WARREN BUFFET SAYS "Only when the tide goes out do you discover who's been swimming naked."

Blockchain Coinvestors: Letter from London

Vol. 1, No. 1, July 2022

WARREN BUFFET SAYS"Only when the tide goes out do you discover who's been swimming naked."

At Blockchain Coinvestors we provide insights and educational resources to our investor community through our regular newsletters, webinars and other publications. This week we are launching a monthly Letter from London that will provide a UK and European view of the current headlines in blockchain and crypto. Our Blockchain Coinvestors partner in London - Mitch Mechigian - will hold the pen and for this inaugural edition, the focus is on the emerging Crypto Mini Financial Crisis.

 

Before launching into the substance of this inaugural newsletter, we want to reiterate comments we have made in prior newsletters about the public market crisis we are living through including in crypto.

Our summary is as follows:

  • Dangerous Times. To add to the dangers of COVID, Inflation, Russia/Ukraine, and a Crypto Blizzard, we now have to add the collapse of a Korean based protocol Terra/Luna and the Singapore based hedge fund Three Arrows Capital with the knock-on impacts on their respective counterparties such as Babel, BlockFi, Celsius, and Voyager among others.

  • Impact on Investment Thesis. We see no reason to change our investment thesis - digital monies, commodities and assets remain inevitable.

  • Impact on Investment Strategy. We see no reason to change our investment strategy of focusing on early and mid stage blockchain venture opportunities - equity and tokens.

  • Conversely, our Investment Strategy has never included public liquid market trading in cryptoassets:

    • We are not traders

    • We do not focus on public liquid cryptoassets

    • We do not invest in crypto hedge funds as a core strategy

    • We do not use leverage

    • We have never participated in staking, yield management or other new and unproven strategies, and we believe that no one should until counterparty risk is well understood

    • The core of the current crypto crisis is that big bets were made by traders who did not understand the counterparty risks they were taking onboard

  • Impact on Fund Performance. Our evaluation will not be completed until we see the next quarterly reports from our fund managers, but we can say today:

    • Blockchain Coinvestors has no direct exposure to the Terra/Luna protocol or the tokens it has issued and we were not investors in Three Arrows Capital

    • Within our family of fund of funds we see 3 out of 45 funds that have more than minor direct exposure so the overall impact given our massive diversification should be slight

    • At the same time, indirect impacts on our funds and their portfolio companies and projects will take time to feed through. We have already seen some indirect impacts such as the markdown in value of BlockFi which is now in a sales process to FTX.

  • Recognize the Opportunity. The analytical evidence says that venture capitalists outperform following a downturn and the best strategy is to heavy up by investing into the downturn.

  • Stick to Best Practices of Venture Investing. We always stick to the best practices of venture investing; we don't plan to change this disciplined approach in any way as the rest of 2022 unfolds.

Bottom Line. We are excited to have capital to deploy, and plan to do so as we get greater clarity on where the best blockchain investors are placing their next round of bets. We believe the timing for investing into early stage blockchain companies and projects is ideal. 

 

We have recently recorded a webinar called Recognize the Opportunity that recaps how well positioned our funds are in this context.

With this said, on to the first Blockchain Coinvestors Letter from London.

 

Crypto’s Mini Financial Crisis

 

While we are not traders and we do not focus on investing in public liquid crypto assets, we can’t help but have our own point of view about the remarkable, and concerning, state of affairs in the global public markets including in Crypto. While they don’t change our investment thesis, strategy or plan, they do give us cause for concern and in this month’s Letter from London we outline why.

 

The crypto industry is deleveraging in a very painful way. In the past month, we’ve seen Terra-Luna collapse, Celsius and Babel pause withdrawals, and we know that Genesis, Voyager Digital, and BlockFi all face a dire liquidity situation, having taken big losses on loans. Of course, at the center of this contagion, sits Three Arrows Capital (3AC), a firm which will likely go down as the crypto industry’s Long Term Capital Management, and whose fall not only threatens significant financial instability in the industry, but strikes a psychological blow to many crypto natives and industry insiders, who for a long time, viewed its principals – Zhu Su and Kyle Davies – as thought leaders in the space.

 

While we don’t know when the deleveraging and pain will stop, nor whether outright fraud was committed, we do know now that many in the industry, including well-seasoned investors and traders, failed to see the connection and correlation between assets in the space. It’s a great time for everyone to step back and reflect on whether areas of diligence and concern were overlooked, in particular the counterparty risk of high yield products.

