Quotes"When I read about #SilkRoad… whether you think that's good or bad, it was a sign to me that #bitcoin was changing the game. It had ripped up an old rule book and put a new one in." ~@philip_gradwell, Chief Economist @chainalysis Click To Tweet "20% of #bitcoin is made up of people who will be moving their $btc regularly. 80% is just sitting there… You've seen a buy-and-hold conviction really take root." ~@philip_gradwell, Chief Economist @chainalysis Click To Tweet "I'm trying to move our #blockchain analytics to measures that make more sense to people, that are more natural, that connect with concepts they're already familiar with." ~@philip_gradwell, Chief Economist @chainalysis Click To Tweet
Welcome to this conversation with Philip Gradwell, Chief Economist at Chainalysis, a provider of blockchain intelligence and compliance solutions to businesses and law enforcement. The interview covers a range of topics including how Bitcoin is used, how much might be lost forever, its concentration among top crypto exchanges, and the true scale of illicit activity occurring on the network.
The conversation is split into 3 chapters:
- Chapter 1: How Bitcoin is held, traded and spent
- Chapter 2: The link between Bitcoin and crime
- Chapter 3: A deep dive on exchanges
Topics Discussed In This Episode
- Philip’s career before Chainalysis
- His role as Chief Economist at Chainalysis
- How a relatively small group of traders influence Bitcoin’s price
- The percentage of Bitcoin that could be lost forever
- How most Bitcoin (80%) is HODLed long-term
- What is a VASP or virtual asset service provider?
- How Chainalysis ties addresses to particular exchanges
- How law enforcement uses blockchain analytics
- How illicit activity accounts for just 1% of BTC transaction volume
- Bitcoin’s concentration among the top 14 crypto exchanges
- Analyzing blockchains that follow different accounting models
- The role of fiat in the crypto ecosystem
- How Tether became the dominant quote currency in crypto trading
- Using on-chain data to verify reported trading volumes
- Making blockchain analytics intelligible for the next wave of crypto adopters
Links Relevant To This Episode
- Nomics’ Fully Customizable Daily Crypto Newsletter
- Clay Collins
- Philip Gradwell
- Bitcoin (BTC)
- Grayscale Bitcoin Trust
- Wasabi Wallet
- Nathaniel Whittemore
- Crypto Exchanges: A History of Crypto’s Most Powerful Institutions
- Ethereum (ETH)
- Dash (DASH)
- Tether (USDT)
Clay: Welcome to Flippening, the first and original podcast for full time, professional, and institutional crypto investors. I’m your host, Clay Collins. Each week, we discuss the cryptocurrency economy, new investment strategies for maximizing returns, and stories from the frontlines of financial disruption. Go to flippening.com to join our newsletter for cryptocurrency investors, and find out just why this podcast is called Flippening.
Clay Collins is the CEO of Nomics. All opinions expressed by Clay and podcast guests are solely their own opinion, [00:00:30] and do not reflect the opinion of Nomics or any other company. This podcast is for informational and entertainment purposes only and should not be relied upon as the basis for investment decisions.
Mike: Hi, this is Mike, producer of the Flippening podcast. I’d like to welcome you to this conversation between Clay Collins and Philip Gradwell. Philip is Chief Economist at Chainalysis, a provider of blockchain intelligence and compliance solutions for businesses and law enforcement.
After touching on Philip’s background, Clay and [00:01:00] Philip discuss the new report from Chainalysis entitled, A Big Look at Bitcoin. I should note that this report includes economic data and analysis that’s never been revealed before. Focused on the report, Clay and Philip discuss a range of topics including how Bitcoin is being used and spent, how much BTC is lost forever, the true scale of illicit activity occurring on the network, and finally, the role of exchanges.
The conversation is split into 3 chapters. Chapter 1 considers how Bitcoin is held, traded, and spent. Chapter 2 [00:01:30] examines the link between Bitcoin and crime. Chapter 3 is a deep dive on exchanges.
The transcript and show notes for this episode are available at flippening.com/philip. That’s flippening.com/philip.
And now, before we get started, here’s Clay with a word from our friends and sponsors.
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Mike: Okay, back to our regularly scheduled program. Here’s Clay’s conversation with Philip Gradwell, Chief Economist at Chainalysis. Enjoy.
Clay: [00:06:00] I think before we get into the blockchain and Bitcoin, in fact, I consider Bitcoin to be the blockchain, but before we get into any of this, I’d love to hear a little bit about your origin story as an economist. How did you get interested in economics? Before you got into Bitcoin and this whole ecosystem, what kinds of questions were you asking about economics and [00:06:30] what most piqued your curiosity?
Philip: I’m probably a slightly unconventional economist that’s why I ended up in crypto. I was doing philosophy, politics, and economics in my undergraduate. Actually, I spent most of my time doing philosophy. I didn’t really get economics. It felt boring and cast the world into a standard box, but then actually, I went to a lecture on the economics of climate change and that is a big problem. How do you change the world [00:07:00] to remove something that’s so essential to it using oil and gas and use a different energy system? That required challenging a lot of the assumptions about how normal economics thinks and that caught my interest.
Basically, that’s what I did after my degree for eight or so years. I think Bitcoin has elements of that as well. It’s actually just challenging how we perceive elementary economics. I was like that catches my interest in the same way that [00:07:30] the economics of climate change did a decade before.
Clay: What were you doing at Vivid Economics prior to Chainalysis? Did this revolve around the climate chain in energy?
Philip: I was an economic consultant essentially providing advice on—say you’re a government, a large company, or an NGO, it was sort of saying okay, we’ve got to decarbonize the sensory system. That’s going to [00:08:00] be expensive, not everyone is going to want to do it. Some people are going to win, some people are going to lose. How do you put the incentives in place so that they might be willing to go through that transition? That was really the core of the job, and it was fun. I got to work with a lot of really interesting people and travel around, but eventually, I felt like doing something new.
Clay: What might be something that is counterintuitive to how most people think about climate change and the [00:08:30] economic incentives that you can share with us? Is there anything in particular that comes to mind? Was there anything in particular that stuck out as being particularly counterintuitive or a narrative violation?
