Paul Chou - Founder of LedgerX

LedgerX CEO Paul Chou discusses Bitcoin derivatives and his fully-collateralized and physically-settled bitcoin options for the institutional market. Paul Chou was a trader on the Quantitative Cash Trading desk within the Securities Division of Goldman Sachs where he was responsible for the development, trading and risk management of algorithmic equity trading strategies for U.S. and Japanese markets. Now he is CEO of LedgerX which is developing sophisticated financial instruments for Wall Street to use in their Bitcoin derivatives.

### PODCAST INTERVIEW TRANSCRIPT

Interview with Paul Chou on bitcoin derivatives

  Trace Mayer:  Welcome back to the bitcoin (or bitcoin derivatives) Knowledge Podcast.  We have a very exciting interview with Paul Chou.  He is the CEO and founder of LedgerX.  Welcome to the podcast.

Paul Chou:  Thanks for having me here.

Trace Mayer:  So, little bit of background, you're algorithmic trader, former trader at Goldman Sachs, decided to build LedgerX.  I'm really curious.  Why have you picked the name LedgerX?

Paul Chou:  Well, we wanted something that would reflect the nature of the block chain in general.  And I think thinking it as global ledger, distributed ledger made a lot sense and at the same time our exchange wants to support perhaps multiple crypto currencies in the future.  So, we didn't want to just necessarily be tied to bitcoin (or bitcoin derivatives).  So, X obviously stands for exchange and I think the combination of two it led to the name.

Trace Mayer:  So, you know, from your website, LedgerX is an institutional trading and clearing platform that has applied for registration with the CFTC to operate as a swap execution facility and derivatives clearing organization.  LedgerX intends to list and clear physically settled options on digital currencies, for example, bitcoin (or bitcoin derivatives).

That's very exciting.  I've kind of talked about how we have these seven network effects all taking place at the same time.  We have speculation, we have merchants, consumers, the security/mining, we have developers.  The sixth, the network effect being financialization, which is the one before kind of world reserve currency status settlement currency status.  And so you're working on something that most people that I interviewed for the podcast just aren't in.

You're in the six area financialization that really feeds the first network effect of speculation.  Let's get a little bit granular.  What is a swap?  You know, for a lot of people listening to the podcast they probably have no idea.  Like what is a swap?

Paul Chou:  Yeah.  So, a swap is a broad term for financial derivatives and a swap can have many different forms. Many different terms in the conditions of the trade itself.  In our particular case, our swaps would be options.  So, they resemble put in calls.  European style exercise, which means that you can only exercise the option at the end of the expiration and they're physically settled swaps.

So at the end of expiration if you decide to exercise you actually receive underlyning bitcoin (or bitcoin derivatives) derivatives.  And that's a key part for a lot of our institutional customers who need a regulated platform here in the U.S. ideally at the federal level to trade these swaps and actually underlyning bitcoin (or bitcoin derivatives) derivatives.

Trace Mayer:  Yes, so let's kind of go through an example of one of these.  It sounds like we've got three different periods.  We've got the opening, the closing and the settlement of the contract.  So, maybe you can walk us a little bit through like the nature or the mechanics of one of these.  Let's take an easy one like a bitcoin (or bitcoin derivatives) dollar option.

Paul Chou:  Yeah.  So, for example we might list something like a one-month call option on bitcoin (or bitcoin derivatives).  Denominator U.S. dollars.  And if you're a speculator and you think bitcoin (or bitcoin derivatives) will end at $500 or greater a month from now, you can take US dollars and actually purchase this call option and a month from now if bitcoin (or bitcoin derivatives)'s higher than $500 like you mention that's when we do the settlement.

So you exercise and say yes, I want to buy bitcoin (or bitcoin derivatives) at $500.  Our clearing house deducts $500 from your bank account, U.S. dollars and then gives you the underlying bitcoin (or bitcoin derivatives) as a result.  So, if a month from now bitcoin (or bitcoin derivatives) is at $700 then you've essentially made $200 profit.

