a huge edge?

They have that in common with the currencies trading the U.S. dollar vs. the euro. It’s not driven by fundamentals. It’s driven by newsflow and sentiment, but those are a weak driver. What’s unusual is there’s a lot of retail participation and not enough institutional participation or capital. As the market becomes more institutional, these opportunities are going to fade away. It’s a retail-driven market. Everybody talks about how these institutions are going to come soon, but they’re not involved in any meaningful way yet.

When are the institutional quant players going to come in and solve the inefficiencies/get rid of the arbitrage opportunities?

Well, I think it will happen fairly soon once they enter. Those guys are good. They have lots of resources. They can throw many programmers and quants at the problems. They have a lot of capital, too. They can compete pretty quickly. It’s a matter of months instead of years. That process will close certain opportunities but open new ones.

What happens when you lose the arbitrage opportunities?

For example, we have some strategies that we’d like to use, but they assume certain arbitrage opportunities hold. To hedge efficiently, you need the hedging instruments to hold close to the underlying spot, and that’s not the case. So, we go in and use the hedge-first spot. If that goes away, we can now use that as a building block for other strategies. This is exactly what they developed in traditional markets: There are inefficiencies, they arbitrage them away, and then create a tool that can be used to chase other opportunities. Financial markets are complex. The number of relationships and instruments grows exponentially. It’s basically impossible for all arbitrage relationships to hold at the same time. Even if you had all the computers in the universe trying to arbitrage, you wouldn’t be able to handle it computationally. It gets harder and the game gets more competitive.

How did you decide to really get into the space? Did you start by putting one foot in?

I started with only a toe in the water. I put money into a cryptocurrency which blew up in my face. It turned out there was a lot of mismanagement and fraud involved. I actually pulled my money out because there were indicators that something was going wrong, so I didn’t lose money thankfully. It was a learning experience. The cryptocurrency market has built a parallel infrastructure to the global financial system of trading, clearing, and settlement, which is the really interesting thing about the movement. We’re never had anyone build parallel trading structures. That’s new in history. It’s still young, but it’s a new event in the financial market.

If you’ve designed a sentiment analysis algorithm for trading common stocks, can you just take that and apply it to the crypto market? Are there any relevant differences?

I think they’re fundamentally still financial instruments and will be traded as such. Now, something like Bitcoin is similar to currencies or gold, and it’s trading in a similar manner. There are other cryptocurrencies that try to be more like securities, so I would expect them to trade like securities. I know a lot of people who are doing that, or are at least pursuing that. I don’t have any experience with that, but I know there are dozens of prop trading shops or hedge funds that are going down that route.

Is it a problem for sentiment analysis that there seems to be more noise/spam/hype in the crypto market?

That’s not that different from stocks. When sentiment analysis first started coming out in the equity market, they had to filter the data feed from Twitter and assume that most of it was fake or manipulated. It’s a phenomena that occurs in the equity markets. You have pump and dump schemes, penny stocks, equity manipulation, and so on. There’s nothing new. They’re just copying all of the old stuff and applying to this parallel market.

Do you trade all 2,275 coins?

We don’t really do anything outside of the top 100 coins. It’s a power law distribution, so it folds very quickly. You have to decide if you’re taking the long-term view or the short-term view. In the long term, most of these will turn out to be failed experiments. 

What do you see as the fundamental value proposition of cryptocurrencies?

I would like to draw an analogy with the U.S. motor industry in the 1910s. There were over 1000 car companies in the U.S. at the end of the World War. Thirty years later, there were only a few. It was a period of experimentation where people were trying to figure out distribution, manufacturing, design, and so on. All of it was very new, and people had to discover and learn. Nobody knows the guide book, and a lot of this market will fail. That’s the nature of the free market.

I would divide the market into three sectors. One part is currency replacement. There, I think we’ll see a strong power law distribution. The winning cryptocurrency will have a huge market share, there will be a couple of niche equivalents, and there will be pretty much nothing after that. That’s similar to traditional currencies. International trade is doing in U.S. dollars. Very little of trade is done in Euros, a little is done in Japanese Yen, and then there’s pretty much nothing after that. In the currency sector, I expect a pretty big consolidation because of network effects.