Philip: The way that I viewed the problem is that essentially, it’s an infrastructure problem. You could take a lot of behavioral measures, you could change things in your life to try and reduce the impact you might have on the environment, but you’re actually going to be constrained by the building that you live in, [00:09:00] the car that you drive, or the packaging system of the supply chain that you get your food out of. That’s frustrating as an individual because you’re like there’s not actually much I can do. It’s about changing a system and changing a system is really hard, but it meant that you had to put a lot of focus on that.
I don’t want to tell people there’s no personal responsibility because actually, if you go out and buy an electric vehicle, that is helping change the system. But it’s all about changing these investment decisions when people [00:09:30] buy a new bit of infrastructure or a new durable good. Those are where the big changes come in.
Clay: Also, whatever any individual does is probably dwarfed by several orders of magnitude by what institutions, governments, and multinational corporations are doing. Let’s transition then to Chainalysis. How did you come across the team? Who did you meet first? Was it a traditional job posting that you applied for? How did you [00:10:00] come to be Chainalysis Chief Economist?
Philip: This interest that I’ve always had in ways that economics can be applied in a slightly different way meant that when I read about the Silk Road on the internet I was like that actually sounds interesting, not necessarily for the other reasons that people find it interesting. I was actually like aha, this is almost a new business model. I logged in and when you check it out you’re like Bitcoin is what’s making this possible. Whether you think that’s good or bad [00:10:30] it was a sign to me that Bitcoin was changing the game. It had ripped up an old rule book and put a new one in there. I was like this is interesting. That was back in 2013.
Jonathan Levin, who is one of the co-founders of Chainalysis, was actually an intern at the company that I was working at, and he just spent that summer talking about Bitcoin prominently, which was great. I had a lot of fun having lunch and chatting about Bitcoin. [00:11:00] Fast forward a few years and I’m looking to do something new. I catch up with Jonathan and Chainalysis is this early 2017. It’s starting to grow things in Bitcoin but not quite as they’re going to be by the end of the year. I’m still looking for a new challenge though.
There’s this prospect of a brand new data set. No one’s looked at what’s going on in the blockchain from an economic perspective, really. That was the invitation and that’s what I took up.
Clay: [00:11:30] What stood out to me is your analysis of Silk Road from an infrastructure perspective. You immediately latched on to Bitcoin as the infrastructure that made all of this possible. It sounds like you really analyzed things at the infrastructure level. It was probably one of several lenses but one that’s really important to you.
Philip: Yeah, absolutely.
Clay: What is a chief economist, at least at Chainalysis, and what does that role entail?
Philip: At Chainalysis, we’re best known [00:12:00] for compliance and investigations tools and software for cryptocurrency businesses and law enforcement. That is doing a lot of blockchain analysis, understanding these addresses they’re probably controlled by the same entity and some of these entities are services like exchanges that we can name. That analysis is somewhat like the local level. You’re trying to understand this set of addresses, it’s owned by darknet market, and it’s sending some Bitcoin here.
My job as a [00:12:30] chief economist, by contrast, is to step back to zoom out and to try and understand the big picture. For example, we say there’s this much Bitcoin that’s flowing in and out the dark net markets, but what is that as an overall percentage of the total transaction volume? That’s the kind of question that I work out.
Honestly, I have been with Chainalysis for two and a half years now. Most of those two and a half years have actually been on really [00:13:00] fundamental almost measurement questions going how do I actually work out what percentage of the total transaction volume is this? What is the actual transaction volume? How do we measure that? That’s what I spent a lot of my time doing is fundamental algorithms and measurement definitions. More recently, as we’ve solved those problems, being able to really start having a proper data-driven insight into the on-chain activity.
Clay: [00:13:30] In terms of the function you play in the org, do you fulfill some kind of service role or is it primarily like content marketing? You’re not a marketer but the job is to produce content that showcases the kinds of questions that one could ask if they had access to this data set, is it kind of both, or is it something else altogether?
Philip: I’ve actually played a number of different roles while I’ve been at Chainalysis. [00:14:00] We’re quite well-known for our blog and the content we put out there. Actually, my first year was really leading that effort. Then I spent a year—we had a pretty large research team where we really were thinking about how to measure things in a very fundamental way. Writing algorithms that would help us trace various flows through the blockchain, trying to understand what’s called clustering problems when you’re trying to map addresses to the entities. [00:14:30] That was really deep research, much more math than marketing.
More recently, as we’ve solved these problems, I do bring these insights together and use that to educate, really. I don’t actually spend that much time answering specific customer requests. Maybe I should do more of that. The thing that’s always got me, and I’m sure you have this too, there’s so much money has gone [00:15:00] into Bitcoin on the basis of so little information. That shocks me, and I’m like but what could happen in this space if people actually had good information to act on? I’ve had the real privilege of trying to work out what that right information is. Now I’m spending more and more time trying to put that out in front of people.
Clay: Is there also some kind of product development role in the sense that if you can answer this question once maybe you can answer it multiple times at scale for a lot of [00:15:30] customers and bake it into the product. Does that ever happen?
Philip: I really am trying to take a lot of the analysis I’ve done and built it into some type of product. The insights that I’m trying to deliver are about describing how overall activity on the Bitcoin blockchain evolves. Whereas if you’re doing compliance and investigations, that’s helpful but that’s not actually your day to day workflow. If you’re someone who is [00:16:00] making an investment in Bitcoin, is tracking the market, or is thinking about making a venture capital investment in crypto business, then you’re perhaps more interested in these overall trends.
The challenge, which is one the blockchain analytics space has actually grown a huge amount in the last year, and it’s trying to work out how to answer at the moment, is how do you give people specific enough insight without [00:16:30] drowning them in data? People don’t often know the metrics that they want to look at. They want to be able to explore, but blockchain data can be really complicated. How do you guide them through that to the right answer? I don’t have the perfect answer for that yet. I think that’s what the blockchain analytics industry is actually trying to solve at the moment.
Clay: Let’s transition to chapter one, which is based on your report. Let’s discuss a little bit about what you’ve learned about how [00:17:00] Bitcoin is used. What have you found about how Bitcoin is used, how it’s held, about where it’s going to, where it’s coming from, and the number of people involved. I realize there’s a lot in there. Let’s just start with how it’s held. What can you share about that?
Philip: There’s about 18 ½ million Bitcoin that have been mined to date. A lot of people actually don’t really understand that a lot of that Bitcoin is just sitting there. It’s not actually [00:17:30] actively used. When we see the price go up or down in the market, that’s actually being moved by a relatively small amount of Bitcoin being bought and sold. The vast majority is actually held for investment.
