BLOCKCHAIN & CRYPTO: Part 2 - From Main Street to Wall Street, institutions are the key to mainstream Crypto adoption...oh the irony

As we know, one of the aims of cryptocurrency was to provide a means to anonymously and securely transfer value between transacting parties i.e., removing the power away from financial intermediaries whose distribution channels exploit fees from those wishing to transact in the current system. Funnily enough, it seems that the very same institutions that crypto sought to disenfranchise, are key to its success. Success here being widespread adoption.

Let's start with mainstream adoption in retail where Flexa -- a payments network startup is partnering with New York-based exchange Gemini to enable crypto payments to be made at an estimated 30,476 stores, including Wholefoods, Nordstrom, and Gamestop. Flexa works by processing the payments made on its platform using its custodial wallet and mobile app called 'Spedn' which enables spending of specific cryptocurrencies -- Gemini Dollars, Bitcoin, Ether, and Bitcoin Cash. Flexa uses its own native coin -- Flexacoin as collateral to secure payments until the transaction is approved on the blockchain, and custody is taken care of by Gemini. Spedn is custodied with Gemini who provide security for this new payment technology. Finally, adoption is enhanced by (1) ensuring merchant's payment processing costs are reduced whilst the blockchain maintains security, (2) no changes are needed to the existing payment hardware, and (3) revenue can be received in fiat as opposed to crypto.

This institutionalization of crypto is also echoing in larger public companies. See NYSE’s partnership with Bakkt. Or XRP being launched on securities marketplace Deutsche Boerse and Coinbase. And lets not forget the likes of JP Morgan's coin, and Fidelity set to launch its crypto Trading service. According to Fintech Analyst Efi Pylarinou Wall Street institutions are looking at crypto as a new structured product business i.e., ETP’s linked to baskets of cryptos (low-hanging fruit) and tokenised real-estate (main focus) which is good if it democratizes exposure to the real-estate market, but bad if we see a reformat of the 2008 mortgage crisis. We will leave this gem for you to make up your mind – Banco Pactual issuing an STO in distressed Brazilian real-estate. 

As the institutionalization of crypto and blockchain continues to gain traction, it is likely to see the services and products they offer provide the gateway into the crypto markets, which may ultimately result in a surge in fresh capital making its way into these markets, and possibly kindling the flame that ignites the next price rally.


Source: Flexa Spedn App (via news.bitcoin)

CAPITAL MARKETS: Winners-take-all as CBOE Futures discontinued and 60 Crypto Exchanges shut down

CBOE has decided not to list any new Bitcoin futures, with the last contracts expiring in July. Does this mean that BTC futures are dead? Not at all -- CBOE's biggest competitor, the CME, has simply won the game. You can see in the charts at the end of this entry a competition in volume over the last year, with CME's product steadily taking the lead. Why did this happen? The short answer is product quality and network effects. The decision to use an auction price from Gemini, rather than CME's approach of building a reference rate from several constituent exchanges, was a primary cause of poor product quality. And once traders shifted away from the product, network effects at the other venue kick in, creating lock-in and returns to scale.

More broadly, we have seen network effects around the top 10 crypto exchanges wreak havok on the rest of the industry. Of the 250-500 exchanges out there, 20% had no trade volume of any kind in the last 24 hours, and less than 1% had volumes over $1 billion. Over the last 8 years, 60 exchanges (and likely more) have been forced to exit the industry. While 75% of those exits are due to forced shut-downs by authorities, hacking, or outright scams -- 20% have exited due to a lack of liquidity. A lack of liquidity is a synonym for losing on network effects, akin to a social media app not bootstrapping enough users. Further, 5% of the exited exchanges have been acquisitions for others, like Circle and Coinbase. This again points to the winner-take-all nature of the market.

What's the solution? In social media, the answer was a Facebook, Twitter or Google identity, which created a portable social graph across the Internet. While those companies may no longer allow the full copying of the graph, they do allow apps to quickly connect users that are already entangled. In finance, brokers are the user platforms that provide best execution across exchanges, playing an analogous role. Distributors aggregate consumers, manufacturers create product, and the two functions are integrated through FIX APIs, processing software, and various other value chain intermediaries. If we want portability across liquidity pools in crypto capital markets, and especially over decentralized exchanges, understanding the separation and empowering each function (rather than vertically bundling everything) is the key.

