Catching the Blockchain Giants

By Shelly Hod Moyal

In light of the recent developments and volatility within cryptocurrency, several of our investors have approached us to hear our thoughts on the industry, wondering if and how they can profit from it. 

The release of new SEC regulations, the forking of Bitcoin and the subsequent crypto rally, all support our original investment hypothesis: this is a nascent industry with a lot of potential that’s still working through the earliest stages of development, moving slowly but gradually towards the mainstream. What we also know is that with cryptocurrencies comes volatility, and one should continuously keep a keen eye on tracking and interpreting every stage of its evolution.

And we have been doing just that, watching cryptocurrencies and blockchain startups intently over the past few years, identifying how they are progressing and stumbling through the adoption curve.

By way of background, in 2009 cryptographer, Satoshi Nakamoto published a white paper outlining the structure of a decentralized system for storing value and managing ownership. It laid the foundations for a shared, incorruptible, digital ledger that allows people to exchange value in real-time and for free. Since then, many exciting things have happened. Bitcoin has become a digital currency, being traded at a volume of $1bn a day and representing a market value of $56bn. Several protocols and innovations around blockchain (the technology enabling the cryptocurrency) have been created, notably the ability to add self-enforcing “Smart Contracts” to the blockchain, an effort pioneered by Ethereum, which has opened the door to “Dapps” (Decentralized Applications), allowing developers to easily create decentralized apps on the blockchain.

Close to 1000+ cryptocurrencies have emerged from these innovations and through next generation crowdfunding in the form of Initial Coin Offerings (ICOs), these issuances distribute the value of the decentralized company among their users and supporters, rather than equity-holders. But more importantly, these currencies allow for the creation of digital assets through tokenization with the promise of allowing exchange of value in the digital realm. While all this sounds exciting, we are still at the very early stages and despite all this infrastructure and innovation, no Dapp has yet been developed to become a real game changer as significant as the likes of Amazon, Apple, Google, Facebook or Netflix. You can track the state of the Dapps here.

Below is a quick overview of the last year:

DAO Hack – In May 2016, the ICO of the DAO took place. The decentralized venture capital fund designed to invest in projects based on Ethereum, held a lot of promise and attracted ~$150m in funds from more than 11,000 investors. In June 2016, taking advantage of a flaw in its smart contract system, $60m worth of investor money was stolen from participants in the ICO. The hack shook the already feeble trust in the cryptocurrency system. Members of the Ethereum community debated what to do and eventually the community decided to hard fork the blockchain by resetting the DAO transaction, restoring funds to investors. This caused Ethereum to break into two cryptocurrencies – Ethereum and Ethereum Classic. In some ways, the DAO ICO hack was a good thing. The crisis allowed the Ethereum Foundation to prove its integrity and gain the trust of more people. The DAO hack also prompted the SEC to begin their investigation into how cryptocurrencies should be classified and regulated. Many worried that the SEC would heavily restrict or eliminate ICOs altogether and hinder the growth of this sector.

The Ethereum Enterprise Alliance – Still, the ecosystem has continued to develop. In March 2017, the EEA (The Ethereum Enterprise Alliance) formed with founding members J.P. Morgan, BP, Intel, Microsoft, Accenture and Wipro, to explore Ethereum’s potential. This diverse set of partners evidenced the far reaching applicability of cryptocurrency technology. So far 150 members, including Samsung, Toyota, and the Indian government, have been drawn in. Since the EEA’s formation, Ethereum has appreciated 15x (1,500%) from a price of $20 to $300 as of August 10, 2017.

ICO Hype – Moving from strength to strength, the crypto market cap surpassed $100bn in May 2017 and over $1.2bn has been raised for ICOs to date. In order to fund their ventures, crypto projects funded through ICOs convert some of their cryptocurrencies into fiat currencies. This mass conversion together with vast speculation of people trying to make fast cash “pumping and dumping”, not surprisingly, causes huge market volatility. As in other cases, cryptocurrencies’ enormous potential is constantly matched with reminders of its current instability:

  • Large investors can move the market – In June, someone sold $30m worth of Ether, accidently causing the Ethereum price to tank from $320 to 10 cents for a couple of minutes and then fully recovered, thereby highlighting the vulnerability of the market.
  • Fake news – Distribution of fake or old news articles circulated to manipulate market prices. A famous example is the rumor that Ethereum’s Founder, Vitalik Buterin, had died.
  • Hacks – Several hacks on ICOs. For example, last month Veritaseum, one of the most valuable cryptocurrencies had $8.4m worth of tokens stolen during its ICO. Thankfully, the tokens did not belong to investors but Veritaseum itself.
  • Scalability issues – The combined ICOs of high-profile blockchain startups, Status and Bancor in June 2017, totaled over $200m, overloading the Ethereum network and demonstrating another shortcoming of the protocol in its current form – lack of scalability.