We actually estimate that it’s about 60% of all the mined Bitcoin is held for investment. This is Bitcoin that’s being held often for many years and that is also held by entities that don’t tend to send much of the [00:18:00] Bitcoin they receive. They’re really just holding onto it and sort of stocking up. That’s about 60%. There’s then actually about 20% of Bitcoin that is likely lost. This is some of Satoshi’s original Bitcoin. There’s potentially sort of one to two million Bitcoins that they hold.
There’s other Bitcoin that hasn’t moved for a very long time. The week before we were recording this, someone did actually move some Bitcoin from the month after Bitcoin was created [00:18:30] in February 2009. That would have previously been assumed to be lost by me but obviously, it’s not, so there are always surprises there. But even if it’s not lost, certainly, those people are holding onto it far more tightly than most other people who are holding it for investment.
Clay: For practical purposes, what’s the difference between someone who doesn’t want to spend Bitcoin for 20 years and it being lost? It’s not affecting the market either way.
Philip: Yeah, exactly. [00:19:00] That leads to the third major use which is around 3.4 million Bitcoin, it’s just less than 20%, that is really used in the trading activity. If you think of the float of Bitcoin that is available on all the exchanges and often sitting off of exchanges but ready to be moved back on if trading picks up, that’s about yeah 3.4 million Bitcoins. All of the heat and [00:19:30] light that’s generated all the noise is actually just coming from just 20% Bitcoin that’s been mined.
Clay: What can you tell us about average holding duration? Is there an average holding duration or what can you say about holding activity?
Philip: This is an important thing to say, actually. When we think about the age of Bitcoin that’s being held we’re not actually just doing it on what’s called the address level, but we’re actually understanding the age of the entity. Because [00:20:00] a single person can hold as many addresses as they want and so we’ve clustered them together. There are exchanges out there that hold millions, tens of millions of addresses. We’re actually looking at what’s the weighted average age of all the Bitcoin held in that entity.
When you do that, we see that about 54% of all Bitcoin has been held for more than a year.
Clay: Wow, 54% of all bitcoin has been held for more than a year. That’s very impressive.
Philip: [00:20:30] It’s the digital gold narrative, really. People just like to hold it.
Clay: Without getting too much into the weeds on methodology, let’s say you’ve got someone who has a hardware wallet. They’ve decided that maybe their private key has potentially been compromised or maybe they just have a new hardware wallet and they want to transfer it but it’s still owned by that same person. Obviously, if they’ve moved onto an exchange that’s different, but in terms of say one hardware wallet to another, how do you guys see that?
Philip: [00:21:00] That example is actually harder. Almost a misconception. Chainalysis doesn’t spend that much effort trying to understand personal wallets because actually, they’re pseudo-anonymous so it’s hard to realize what’s going on, but also, most of our focus is on the services because that’s where the compliance workflow takes you. But that aside, you can understand even among all the addresses that are held by [00:21:30] individuals, they will group together. We’ll see this address and this address they’re connected to.
There are common ways that you can look at that. There’s a thing called the co-spend heuristic when two unspent transaction outputs from different addresses are put together in the same transaction hash, suggesting that the private key of those two addresses is controlled by the same person. There are things like CoinJoins and so on that do start to confuse that. There are other ways in which we can [00:22:00] understand common control of addresses.
In that instance, say we were able to do that as they move from one hardware wallet to another, then we would just group those two addresses together. That would mean that the age of those bitcoin would actually stay. The age when it came into that original wallet rather than seeing that age get reset as it moves to the new one because those internal transfers would be removed [00:22:30] from our calculations. When you look at the entity level rather than the address level, you get a more accurate picture of what’s going on.
Clay: Have you found that holding activity or holding behavior is affected by price? Have you found any correlations there?
Philip: The way that I think about bitcoin is there are two reservoirs. There’s the reservoir of bitcoin that is held for longer term by the investors, and then there’s a reservoir of bitcoin that is used to [00:23:00] trade. The key thing is when some water sort of sloshes over from one reservoir and goes into the other. It’s most important when that bitcoin that goes from the investment reservoir into the trading reservoir because there actually isn’t that much liquidity. There isn’t that much bitcoin being traded relative to how much is being held for investment.
All of a sudden, you can actually get a lot more bitcoin being made available, or if it’s taken out of that trading reservoir and goes into storage, then the amount of liquidity the exchanges start to shrink. If we go March this year, we saw a really big price decline—around 40% over a couple of days in mid-March. What was interesting is that actually, most of the extra bitcoin that went into exchanges outside of the normal bitcoin that just circulates around was from people who had been holding bitcoin for less than a year [00:24:00] but more than three months.
That for me was really interesting because that suggested people who had gone into bitcoin from mid-2019, maybe a little bit earlier, as things started to get almost a bit more exciting in the space, then people and institutions and professionals started to get involved, and then all of a sudden, as all the financial markets dropped, they also sold a lot of bitcoin. You can see that. They’re not the long-term committed [00:24:30] holders. They largely rode out that price volatility in mid-March, but it was actually people who had been holding bitcoin for that medium amount of time who sold.
Clay: Within a certain individual’s holdings or an institution’s holdings, have you found that their use of that bitcoin is maybe segmented? Maybe there’s a portion that’s for holding, there’s a portion for trading. What can you tell us about how bitcoin holders segment their [00:25:00] holdings and assign various purposes to them?
Philip: It’s hard to get into that like how does an individual say split up their bitcoin usage? The thing I’d say though is the overwhelming amount of bitcoin, it’s not just that it’s being held for a really long time, but it’s actually over 80% of bitcoin is held by entities that have never sent more than ¼ of the bitcoin that they’ve received. [00:25:30] They are just like a sink of a bitcoin.
This conception that actually there are some people who have very active wallets where they take their bitcoin in, then they’ll sell it again or spend it on something, then they might get a bit more bitcoin in, and then they’ll send it on. There’s actually very few of those. It’s like 20% of bitcoin is made up of people who will be moving their bitcoin in and out regularly, and 80% is just sitting there.
Clay: I personally don’t know of another asset where the data suggests this [00:26:00] level of confidence and conviction. Just to reiterate what you said, over 80% of bitcoin is held by folks that have kept more than ¾ of the bitcoin they’ve ever received. That’s truly remarkable. That seems very bullish for this space.