 

What we are seeing is, in effect, a mini-financial crisis inside of the crypto industry, concentrating now on the centralized lenders, but having rippling effects throughout the ecosystem. Unlike in a financial crisis like 2008/9, there is no lender of last resort, nor a government backing of customers’ deposits in these institutions. Of course, ‘when there’s blood on the streets, buy real estate’ as the saying goes, and the current market presents a compelling opportunity for both investors and well capitalized firms alike (more on that below).

 

There’s No Free Lunch Yield

 

While the contagion continues to spread, and we won’t know the full story for some time, it seems clear that a, if not the, central problem was high yield products offered by centralized lenders, which were presented to consumers as ‘low risk’. In practice, these centralized shadow banks achieved these lofty yield targets – often as high as 18%+ – via risky strategies, unsecured lending, and of course, high leverage. It seems that neither consumers, nor the long list of reputable investors backing these companies, understood the degree to which deposits were funneled to risky strategies. In effect, they did not have a clear view of counterparty risk which is a fundamental requirement for any trading or lending activities.

 

So how did this wind and unwind occur? Below we provide a simple mental model for understanding how the system wound and then unwound.

 

Note, this isn’t the whole story, but rather tries to show one way in which the system leveraged and then deleveraged. There’s plenty more to be written on the topic of 3AC’s GBTC exposure for example.

 

The Wind: Number go up!

  1. Celsius, BlockFi and other centralized lenders offered high yields to customers in exchange for deposits of their crypto

  2. To obtain the high yield, two principal strategies seemed to have been used: leveraged DeFi strategies and large loans to hedge funds, namely 3AC, which were also levered into risky trades

  3. For instance, we now know Celsius had exposure to a leveraged trade in stETH, which is staked ETH that earns yield and will be redeemable for ETH after the merge

    1. Aside: this is classic risky lending strategy where you have a liquidity mismatch, e.g. you have short term liabilities (borrowing from consumers today) but long term assets (stETH converts to ETH at some undefined point in the future)

  4. Celsius took it’s stETH, and bridged it to the Terra-Luna ecosystem, where it could get even higher returns via it’s Anchor lending platform

  5. We also know Genesis, Voyager, BlockFi and other lenders offered hundreds in millions in loans to 3AC

    1. Aside 2: some are suggesting that 3AC may have used the same collateral in each situation to secure the loans and there are also reports some of these loans were unsecured

  6. Thanks to on-chain forensics, we know that 3AC then took leveraged positions in Terra-Luna and stETH

  7. As long as prices kept rising, the yield was flowing, and customer deposits were pouring in, the trade could be wound and wound as leverage in the system kept increasing

  8. Celsius valuation reached as high as $10bn and 3AC reportedly had as much as $10bn in AUM

The Unwind: If I owe you $100, I have a problem. If I owe you $100 million, you have a problem

  1. May 7–16: a general drawdown in crypto prices caused the Terra-Luna ecosystem to collapse, with its algorithmic stablecoin UST falling from its $1.00 peg to just a few cents

  2. With much stETH bridged to Terra-Luna, a liquidity crunch occurred as investors raced to get their stETH back to the main Ethereum chain, causing major selling pressure on stETH

  3. The price between stETH fell relative to ETH, hitherto 1:1, lowering the value of the collateral used by Celsius and 3AC (something they clearly had not foreseen)

  4. With collateral value falling, those in a leveraged trade were forced to unwind; we know that Celsius and 3AC became involuntary sellers, and took major losses

  5. Fear and contagion spread as lenders started calling back their loans from 3AC or liquidating the collateral they did have

  6. 3AC, with large positions in long term illiquid positions, failed as it was unable to cover its margin calls

  7. Now the contagion really spread, as major lenders realized their loans to 3AC were completely at risk

  8. By mid-June, Celsius, Babel, Voyager, and Coinflex all had either paused or eliminated the ability for consumers to withdraw their deposits, in an effort to stave off a full scale bank-run (for what it’s worth, BlockFi only removed free withdrawals)

While there is a lot going on here, the most important takeaway for us is that an emerging area of finance that is unlocking enormous benefits of lower costs, higher speeds and greater accessibility, was scaled up before it was fully understood. As with all new innovations, it takes time to appreciate all of the benefits and risks and in the case of public liquid crypto borrowing, lending, staking and yield farming, the risks, dynamics and potential vulnerabilities and points of failure were simply not fully understood.

