Monday, December 11, 2017

Jim Orlando

In our last blog, we talked about the state of Canadian affairs in the fintech universe, and touched on various bitcoin and blockchain items. Today we will elaborate more on blockchain-related developments. And if this topic really interests you, check out the review session we are hosting on December 18.

Digital currency prices have surged throughout 2017, with the bitcoin price leading the way at 13X this year. This has sparked both boom and bubble predictions, similar to those during the early internet era. Like with that earlier "largest legal creation of new wealth in the history of the planet," new entrants are waking up to digital currency as a viable emerging asset class and with that the short-term will bring a rollercoaster of ups and downs. But our long-term view on bitcoin and blockchain technology and related startups remains bullish. Given the amount of capital and brain-power being applied to the sector, some long-term "Amazon" or "Googles" will eventually emerge.

Canadian blockchain startups have raised CAD $120M in venture funding since 2014, representing 7% of total investment in the North American blockchain sector. It should be noted that 90% of that funding was made in Blockstream, a provider of blockchain technologies and professional services in the financial services sector. 

If Blockstream were to be removed from the equation (with Austin Hill no longer the CEO, its roots in Montreal are somewhat weakened), Canadian blockchain startups would represent less than 1% of North American funding in the sector. This is well below the 7% figure cited above and well below typical Canada/U.S. venture funding ratio. Startup formation and venture-backing in the sector is quite low.

The venture funding data does not account for $45B in market value of Ethereum, a smart contract protocol and blockchain with strong Canadian links, nor does it include the amount of Initial Coin Offering digital token capital raised by Canadian startups (more on this below).

While the number of startups using blockchain technologies continues to grow, VC funding has stabilized over the last twelve months. As 2017 comes to a close, here are some general observations for the year:

·      Canadian public markets investors are pursuing bitcoin-related stocks aggressively. Stocks of several entities active in, or even proposing to be active in, the sector have climbed aggressively. The Globe and Mail has summarized all the activity in the sector.

·      Futures and derivatives markets are opening up in the U.S. With the SEC apparently not allowing bitcoin-linked ETFs, Canadian ETFs (launched by Purpose Financial and Evolve Funds Group) could have a first mover advantage. [Disclosure: OMERS is an investor in Purpose Financial.]

·      Cross-border payments continues to be the main use case for blockchain technology. Although we could not find any Canada-specific data, several estimates put global payments/remittances using bitcoin as approaching a $1 billion run-rate.

·      Global cryptocurrency trading volumes continue to accelerate and grow in diversity, in terms of geography, exchanges and currencies. Global volume exceeded 500,000 daily transactions in 2017.

·      Transaction fees hit an all-time high in 2017, as block size limit is consistently reached. Scalability continues to be a significant challenge for the blockchain sector. The once popular notion that bitcoin transfers between parties can be frictionless has been all but abandoned.

·      Interoperability remains an important focus. Numerous groups and protocols are now tackling connecting multiple blockchains for transaction and trading on diverse ledgers.

Bitcoin

It is hard to ignore the recent surge of bitcoin price above USD $15,000 as of this writing. This comes despite scaling challenges and increasing transaction fees for bitcoin purchases, which has resulted in a prevalent view that bitcoin is more of a store of value akin to gold. Regardless of bitcoin price volatility, we expect an increasing number of retail and institutional participants to invest in bitcoin.

From a Canadian retail investor perspective, it is difficult and expensive to participate in the bitcoin ecosystem. Canadian banks are staying away from bitcoin transactions, US based wallet services such as Coinbase have purchase restrictions, and services like Kraken force users to fund accounts using offline wire transfers. However, bitcoin purchasing barriers are easing as made-in-Canada solutions are emerging - there are several exchanges with Canadian-friendly connectivity, such as CoinSquare and QuadrigaCX. In addition, as mentioned above, a few Canadian bitcoin ETFs are expected to emerge in early 2018, thereby allowing exposure to bitcoin in a traditional brokerage account.

