2018 Year in Review - Key Milestones

Author: Will Peets, CIO of Passport Digital Holdings, @WillPeets

Reflection

Last year was an exciting year for the broader digital asset space, with several noteworthy milestones reached. Despite the volatility in the market, we continue to see strong forward indicators with respect to the development of the technology and the surrounding ecosystem. Awareness of the asset class is growing. Our macro thesis can be summarized by the following:

  • Markets are poor discounters of long-term secular trends, in particular when there is no historical precedent

  • Blockchain is a transformational technology, which will manifest across large swaths of the global economy. It will create big winners and losers, with ramifications for both new and existing businesses across multiple verticals.

  • Worldwide developer activity is shifting rapidly towards blockchain technology, a meaningful leading indicator for innovation and technology adoption. We are in the very early innings of a platform shift, but it will come quickly, accelerated by the internet and open source technologies.

  • Demographic and social trends driven by millennials’ relationship with technology, growing distrust of the banking system, a increased concern about privacy and usage of personal data, and the influence of Gen Z who were “born digital” are a tailwind to adoption

  • Institutional interest will bring large incremental capital to the cryptocurrency market

While there was consolidation in the market in 2018, our macro view on the importance and trajectory of the asset class remains unchanged.

Market Observations/Evolution

Distributed ledger technology, digital currencies, and blockchain based peer-to-peer protocols represent early stage technology. This holds true even for Bitcoin, which despite being in existence  for 10+ years is just now starting to see innovation that empowers utilization by the masses. While this may be an obvious statement - I think it’s important that we remind ourselves of this as it appears the market may have overlooked this. Liquidity, real-time market pricing, exchangeability, etc.are attributes that are normally reserved for mature assets: stocks, debt of mature companies, etc. The transfer of value peer-to-peer (e.g., money, data, compute) is at the heart of digital currencies and distributed ledger technology; thus, liquidity is a “native” attribute. As a result, the market (and market participants) may have felt that the technology is further along than it really was. Seasoned venture capitalist Fed Wilson captured this well in a recent blog post where he states, “the bubble came early because blockchain technology enabled liquidity earlier in its life cycle”.

The speed of price discovery in the digital asset space is a positive attribute that distinguishes digital assets from traditional early stage investments which are generally illiquid. In the case of digital assets, the liquidity of the asset class and the notion of “liquid venture” was alluring: venture returns in a sub 1yr horizon with immediate liquidity! In reality, price was a reflection of animal spirits and the speculative value the technology, with valuations far exceeding the current state of the technology. This was exacerbated by the fact that market participation was disproportionately retail, with under representation from institutional investors (FundStrat estimates <4%). Last year, this mismatch was partially reconciled, with a large consolidation in price of Bitcoin down -72.9%, and the HOLD 10 index down -79.2% and total market cap as estimated by Bitwise 100 index down -81.9%. Taking this at face value, it may indicate that:

  • Market valuations got ahead of the technology (adoption/utilization)

  • While liquidity is a native attribute, it still takes time to develop networks and build companies

  • Bitcoin is still in the lead in terms of utilization, adoption, network effects (judging by BTC dominance)

For those close to the technology and the ecosystem, this consolidation was required and is a net positive. While there are still several projects that remain overpriced, price behavior and valuations are now becoming a little more rational. An anecdotal observation that reflects this is the lack of price response to headlines. Instead the market is waiting for actual follow through by the company, protocol, regulator, etc.. Furthermore, just as price was a bad indicator of current utility/adoption of the technology during the run up in 2017 (low), the year over year change in price in 2018 is, in my opinion, a bad leading indicator of the long term utility of the technology. There are some strong analogs between the dotcom era and the digital asset space. There is a tremendous amount of hype around blockchain and several ideas that are being discussed now that are simply too early relative to the stage of the technology similar to how Pets.com was too early relative to the state of the internet in 2000 and last mile delivery capabilities. There were many Pets.com equivalents in the digital asset space in 2017 and will likely be poor long term investments. Pets.com however was not an indicator that the internet did not/would not have value it was simply too early. Our expectation remains that the development of this technology will be faster than the market expects. A cheeky comment of one investment manager holds true: “the internet would have been developed faster had we had the internet”.