Trace Mayer:  So we're not dealing with any smart contracts yet when we're settling these instruments.

Paul Chou:  That's correct.  So the options themselves are handled by the exchange and so they're designed and settled by the exchange itself.  We do on-block chain transactions for customers to send collateral to us.  And for us to send the bitcoin (or bitcoin derivatives) they want back to them.  But smart contracts are not currently part of it all.

Trace Mayer:  So, with LedgerX they're physically settled into bitcoin (or bitcoin derivatives) on the block chain as opposed to tier exchange.  They're cash settlements.  So you're getting dollars even if you bet on price of bitcoin (or bitcoin derivatives) going up.

Paul Chou:  Right.

Trace Mayer:  Why should people use LedgerX then?

Paul Chou:  I think there's a very big difference between cash settle contracts and physically settled contracts.  You know, I think they both have their use cases.  For us, our customers in the course of their business many of them actually need underlying bitcoin (or bitcoin derivatives).

So having something that's physically settled is very important because some of their users will actually be interested in obtaining it at some point.  So giving them the ability to hedge on a physically settled platform is really important for a lot of our customers.

Trace Mayer:  So just like a car manufacturer might need its commodity or somebody might want the physical gold or the physical silver from those contracts so likewise, you know, people can't eat dollars, but they can eat pork bellies or they eat cattle or they can eat weed, right?  So it's important to get actual underlying commodity settled or at least that's kind of your opinion on it.

Paul Chou:  Yes.  So our opinion is that, again, both are very important.  I think for a lot of speculative cases cash settled options or futures or other swaps make a lot of sense where you are only really interested in the kind of economic exposure of it.  But there's also a huge category for physically settled.

And I think one of the powerful things about bitcoin (or bitcoin derivatives) is that it's a lot more than just a price index to make bets on.  Once you actually have, whether you're an institution or otherwise or a company once you have access to underlying bitcoin (or bitcoin derivatives) what you going to do with it afterwards is tremendously broad and flexible.

Trace Mayer:  Former Commissioner Burt Chilton, he seemed to be very interested in the actual delivery in the gold and silver markets, for example.  And we've also got things that prevent or give excuses for not physically delivering.  Like force majeure or duress.  What are some of the conditions where people could be forced not to settle into their bitcoin (or bitcoin derivatives), but actually have to receive dollars, for example?

Paul Chou:  Yeah.  I mean, there are always these force majeure cases that could come up.  You know, the most extreme one obviously is if the entire internet goes down.  Then it's impossible to obviously broadcast a transaction to move anything on the block chain and so we have procedures in place so we could delay settlement.  Almost in every case, we won't -- you know, settlement in U.S. dollars won't necessarily be the way to do it.

Trace Mayer:  How about counterparty risk?  Are people who open up these contracts then exposed to the counterpart risk of someone who's taking the other side of it?  How does that work out?

PAUL CHOU:  Yeah.  It's a great question.  I mean, I think if you look at the ecosystem right now, the vast majority of trades in a lot of ways are done bilaterally over the counter between trusted counterparties.  So you might have a very big institution that, say, your second market and you have a trading desk.  Many people are comfortable doing the second market and comfortable with that particular transaction.

Now, unfortunately there is always sort of a risk with bilateral transactions that counterparties would default which could leave you in a very exposed position from a risk point of view.  So LedgerX's approach from the beginning was to also not just start an exchange, but have a clearing house attached to that exchange.  They'll be the central counterparty to all transactions and so you wouldn't face individual counterpart risk that you would with doing over the counter bilateral trades.

Every single trade is novated and the clearing house guarantees those trades.  And I think that's very important because you no longer have to monitor the credit risks of all these multiple trading counterparties that you might have and you increase the size of the potential liquidity.  Because now a lot of smaller players that bigger institution were unwilling to deal with before because they couldn't trust their credit essentially can now on the platform because the credit issue is mitigated.

