The Global Financial System Is Structurally Broken | David Dredge

The 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 build up of dry brush in the forest that allows that one lightning strike to spread, tree to tree to tree to tree, a burnable forest out, positioning is the only thing that matters. I'd be very cautious about being too enthusiastic about Treadfy getting their dirty little fingers into Bitcoin, I think it's 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's 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 at first time on the show I know you're not a diehard Bitcoinist, 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, 6pm on the Friday before Christmas, 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 building what would be the emerging market trading businesses for bankers trust, a leader in the derivative risk innovation world back in the early 90s through the 90s and through the Asian crisis and stuff, so have a lot of experience and still apply my skills in the world of financial derivatives in 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 risks so that they can grow wealth more efficiently. So with that until rate seven crash, what happened and 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 black or Tuesday because the next day out here, they hang saying index in Hong Kong and what is now the AS 51 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 like wrist management before that, or was it seeing the stock market's 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 rollout here in Singapore. And it dawned on me that the simple measures and methodologies around risk management in what was 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, 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, I've 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 may be commonly mistaken 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. And so how do you trade off the volatility and the unpredictability, the risk on the other side of it? Yeah, exactly. And you know, 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 and 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 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, and that says I'm referring to it as derogatory as I can. And that, you know, sort of hard of that from an investment perspective is what's known as the sharp ratio. And so as you said, in the 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 beatingless. And, and that 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 flag 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 down side. And over the last year, it's really not. Like, 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 removed 126K, we're back down to 87 or something, as the time we're 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 Sharpworld is telling people to do. So Sharpworld is telling people, "Ball activities risky, so avoid it. You're 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-tail, 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, twenty-five percent drawdowns in the last three or four years, and is up to 150 percent. 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 compliment 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, next gold, up to a certain point, and then in the recent months, it has a pretty good pullback. And it's been a pullback that obviously, you'll see it clearly that I do, has been somewhat idiosyncratic. It hasn't been part of a correlated market dislocation. Maybe you can say there's been some noise around some of the high-flying text-doc single names, but at the index level, indices have been certainly not troubled particularly in recent months, I don't know when you would just date the sort of origination of this pullback in Bitcoin, September. It was probably early on top of that, roughly. Yeah. And so you had some noise around some of the other things, but that noise is kind of dissipated and meanwhile, Bitcoin still give or take, not at its lows, but maybe $6 or $7,000 off its lows. And I don't know exactly what drove that, but when I talked to our friend, Checkmate, and we had discussed over time about my thoughts about leverage in systems and how little leverage there actually was in Bitcoin, in particular because the native exchanges that apply by an answer, BitMexer, even the one that went out of business, FTX, FTX, they cut the guy's position when he runs out of margin. It's not like the traffic system where they give you a call the next day and say, when it's convenient, send us more margin, particularly if you're one of the big banks who is blessed by the monopolistic gift of the governments that underwrite them, they can keep 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 Treadfy went out of business like FTX did. I mean, the sister talked 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. So, but what's kind of happened, and this is what Checkmate wanted to talk to me about the time, was this sort of proliferation of growth in the Treadfy world, obviously, the ETFs. And then more significantly in terms of what time rumor 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 Treadfy style of leverage into the system. And the evolution, inevitable evolution of the availability of these IBID options, which dominate the volumes in that space, into the world that I really do focus on, which is the structured product that complex embedded short volatility, yield and answering investment products, auto-cullibles and stuff like that, that really drive the leverage in much of the equity interest rate, FX markets that are dominated by the Treadfy world. And that's kind of, I think probably why some sensitivity build up there, because everybody's familiar with the leverage from micro-strategy and in DATS, I think you guys call them. But you just got enough leverage build up in kind of a short time that you needed to clean out of it. 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I'm almost 100% into Bitcoin, and I just leave it there, and I wait. That's all I do. So when it comes to the I-bit 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. 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, that in exchange, you're taking a lot more risk for the amount of capital that you have. And then 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 could lose because the position gets extinguished. But in the trad-fi 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 and the tails. And so when you start getting a world where option sellers, volatility sellers, can come in, usually with somebody else's money, because they're a fiduciary. And they're 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 under-capitalized risk in the system, which will start to make that underlying component negatively skewed. So you'll get the movement where it pulls at the direction where the weakness, the fragility is in the system. And so that vol selling, you know, 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, that'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 Ibit, 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 them a fee. Now, in the long run of something that is driven by its ups and downs, which is, you know, interestingly, particularly fat-tailed 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, daddy and the other, you know, there's me and you, there's Czech mating, there's Pete and etc. and 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 out of percent of the average because it's a power law distribution, not a normal distribution like we were trying to guess the average height, right? These height is going to be enough to, you know, 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 televents 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 my worst case is one standard deviation downside, only to find out that the one standard deviation downside was a lie in a world that has accumulated leverage and has significant uncapitalized risk that will generate this fat left tail when it occurs. So we're obviously talking a little bit before about how Bitcoin's volatility has dampened. 