I’m often asked what I think the catalyst will be for the market to move higher. My view is that this is going to be a slower build based on actual adoption and, proven use cases. There are catalysts that could spark a large price move, specifically around regulation and the activation of new trading venues and consumer/institutional on-ramps that will enable large groups of new incremental buyers but we are focusing our attention on a mosaic of data points that could create a potential floor in the price of BTC and future development in the ecosystem.

Milestones

Despite the volatile market and the overall downturn in price, there are several milestones achieved in 2018 that bode well for the future of the asset class. Many of these milestones are related to the “fulcrum points of adoption” that we discussed in a previous blog post. These include:

Infrastructure

  • Custody: Coinbase Custody is now live, Anchor Labs came out of stealth at the beginning of 2019, and Fidelity Digital Asset Services confirmed their Q1 entrance into the market

  • Exchanges: We’re seeing the development of more regulated trading venues, who are adopting technology or directly backed by traditional exchanges (ICE/Nasdaq)

  • Security Token Exchanges: There were several security token exchanges that came to market and started to list security tokens (STOs). This includes Open Finance, Sharespost, Templum, and TZero among others. Tzero is noteworthy given was among the top 10 ICOs in 2018 (by capital raised) and launched with limited functionality this January. It also owns patents that detail the interoperability of traditional exchanges and security token exchanges which provides a glimpse into the direction of the market. This article does a good job discussing the activity here.

  • Bakkt, while delayed by the CFTC continues to move forward and is anticipated to launch in Q1 with ICE expected to spend $25M on the platform this quarter

  • Platforms like Tagomi and OTCXN aim to facilitate rapid order execution while simultaneously reducing the risk of holding assets in hot wallets

Institutional Awareness

  • Marcos Veremis of Cambridge Associates, an investment management and advisory firm with an institutional client base published a piece that provides an overview of the digital asset space, highlighting that it’s “developing not faltering” and encouraging institutions to start exploring it.

  • Several endowments and pension funds including Yale, Virginia's police and state employee funds, University of Michigan, to name a few.

  • J.P. Morgan announced plans to launch JPM Coin, a “cryptocurrency” that will be used to improve settlement efficiencies, at first focused on international settlements by major corporations, helping speed up transactions that currently take a day or longer using SWIFT. While it’s questionable to call this a cryptocurrency, given its initial use is limited to an internal ledger - this is a noteworthy pivot for a firm whose chairman previously called Bitcoin a fraud casting doubt on the technology.

  • We also saw the launch of some projects that we believe will help bridge the gap between “interesting tech” and real adoption - one of which is Figure/Provenance. Figure is a consumer finance company, focused on home equity loan and purchase-lease back agreements. They are originating loans “on chain” and cultivating the Provenance network which could bring a lot of traditional market participants to the table. Independent of its future success, this is an important milestone as it relates to gaining institutional mindshare.

Volumes

  • Despite the drop in volumes on many crypto exchanges which took place in tandem with the drop in price, trading volumes for institutional products on the CME continued to grow in absolute terms but also as a proportion to volume on dedicated crypto exchanges. Daily volume for BTC futures made a new record February 19th with 18,388 bitcoin contracts, which is equal to 91,690 BTC or $360M

Source: CME, Passport Digital Holdings

Source: CME, Passport Digital Holdings

  • This migration to regulated, institutional products reflects market maturation. Furthermore, there are several other regulated institutional exchanges which have come or are expected to come to market in 2019 (Eris X, Seed CX, Bakkt, etc.)

  • The internal index we compile that  aims to track BTC held in “institutional products” continues to make new highs, currently around 287k BTC (just north of $1B dollars and 2% of available circulating supply)

Source: CME, Bloomberg, Passport Digital Holdings

Source: CME, Bloomberg, Passport Digital Holdings

Regulatory

  • While there are still several blind spots in the regulatory landscape, we’re seeing a lot of legislation being proposed at both the state and federal level as well as in the international arena.