The second sector which is interesting in the long term is the security token. These are basically stocks or bonds being traded, clear and simple, in this alternative financial system. You could have thousands of them, much as you have thousands of stocks listed in the U.S. In fact, there are about 3.5 thousand reasonably-sized stocks in the U.S., and the same number overseas, so about 10 thousand reasonably-sized stocks globally. The same could happen in the security token space. 

The final sector is cryptocurrencies and businesses. There, you could have hundreds of thousands of businesses providing all sorts of services: payment processing, asset management, trading, security custody, consulting, and so on. We can imagine all sorts of areas by analogy to what we already have, and then there will be some which are brand new.

What’s your unique value proposition with respect to trading?

There are dozens of people like us. Pretty much everybody in the space is very small. They haven’t had time to grow. I don’t think we’re that unique. There’s a lot of activity happening under the radar. People are learning, people are experimenting, people are trying new strategies. This is an adventure.

Out of curiosity, why did you leave the hedge fund industry for crypto?

I think people have an unrealistic expectation about the hedge fund industry’s attractiveness. There are more U.S. hedge funds than Taco Bells. There’s too much competition. People see the winners in the newspapers and magazines, but the winners are a tiny portion of the whole picture. The vast majority of people are working really hard, competing hard, delivering good returns, but still not living the lifestyle of the rich and famous. It’s very rare to be a billionaire, to be that successful. The power law distributions holds there as well. There’s a long tail of struggling analysts.

Relative to entering the hedge fund space, is crypto a viable option?

If people tell you to go to hedge funds to get rich, it’s like getting a lottery ticket. Thinking about the probability of that, the hedge fund industry is pretty competitive: it’s full of smart people who like competition and are quite capable of executing. A lot of people are noticing the cryptocurrency markets. They’re noticing its inefficiencies. It’s easier to make money there, now, than in more competitive, traditional markets. You don’t need as much infrastructure, so people are starting to migrate.

I would tell you to go into crypto if you think it’s neat and that it’ll give you other non-monetary rewards. You have to find it interesting and enjoy learning. I wouldn’t do it for the money. The market is still very small. The total crypto capitalization is smaller than any of the top 10 stocks in the U.S. Just think about that. This is a small, small market. If you are a hedge fund analyst in a traditional fund, and you’re doing well, just keep doing what you’re doing. This is really a place where people are driven by their curiosity and their inner passion. It’s definitely not an easy way to make money, I don’t want to come across sounding like that.

The issue with the fact that there are a lot of inefficiencies is that you end up writing your own management systems and a lot of the software infrastructure. It’s a bit of grunt work, and it’s not that exciting, but you have to do that in order to play, or to put the first chip on the table. You have to build from the ground up. If you don’t have the motivation to do that, then don’t come into the space.

The other thing that we haven’t talked about at all, because we focused on the trading system, is Bitcoin itself. We haven’t talked about its point and its promise, and that’s really kind of the motivation for me to be involved, because I think it’s an absolutely amazing new technology that will never be uninvented. We still be stuck with the consequences of the invention of Bitcoin no matter what. We are still working out the implications of what we can do with that, and it’s going to be a long-term project, but that’s a big driver. A certain amount of idealism goes a long way.

What aspect of Bitcoin’s point/promise attracted you to the space? I.e., Decentralization?

It’s a very neat technology. Satoshi Nakamoto solved a computer science problem that people thought was unsolvable: how to keep multiple nodes synchronized with the same info. Computer scientists were able to synchronize 40 to 50 nodes, but after that number, it was impossible to keep them in synch. Bitcoin network, on the other hand, keeps thousands in sync, and that should be impossible. At any point in time, some of these nodes have different ideas, but over time, they converge to the blockchain by solving mathematical problems. Bitcoin would be quite an invention in computer science by itself.