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 offpan 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 hybrid 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. What did the tradfi world eventually really drives this accumulation of leverage and short volatility is these much more highly juiced structure product things. So the auto-colables, the example, and I mentioned it on that conversation or the checkmate. The first major institutional long dated auto-colables started coming out. So one was issued on October 31st, and the embedded in that is a, 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 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 we 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 we got the market searching for Max Payne. Correct. That's exactly what it is. It's exactly what it is. So that's, again, triggering that sensitivity, whether it's the bank who's managing that risk, hedging it, and he's trying to manage negative gamma and hurt somebody, and 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, obviously, no way near the level of view, this Max Payne just amine, because I see people say the market always wants to find a 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 you're getting 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, 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? 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 think of the world, Danny, is that all the risk that matter, a dredges of 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 lighting 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 then 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 in fines, 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 weekends that over levered or under capitalized risk, and cause the biggest pain. That's the way, if you ask me, that's really how markets work. And so the other thing that I've kind of been trying to figure out on the eye bit options is, if it's going to have a negative impact on Bitcoin price, because it seems to me at least that in Bitcoin history, it's largely been driven by people, like just retail, obviously ETS with a start of Wall Street really coming into this, and with options which can be much larger on top of that, is this 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. And since I think that is the question, I've known to say, and this goes back before there ever was a Bitcoin, and what, I guess I wouldn't have used the term "trad-fi," but now that we're all used to it, I'll say "trad-fi," but I would have said "sharp world," "trad-fi destroys everything," 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 if you think about it, the great example, the easiest example, Danny, think about, you're maybe too young, but 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. What's safer than the guy owning his own house? And yet the "trad-fi" 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 trust me, explicitly constructed to try to subsidize homeownership. I mean, think about all the rules in banking and in tax treatment and in 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 monolite insurer who's a AAA rated guy because he only ensures 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-weighting 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 US housing market, destroyed the global banking system, right? You know, so I'd be very cautious about being too enthusiastic about "trad-fi" getting their dirty little fingers into bitcoins. I think it's 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, that 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'd 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-of-forty-lap formula, one race, who wins the race? Well, the guy with the best breaks, right? Because the guy with the best breaks doesn't crash, and he could 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 unorned 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 breaks 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, skills. 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 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 next to you next to him. And so is the guy sitting next to him because you're all following the same rules and paying on the same incentive structure. And so 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 you know, US mortgage structures that had been gained to add infinitum, but not just that, all of the lack of capital around complex structure, derivative type activities was massively under capitalized 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 print code, you know, that 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. 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 analogy, you know, pick pennies up in front of the steamroller. What Bitcoin did is brought to you by the massive legends, iron, the largest NASDAQ listed Bitcoin minor using 100% renewable energy. Iron and not just power in the Bitcoin network, they're also providing cutting edge computing resources for AI all backed by renewable energy. We've been working with their founders down and will for quite some time now and have been really impressed with their values, especially their commitment to local communities and sustainable computing power. So whether you're interested in mining Bitcoin or harnessing AI compute power, iron is setting standard. Visit iron.com to learn more, which is iren.com. 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The thing that I find frustrating about this kind of thing is that, and this is talked by 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 this sort of Fiat currency world frustrate you? No, it's so much. It's my enemy. Again, Sharpworld is my, it's funny, and people talk about this because you're followers and listeners can go and trek me down and hear me talk at things that podcast and interviews and conferences and stuff, and I am a very vocal and have been for 30 years outsmoking critic of Sharpworld, 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 Sharpworld is what provides the opportunity that my business lets 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 that 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, correctly 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, yes, sort of been the sort of singular growth policy since the, since that 87 crafts, 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 it was implemented all over the world and became inflation targeting central banks, beginning with the New Zealand central bank and then standardize 