  • One state of particular interest is Wyoming which has passed and/or introduced several bills which would define three categories of digital assets and treat them as property, grant assets designated as virtual currencies the same legal status as money, create a new bank charter scheme that would allow banks to hold digital assets in custody, allow corporations to issue certificate tokens that represent shares, and create a regulatory fintech sandbox aimed at further diminishing any regulatory hurdles to industry startups

  • We’re seeing proposed legislation and rulings in several other states

    • Pennsylvania - rules that crypto exchanges and ATMs are not money transmitters

    • New Hampshire and Ohio are allowing the state to receive payments in Bitcoin

    • Florida - a case brought in Florida resulted  in Bitcoin being defined as “money” for the relevant Florida statutes.

  • While all of these examples are not groundbreaking, they’re indicative of the groundswell of legislative activity that will eventually provide greater clarity

ICO Market Normalization/Consolidation

This chart provides a great illustration of the peak to trough ICO issuance:

Source:  Smith+Crown

Source: Smith+Crown

  • The dramatic rise and fall of the initial coin offering (ICO) market is the result of several factors:

    • Regulatory scrutiny/clarity on ICOs and the subsequent change in deal structures (equity, tokens + equity, etc.)

    • Improved understanding of crypto economic models and the “need” for a native token. The need for a native token is a high bar and largely limited to public permissionless blockchains.

    • Recognition that it takes time and effort to build a network

    • Increased venture capital participation, and the demand for more governance and investor/project alignment. According to data provided by Pitchbook, in just the first three quarters of 2018, blockchain and crypto companies raised nearly $3.9B through traditional VC - 280% more when compared to last year (see chart)

Source:  Diar

Source: Diar

  • While we’ve seen some definite cooling in the ICO market, the structure remains an innovative way for raising capital and is maturing with the development of the STO market and platforms for conducting legal ICOs via reg. CF (crowdfunding)

Consumer Adoption Greenshoots

  • While still early, we’re seeing some developments that will make it easier for consumers to interact and use this technology. A few examples include:

    • Native crypto wallet in the next gen Samsung S10

    • Built-in crypto wallets to internet browsers (OPERA)

    • User friendly/utility rich applications like ABRA

    • Facebook’s creation of a team dedicated to evaluating the incorporation of blockchain technology into their platform, as evidenced by their acquisition of Chainspace and reports that they are already in talks with exchanges for listing their coin and plan to have a working product out in the first half of 2019.

    • Square Cash App, which now has more downloads than venmo, has enabled the purchase of Bitcoin and has hinted at integration of lightning network/payments

    • Lightning network growth in terms of channels and network capacity is growing exponentially

Source:  P2SH

Source: P2SH

Bitcoin maintains dominant lead

  • At the time of writing, Bitcoin is just shy of 60% of the total network market capitalization

  • This is important for several reasons

    • There has been a lot of innovation in the space over the last couple of years, which was a primary driver of many “alt-coins” which looked to innovate on and address limitations of the bitcoin protocol

    • This was supported by the market via the ICO craze which helped to fund many of these projects

    • Many of these same use cases are now being re-envisioned as applications built on top of Bitcoin in the form of applications or layer two solutions

    • The network effects and the inherent security of the network given the large capital investment that has gone into dedicated mining chips (ASICs) remains a large and important differentiator

    • We envision a world where there are less ICOs and competing protocols and more, traditional VC backed companies that will build on top of Bitcoin

Decentralized Finance

  • While Bitcoin and the companies it will support have a strong lead, we’re seeing a lot of innovation within open finance (also referred to as decentralized finance or “De-Fi”)

  • This consists of several projects (largely based on Ethereum) that enable peer-to-peer, permissionless lending/borrowing

  • Active loans outstanding on these platforms rose form $6M as of Dec 31st, 2017 to $72M as of December 31, 2018, an increase of 1,200%

  • The total loans originated in 2018, as compiled by Blockboard

Source:  Bloqboard

Source: Bloqboard

  • It is too soon to tell if this momentum will continue, it’s certainly worth watching

While 2018 was a volatile year, paying attention to just the price would be to overlook all of the progress that took place in the industry. The founder of Passport Capital, John Burbank, has famously said “price is a liar”, a comment that price simply reflects the current equilibrium of buyers and sellers and does a poor job of discounting future events - especially those without historical precedent. While it remains early days, there are many encouraging trends spanning technological development, regulation, institutional awareness, and consumer adoption.