Philip: I agree with you absolutely. I do think there have been waves of it. Around 2014, there were some people who exited who had been holding on for a longer time. That was a big [00:26:30] increase in the share of bitcoin that was younger then because it had changed hands and it did become more liquid as well, so more people were sending a greater proportion of what they had received. There have been waves. I do think there was some of the earliest bitcoin is probably dead sell-out, but since then, you’ve seen that buy-and-hold conviction really takes root.
Clay: Do you think it’s better for bitcoin for it to be lost or for it to be hacked?
Philip: [00:27:00] I would say it’s better for bitcoin to be lost. When there’s a hack, it just puts a lot of fear actually into people in the space. That means everyone has to stay and keep watching that hacked bitcoin to see if it ever moves. Whereas, if it’s lost, it sucks if you’re the person that lost it, but at least we know it’s out of the supply.
I guess the one saving grace if it’s hacked is there is an increasingly good chance of it [00:27:30] being recovered because there is greater cooperation amongst exchanges and blockchain analytics gets better and you can trace it all in real-time. Also, hackers of cryptocurrency exchanges are not always the best people. North Korea, for example, hacks a lot of exchanges and uses that bitcoin for their own ends. I think it’s safer actually if the bitcoin is just lost.
Clay: It’s deflationary, which is good for price movement and then you don’t have [00:28:00] that narrative floating around. I would agree with you. That makes sense. One thing in your report that I found interesting was you mentioned that 60% of available bitcoin is held by Virtual Asset Service Providers or VASPs. What are VASPs?
Philip: It’s a bit of jargon that’s been added into the industry through some anti-money laundering regulations. There’s the Financial Action Task Force, which is a global body that advises on anti-money laundering and [00:28:30] compliance rules for different countries should implement. They had to come up with a definition of the cryptocurrency business and they’ve called it a Virtual Asset Service Provider. Essentially, it is any service that takes custody of your bitcoin, more or less.
Clay: Got it. So decentralized exchange or noncustodial exchange would not count as a VASP?
Clay: So 60% of available bitcoin is held by a VASP. Is that mostly [00:29:00] exchanges would you say?
Philip: It’ll exchange but also hosted wallets. It’s an upper bound estimate, but the lower bound probably isn’t too much less than that. Basically, between exchanges and hosted wallets, that’ll be the vast majority of it.
Clay: If your assets are sitting in your Coinbase wallet, Square Cash, or Cash app something like that, all that is VASP-held?
Philip: Yep. That’s right.
Clay: What if you’re with an institutional custodian, would that also be considered [00:29:30] a VASP?
Philip: Yeah, it would.
Clay: The space high level of conviction, but in terms of the adherence to the decentralized ethos the data would suggest that most people—the vast majority of bitcoin—[00:30:00] is held by people that probably do not know their own personal keys. Would you say that’s accurate?
Philip: Yeah, I would say that it’s accurate. One thing here is you talked about available bitcoin or just called available bitcoin—the bitcoin that’s mined but not lost. It’s either the bitcoin’s all held by people who don’t know their private keys, some because they’ve forgotten them but some because they’ve given them up to a third party.
Clay: Just going to methodology a little bit, how do you define lost? Is it no movement within some period of time?
Philip: You can identify the original Satoshi clusters, that’s important because that’s one to two million bitcoin that we assume is lost. You can look at the bitcoin that hasn’t moved in a very long time. [00:30:30] There, we’re not just looking at the addresses but we’re also looking at the entities, which is important, because sometimes, you’ll have an entity that has some addresses that got bitcoin sat there for a very long period of time, but they might have an address that they sent the bitcoin from very recently.
That tells us that actually that set of addresses is controlled by a person who’s still active on the blockchain. Therefore, those old bitcoins aren’t lost. That’s an important caveat that we do capture those situations. [00:31:00] We also do look at what we call this liquidity. Does this bitcoin send? What percentage of the bitcoin they received do they send? If you end up with entities that have not moved their bitcoin for a really, really long time and they’ve stopped sending it for ages, then we think of that as lost.
Clay: Of the bitcoin that’s liquid, what do you know about the percentage of that movement being related to [00:31:30] financial trading versus buying goods and services, a percentage of which might be illegal?
Philip: The vast majority of the bitcoin that’s flowing on the blockchain is actually moving between exchanges. There’s 40% of all the bitcoin that flows we know is going between exchanges within a week. There’s around another 40% where we don’t know the direct counterparties of that transaction, but [00:32:00] we are able to say where that bitcoin came from and where it’s heading to if it arrives at something like an exchange later. The vast majority of that 40% that we don’t know the sort of direct counterparties we know that’s heading between exchanges as well. You’re really looking at between 40% and 80% of all bitcoin is actually just flowing between exchanges.
Clay: How do you go about tying addresses to specific financial [00:32:30] institutions, exchanges, or VASPs?
Philip: At Chainalysis, we have to have a very high level of evidence to say that this address belongs to an exchange because our customers are making compliance decisions on the basis of that, or they’re making law enforcement decisions on the basis of that. It’s actually a pretty huge effort that requires a lot of human verification. We will actually go and we will interact with these services, we’ll make a deposit address, we’ll send some [00:33:00] bitcoin to it, we’ll interact with the service, and that gives us that ground truth that this service belongs to this service. Then what we do is we understand the sort of network of addresses that are connected to those ones that we’ve identified.
There are these two stages. There’s identification saying this address belongs to this exchange, and then there’s aggregation. We’re actually saying all of these [00:33:30] other addresses around it, we can know that they actually belong to that exchange. There’s a combination of very manual process of identification, and then there’s leveraging a lot of algorithms, logic, and blockchain analysis to understand all these other addresses where they’re actually part of the same business.
Clay: Let’s say I have a Coinbase account, hypothetically, and I decide to generate a new wallet address to deposit funds. [00:34:00] I send funds there, it’s a net new address, how do you guys know that that’s associated with Coinbase? Is it because right after the deposit, Coinbase tends to transfer the funds from that one address to some central—more commonly-used address—that you guys have identified as being the recipient of all the transactions from these ad hoc addresses generated by users? Is it something like that?