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 can go and see the numbers, the consumption that drives the growth in places like the US in particular, in more and more and fewer and fewer hands and the bigger and bigger and wealthy people, 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 in the sort of fragility of systems, 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 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, 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? I'm not good at time. In fact, in a sense, my job is solving the problem of time. I don't know when the lightning strike is 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, whether the fire is going to start because of lightning or because kids are playing with matches or which direct in the winds going to blow, I don't know. But there is a lot of fragility in the system. The, I'll go back to this sort of basic core of 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, let's reclassify them, declining taxpayer and saver population. And so I say this all the time that I find it as the, you know, 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, so every time you live in Australia, if I'm here, yeah, yeah, every time Rachel Reeves talks or Governor Bailey talks or Governor Bullock talks or, you know, Scott Besson talks or a way to song 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 pay, you know, fewer sources of revenue for the governments in the future. And now over on a argue and noted this is 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, which is known as Basel one, Basel two, and now Basel three is an 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 the 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 year, 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 tax paying, 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, et cetera, which requires more taxes from a smaller tax-bank cohort, who are also burdened by the higher cost of living. And so once you tax them more and they consume in 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. But they announced they weren't 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 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 they weren't smart enough to get on board Bitcoin to finance their retirement. It's a very difficult loop to get out of. 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 an aging demographic, more reliant on Social Security retirement schemes around the world and becoming more heavily reliant on Medicare and the NHS here in the UK, it gets messy really quick. And it's the only way out of that essentially to print more money. And so when I ask, does the fear 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 added more fuel to that fire today with their own policy nonsense. And they've chosen this. And so if you, if you stay in this loop, we build a model with 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 rates declining and you start to get the imbalance between retired turtles, we call them in the, 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, 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 and 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. I'll log Janet Yellen, you know, joking about it in 1996 when the Fed was talking about going to inflation targeting in Alan Griespan, thought the inflation target should be zero. And Jan, Janet Yellen thought it should be 2% because workers wouldn't know they were having their real earnings debased and their benefit to the corporate, to the employer would encourage him to hire more workers because, you know, he's kind of getting the 2% that they're losing. And that's literally, you know, that's, that's it, transcripts from the Fed. I wrote about it one month. Janet Yellen was my econ professor at grad school. So I really, it's so insidious though, because like before I got into Bitcoin, I didn't even necessarily think inflation was a bad thing. I thought if we were a 2% inflation, 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. And so the productivity is an interesting one though, because the obvious place where that could come from is through like AI 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 shorter? I guess maybe, you know, I don't know. I don't have a lot of, you know, I like AI as it functions as a simple tool, but I don't have a lot of respect for it. AI or LLIMs, sort of current version of AI that's actually available for use is a LLIM. And an LLIM is exactly like Sharpworld, right? It, I coined it. So again, your readers want to go, I wrote one of my notes that I titled the Palani paradox. Have you ever heard of Michael Palani? No. He was a philosopher, scientist in the mid 1900s. And he coined, actually another guy, David Otter, a current economist coined, referring to him, the Palani paradox. So what Palani is known for is what's known as tacit knowledge. And he, in the Palani paradox is known as, we humans can know more than we can tell, because we have tacit knowledge. So we, we can know how to write a bike, but we can't necessarily write down the mathematical formulas of physics to explain it to somebody, right? But we know, we, we know that jumping off, you know, using a Dossim teleb, you know, fragility analogy, that jumping off a, a one meter high fence, 10 times won't hurt us, but jumping off a 10 meter high fence one time probably will. That's tacit knowledge. It's skin in the game, right? Well, I coined the reverse Palani paradox in this note about LLMs. And the reverse Palani 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? It's just another normal probability distribution, saying that in the course of, you know, human data that I have access to, what's the, you know, middle of the distribution, and I'll put that word next. And it's really remarkable how it does that. Now quickly it doesn't now fast and 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, 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 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, so I have very little hope in the current formation of AI. And I have a lot of doubt that the, the promises of generative AI will produce what they claim it will produce, because I struggle to understand how AI learns. It's 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, I criticize central bankers with all the time, because they also seem to be incapable of learning. And that, you know, it's a nossim telebism. Without accountability, there can be no learning. Right? If you're, if you're never punished for your mistakes, you know, 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 past the AI. You don't think he's actually intelligent. So, 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 it, 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 when that's kind of the whole point. And, and so finding thing, you know, Elon Musk energy. Yeah. You know, 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. I was having dinner with my dear old friend, Pippa Momgren ever heard of Pippa Momgren. Reason how to do geopolitical, economist strategy person. Also, an ex-banker's trust alum. And, you know, we were, we, we, we, we think we were all brainwashed the same, not seem to lab and me and Pippa all brainwashed the same way in our bankers' trust days when we were actually in the risk business. And, and something I say, you know, the, 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, and that's how I advocate people manage their risk portfolio. 