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Source: Trading View (XBT vx BTC), Wall Street Journal (CBOE), Messari (CBOE)

CRYPTO: BitMax and $1.5 Billion in Phantom Daily Volume from Transaction Mining

Once in a while we land on Coinmarketcap's crypto exchange ranking, and choose "Reported" volumes instead of "Adjusted" ones. In that world, everything is topsy turvy. Binance is no longer on the top, and BitMax, Bithumb and other unmentionables float around the meniscus. The answer as to why this happens is called "Transaction Mining", and was a big deal halfway through last year. This practice is not really mining, as much as it is churning. Normally, an exchange charges a fee to the buyer and seller for facilitating a trade on its platform. In this case, however, the exchange also pays the trader a rebate in the form of its own token. The more you trade, the more of the exchange's proprietary token you receive. And some tokens, like Binance's BNB, have become valuable to the tune of $2 billion.

The positive way to look at this practice is to say that it is "growth hacking" the exchange rankings, thereby creating more visibility for high ranking platforms. Imagine you are trying to maximize visitors to your website. Well, you might practice some search optimization techniques, get back links from blogs, and perhaps even pay for some fake ones. Or, you are growing a social media audience, and decide to cheat by buying fake followers to create the impression of engagement. These techniques -- while misleading -- are merely meant to get you noticed, and then real activity can begin. Traditional banks offer $250 rebates to sign up for a new account or credit card all the time! And in the case of crypto exchanges last year, a number of them used transaction mining to growth hack the rankings, spread around their token, and have now switched to more accepted pricing models.

But Bitmax, and its $1.4 billion of mined volume per day, seems an extreme. The negative way to look at this practice is to compare it to churning an account. If a financial advisor with a fiduciary duty directs trades in a client's account in order to generate fees and create the impression of activity, they are breaking the law. In such an example, the financial advisor has full control of the account. You may say that crypto exchanges are optional, and that the decision to churn trades in order to generate/mine exchange tokens is voluntary. Sure. But if bot-driven advertising can swing an American election, certainly misleading financial incentives can skew how people make investment decisions. The belief that the exchange token is worth something -- backed by little other than promises that it will be worth more once other people have it -- leads to destructive financial activity. To us, this looks a lot like a digital-first version of churning driven by a suspect financial promotion. 


Source: Coinmarketcap (Exchanges), CoingeckoBitmax, Crypto Currency Hub (Is transaction fee mining a ponzi scheme)

CRYPTO: 190 Exchange License applications in Japan, $183 million in funding for ICE's Bakkt

We'd love to write about all the interesting decentralized applications that the crypto community has scaled to millions of users. But we can't, because it hasn't. So instead, the news cycle is still stuck on the financialization and securitization of tokens in the far reaches of the Internet. At least it is a re-thinking of capital markets from the bottom up -- and this being a financial technology newsletter, we will oblige with the theme. But what may seem obvious on the surface is really not. Blockchain-based exchanges are not about better systems today (they may be in the future), but about finding cash flow to survive the nuclear winter and later expand into adjacent verticals (e.g., Coinbase, Binance).

The first story is about Japan, where a crypto-friendly regulator has received 190 cryptocurrency exchange license applications. Pause on that. Financial instrument exchanges are not this popular organically, with just 16 stock exchanges accounting for 87% of total stock exchange market cap (see chart below). In Europe, a similar fervor is in place about starting up new banks -- something about the power of the Crown in the palm of your hand. So seeing a wave of small, uncoordinated capital markets infrastructure teams try to bootstrap into a licensed, centralized/monopolized venue for financial exchange across the world isn't a sign of positive progress. It is a sign of a meme echoing across Twitter.