Philip: Yeah, that is broadly the method. A lot of exchanges sweep funds [00:34:30] into a central wallet. That is because they want to protect their customers really from the risks of hacking. They want to keep as much of their bitcoin in a cold wallet that is air-gapped, not connected to the internet, and they have a small amount that’s kept hot to fund their day-to-day operations. If you deposit bitcoin, they actually want to get that into their cold wallet pretty fast. That’s why they sweep bitcoin, and through that, there are common patterns that you can see on the blockchain. [00:35:00] But exchanges do do different things. You do have to take it case-by-case especially for some of the bigger services.
Clay: What are some of the maybe more common use cases for law enforcement agencies? What’s a typical question that they’d attempt to answer with your data set—if you can share this kind of thing?
Philip: In terms of the biggest types of criminal activity that law enforcement has had to deal with, actually, in 2019, the biggest were scams. [00:35:30] There’s a lot of Ponzi schemes out there. Bitcoin has a problem in that a lot of people actually did get rich quick from bitcoin. If someone turns up and says come and send me some bitcoin and I can help you get rich quick, a lot of people actually think there’s some truth to that. Unfortunately, we’ve seen billions of dollars flow into these scams.
Clay: Hey! I wanted to pause for a second to let you know that this episode of the Flippening podcast is brought to you by our longtime and trusted partner, nexo.io. [00:36:00] As someone who personally uses Nexo, I want to point out a few things that I especially like about their crypto-backed loans.
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A second thing I really about Nexo is that you only pay interest on the amount that you borrow. I’ve seen Nexo competitors [00:36:30] require you to take out loans and force you to withdraw the entire amount. With Nexo, you get a credit line and can withdraw only the funds you need and not a cent more—paying them back whenever you want, with interest assessed daily. Again, this just isn’t something I’ve seen other providers do.
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Okay, let’s return back to the show.
Philip: That’s the biggest source of criminal activity in 2019 followed by darknet markets. It’s people using the latest versions of the Silk Road. They keep evolving these different darknet markets. [00:39:00] Law enforcement will also focus, even though these aren’t always for the biggest crimes by dollar value, they’re often the most serious. There are things like attacking ransomware. People send a virus to someone else’s computer, it encrypts all their software, they can’t get that unencrypted unless they pay a bitcoin ransom. That’s become increasingly sophisticated in recent years and people are targeting bigger and bigger institutions like hospital networks, schools, and governments.
[00:39:30] While it’s small, it’s very serious, Bitcoin, for example, last year was used in a child abuse material site called Welcome To Video. That was actually shut down in part because the blockchain analytics generated some leads that when combined with the KYC information on exchanges, led people to the perpetrators. There’s a whole range of how law enforcement investigates and blockchain analytics. [00:40:00] It ranges from the very high dollar scams to some of the more serious stuff.
Clay: Just going a bit back to exchanges, I’ve got a particular interest in them. When SegWit activated, there was a huge push to get exchanges to adopt SegWit. The advocates were really pushing for exchanges to implement this with the idea or suggestion being that a high percentage of bitcoin flows were either between individuals and exchanges [00:40:30] or from one exchange to another. What can you say about that? Does that seem to be an informed advocacy path? What percentage of activity happening is either between an exchange and an individual or from one exchange to another?
Philip: I would say it’s around 40%-80% of all of the activity on the blockchain is between an exchange or an individual or between exchanges. It’s like the vast majority of activity. That said, exchanges have been relatively slow to [00:41:00] adopting SegWit. It’s only in the last year that some of the more major exchanges have started to do that. The right advocacy path took a while for it to be effective.
Clay: At a high level, if you were to compare the Bitcoin ecosystem to a country, is there a country that you would most closely pin it to in terms of average transaction volume, liquidity, and GDP, that kind of thing. Is there a good analogy here [00:41:30] or not really?
Philip: I don’t actually think there is a great analogy. That’s because the Bitcoin ecosystem actually doesn’t have the level of complexity yet that a real economy has. The question of what is the GDP of Bitcoin? It’s slightly the wrong question because there isn’t that much that is actually made—there are not many firms that accept [00:42:00] Bitcoin as a payment and sell their goods for Bitcoin. You can do the accounting of that profit and loss in Bitcoin. It is a lot of financial speculation. That’s why we haven’t quite got those core metrics yet for Bitcoin that would allow us to make that comparator.
For me, the most solid metric that is comparable is, looking at the dollar value that’s moved over the blockchain. That’s around $14, $15 billion a week [00:42:30] at the moment. That’s an upper bound estimate because there’s a lot that you need to remove, a lot of noise, just transactions that are internal to exchanges, and so on. We remove that as much of that as we can. That’s a decent size payment network if you’re moving $15 billion a week between different people.
Clay: Do you think on-chain transaction volume is a good measure of means of exchange or something is there something else better for that purpose?
Philip: That 14 billion [00:43:00] that’s moving on-chain, it’s actually only maybe 2%, 2 ½% percent, which people actually buy goods and services. Half of that is illicit goods and services. Around 1% is illicit goods and services. That actual exchange of Bitcoin for goods and services is tiny. That means of exchange use case [00:43:30] isn’t really there yet. I actually think most of the on-chain activity is providing liquidity for people who are using Bitcoin as a store of value.
Clay: Facebook, Twitter, social networks, or TikTok often brag about the number of monthly active users and things like that. Is there a corollary for Bitcoin that makes sense given how much of this is just being held? Are you a monthly active user if you’re just holding it out? [00:44:00] I would argue that you are. That simply by holding it you count, even if you haven’t moved anything at all. If you were doing an earnings call for the Bitcoin network, what would you say to a very high level about active users or just a level of engagement at a high level with a network?
Philip: I agree that you have to include these owners of Bitcoin. They may not be active moving things on the blockchain every day or every month, [00:44:30] but they, as we discussed, are the majority of the holders. If you look at the number of entities that are holding Bitcoin on the blockchain but not necessarily moving it, it’s harder to estimate this because you have this problem of understanding what’s an address versus an address that should be clustered with an entity. But broadly speaking, we’re looking at millions—less than 10 million, more than 1 million, probably. Maybe [00:45:00] 5 or 7 million people holding Bitcoin on-chain.
But they’re not the only holders of Bitcoin because actually, the vast majority of holders are actually holding on exchange websites. They made a fiat wire into an exchange, they then bought some Bitcoin, and in a sense, that was the end of that Bitcoin journey. They’re just holding that Bitcoin on that exchange or the exchange is holding it [00:45:30] on their behalf. That’s obviously a number that we don’t see on the blockchain, but it’s probably in the tens of millions. An order of magnitude larger the number of people who actually go and top the blockchain.