Trace Mayer:  You used an interesting term there, novation.  In the context that we're talking about, what exactly is a novation?  How does that impact legally the structures and the contracts that we're talking about?

Paul Chou:  Right.  So, you know, Trace, for example, if you've signed up to LedgerX and I was on the platform as well, and you and I did a trade.  Initially at the first moment of trade, you and I are facing each other in terms of risk.

So novation is a process where at the time the trade is completed before it's sent to the clearing house the counterparty is changed from each other to LedgerX clearing.  So now you only face LedgerX clearing in terms of risk and I only face LedgerX clearing as well which increases stability of the market.

Trace Mayer:  So this is a way to just preempt the types of risks that we saw with Refco or with Herstatt Bank back in the 70's.

Paul Chou:  Yeah, absolutely.  I mean, I think a more recent example, if you look at 2008-2009 during this turbulent financial crisis you saw that credit default swaps.  They were always done bilaterally between large banks and institutions and as certain banks and institutions start to get weaker from a capital point of view the counterparty risk would increase and you are left with a position where multiple institutions face defaults against each other in a way that was very destabilizing for the financial system.

So a lot of the point behind Dodd Frank was to try to encourage a financial industry to go away from bilateral contracts and move more towards essentially clearing contracts and you know, that's the LedgerX approach as well.

Trace Mayer:  Is part of this also then that when the auditors come in to look at an asset on the books of one of your clients that there's a lot more transparency to the actual valuation of the swap that’s been executed?   Paul Chou:  Yeah, that's a great question.  So, you know, sort of what you're discussing is that if you have counterparty risk with a certain swap sometimes you have to discount the value of the swap if your counterparties is in not great financial health because there's a less of a chance that they'll actually come through the trade, right?

So by centrally clearing and that's a very messy process, you have to make a lot of assumptions about your counterparty's credit worthiness and their ability to repay with you and especially if you have a lot of counterparties, then you're making a lot of assumptions.  So you're right that regulators don't really understand the actual true risks and in a lot of these bilateral trades.

Now for essentially clear trade, there's a lot of visibility because all the counterparties, there's only one counterparty for our transactions and it's a clearing house and because you have a central clearing house that regulators can now just go one point and actually audit the clearing house's financial stability to get a sense of how stable all the contracts are.  And at the same time, they also have visibility as to how big the positions are that all participants have because the clear house has records of all of that.  Whereas with swap and bilateral trades it's a little bit more difficult to see whether there are enormous positions being taken and I think regulators want to see that you don't want to have a few players concentrating risk in such a massive way like we saw with JP Morgan-Whale London, for example.

Trace Mayer:  And also impacting the ability of the auditors to get in a true or accurate assessment of the underlying assets that are on a balance sheet.  For example, we could see real estate owned assets that are wrapped up in a swap and then swapped only for like a 30-day period or even a 5-day period to appease the auditors and then it kind of comes back and if they're doing that with trusted counterparties that would be a way that they could obfuscate the true state of their financial condition.

Paul Chou:  Right.

Trace Mayer:  Even to regulators, for example.  But when we have the central clearing house that's going on, it's going to be much more difficult to engage in this type of accounting sorcery.

Paul Chou:  Yeah, absolutely.  You know, the central clearing house takes a lot of precautions to make sure that the records and position sizes in counterparties that own those positions are accurate and they reflect the true economic exposure that each of these participants have in a way that's very difficult to obfuscate.

So you know, the classic thing is we do extensive KYC on our customers.  We don't need prevent things like the same customers signing up for two accounts and therefore having a misleading view.  That's what their underlying risk is.  So, you know, and the way that you would net it between the two prevent things like that from l happening and so I think a clearing house gives regulators one of the best most transparent and most economically sound views as to what participants are doing.

Trace Mayer:  And what's actually going on with these contracts which given bitcoin (or bitcoin derivatives)'s volatility we could see really big changes.  Particularly since there are only settled at the end of the contract term correctly.