Second, we point to the $182.5 million funding round just raised by Bakkt, owned by the Intercontinental Exchange (also owner of the NYSE). Microsoft, BCG, Galaxy, Pantera and others chipped in. This is a fat raise, and it reminds us of R3's bank consortium, Digital Asset's trading systems, and a bit of Telegram's $1.7 billion venture capital black hole. Wall Street is building infrastructure for Wall Street, expecting to be the owner of all crypto OTC and institutional flows -- the blue ocean opportunity is now gone. Yet Asian exchanges like Binance continue to be the life-blood of retail crypto finance, built for users trained on video game money. Dressing this stuff up in a suit and trading a lot of it is a meme as well.


Source: Cointelegraph (Japan), Japanese FSA (Virtual Currency report), Visual Capitalist (Stock Exchanges), Coindesk (Bakkt)

CRYPTO: The $1 Trillion market where Stablecoins will succeed and why most will fail

Last week we talked about the value of having a bag of cash in a down-market, using Circle as an example. This week, the news broke of Coinbase raising $300 million from Tiger Global (which had also invested in roboadvisor Wealthfront, among others). Circle and Coinbase earlier joined efforts to popularize their stablecoin USDC, their version of crypto cash pegged to the US dollar, which has reportedly had over $125 million in circulation since September. Meanwhile, USDT (Tether) associated with Bitfinex has been seeing outflows and general anxiety about whether the currency is a fraud -- with the total market cap falling by over $1 billion. Tether just released a statement from a Bahamas based bank that claims the firm has $1.8 billion in portfolio cash value; however, this statement was not signed by a named officer and disclaimed all liability. So at the very least, we can say that Coinbase+Circle seem to be forming a more credible stablecoin alternative than Bitfinex+Tether in the short term.

But what should we think about the usefulness of stablecoins in the first place? The core thesis is that BTC has not been used as a currency because of its volatility, and therefore merchants and individuals would not rely on it as a unit of account or medium of exchange. This premise is not entirely true -- volatility is only partially explanatory of why BTC is not being used by consumers. In our view, the main barrier is not volatility but ease of use and form factor. It's just too hard to figure out how to actually pay with BTC or any other digital currency for real (i.e., non digital) goods and services. Second, volatility in Bitcoin has actually subsided over the last 6 months -- that's not enough for long term company planning, but if it were the problem in commerce, then we would have seen a spike in economic activity correlating to this volatility damper. 


Any floating currency needs to be collateralized, whether or not it is printing money algorithmically or has bots arbitraging itself against exchanges. Otherwise you cannot fund redemptions (and if you can't fund redemptions, then you are just printing specious moneys). Holding the peg to your desired currency basket, whether USD, yuan or Euro, requires being able to defend the currency with capital reserves. Any private capital reserve can be broken by a larger private capital reserve -- or even by a government actor. Consider Soros and the Bank of England. As a result, these coins are fragile and ripe honeypots for attack and manipulation. In the case where the reserve becomes so large as to be unbreakable, and where the currency is meaningfully used as a medium of exchange, it becomes a threat to the world's actual reserve currency, the USD. The US sovereign is unlikely to allow private parties to issue and own a digital dollar at scale -- though the Treasury may be catalyzed to mint digital dollars as a result.

Here's what we think will work -- private company networks that ride the blockchain rails with the equivalent of a Cash Sweep account or a Money Market Fund. Imagine opening up a Schwab brokerage account. Your free cash in a portfolio -- let's say 1.5% -- would get invested into a cash sweep vehicle, which could be a money market fund, or a trust company cash account, or something similar. For a crypto financial company, you are unlikely to want to hold a financial license for traditional banking or investment services. But you still need to manage the cash somehow. So efforts like UBS settlement coin, or any of the exchange-backed stablecoin projects, could fill in the gap of moving USD around within a limited size network in order to reduce friction between going in and out of fiat. If the network gets so big as to include the entire economy, then it again pops up on the Treasury's radar. That's not to say it's a dead end -- MMF assets were nearly $1 trillion for retail and $1.8 trillion for institutional investors. And banks print money by issuing credit all the time, levering up the economy many times over, they are just heavily regulated to do so.