An interesting third category of owners that are starting to emerge, which are people who are holding via trusts like this Grayscale Bitcoin Trust or through some of the ETPs that are out there. That’s probably only in the tens of thousands, but it’s an interesting new avenue [00:46:00] for people to own Bitcoin.
Clay: Let’s move on to chapter two, which is about the illicit activity. Every time a politician gets on-screen or someone’s arguing against Bitcoin, it seems like frequently they’re making reference to illicit activity. Completely sidestepping the amount of illicit activity that happens with cash, particularly US dollars but also euros and a [00:46:30] variety of other paper fiat currencies, you seem like someone who really appreciates nuance and who has thought about this at a pretty deep level. What would you say just broadly about the characterization of Bitcoin as a means for doing illegal things that hurt society? Is that a fair characterization or is it much more nuanced than that?
Philip: Yeah. As you said, I will always pick up on the nuance or something. [00:47:00] In fact, I actually think that there’s always less nuance to this than I need to go into. The overall level of illicit activity on Bitcoin is around 1% of the transaction volume. That’s low. Again, that is a lower bound estimate, but I spend my time analyzing all the activity on the blockchain. In fact, that’s what’s amazing about the blockchain is because we can analyze everything, we can say whether we think something’s a lower bound or upper bound. We can [00:47:30] say whether we think that lower bound is going to be perhaps twice as high as it is or 10 times as high as it is. I don’t think that around 1% estimate of transaction volume is going to be more than a couple of times higher in the worst case.
Actually, Bitcoin, it’s definitely used for some illicit activity, some of it is very serious, but in terms of the [00:48:00] relative amount, it’s actually really low. We have confidence that we don’t have in any other fiat currency or assets.
Clay: I imagine what percentage of paper fiat currency is being used to buy and sell drugs and things like that, but can you make a relative comparison? Is 1% above or below estimates of the percentage of USD used for illicit activity—or euros, British pounds?
Philip: [00:48:30] Generally, we’ve talked to people who try and estimate this and it is very hard. Some of the estimates are that illicit activity in the field economy is say 5% of GDP, but that is not an apple for apple comparison because as I said earlier, we don’t have a GDP number for Bitcoin in terms of the economic value that’s created by the Bitcoin economy. If you were to [00:49:00] look at the transaction volume in fiat, it would a very small number—the amount of illicit activity—just because the transaction volume of fiat is so enormous because you have different types of monies you have M1, M2, M3, and so on.
Some of that is just these money market funds that move huge amounts of money overnight to finance institutions. Getting the right percentage [00:49:30] is not an easy task and finding the right comparison is not an easy task. But for Bitcoin, saying if you were to get a random Bitcoin, one out of every hundred might have been involved in illicit activity. That is actually a helpful way to speak to say people who are in compliance because they’re like that’s some odds I can work on.
Clay: I don’t know if you’re allowed to say this but CoinJoin is pretty popular. There’s Wasabi Wallet, there’s [inaudible 00:49:58] transactions. [00:50:00] What do you know to be the favored method for illicitly spending your Bitcoin? Is there a particular technology or wallet that stands out and it’s head and shoulders above the competition?
Philip: I don’t know what is in vogue at the moment, actually. There are definitely people in Chainalysis that do but I focus more on the economics than understanding that. One of the really interesting things actually is that, especially in 2019, [00:50:30] a lot of illicit activity just went directly to exchanges rather than going through mixes so and on. A lot of that was related to scam activity where large amounts were raised in these Ponzi schemes and then it was sent through a set of what we call rogue over the counter brokers.
These are people who will normally buy and sell large amounts of Bitcoin because there isn’t the liquidity on the exchange. They appear not to have asked hard enough [00:51:00] questions about the source of some of their funds. OTC brokers will often also then sell on an exchange because they need to manage that liquidity. A lot of the Bitcoin that came from these Ponzi schemes were sold to OTC brokers and then actually would end up on an exchange.
Clay: Let’s transition to chapter three, which is about exchanges. Hopefully, I’m not putting you too much on the spot here, but given the data that you’re seeing, who is the biggest [00:51:30] exchange based on what you’re seeing in terms of inflows and outflows. Is it still Binance or is it someone else?
Philip: It is still Binance. This is an interesting perspective that we have is actually seeing how much Bitcoin comes in and out of the exchanges on the blockchain. That’s the measure I’m using here, but it’s Binance, it’s Huobi, and it’s Coinbase are really the top three. What I also find fascinating is that the top four exchanges, they receive 40% of [00:52:00] all the Bitcoin that was received by exchanges in 2020, and then the next 10 received another 36%. You’ve got over 75% of all the Bitcoin coming into exchanges coming into just 14 of them.
Clay: Do you see that becoming more concentrated or less concentrated over time?
Philip: As you had a great podcast with Nathaniel Whittemore, the history of exchanges has gone through different periods and phases.
Mike: Hi, this is Mike cutting in from the editor’s booth. [00:52:30] Philip is referring to Flippening episodes 57 and 58 Crypto Exchanges: A History of Crypto’s Most Powerful Institutions, which we recorded with Nathaniel Whittemore. It’s a deep-dive covering everything from Bitcointalk and Mt. Gox to Binance and ICO mania to the rise of crypto derivatives trading. Catch it at flippening.com/history. That’s flippening.com/history.
Okay, back to Philip.
Philip: I do think it’s helpful to think of post-January [00:53:00] 2018 epoch for exchanges. Binance established itself, Bitcoin was coming off it’s all-time high, and the exchange ecosystem somewhat settled in that period of time. In that period of time, it’s been fairly constant around ¾ of all the Bitcoin inflows to exchanges going into the top 14. But there’s definitely been some shuffling between some of the biggest exchanges. They [00:53:30] change rank, but there’s still a core 14, 15, or so exchanges that have dominated. But there’s still a very long tail because there are hundreds of exchanges as you well know.
Actually, they often play a really important role in local currency markets for example or in offering some new and exotic way to interact with crypto.
Clay: I do as well. My hypothesis is I believe that the long tail is going to get longer, maybe not [00:54:00] if you look at Bitcoin, but there’s a lot of really interesting things happening in DeFi and the lines are getting blurred like is this an exchange, is this a UI on a smart contract, or is this something completely different altogether? What is Namebase? Is that an exchange or is that a domain name registrar? Should we consider these non-fudgeable assets? There’s CryptoKitties, there’s just there’s much that’s happening here.