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 and wealth management or deaths 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, you know, would have told you that we're going to run out of 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, and that's shrinking yellow sort of being hard coded over the next two or three generations because the birth rate decline, the free, the fertility rate decline has 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, 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 we, 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 basil one 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 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, but we went the opposite way. And then, and then 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 as 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 is, and any work close to what people are telling you it will do. But maybe they get it there. Yeah, I don't know if this is recently by us, David, but it feels like we're living in the most interesting times for good or for bad. Like 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 is 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've 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 for a mess are we in? Like you're always looking for risks in the market. 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 a pairbox, sandpile, self-organized criticality language. You don't have to, you don't have to be too much of a rocket scientist to understand that still going back where you got a real stiff of it in 2022. There's a lot of uncapitalized risk leverage in government bonds. So government bonds were piled on to 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 regulated a heavily regulated bank goes out of business, goes insolvent following the rules because it owned US 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. And so banks were told these bonds, US Treasuries, French government bonds, guilds, boons, JGBs, Australia were riskless. And 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 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 it's not hard to see. And then you get the stupidity like the liability driven investment strategies in the UK, where pension funds are levering long dated duration guilds, 5X, and accounting that is risk reducing for their otherwise equity portfolio. Only to find out that they need to get bailed out because all of their risk is the leverage in the guilds. And so that still remains arguably one of the biggest risks in the system. And you know, 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 of the systemic risk without fail will be in the banking system because that's where the bulk of the protected leverages and that's where the sensitivity when things go wrong are. Having said that, you know, 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 mag seven, the crypto style, 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 the of Trad Phi attracts more leverage. So, you know, let's take a 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 micro strategy who's getting it from both sides. And eventually we might see another high-flying meme stock. So those are things I think, you know, we saw quite a bit of volatility around them. Some have recovered, some have not recovered, micro strategy 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 they were done this big deal and our stock prices will go up. And then those are getting embedded in three times levered auto callable structure. 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 don't, as I'm, you know, I hope I've made it clear, I don't know when or where lightning's going to strike. I don't even know if lightning's 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, you know, if, you know, people, and I don't necessarily agree with them, but people are more familiar with the, what they call the Lehman crisis, the 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. You know, I've long said that the next trigger is going to be Japan. Japan is the likely spark because of the, the fragility in the Japanese market system economy after, you know, the longest period, 35 years of manipulating interest rates, manipulating the price that should balance between borrowers and vendors, 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 markets decided they've had enough of that and the transition away from that is proving challenging. And I think still has a, you know, 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, you know, 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 a hundred 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, yeah, 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 for nine, you know, out of nowhere. So there's been, you know, to my knowledge, nobody voted for this. It's not been an 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 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 Ukraine that they're going to fund issuing bonds. And so this gets to, again, back to the government body 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 in Saver. And so this competition that now Germany has waved their constitutional debt ceiling and started what they call the maiden Germany to bring capital back to my German bond 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, hasn't had an approved budget in history is just an outfit 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 annealed 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 bond older in most markets. And the EU is now competing. Where does that lead 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 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. 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 critic 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 NICA 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. And I mean the whole macro world seems to complete mess at the moment, but I guess the good news for you is that you're going to be in a jump for a while. Yeah, well, we always say, and we say it every day, we and our investors hope we never make money, right? You never want your insurance to make money, right? But that 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'll find the opportunity that knowing you've got good safety net allows you to go take. What you need to avoid is the opposite of that, which is what sharp rules 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 model, 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 again at some point. We should maybe we should do a history lesson on layman and get into why Japan could be the the start of this next fire. But thank you so much. Tell everyone where they can go to to find your work and everything that you do. Yeah, so I'm you know, 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.strategy.com and there's I don't know, at least a hundred 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 that 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 and I always say this and you know, when 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 the style of that. Thank you so much for 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. [BLANK_AUDIO]