Source: Cointelegraph (Coinbase), Bitcoinexchangeguide (USDCCirculation), Centre, Medium (Bitfinexed), Bloomberg (Tether), Coindesk (Tether Bank Statement), Investopedia (Sweep account), ICI (Money Market Funds), Bitcoin Volatility 

INVESTMENTS: New York on Crypto Exchanges, Robinhood and the Ethics of Trading

The Attorney General of the New York State just released a report on the integrity, traditionally speaking, of the crypto asset markets. The exchanges surveyed included Bitfinex, bitFlyer, Bittrex, Coinbase, Gemini, HBUS, itBit, Poloniex and Tidex. Notable, it excluded Binance, Huobi, and Kraken who refused to participate -- as well as another 100+ crypto exchanges that operate globally but steer clear of New York. Kraken is known for having rebuked the questionnaire from the Attorney General as overbearing and disrespectful, and at first glance we had agreed that perhaps it was overreach. But after reading through the report, we changed our mind entirely. It has great information and provides transparency around best practices, or lack thereof, helping investors focus on the right concerns and conflicts of interests.

Let's snooze the questions about KYC/AML, poor security or service, and instead focus on conflicts of interest. Unlike in traditional online brokers, crypto exchanges are both a venue connecting parties, broker/dealers that represent trades as agents, proprietary traders for their own accounts, large owners of the underlying traded assets, and also issuers of their own tokens. Why do we care about conflicts of interests like this? Because misalignment leads to rent seeking, corruption and manipulation. Think about the separation between equity research and investment banking that came about after the DotCom collapse (e.g., Henry Blodget). Or something simpler, like an exchange giving better pricing to large institutional traders that can trade ahead of retail sentiment.  Or worse, an exchange using its own large capital to trade, creating the impression of volume or price movement. We care about things like this because the retail investor is literally having value transferred out of their pocket into that of an arbitrage robot, unknown and unpoliced so far.

Let's now take a 90 degree turn into Robinhood, the free trading app with millions of Millennial customers eyeing an IPO in the billions. A recent take down article on Zerohedge walked through the start-up's business model. How can you give away something that has hard marginal costs, other than burning venture money? Freemium and selling your customers. On the freemium side, Robinhood does have the margin offering and can earn interest on cash sweep. But on the latter, it certainly does get paid for the activities of its customers in the aggregate. How? By directing order flow (i.e., those millions of little trades for AAPL) to quant trading firms like Citadel (70%) and Two-Sigma (16%). In turn, those firms can use the retail sentiment to make directional bets, or to mask large block trades without moving the market, or perhaps to find another pricing advantage. Robinhood users don't see the costs, but they could be in the execution -- though we note that Robinhood has released a statement re-affirming they deliver best execution. Tense!


Source: New York State (report), Zerohedge (Robinhood), Medium (Robinhood privacy arbitrage), Robinhood (statement on orders)

REGULATION: Why Coinbase would want an OCC bank license


What do you do if you business prints $1 billion per year (Coinbase) or $200 million per quarter (Binance), but people in suits still think what you do is at best a bubble and at worst a scam? Sure, you can hop from jurisdiction to jurisdiction trying to find a friendly regulator. Or, you can try to play by the existing rules and pay for the compliance overhang. While many Fintech companies complain about how expensive and time consuming licensing is (looking at you digital lenders and neobanks), crypto exchanges can afford it. Especially crypto exchanges that want to build out a custody business and make a spread on customer funds.

The WSJ reported that Coinbase approached the OCC earlier in 2018 about a banking license. This should not be a surprise, but a natural institutionalization of the crypto sector. Unlike Fintech, which still struggles to persuade customers that they need financial products over the web, crypto is actually something that consumers want. In an age where Millennials are saddled with record generational debt, everyone wants to buy lottery tickets. And if you accumulate a large enough consumer base, building from crypto to payments, from payments to deposits, and from deposits to financial advice is a natural path. We've written before about the links between regulatory custody and legitimacy -- and symptoms like Nomura partnering with Ledger to offer this, given the popularity of the asset class in Japan, prove the point.