Philip: That’s what’s exciting about it as well.
Clay: Yeah, absolutely. The level of analysis you’ve done on Bitcoin. I know that there’s more data here and there’s probably more interest from institutions and law enforcement agencies and such, but do you have this analysis available for Ethereum as well or is there something about that chain that makes it harder to get this data?
Philip: No. all of that [00:55:00] data exists in one of the big things we’ve actually worked on Chainalysis is making sure that our metrics work as well for Bitcoin as they will for Ethereum or for any other blockchain, which is not trivial because they have different—like Bitcoin is an unspent transaction output. Blockchain and Ethereum is an account-based blockchain, so they have a different data structure more or less. You’ve got to try and map that into [00:55:30] a common schema. You’ve got to design all your metrics to operate, taking into account their differences to make sure they’re comparable.
It slows down, if you like, the process of building all these metrics, but actually then, once we have it, we can run this analysis over everything. That said the stuff I’m sharing with you is fresh that we actually haven’t rolled it out across all the different cryptos yet. We’ve done it experimentally, [00:56:00] but not to polish or detail that we’ve got for Bitcoin yet.
Clay: What have you seen about the role of fiat over time? Does there seem to be more fiat interest? What I’m getting at is I’ve seen some interesting analysis of net fiat inflows versus outflows. Let’s say you bought a thousand dollars’ worth of Bitcoin back in the day when it was trading in single digits. That grows and then at some point, maybe you purchase [00:56:30] into the Ethereum crowdsale and obviously that takes off. Then there’s the […] coin lottery of 2017.
You buy some dash and that goes up and you buy something else. Your initial investment is $1000, but on paper, it’s all worth much, much more than that—let’s say in the millions. But the fiat inflows into the whole ecosystem is still just at $1000. Have you done any analysis on net [00:57:00] fiat inflows and outflows and where that sits right now?
Philip: The role of fiat in the crypto ecosystem takes a little bit of unpacking because there’s a number of things going on. How many dollars’ worth of fiat actually enter the ecosystem? That’s a crucial number to watch, although it’s very hard to observe, because that’s the value that’s coming into the industry. That’s really what [00:57:30] drives the market cap higher is that demand. Most people will acquire the crypto because they onramp via fiat. Then you’ve got this question, this person that you described who put $1000 in originally but they have made some really big paper gains, are they actually that rich?
My answer is kind of no. The reason for that is because [00:58:00] liquidity in crypto is still small. If they wanted to liquidate a large position, they could move the market and they would no longer be as rich as they originally were on paper. We even debate internally. When you’re looking at on-chain transaction volumes, you really need to probably think about them in what we call native asset terms, the Bitcoin terms rather than dollar terms, because there’s not actually that [00:58:30] many dollars’ worth moving on the blockchain. It’s only when it’s being moved to an exchange and then sold that actually crystallizes into that dollar amount.
The other, to me, fascinating fact actually about the on-chain activity is when we look at the exchanges. It’s actually the crypto to fiat exchanges that are dominating the on-chain flows between or into exchanges. 40% [00:59:00] of the exchange flows are actually between crypto to fiat exchanges. The other 32%, which is either to them or from them. Actually, crypto to fiat exchanges are responsible for 75% of all of the Bitcoin flows between exchanges. The people who think crypto was all about the crypto to crypto casinos, it’s actually about the exchanges that have big fiat on-ramps.
Clay: What do you make of Tether’s quote currency dominance? [00:59:30] If you would’ve asked me, and I’m not looking at the data, what are the biggest trading pairs or what’s the biggest quote currency, I would have said it’s probably USD, Bitcoin, and Ethereum, but it turns out that Tether is just crushing everyone.
Philip: Tether is—I don’t think you can really talk about Bitcoin without talking about the role of Tether. Tether, it’s [01:00:00] particularly used on places like Binance but also Huobi and OKEx. A big use case for Tether emerged when the exchanges that were previously domiciled in mainland China had to move off in 2017. That meant it was hard for them to get fiat on-ramps and Tether filled that gap. It’s a real sign actually of the crypto [01:00:30] ecosystem innovating. It’s like we need this thing. We can’t get it from the traditional world so let’s invent it.
Tether has played a huge role in keeping the crypto market liquid and enabling those exchanges to operate. There are, for me, three reasons why Tether has that dominance. One is as a lot of the Chinese exchanges closed down, a lot of that Bitcoin that people held was actually sold to [01:01:00] Tether. There are hundreds of millions perhaps even billions of dollars of Tether which are just held by people who essentially crystallized the gain that they had from Bitcoin when they were forced to sell it and they weren’t quite sure what to do next.
That then created this, as you said, huge network effect particularly in Asia where people had sold a lot of Bitcoin for Tether, they then wanted [01:01:30] to start trading again, and they had these dollars to do that with. That is related to the second reason why I think Tether is popular. Really, it’s because it gives exposure to dollars but outside of the jurisdiction of the dollar system. That’s not necessarily to say it’s good or bad. It’s just there are definitely people in the world who want that. There’s the Eurodollar market that is set up in London [01:02:00] that uses fiat dollars to do exactly the same thing. That started in the ’80s, people wanted to use dollars outside of the US banking system, and created the city of London.
Tether is doing essentially the same thing in Asia. That’s the third reason why Tether is actually being betted on. That’s because there’s actually some evidence, when we look at it on-chain, that Tether is not just being used for trading, but actually, there’s a large number, an increasing [01:02:30] number of Tether transactions for smaller almost means of exchange amounts. It’s harder to pin down the services. Anecdotally, you hear about people using Tether as currency in China or for cross border trade—say between Russia and China.
Actually, people don’t necessarily want a cryptocurrency, but they want a dollar that they can transfer outside of the dollar system, and Tether [01:03:00] fits that use case in a way that the regulated stablecoins don’t.
Clay: Is there anything in particular that stands out that bears highlighting from your report about exchanges that you think merits coverage this far into this podcast?
Philip: One is talking about people who have discussed if this is a retail market or a professional market? The second is can we actually use on-chain data to try and understand whether the trading volumes are accurate, [01:03:30] for example? The first thing is that the vast majority of the retail market remains on exchange websites and rarely interacts with the blockchain. This is where you’re tracking these things at Nomics. That’s excellent data to try and understand that. But it’s clear that even looking at things like web traffic data, the vast majority of the number of people who are interacting with Bitcoin are just logging into websites, not actually moving things on-chain.