The SEC Ruling on DAO – Last month the SEC ruled that the DAO tokens would have been rendered securities which would have required them to adhere to the SEC’s regulations. In its announcement, the SEC referred to the SEC vs. Howey case that specified 3 factors to determine if an investment contract is a type of security:

  • The investment includes an investment of money
  • The investment is in a common enterprise
  • There is an expectation of profits predominantly from the efforts of others

While we don’t expect this ruling to be the last time we hear from the SEC, the fact that it did not ban ICOs, implicitly (and paradoxically) has actually legitimized them. For companies, clearer regulator guidelines make the path to an ICO easier to understand and much easier to pursue. And the more clarity companies get from regulatory agencies, the easier they can make strategic choices. Of course, the SEC’s regulations do mean new hurdles and red tape but based on the latest ruling, it seems more like a speed bump rather than a roadblock.

Bitcoin Split – The scalability issues briefly discussed above have been a topic debated for a couple of years already and it is clear that if a solution is not found, it will limit the potential of the blockchain industry. Accordingly, there has been an industry wide discussion over the best way to increase Bitcoin transaction performance and future-proofing Bitcoin. The community proposed 3 solutions which miners were to choose from. This whole reassessment of which future pathway to take, resulted in Bitcoin’s split in August 2017, after one of the largest miners, decided to fork independently by increasing the block size (one of the 3 solutions proposed) and see if other miners would follow suit. The market for BCH, this new currency, has been volatile and it’s unclear as to whether the new coin will be adopted. But despite the Bitcoin split and its relatively unknown outlook, the currency soared in value this week, setting itself, yet again a new record high and a combined crypto market cap of over $120bn.

Casper The Ethereum community is also working on a solution to the scalability issues of the blockchain protocol and the “ecological waste” caused using the “proof of work” consensus algorithm (currently used both by Bitcoin and Ethereum). In “proof of work”, miners are rewarded for expending the most energy to complete difficult computations. Ethereum is now developing Casper, a “proof of stake” mechanism to replace “proof of work.” In “proof of stake”, instead of verifying miners legitimacy by forcing them to expend energy, the algorithm weeds out malicious minors by forcing them to put down a deposit, or a “stake” in the system. In the next couple of months we look forward to seeing how the market and community react to this transition.

Our interest in and tracking of the cryptocurrency space has been ongoing for several years and the events of the past year certainly signal to us that the ecosystem is slowly maturing with new regulations and increasing participation priming it for more mainstream adoption.

But it’s still important to be aware that despite the endorsement of central banks, S&P 500 corporations and hundreds of trusted tech icons, Blockchain still has a way to go in terms of its evolution and ability to create significant value, first and foremost by creating a real ecosystem of Dapps that actually adds value to our lives beyond speculation.

For our investors wanting to take part in the excitement around blockchain and are willing to take the risk, we recommend creating a diversified portfolio which is most heavily weighted in the established coins (like Bitcoin and Ethereum). We believe these coins still have significant potential upside were this industry to take off (imagine investing in Apple before the iPhone) and a much smaller allocation in select emerging coins.

Just like in the “traditional startup world”, we believe that 95% of coins will lose 95% of their value but those that will stay can be 10-100 times the value they are today. So, similar to what we do when we analyze traditional startups, when investing in cryptocurrencies, we try to identify those strong commercial teams that stand a chance of creating value and have the ability to carve a path through the minefield of overhyped competitors. 

We believe that the restructuring of the internet and evolution of Blockchain is promising, bringing with it real potential for investors. One should tread cautiously, but with careful analysis and a continuous eye to this ever evolving market, the startups that we invest in today could become the Blockchain giants of 2025.