Unlike Coinbase, which may cash in its chips into the traditional financial system, exchanges like Binance and Huobi have gone the other direction by pursuing token offerings to the crowd. For an upcoming analysis, we looked deeper into Huobi and again come away with a raised eyebrow. The token is a discount coupon on future trading fees, with a vague promise attached to exclusive access and events, and a promise to link to airdrops. It trades into other crypto currencies on the, you guessed it, Huobi exchange, which means that belief in its value can be monetized immediately. And there's now about $250 million of this belief, according to Coinmarketcap. That reflects very short-term thinking in our view, but such financial engineering isn't unique to crypto. Last we remember, JP Morgan and Goldman were called out for "laddering", i.e., manipulating the price trajectory of Initial Public Offerings during the tech bubble. Now laddering is built into software and promoted by bots. History rhymes!

Source: WSJ ( Coinbase ,  Laddering ), Cointelegraph ( Nomura custody ), Coindesk ( Huobi ), American Banker ( graphic ), Harvard Law School ( laddering )

Source: WSJ (CoinbaseLaddering), Cointelegraph (Nomura custody), Coindesk (Huobi), American Banker (graphic), Harvard Law School (laddering)

CRYPTO: $34 Million for Hacked Exchange

Source: Coincheck

Source: Coincheck

Bloomberg picked up our note last week about how crypto exchanges are taking sky-high fees to list tokens and altcoins. Looks like the traditional finance world is noticing too. First, the Gibraltar Stock Exchange has a platform called the Gibraltar Blockchain Exchange (that’s why some many startups were jurisdiction-shopping Gibraltar!) that has a standardized ICO process with disclosure and vesting baked in. For a more open version, see Messari. There are multiple efforts from the capital markets as well as legal community to create such standards, but so far nothing has stuck. Some ICOs still just list on a website, others go through a SAFT, and yet others are shopped around by investment banks. Perhaps a defined path to liquidity can motivate some best practice.

Second, TMX, the operator of the Toronto Stock Exchange is working with Paycase Financial to launch a Bitcoin and Ethereum trading desk. This will be a regulated broker/dealer under Canadian regulations, launched in the second half of 2018, and (we expect) would offer a more direct ownership structure of the underlying asset than the CBOE/CME futures product. Reminds us of Exante in Europe. Maybe with this in place, someone can finally build at ETF? Further, the Canadian ecosystem seems to be quite forward thinking in its approach to blockchain. Though last year’s bungled attempt by the Tapscotts (due to misrepresentation) to launch a public vehicle holding $100 million for crypto investingdid take a toll on reputation.

And third, Monex Group (not the American Monex) is cutting a $34 million check to buy Coincheck. Yes, that Coincheck -- the one that lost $500 million of NEM tokens earlier this year. While this is a far cry from the Poloniex acquisition, it’s still real capital from a publicly traded financial institution. Maybe the largest financial institutions are not impressed with the tech behind crypto exchanges given limited speed, scale, and liquidity, but we think the revenues are too tempting to pass up for the middle market. It’s a land-grab, and the risk-takers will get there first.

CRYPTO: Token and Coin Exchange Listing Fees

Source:  Nasdaq

Source: Nasdaq

We’ve done some sleuthing on the crypto rumor mill, from Telegram groups to whispered numbers between entrepreneurs. It sounds like the market price to list a crypto token on an exchange is $1 million for a reasonably regarded token, to $3 million for an opportunity to get quick liquidity. We don’t know these numbers with certainty, but suspect the order of magnitude to be roughly in line with today’s reality. In comparison, according to Autonomous partner Vincent Hung, listing fees on traditional equity exchanges are about $125-300k, with annual fees of $100-500k to remain listed. And that is for fully registered securities that have gone through an IPO process and are likely generating meaningful cash flow via operating businesses.

This implies an odd mechanic in today’s long tail of the crypto markets. First, you sell non-dilutive digital assets that are in many ways just free funding. You owe nothing to your utility token buyers by law, no more than a Kickstarter campaign doing its best to deliver a product. Only Internet reputation reigns here. Second, you overfund the project by a factor of 5-10x relative to early stage Fintech. While many Bitcoin maximalists may have a philosophical preference for crypto gold, tech companies, for better or worse are still embedded in fiat economies. ICO fund-raisings come with an illiquidity premium (can’t find a bank), a block conversion premium (good luck selling your $5mm of ETH for USD), and a regulatory premium (hope your jurisdiction is permissive), among other handicaps. We think these will dissolve over time, but are definitional to the space currently.

