Pricing Loans on Cryptocurrency Assets

The early stage of the cryptocurrency lending market has dramatically changed in the short time since the birth of the industry. These changes were driven by a combination of digital asset volatility, increased competition, an influx of financial products, and correlation to traditional market events. Investors and lenders are still struggling to find equilibrium pricing on interest rates against the backdrop of high price volatility and reduced demand during the protracted cryptocurrency bear market. Below, we review traditional loan pricing fundamentals and extrapolate what lessons can be applied to this dynamic, emerging asset class.

Loan Fundamentals Review1

Pricing

Loans are typically priced as a percentage of par value (per $1,000 in most cases). Discounts reflect percentages less than 100% and premiums reflect percentages greater than 100%. Discounts to par indicate that the buyer of the security requires some level of return when they are repaid their principal balance. For example, a buyer of a loan may pay 99% of par ($990) to get $1,000 at some point in the future when they are repaid by the borrower. This specific structure would reflect a return of 1% ($1,000 / $990 – 1) over that period. If the yield of 1% is generally attractive for this type of loan, it would be considered the yield to maturity; i.e., the expected rate of return. If the rate is too low, lenders will not underwrite the loan. If the rate is too high, competition will quickly bring prices down.

The yield to maturity (YTM) is considered the ‘discount rate’ for loans. Generally speaking, the lower the YTM, the lower the risk. The ‘risk free rate’ represents a theoretical return with zero credit risk. In the US, US Treasury rates are typically used as a proxy2. The difference in the YTM for other assets (assuming securities other than Treasuries have greater than 0 risk) above the risk-free rate is considered the credit spread (i.e., credit spread = YTM – risk free rate). 

Coupon Rate

Often confused with the YTM, the stated coupon rate is the interest income paid to the lender by the borrower. The payment can be made in multiple forms:

  • Cash – Reflected as a periodic payment paid as a percentage of the total principal value (i.e., the loan amount) to the lender. For example, an 8% coupon rate on a loan of $1,000 would reflect an $80 payment.
  • Payment-in-Kind – The payment is instead reflected as compounded interest and paid lump-sum on exit. In the example above, the $80 would equal $1,080 total balance due to the investor. These structures typically demand a premium to a cash payment structure given they are utilized by issuers with imminent cash flow needs.
  • Interest Only – Only interest is paid to the lender until the entire principal balance is paid at exit (referred to as a bullet payment).
  • Principal + Interest – Each payment to the lender includes a portion of interest and a portion of the lent capital. This reduces the burden of paying a lump-sum payment at exit. This structure is typical with real estate mortgages.
  • Variable versus Fixed – Interest rates can fluctuate (floating-rate securities are typically used to hedge inflation risk) or be paid in the form of a fixed amount. Historically, the interest rate on these loans are expressed as a rate on top of a floating instrument (e.g., LIBOR, TIPs, etc.).
  • Hybrid – Each of these instruments above may be combined for exotic instruments to fit various needs.

Origination Fees

Fees paid to the lender (or the originator of the deal, I will keep it simple for this post and assume they are the same) for work performed to consummate the deal. The funds go to pay the lender for time spent preparing documents, marketing the loan, covering expenses for legal and accounting, etc. In complex deals, the origination fees are greater.

Origination fees can be paid in multiple forms. They can be paid up front, as a portion of the notional balance (e.g., original issue discounts), or built into some exit fee (usually as a multiple of the amount).

A portion of the interest is paid to a servicer. A servicer performs administrative duties (such as recordkeeping, recording the ledger, etc.) related to the loan. More complex instruments generally require a greater fee. Larger banks may have deals where a lender teams up with a servicer and structures as a revenue-share or a JV model. 

Prepayment Penalty

A penalty imposed by the lender in case there an is voluntary early prepayment of a loan. The fees are assessed on exit; for example, a 1% prepayment fee would mean the lender would need to return 101% of the principal balance if paid before the stated maturity. Exit fees can also be assessed, where a premium or discount is reflected in the final payment. The purpose of these structures is to protect the lender against early repayments, which negatively impacts their ability to find a replacement borrower at the same (or greater) interest rate.

Credit Ratings

A financial scoring system for issuers that provide standardization for risk analysis. S&P’s rating system, for example, goes from AAA down to C. Indices can be measures for loans with the same credit rating to get an average yield. Some of these indices can be observed on the St. Louis FRED system with daily reported yields and spreads3. The ratings typically reflect the probability of issuer default, although more recent models with the advent of P2P alternative lending may reflect a greater breadth of data points (although it is questionable as to which data sets contain statistically significant data with meaningful predictive power).