Paul Chou:  Right.

Trace Mayer:  So, we saw bitcoin (or bitcoin derivatives) go from what, $13 to like $1,300 in a year period.

Paul Chou:  Right.

Trace Mayer:  It could get kind of crazy.

Paul Chou: Not many asset classes have that kind of volatility and those kinds of moves, yeah.

Volatility of bitcoin (or bitcoin derivatives) Derivatives

Trace Mayer:  Do you see that type of volatility returning to bitcoin (or bitcoin derivatives)?  It's only got $3 billion market cap, supporting an economy with at least hundreds of thousands of very active participants and now an entire industry being built on top of it with companies like Bitnet, BitGo and BitPay and Overstock.com wanting to pay employees in bitcoin (or bitcoin derivatives) and all the way up and down the supply chain.

I mean, what are we looking at in terms of the volatility of bitcoin (or bitcoin derivatives)?  Is it going to return?  Is it going to get crazy again?

Paul Chou:  Yeah.  So this is one of those cases where volatility is a good thing for options contracts in particular.  You know there are a lot of types of derivatives, futures, forwards, others have some swaps.  Options in particular can often benefit from volatility of bitcoin (or bitcoin derivatives).  You know, as you mentioned it is $3 billion market cap right now.

I think one of the key beliefs here at LedgerX is that with a federally regulated U.S. platform a lot of institutional money that's been on the sidelines will now get to flow into bitcoin (or bitcoin derivatives), which will hopefully increase the overall market cap.  And I think that particular phase, once that happens will probably encourage quite a bit of volatility in the price.

You know, we've been following bitcoin (or bitcoin derivatives) for the last three, four years now and we've seen a lot of these phases where there's quite a bit volatility and interest in speculation and then periods of consolidation and just months where the price is stable which I don't necessarily think is a bad thing.

In fact, I think, to be very healthy for bitcoin (or bitcoin derivatives) in general.  I think we're in one of those phase right now where there is a correction.  And I think we're kind of consolidating at this phase.  I think there will be other catalysts that come down the line that will bring volatility back into bitcoin (or bitcoin derivatives).

Trace Mayer:  Is there any reason why your contracts would not be able to settle into bitcoin (or bitcoin derivatives)?  For example, we see with gold for gold markets that they can force cash settlement in some cases.  The last time I checked there was plenty of gold above ground stockpiles.  There should never be a shortage of gold.  It's just a function of price.  So, likewise is there any reason why we wouldn't be able to physically settle these contracts with bitcoin (or bitcoin derivatives)?

Paul Chou:  No, not in my view.  You know, I think that gold, oil and other commodities area examples are interesting because outside of the valuable supply issues, you can have delivery issues.  So, if you're waiting for a tanker to come to certain port and/or delivery point and there's a hurricane that happens during that time, you can delay delivery significantly and other commodities are also very difficult to transport and so those things affect whether you can actually physically deliver at the point of exploration.

With bitcoin (or bitcoin derivatives), you know, in a lot of ways looks like a commodity.  Delivery is one the easiest parts of it.  So we kind of just completely remove all those classic issues like commodity futures and commodity markets contracts used to have and that complete that side of things. So I think delivery of bitcoin (or bitcoin derivatives) and settling these contracts physically will not be an issue compared to other commodity markets.

Trace Mayer:  When I was down at the Miami conference one of the questions to the VC panel was, you know, does bitcoin (or bitcoin derivatives) have a killer app.  And I was the last one to answer.  I said, yeah, bitcoin (or bitcoin derivatives)'s killer app is that it's no one's liability like gold.  So when we're talking about being able to settle into something, do you think there's an importance there with bitcoin (or bitcoin derivatives) not being anybody's liability with it acting like a commodity but still having this transportability?

