Chapter 1: What is the main topic discussed in this episode?
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 out. 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.
Chapter 2: How does David Dredge define risk in financial markets?
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.
Chapter 3: Why is leverage considered the real risk in trading?
I appreciate it. I run a little business here that's focused on long volatility, long convexity that... Our investors use us as an 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 run a business that helps people manage risk so that they can grow wealth more efficiently. So with that October 87 crash,
Chapter 4: How is Bitcoin's market structure affected by traditional finance?
What happened? Was that when the stock market crashed? Was it 50% or am I out of base there? So the S&P, the US 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.
Chapter 5: What does the 'Max Pain' dynamic mean for market positioning?
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 a
FX and interest rate trader and and saw, you know, the just absolute devastation, you know, two weeks into my new role out here in Singapore. And and it dawned on me that the 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
Chapter 6: How does suppressed volatility influence investment strategies?
businesses in the world that they didn't have any idea what risk was and 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.
Chapter 7: What role does Japan play in global financial stability?
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 is 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, which we all get taught in school and that which is 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.
Chapter 8: What are the future implications of AI on financial systems?
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 sharp ratio. And so, as you said, in a sharp 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 gonna 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 like a ripping bull market. And we, I mean, we saw a move to 126K.
We're back down to 87 or something as of time of recording. Like, 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.
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