But [01:04:00] if we look at things on-chain, then there are around 1 million transfers into exchanges each week. Around ¾ of those are actually for less $1000, which is a retail amount. But if you look at the value that’s moved by larger value transfers—say transfers over $10,000—they actually move over 85% of all the dollar value of [01:04:30] Bitcoin into exchanges each week. You’ve got the largest number of people who are actually moving smaller amounts, but then there’s a small number of people who are actually moving most of the value into exchanges.
The way that I think about it is there’s a set of—I don’t know whether to call them institutions, but certainly professionals who are actually managing the liquidity across all the exchanges. There’s this large number of [01:05:00] retail customers who essentially have taken that liquidity instead of buying and selling around the margin.
Clay: Whales truly can control the price or at least collectively they can. Maybe no one in particular can.
Philip: I think if you had around 10,000 Bitcoin you can easily move the price.
Clay: Interesting. How did you arrive with that number?
Philip: The amount of Bitcoin that’s going into exchanges every day at the moment is around 70,000 [01:05:30] Bitcoin. If you put 10,000 Bitcoin onto an exchange, you’re 1/7 of everything that’s going in that day. If you do it in a very small number of hours, then you can basically 100% of all the Bitcoin that goes into exchanges. If you sell it, then you’re actually going to burn through an order book pretty fast.
Clay: What was the second point that you were making about exchanges?
Philip: As you well know, there’s this big discussion around how much of the [01:06:00] reported trade volume is actually real versus wash trading, misreporting, or whatever other reason. What I find fascinating when we look at the on-chain data is it gives us a bit of a benchmark because moving Bitcoin on the blockchain, you could do that if you like just to boost your metrics, but I don’t think—
Clay: But it’s not free.
Philip: Yeah, exactly. It’s not free. [01:06:30] You have to have a lot of capital tied up in doing that. You have to pay the transaction fees, you have to bear the risk of moving lots of Bitcoin, which I think is probably the bigger disincentive. I do actually think these on-chain movements are real. You can take the ratio between the reported trade volume and the on-chain volume, and you can compare that across different exchanges.
That can give you a sense, [01:07:00] not necessarily about whether the volumes are true or not because some exchanges have very different business models, but it can help you understand what’s in a reasonable range. Sometimes, you’ll find some exchanges that are way out of whack for standard range or sometimes, you’ll see exchanges that will have a fairly sensible and constant ratio, but then there’ll be a point in time when all of a sudden that ratio will essentially go haywire and they’ll start trading a lot more Bitcoin for every [01:07:30] Bitcoin they received on-chain. For me that’s an alarm bell goes off then.
Actually, looking at this data, there was a period of time where some South Korean exchanges went through a period of inflating volumes, and there are actually legal proceedings at the back of it to confirm this. When you look at these ratios at that time you can really see that happening. That for us was a nice confirmation that we can use this data to spot that type of activity. Maybe you could have spotted it anyway, but it showed that there was this disconnect [01:08:00] between the actual amount that Bitcoin exchange had versus how much it claimed and was actually being traded.
Clay: Let’s transition to talking about the future of your various lines of inquiry. What kinds of questions are you most interested in getting answered in the future? Is it more about new questions or is it about going deeper with the boring basics and the fundamentals here? What are you most excited about when you think about maybe the 2025 version of this [01:08:30] presentation?
Philip: For me, the biggest thing is about getting a set of metrics that the next stage of crypto adopters will understand because I do think the next stage will be those “institutional investors.” They are the type of people that don’t make decisions without data. You go into any business or boardroom and you say come and get involved in this space, invest in this. They’ll say [01:09:00] give me some numbers so I can understand what I’m getting into. But those numbers need to be meaningful and honestly quite simple because you’ve got to get people up a big learning curve.
Blockchain analytics focuses on some very technical concepts very often. I’m trying to move our analytics to measures that just make more sense to people that are more natural to connect [01:09:30] with concepts they’re already familiar with. That actually takes a remarkable amount of effort and time and iteration. That’s my big focus. If I can get a set of five metrics that really speak to people who make big business decisions and that helps convince them to get into cryptocurrency, then that’s a success for me.
Clay: Do you have collaborators in the academic world or [01:10:00] are there some below the radar economists that are pushing on-chain analysis forward in terms of methodologies, technologies, things like that? Other than you and Chainalysis, who do you think in the academic world is doing interesting work that might be worth noting on the podcast?
Philip: In terms of the academic investigations of on-chain analytics, we do quite a number of [01:10:30] academic collaborations because we want to help the academics get over the barrier of getting access to good data because that’s genuinely one of the biggest tasks. Academics don’t necessarily want to run nodes and so on. But even once they’ve done that, they need to structure the data. We can help shortcut some of that. We have active collaboration with City University of London, [01:11:00] also with Oxford, and with NYU. That’s actually looking more on the dark net market activity.
In terms of economics, there are various groups. UCL in London has a great team in that InfoSec group. Imperial London also has a good group.
Clay: In closing, Philip, I’ll ask you the same question that I ask every guest now which is this, if you could [01:11:30] altruistically wave a magic wand and instantly make something happen for this ecosystem that brings it forward, what would you do?
Philip: I would probably give Bitcoin the social network that Facebook has because then, the thing that people are really excited to say about Libra is that it brings this ready-made community of people who are already connected to each other and doing things. [01:12:00] If we could bring that to a native cryptocurrency I think that would be really, really exciting.
Mike: That concludes Clay’s conversation with Philip Gradwell, Chief Economist at Chainalysis. I hope you enjoyed it.
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To subscribe, go to news.nomics.com. Again, that’s news.nomics.com.
All right, that‘s all for this week. Stay tuned for next week’s episode. Until then, take care.
Clay: That’s it for this week. To sign-up for our free crypto investing newsletter, listen to other episodes, or get the show notes [01:13:00] from this episode, please visit flippening.com. I also invite you to check out the startup that funds this podcast, Nomics at nomics.com. Finally, if you got value from the show, the biggest thing you can do to help us out is to leave a five-star review with some comments and feedback on iTunes, Stitcher, or wherever you listen to podcasts. Thanks for listening and see you next week.