 

A Silver Lining for DeFi

 

At Blockchain Coinvestors we label firms like Celsius and BlockFi as centralized, and that’s purposeful. If there’s anything positive to take away from this deleveraging event it is that DeFi – or decentralized finance – as a separate sector has withstood the market drawdown and deleveraging. That’s mainly to do with the fact that loans in DeFi are for the most part overcollateralized, and the smart contracts which govern the protocols are open source and transparent, and thus can be audited by counterparties for bugs or risky schemes.

 

The sector is not completely unscathed, and has seen a drawdown of value locked in the system from about $250bn to about $80bn. But importantly, ‘blue-chip’ protocols such as Aave and Compound are working just fine as always, and consumers’ deposits are secure.

 

The DeFi protocols have done a better job than their centralized counterparts.

 

What Now? The View from London

 

Here in London, the view is that there will be benefits from this crisis, as well as some inevitable consequences:

 

1.  New Opportunities for Investors

 

Well capitalized companies and investors with dry powder maybe able to benefit from this crisis as valuations fall and distressed opportunities surface. We have already seen a flurry of M&A activity – FTX is reportedly purchasing BlockFi for up to $240m. Yes, that’s $240m for a firm that just two months ago was closing a round at $1bn and was previously worth over $4bn. Goldman Sachs is rumored to be arranging a group of investors to purchase Celsius’ assets.

 

For our part, we’ve seen valuations in the private markets fall already, which allows blockchain venture capital firms like those we invest in through our fund of funds, as well as our own early stage token and mid stage growth funds, to invest at lower valuations.

 

2.  More Interest in DeFi

 

Of course, the fall of centralized lenders is almost an advertisement for DeFi – an open, transparent and overcollateralized parallel financial system. We’ve seen no bank-run style collapses and customer deposits have been protected. While the popular press may confuse centralized institutions with decentralized protocols, we encourage our readers to take the time to understand the differences since they are simply not the same at all.

 

3.  Better appreciation for the advantages of self-custody

 

The failure of centralized custodians also should put a positive spotlight on the benefits and advantages of self-custody. We’ve seen European and US regulators alike take aim at pejoratively labelled ‘unhosted’ wallets. Self-hosted wallets allow users to directly store their cryptocurrencies with private keys and interact with the DeFi system directly. While certainly not everyone will choose to go down this path, it seems more important than ever that the option should exist. Said differently, with no potential for self-custody, consumers would be forced to choose from a list of centralized custodians, and effectively take large counterparty risk in so doing.

 

4.  A New Round of Regulation

 

Finally, we think some modest regulation could be beneficial with regards to centralized lenders. In the US, the SEC already determined BlockFi’s lending product should be a registered security and similar questions were being asked of Celsius. Here in London and in Europe the view is that investor protection issues, with particular regards to the marketing of certain products, should be addressed. The view is that regulation will be good for the public liquid crypto markets by providing clarity to companies, addressing bad actors, and giving consumers some level of protection.

 

Expect to hear more on this from the regulators in London, Zurich, Frankfurt, and other European financial centers.

 

Is That All?

 

We’re in the middle of the unwind, and there may indeed be another shoe to drop before this is all over. The good news is that much of the excess leverage in the system has been washed out and the unwind doesn’t seem like it will spread to broader financial markets. We’re cautiously optimistic the worst of the pain of crypto’s mini financial crisis is behind us.

 

Here at Blockchain Coinvestors, our thesis that all of the world’s monies, commodities, assets and commerce are digitalizing remains constant, as is our belief that blockchain is the technology that will underpin this transformation. There are many incredible founders and builders in the space bringing to market powerful use cases including digital payments and remittances, digitized assets, DeFi, NFTs, and GameFi to mention a few.

 

We can learn from this period and take away lessons, while taking advantage of the new paradigm.

Thank you for reading.

Mitch Mechigian

 

Partner, Blockchain Coinvestors, London

 

ABOUT BLOCKCHAIN COINVESTORS

 

Launched in 2014, our goal is to provide broad coverage of the emerging unicorns and fastest growth blockchain companies and crypto projects. The strategy is now in its 9th year and has to date invested in more than 40 pure play blockchain venture funds in the Americas, Asia and Europe; and in a combined portfolio of 400+ blockchain and crypto projects including approximately 60% of all blockchain unicorns. Our funds rank in the top decile amongst all funds in their respective categories on both Pitchbook and Preqin. Headquartered in San Francisco with a presence in Grand Cayman, London, New York, Zug and Zurich, the alternative investment management firm was co-founded by Alison Davis and Matthew Le Merle.