On top of that, there’s been interesting work like the Lightning Work, highly-distributed networks. From a computer science perspective, this is very interesting research. From a monetary perspective, this is an amazing experiment. We’re watching the potential creation of an alternative currency that could be around for 100 years if not longer. 

One of the reasons that more traditional types are having a hard time wrapping their heads around Bitcoin is that, for the last 200 years, “currency” was whatever the government deemed to be currency. In the long arc of human history, that’s a very brief phenomenon. People agreed on what would be used as currency, but the government didn’t really enter into it. They may have certified the mint, but they weren’t able to say, “We’ll use something else.” They tried many, many times, and they often had inflation and monetary collapse. But before governments got into the currency business, people found that they could agree on a commodity or an instrument for use as a means of exchange or a store of value. Now, we’re seeing that reply itself in the cryptocurrency space, specifically with Bitcoin, and it’s interesting to watch the dynamics.

There’s the amazing economist, Martin Shubik, who was my advisor at Yale. He did a lot of work on the game theory of money. He was the kind of genius who gets no recognition in his time, although that’s slightly unfair, because he did get some recognition for unrelated work. The Economics Department of Yale thought of him as a total incomprehension in the late 80s and early 90s. He was curious about how people agreed on using a certain instrument and the game-theoretical dynamic behind that choice, so he spent a lot of time theorizing and drawing on historical data to answer that question. But here we are living that dynamic in real time, and it’s thanks to his research. That’s another reason why I found the space so fascinating and was drawn to it. He was my advisor when I was an undergraduate at Yale, and I learned a lot from him.

At one point, as you mention, there were interpersonal agreements as to which financial instruments to use. Later, the central bankers began mandating which currencies and financial instruments to use. Why did that shift happen? What problems of interpersonal agreement gave rise to the central banks?

They were trying to control more resources than they could have otherwise controlled. Central currencies are a tool to control more of the economy. Specifically, the collapse of the gold standard during World War I was due to the demands of wartime funding and the mobilization of resources for a total war. Nothing like that has been seen before. The planners had to come up with new ways to commandeer more of the economy, and taking control of the currency was one of those tools. Suffice to say, that turned out to be a powerful tool, so they never relinquished their power over the currency, and to this day, they’re still trying to use that tool to pursue economic policy plans.

That’s interesting. Am I correct in saying that your view isn’t anti-central planning, per se, but rather that those planners are unnecessary now, and so we’re undertaking a natural progression towards crypto? 

Whether we need that or not is a separate question: That’s the state of the world. There really was no alternative other than gold, which works in theory but in practice isn’t very convenient. Gold has been fairly successful, but pushed aside as a non-factor in monetary economics. What Bitcoin is doing is creating a numeraire currency currency completely outside of the world of traditional finance and government control. 

It’s still too young and volatile to really be used as a currency. With 100 percent annualized volatility, nobody is going to use that as a payment. But here it is maturing. The volatility is slowly declining as it matures and more people  like us trade on its volatility and find inefficiencies in the market. So, I think we’ll see declining volatility, and that will make for more attractive uses cases which are today unfeasible. On the other hand, the transaction processing payment systems that already exist on Bitcoin are in place, and they’re used today.

“Unnecessary” is maybe not the right word. Economic policy, as we understand today, really didn’t exist before World War I. If you look at government spending as a percentage of GDP Before World War I, it hovered between 2-4 percent of GDP, an order of magnitude different than is typical. It was a different world, and in order to come out as a winner, that was no longer sustainable. You had to mobilize the country’s resources just in order to avoid annihilation, and people who weren’t successful in doing so are no longer around. For instance, Austria-Hungary is no longer around, because it was the least successful in mobilizing economic resources.

So, I’m not saying that central planners are unnecessary. I’m just saying that their control of the monetary supply is a natural outcome of the war and competition, because the only way to win World War II was to mobilize all of the resources. If we hadn’t done that, we would’ve lost the war. I’m not saying this is some kind of evil plot dreamed up by people but that it’s an economic dynamic that exists. If today you wanted to go and keep government spending down below 2-3 percent of GDP, I don’t think society would survive.

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