Ethereum

A little over four years ago, a team of bitcoin enthusiasts got together in Toronto to find a way to use the blockchain for more than just money. Vitalik Buterin and his team released Ethereum, a decentralized platform that runs smart contracts. Ethereum’s ease of development has made it the platform of choice for a new class of applications, distributed apps. Interestingly, the primary use case of Etherium has thus far been the creation of even newer cryptotokens, each of which is used for specialized functions, and in aggregate have themselves raised billions of dollars via Initial Coin Offerings (ICOs).

The first killer consumer app built on Ethereum appears to be Vancouver-based www.cryptokitties.co. CryptoKitties came onto the scene at an Ethereum hackathon in Waterloo in October. Since its formal launch in late November, these digital collectable kittens have taken the tech world by storm. Users can breed their kitties to create more new kitties for their collection, with ownership validated by the blockchain. You can trade them, sell them…or simply admire them. CryptoKitties have become so popular that almost 20% of Ethereum transactions were driven by the ecosystem in a single day, thereby stressing Ethereum’s transaction speeds.

Initial Coin Offerings

Blockchain startups are increasingly looking to participate in ICOs to fund their growth. These companies are building blockchain applications or protocols with underlying tokens with inherent network effects. Investors (including other startups) purchase these tokens to access functional utilities of the protocol or to engage in trading activities.

This new model of fundraising for startups has significant differences from the traditional venture capital route -- the main one being that ICO investors make their decisions mainly based on the token’s whitepaper and little else. There is a wide discrepancy in early-stage valuations in the traditional venture capital world versus those seen in the ICO world. You can read more related to our thoughts on the ICO trend in an earlier post. Canadian-based companies have accounted for approximately 5% of the USD $3.5 billion raised via ICOs in 2017. About half of the Canadian amount went to Kik, which raised $98M in their Kin token sale in September, and is currently one of the top 10 highest ICO raises of all time.

However, ICOs may face a slight cooling-off period in the coming months, as regulators in various markets have begun scrutinizing this method of fundraising. In late August, the Canadian Securities Administrators (CSA) issued a staff notice on cryptocurrency offerings, stating that many of the ICOs involve sales of securities and as such may be subject to Canadian securities laws. Following this announcement, Kik Interactive decided to exclude Canadian investors from their upcoming ICO, in order to steer clear of any legal issues in this country.

Other jurisdictions have made similar announcements, including in the U.S. The SEC issued a report in July mentioning that ICOs could be subject to U.S. securities laws (albeit less sharply toned than the CSA’s notice). Moreover, both China and Korea banned ICOs in September over consumer protection fears.

Regulatory uncertainty aside, we believe the underlying protocol innovation and funding model of the ICO will remain relevant in the long term. Startups such as IPFS are building core protocols which will power the distributed web of the future. Similar to the large companies that emerged out of the internet funding bubble (e.g. Amazon), there is potential for new technology giants to arise from a potential ICO bubble. Within the right regulatory framework, perhaps on purpose-built platforms such as CoinList or TokenFunder, we should see more Canadian startups raise funds through cryptotoken mechanisms.

Enterprise Blockchain

We have yet to see Canadian financial institutions embrace blockchain technology beyond proof-of-concept trials and in several instances financial institutions are rationalizing the number of proofs of concepts (POCs). Scalability, interoperability, implementation complexity and regulatory uncertainty are hindering enterprise adoption. But enterprise blockchain is not dead as permissioned enterprise blockchains are moving beyond concepts, and major platforms such as Hyperledger pick up corporate funding and integrations. Enterprise blockchain trials are not just being undertaken in the financial sector – numerous non-financial entities are trialing blockchain technologies in areas such as supply-chain management and asset tracking.

What Lies Ahead

In summary, we see exciting developments in the blockchain and cryptocurrency space that will have long term repercussions on multiple industries. With bitcoin-linked ETFs hitting the market in 2018 and consumer interest continuing to increase, it is difficult to predict a prolonged slowdown. However, a market correction appears likely.

The year 2018 will be an even more interesting for blockchain and cryptocurrencies. We expect to see:

·      lawmakers begin setting regulatory parameters around cryptocurrencies and ICOs;

·      some form of correction in the price of currencies;

·      a slowdown in number of ICOs;

·      and more focused enterprise implementations of blockchain technologies.

(This article was coauthored by my OMERS Ventures colleagues Prashant Matta and Hooman Mehranvar.)

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