 

FUND PERFORMANCE

 

Blockchain Coinvestors Fund III (Fund of Funds) was created to provide diverse coverage of the best blockchain pure play venture funds in the Americas, Asia, and Europe. Blockchain Coinvestors Funds I and II have already experienced significant appreciation. Fund I Net TVPI is 4.72x with an IRR of 72%. Fund II shows equally impressive early results with Net TVPI of 2.08x and an IRR of 146%. Almost all of our fund investments are performing as top quartile against the Cambridge Associates Venture Benchmark.

 

BLOCKCHAIN COINVESTORS FUNDS

Blockchain Coinvestors’ goals are to provide broad coverage of the emerging unicorns and fastest growth blockchain companies and to capture superior returns from investing in the leading blockchain venture partnerships. Our funds are open to investors that meet the Qualified Client definition with a minimum subscription level of $250,000 at the discretion of the Manager. 

 

  • Blockchain Coinvestors Fund III (Fund of Funds) was created to provide diverse coverage of the best blockchain pure play venture funds in the Americas, Asia, and Europe. Blockchain Coinvestors Funds I and II have already experienced significant appreciation. Fund I Net TVPI is 3.64x with an IRR of 69%. Fund II shows equally impressive early results with Net TVPI of 1.72x and an IRR of 161%. Almost all of our fund investments are performing as top quartile against the Cambridge Associates Venture Benchmark.

  • Blockchain Coinvestors Fund IV (Early Stage Token) provides direct access to promising private stage token projects accessing our relationships with many of the world’s leading blockchain investors. We leverage asymmetrical information from our 40+ VC Funds to pick the most attractive opportunities. This is a continuation of the direct token investing strategy of the Fund Manager that has included private stage investments in Acala, Filecoin, NEAR, Polkadot, Structure, and others.

  • Blockchain Coinvestors VI (Mid Stage Growth) provides direct exposure to the emerging category leaders in the blockchain and crypto ecosystem. The fund leverages our unique sustainable competitive advantage (USCA) in blockchain, web3, and fintech to create a concentrated portfolio of between 20 and 30 investments with attractive return profiles and visible paths to liquidity. The fund assesses the more than 400 blockchain and crypto projects in which we are direct and indirect investors and employs a robust investment framework to select investment opportunities into the leading mid stage growth rounds - typically Series B, C and D. This is a continuation of the mid stage investing strategy of the Fund Manager that has included investments in Bitwise, Brex, InfiniteWorld, Securitize, Uphold, Wyre, and others.

Please visit the Blockchain Coinvestors website to learn more about our offerings. You can also reach our Investor Relations team directly at ir@blockchaincoinvestors.com.

 

BLOCKCHAIN COINVESTORS SWISS

We are excited to announce that Blockchain Coinvestors Funds are now available through Swiss certificates for those of our non-US investors who prefer this approach. The underlying fund is the same, however, our Zurich based team at Blockchain Coinvestors Swiss, who will introduce in future weeks, can provide detailed information regarding this investment option. Email us at mlemerle@blockchaincoinvestors.com to learn more.

 

BLOCKCHAIN COINVESTORS ANGELLIST SYNDICATE

Continuing the theme of the democratization of investing, we have a rapidly growing Blockchain Coinvestors syndicate on AngelList providing access to selected coinvestments. Please join us and our partner Lou Kerner on AngelList.

 

Click here to receive the insightful weekly crypto newsletter and webinar invitations from our Blockchain Coinvestors partner Lou Kerner.

 

REGISTER NOW FOR UPCOMING WEBINARS AND CALLS

 

Our investment team hosts regular webinars and calls to help educate our community about the Fifth Era, fintech, blockchain and crypto. We discuss important trends, tailwinds and investment themes including what we have learned and how we are using our knowledge to inform our own investment thesis and actions. Below is a list of upcoming webinars for which you can register by clicking the links:

 

Options for Investing in Blockchain & Crypto
- July 25th, 7:00am PT
- July 25th, 12:00pm PT

 

Investing in Early Stage Tokens

- August 8th, 7:00am PT
- August 8th, 12:00pm PT

 

AMA with Blockchain Coinvestors

- August 22nd, 7:00am PT
- August 22nd, 12:00pm PT

 

Recordings of past webinars and calls can be found at www.blockchaincoinvestors.com/webinars.

 

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