And third, ICO projects are now expected by buyers to get liquidity on the crypto exchanges. There is a natural rank order for these exchanges — sometimes a token will need to be listed on a small unknown one before making it up the food chain to an exchange with bigger volume. Fiat off/on ramps are king. These listings are seen as important and good for early supporters, even though it does lead to immediate selling action of tokens representing projects that likely have no production software. Thus the $1mm fee on the backend to the exchange, since ICOs have that buffer built into the raise amount. And on the front-end, ICOs pay out 5% to advisors, not unlike the 3-8% in fees that go out to investment bankers in IPOs. But ICOs also have to pay out bounties and other marketing expenses, since in large part the process is self-run. 

As a result, we see a bifurcation in the early crypto markets. On the one hand, there’s a known path to liquidity straight from idea that we’ve just described here. It costs “other people’s money” to startups, so they are incentivized to do it, but it is in many ways expensive, and benefits the Wild West of crypto capital markets infrastructure providers. On the other hand, well connected teams with traction or reputation can skip ICO entirely and go the private sale route. See Telegram, raising now over $1.7b, and perhaps even outraising the endless $1b+ EOS public token sale. We have such complexity in traditional equity markets, so it should be no surprise an analog is developing in crypto.

CRYPTO: Institutional Trading & Custody vs Binance

Source:  Coinhills

Source: Coinhills

Autonomous hosted 3 panel sessions with experts from the crypto world in London last week (Alex Baitlin of Trustology, Kevin Beardsley of B2C2, David Siegel of Pillar ProjectJohn Pfeffer, and Alexander Shelkovnikov of Semantic Ventures). We talked about the development of infrastructure surrounding crypto, the institutionalization of ICOs, and approaches to valuation. Two key developments are needed for traditional finance and the crypto economy to meet -- and get us out of a place where the only tradeable product is a derivative settled in cash.

First, custody of traditional financial instruments is not the same as the custody of crypto - controlling someone's key to access a digital asset is fundamentally different from keeping books and records of stock ownership. Hot wallets (online storage) expose your private key to hacking, and cold wallets (printed note) expose it to the elements (weather, xrays etc.) where the wallet is based. Multisig solutions, where 2 or more sets of keys are required to sign transactions -- one owned by you and one by the service which operates the custody -- are an effective means to ensure custody security but are hard to operationalize. A crypto-custody smart account may match private banks on bespoke features when built. But it could take the large custodians (BNY Mellon, State Street) several years to get through a budget cycle, get a product planned, and put software in place. While this happens, firms like BitGo and Xapo have an open field.

Source:  Coinhills ,  Xapo Custody

The second layer that's needed for capital markets is effective institutional exchanges. Today's exchanges are lightly regulated, have no best-execution requirement, have widely different liquidity, and offer different prices. OTC brokers like B2C2 and Genesis have been building out software and capital solutions in the space, but we are still early. Decentralized exchanges, like Republic Protocol raising $34MM, are a potential solution in the future, but that infrastructure is not here yet either. A good example of the current state of play is Binance, which is getting chased out of Japan by regulators, and is now headed to Malta.

Binance has grown incredibly quickly (rumored to be running at an MRR of $10-100 million) to be one of the top retail crypto exchanges world-wide for several reasons. First is the rush into altcoins out of the large cap cryptocurrencies -- with retail investors chasing 100x returns, while the beta of the crypto space drags everything else down. You can imagine regulators being least comfortable with these types of assets. Second, Binance has a referral program that rewards people in a percentage of commissions from anyone they refer into the exchange. By paying users commissions on referred trading, they are essentially turning all their clients into unlicensed brokers of potential securities

And last, the Binance Coin ICO tokenized a coupon token that discounts trading on the Binance platform, a token with a market cap all-time-high of $2 billion. The company also promised buy-backs (burning) in order to influence the price. Mature companies do plenty of financial engineering through share buy-backs, but it is a highly sensitive and regulated area of the capital markets to avoid market manipulation and insider trading. So it feels like we are still 6-18 months away from an institutional chassis. The question is -- does that matter, and for whom?