Paul Chou:  Yeah.  I mean I think that's bitcoin (or bitcoin derivatives)'s greatest advantage.  You know, it is like gold in that it's a commodity that's fixed in supply in a lot of ways.  But the transportability of it is incredibly convenient.  The divisibility of it which is always been important for commodities that we're using sort of more monetary transactions.  The precise ability to divide bitcoin (or bitcoin derivatives) to whatever precision that you want gives it a huge advantage in a lot of ways.

Trace Mayer:  Do you see other commodities and currencies eventually being settled into bitcoin (or bitcoin derivatives)?  Like are we going to see gold to bitcoin (or bitcoin derivatives) swaps or oil or other commodities like that being traded like an oil-bitcoin (or bitcoin derivatives) contract?

Paul Chou:  Yeah.  Actually our internal view is that bitcoin (or bitcoin derivatives) will be very complementary to a lot of the other fiat currencies.  So just like you have things settled into euros or yen or U.S. dollars, of course, other contract will, you know, because of the portability of bitcoin (or bitcoin derivatives) and how easy it is to transfer, I think, there will be large demand for gold to bitcoin (or bitcoin derivatives)s settled contract or any other commodity or even other financial products.

Trace Mayer:  Now, all of this is great, but it has to be built on a solid foundation of security.  You know, if you're going to be physically delivering bitcoin (or bitcoin derivatives)s you got to make sure that they're secure.  I've interviewed Michael Perklin from C4.  They recently released crypto security standards, work they've done in conjunction with BitGo and Armory.  Can you talk a little bit to that?  Are the bitcoin (or bitcoin derivatives)s safe here at LedgerX?  Why would they be safe?  I mean, that's the foundation all of this is being built on.

Paul Chou:  Yeah.  And honestly that's a very important question, of course.  We get the same exact questions from our regulators.  You know, as a clearing house we custody bitcoin (or bitcoin derivatives) on behalf of our clients.  So safety of that bitcoin (or bitcoin derivatives), but also the quick and timely settlement are very important to us.  So by far the vast majority of our resources both time and money have been spent on layer after layer of security procedure associated with our bitcoin (or bitcoin derivatives) holdings.

So we obviously use multi-sig.  We use an outside vendor to measure hot keys.  So, even if LedgerX clearing is completely compromised the attacker won't have access to transfer that bitcoin (or bitcoin derivatives) out.  And we've invested a lot in state of art hardware and software security modules to secure our particular hot keys when we use them.

And, you know, it's the kind of thing where our model is a little bit different than I think other spot exchanges were as others spot exchanges had grown over time.  They just end up custodying more and more of their client's bitcoin (or bitcoin derivatives)s.  So they become more and more attractive a target to hackers.

For us, we hold bitcoin (or bitcoin derivatives)s for the life of a swap.  For the life of the option trade.  After the transaction is over you can do whatever you want with the bitcoin (or bitcoin derivatives).  In fact, we anticipated that most of our customers will withdraw significant amounts of bitcoin (or bitcoin derivatives) after the contract is settled.  And so we don't intend to be a long-term with large depository of bitcoin (or bitcoin derivatives) holdings.  We happen to do it just to support the contracts trading themselves.

Trace Mayer:  Now I've heard rumors that some of the large banks they run these drills like they want to find all the gold being held by customers in their bank and they run these drills where they need to figure out how to quickly re-title that into the name of the bank so that, you know, ultimately it can probably be given to the government as part of a seizure, if we were to have some type of currency crisis or things like that.

You mentioned, you know, the contracts settle.  You're not going to be holding those bitcoin (or bitcoin derivatives)s.  You assume the customers are going to want to withdraw.  How quickly can they do that?  How fast can the client demand physical delivery of their bitcoin (or bitcoin derivatives)s and verify it in the block chain?

Paul Chou:  Sure.  So our operational procedures are designed such that when a customer logs into their customer portal and request withdrawal of bitcoin (or bitcoin derivatives) assets we'll deal with the transfer to whatever address that you want.  So if you compare it to the stock market, for example, where you have T+3 settlement it's significantly faster.  In fact, talking to regulators, I think, they're often surprised at how quickly we can settle versus other commodities or securities that they're used to seeing.