The intent of credit ratings is to standardize risk and allow for comparability. Typically, both the issuer and the actual loan receive a credit rating. No blockchain-based loan (nor issuer) currently has a credit rating associated with it.

Primary versus Secondary Markets

Primary markets involve the issuance of new securities to investors. Secondary markets involve the purchase and sale of securities after the borrower has sold its shares in primary markets. Secondary markets may reflect updated prices as the YTM changes based on a company’s credit rating over time, macroeconomic changes (such as a liquidity crunch), or demand for a particular issue. Primary market dealers may receive favorable pricing (up to a 50% discount in many cases) for providing liquidity.

Loan-to-Value Ratio

The Loan-to-Value ratio is expressed as the ration of the loan’s principal amount to the value of the firm or asset. For example, a company that takes out a loan of $500 and is worth $1,000 has an LTV of 50.0%. The inverse of the LTV (1 / 50% = 2x) represents the asset coverage ratio.

As the LTV increases, it becomes riskier for the lender and they may compensate by increasing the interest rate or adjusting the loan structure to acquire a greater rate of return.    

Loan Risk

There are four primary risk factors to consider as a lender:

  1. Interest Rate Risk – Loan prices are inversely related to market yields (the coupon rate certainly plays a part in determining price, but the coupon rate is distinct from a YTM). The impact of a shift in rate of return expectations are measured by factors such as duration and convexity (which estimate the magnitude of the change given a change in interest rate expectations). Also, when interest rates decline, lenders worry about the impact of prepayments on their portfolio.
  2. Inflation Risk – The risk that the interest you earn as a lender is less valuable considering future inflation. This risk factor helps us understand why a rate of return is expected even on ‘risk free assets’ such as T-Bills.
  3. Market Risk – Represents the systematic risk of the loan market (e.g., a liquidity crunch).
  4. Credit Risk – An asset specific measure, standardized risk buckets are estimated by credit rating agencies. This factor is more commonly referred to as default risk.   

In order to deal with the risk factors above, derivative contracts have become popular. These contracts are either embedded within loan structures (e.g., calls/puts) or traded in the form of OTC products (e.g., interest rate swaps or forward contracts). Borrowers utilize these contracts to either create more predictable cash flows (e.g., swapping floating for fixed payments) or speculating on future rates (e.g., swapping fixed for floating payments).  

Loan Valuation Methods

Loan valuation techniques are primarily based on cash flow analysis. Given that the structure of the cash flows is predetermined based on the credit agreement (as opposed to estimated in an equity valuation), modeling the cash flows is a relatively straightforward exercise. The key input used to value these loans is the discount rate (i.e., the yield to maturity). The YTM can be extrapolated based on the factors explained above; however, the general build-up to a discount rate will look like (not intended to be drawn to scale) the image below. Like the capital asset pricing model used to calculate the cost of equity, the cost of debt is built using the risk-free rate as the base. On top of that, layers of risk are added based on various, mutually-exclusive risk factors. In the chart below, the YTM is comprised of the risk-free rate, a premium for expected inflation, and an asset-specific risk factor. The combination of the tenor and the asset-specific risk is the ‘credit spread’.

The rates of return for bonds by credit rating are posted daily on the St. Louis Federal Reserve database3. In more private transactions, information on comparable yields are typically harder to acquire given investors benefit from the information asymmetry. However, some companies – such as SPP Capital – post average rates for recent transactions4. Either way, increasing yields (referred to as ‘widening’) point to lower credit quality and decreasing yields (referred to as ‘tightening’) point to improving credit quality.

The YTM deciphered for each asset represents an array of risk factors; however, the primary concern for any lender is default risk – i.e., 100% loss of capital.

Extrapolation to Blockchain-Based Loans

The initial model for blockchain-based loans has been focused on providing liquidity for popular cryptocurrency assets such as Bitcoin, Ether, and Litecoin. This conversation will focus on loan products targeted at these assets; however, I note the expansive universe of securitized assets will soon hit the industry. In determining an appropriate yield for blockchain-based loans, it is important consider a few factors:

First, this is a completely new industry. Granted that Bitcoin has been around for more than 10 years, the initial retail ‘splash’ happened late 2017. A true understand of market risk (from the standpoint of traditional financial theories) has not been developed.

Today’s popular blockchain-based loans are effectively margin loans, the same as those you would have access to in a typical brokerage account5. Interest rates are developed based on consideration of trading liquidity (which is exponentially deeper than cryptocurrency markets), algorithmic / high-frequency trading with sophisticated electronic networks, operating expense margins, and an appropriate margin to the cost of servicing the loan. Given that price volatilities today on crypto assets are 3-4x broad equity indices, the need for a lender to have high-quality OTC and exchange relationships with sophisticated trading functions are a priori.