Trace Mayer:  You know, I've been around bitcoin (or bitcoin derivatives) for a long time and dealing with counterparties has always been perhaps one of the most difficult parts of buying or acquiring bitcoin (or bitcoin derivatives)s.  Been able to observe Goxings on a regular basis, since the first time when it ran up to $32 from about a dollar.

Paul Chou:  Yeah.  Summer of 2011.

Trace Mayer:  Yeah.  Summer of 2011, you know, stampings now $5 million, getting lost at Bitstamp.  Are we finally beginning to see the professionalization of bitcoin (or bitcoin derivatives)s start to happen where these types of Goxings and stampings are hopefully a thing of the past?  That these bad actors, these unprofessional non-mature actors are just getting flushed out of the system and we're going to see much more professional and capable actors?

Paul Chou:  Yeah.  I certainly think so and I think we're witnessing that right now, to be honest.  All credit to the early entrepreneurs before bitcoin (or bitcoin derivatives) became such a big mainstream topic with a lot of venture capital flowing into it.  It was difficult to track $10-15 million whatever necessary capital to build really, really high grade security infrastructure both physical, software, and hardware.  So the initial efforts that we can became large were done on a shoestring budget with not, you know, very large developer teams.

And so they, you know, obviously had some weaknesses that don't make it appropriate once bitcoin (or bitcoin derivatives)'s market cap which is several billion dollars.  And I think that the latest round of exchanges that we've seen come out both spot exchanges and derivative exchanges have quite a bit of venture capital behind them and therefore are able to attract large experienced teams.  There are a lot of people, my colleagues from Goldman they have left to join bitcoin (or bitcoin derivatives) companies.

And so with these resources they've been able to bring a different level of talent to design these exchanges and also not just from the security point of view, but also be able to invest in the regulatory framework.  So complying with the appropriate FinCEN laws.  In our case, being able to apply to the CFTC which is not exactly a very cheap procedure to do, but is made possible recently because of all the VC capital that's flown into the industry.

So, I think this next generation of exchanges will be very professional efforts that are very well regulated as well.

Trace Mayer:  Yes.  We've have got a pretty serious interview talking about, you know, the six network effect of the financialization.  But bitcoin (or bitcoin derivatives) is a lot of fun.  You know, the entertainment value here is just kind of unbelievable.  Do you have a story to tell like what's the most fun you've had in bitcoin (or bitcoin derivatives) or just kind of craziest story that you've had in your career so far in the bitcoin (or bitcoin derivatives) landscape?

Paul Chou:  You know, I think for me especially living here in New York, the stories that always surprise me are the ones that show how widely followed bitcoin (or bitcoin derivatives) is.  You know, not just the geeks like myself that have computer science backgrounds, but I have a friend who has this bitcoin (or bitcoin derivatives) debit card and I did this experiment for a month here in New York City.

I would use exclusively that and I would meet people in bartenders and I pay my tab with it and it's like what's this.  I'm like debit from my bitcoin (or bitcoin derivatives) account.  And he's like oh, man I just got paid for a job last week.  It was like a construction job in bitcoin (or bitcoin derivatives).

And to see that kind of penetration and just the way it's captured this guy's eyes is just especially here in New York City has been really rewarding and just also crazy at the same time.

Trace Mayer:  Kind of crazy fun like.  Yeah.  I mean there was a time when like bitcoin (or bitcoin derivatives)?  Nobody had any idea what it was.  Like crickets.  Oh, it's magic internet money.  Now, we're trading it with a swap execution facilities and other fancy financial tools.  It's been a great interview.  Thanks for being on the podcast.  We've had Paul Chao, CEO and founder of LedgerX.  Thanks for being with us.

Paul Chou:  Thanks for having me, Trace.