Another consideration involves estimating supply & demand for various security structures, a process typically known as price discovery (i.e., the notorious invisible hand of the market). The market has evolved so quickly that APRs have declined from greater than 20% at the top of the market to below 10% within a year. This decline is the result of greater competition in the space, low interest rate pricing strategies, and further development of portfolio surveillance and monitoring systems. At some point in the future, capital pricing may begin to reflect equilibrium. Until then, pricing competition between firms may reflect hyper competitive behavior as the market continues to discover itself.

There is also a focus on ‘paying down’ points at origination. In real estate mortgage loan structures, the borrower usually has the option to pay an additional amount to reduce the interest rate on their loan. On average, paying the lender approximately 1.0% of the notional balance of the loan will reduce the interest rate by 0.25%. For crypto loans, there are different methods for a borrower to reduce their interest rate such as the traditional ‘paying down’ points method, membership / token purchase staking, or through increasing AUM on a company’s platform. 

The lack of a securitization and secondary trading market contributes to a slower growth profile of blockchain-based loans. Traditional unsecured credit markets were previously disrupted by a slew of new fintech P2P lending models that could still quickly sell their loans given they had the same look and feel of traditional bank loans. Currently, no market exists for lenders to quickly sell / securitize blockchain-based loans, forcing them to be conservative with underwriting and in developing their risk models. Despite being 100% secured and ~2x collateralized, loans against these cryptos are sold at a premium given the nascent stage of the industry.   

The intent of many cryptocurrency advocates is to reduce reliance on traditional central banking influenced economic models. Given the lack of a central authority influencing the cost of the largest cryptocurrencies (although one could argue that the exchanges, operating costs of miners, and primary markets are currently influencing prices for their benefit6), debates about the concept of a ‘risk free rate’ are now emerging. As the market evolves, it will be critical to observe correlations in traditional interest rates with those in emerging cryptocurrency assets.

Finally, the lack of custody and asset insurance solutions has been discussed in depth since inception of blockchain-based loans. Given the lack of these products, potentially billions of dollars are currently on the sidelines7. Moreover, effective custody solutions are just now beginning to emerge, but it will be years before institutional investors begin to see blockchain-based financial products as a common piece of their investment portfolio. Security audits can and should be mission critical items to review during due diligence.

Final Words

Margin loans are quite risky. If underlying assets fall, it could lead to an uncomfortable situation for the borrower as they either need to come up with the money to add LTV cushion, sell assets, or get liquidated – all at a magnified loss given the interest paid on the loan. The future of blockchain-based loans will depend on a decline in price volatility and maturation of institutional investment administration products.     

While no exact science exists today, the bright future for the cryptocurrency industry will compel the creation of new financial products to accelerate liquidity in this burgeoning market. We see an array of products built this year on the back of crypto technology, such as interest accounts, derivatives contracts, custody solutions, and the addition of many more types of digital assets on these lending platforms. Reaching equilibrium will require an optimal balance of supply & demand, and I believe we are on a long path to its discovery.

Finally, I leave you with a short comparison of blockchain-based loans and two similar loan structures: auto loans and stock portfolio margin loans.

Footnotes

  1. The overview is not meant to be robust, but see the following article on Investopedia for a great overview: https://www.investopedia.com/university/Loans/
  2. Federal Reserve Selected Interest Rate Data – H.15. https://www.federalreserve.gov/releases/h15/
  3. FRED (Federal Reserve Bank of St. Louis). https://fred.stlouisfed.org/
  4. SPP Capital, see the “Market Update” section on the top right: http://sppcapital.com/
  5. Data aggregation of various margin Loan rates today: https://investorjunkie.com/12389/best-margin-rates/
  6. See the Bitwise report on the difference between reported and actual trading volumes. https://www.bitwiseinvestments.com/
  7. Coinbase Reportedly Secures $20 Billion Hedge Fund Through Its Prime Brokerage Services, July 18, 2018. Coin Telegraph. https://cointelegraph.com/news/coinbase-reportedly-secures-20-billion-hedge-fund-through-its-prime-brokerage-services

Crypto Millionaires and the Estate Planning Quandary: Using Traditional Life Insurance Policies to Hedge Downside Risk

The rapid inflation in blockchain-based asset values has contributed to a new generation of “crypto-millionaires.” As of the date of this article, there were 7,046 active addresses with greater than $1.0 million in BTC assets. Back in August 2018, there were approximately 24,000 addresses with greater than $1.0 million in BTC assets. Estimates at the height of the market range from 10,000 to 200,000 addresses with greater than $1.0 million of BTC1. Assuming BTC values grow over the next 2 decades, I expect for this figure to exponentially grow.

A key question for these millionaires is how to create liquidity using BTC (in a world where common goods cannot be purchased without BTC) in a tax efficient manner. Today, utilizing BTC for the purchase of goods and services would require two levels of taxation: (i) income / capital gains tax on the appreciation of BTC and (ii) sales tax. Another unforeseen tax is the estate tax, which is a unique consideration given that many crypto-millionaires had a low cost basis when entering their positions.   

While many structures will likely exist in the future to facilitate tax expediency with blockchain-based assets, I propose a strategy using a traditional universal life insurance policy and loans acquired through a crypto service provider as a means for an investor to both protect against steep declines in blockchain-based assets and boost returns.

Life Insurance Structure

Before going through the math, I wanted to start with an overview of the structure. The graph below depicts the mechanism in 3 stages. The blue boxes represent a crypto service provider activities, the green boxes represent activities of the investor / grantor, and the pink boxes represent activities of a life insurance company.

The first step in the process is for the investor to post their crypto collateral to a crypto service provider. A crypto service provider then secures the assets in their cold storage wallet with multi-signature functionality and lends fiat currency against the crypto collateral. The fiat currency is then used to facilitate a single-premium universal life insurance policy and an 8-year annuity (this is the max allowable LTV based on the math below). The selected universal life insurance policy is structured to provide a return linked to the S&P 500 with a floor / cap of 0.0% / 8.0%.

The investment thesis is to provide a greater rate of return on $5.0 million of BTC while protecting against downside risk. Below, we detail the steps in the process and the sensitize the resulting economics to the investor.

Exhibit 1: The Structure

The Math

The first step in the process is to obtain a loan from a service provider. Currently, you can take out a fiat-based loan against 50.0% of the value of your BTC assets. For example, if you have $5.0 million in BTC, a crypto service provider would offer a loan up to $2.5 million. While the lowest rates offered are around 6-7%, we used 8% in our analysis. The loan proceeds are granted by an investor to an ILIT to avoid the proceeds being counted as part of the owner’s estate.

The amount of the loan required to facilitate the strategy would be $2,347,852. This amount is calculated as 14.5% LTV for the fiat loan (in order to finance the premium payment) plus the amount required to finance an annuity that covers interest payments on the total loan balance ($2.4 million) for the longest period possible (in this case, 8 years). We estimated that the insurance premium for a $5.0 million universal life insurance policy to be roughly $725,0002. Assuming a time to liquidity of 20 years (i.e., death), the annual loan payment would be roughly $240,000.

Exhibit 2: Loan Payment Calculation

Exhibit 3: Financing the Annuity3

Note that the total debt ($2.4 million) was established at a 47.0% LTV.

Phased Approach

In terms of the change in value of BTC, we assumed no growth. Later, I sensitized the results on both the upside and downside. In order to understand the strategy, I broke it down in the following phases:

  • Phase I: Annuity Payments cover interest payments through the initial 8 years. Increasing the number of years would take above the LTV target. These payments would be made at the beginning of the year / period. The annuity payments have another function in that they defer the risk for the underlying collateral base – if BTC has 8 more years to gain liquidity (and one is a believer in the growth story), the annuity offers a valuable strategy to defer the holding cost of holding BTC.
  • Phase II: Annuity payments have ended; therefore, future interest payments would be funded either through liquidation of BTC (given LTV is more favorable as a result of the PI structure of interest payments) or accessing the cash value (discussed below).
  • Phase III: Exit and distribute proceeds to trustees of the ILIT. For the purpose of the below analysis, we assumed that the ILIT would immediately distribute the proceeds on the date of death.

Cash Value

A key component of life insurance policies is the cash value. The cash value represents an internal account within a whole / universal life insurance policy that could be accessed by the owner on a tax-free basis. For a whole life policy, the cash value usually turns positive beginning year 4 or 5. For a universal life insurance policy with a single premium, approximately 25.0% would be kept by the insurance company for fees, and the remaining balance would be deposited as an immediate cash value balance. That amount could be accessed by the grantor for whatever reason, like paying interest due. Day 1, the cash value would cover about 2.3 years of interest ($725k * 75.0% = $534.8k / annual interest). Assuming a long-run growth rate of 5.0% for the S&P 500 over the next 8 years on an annualized basis, the cash value account would be worth $803.4k, covering 3.4 years of payments.

Exhibit 4: Cash Value Calculations

Remember, any loans taken from the balance would be drawn 1 for 1 against the ultimate life insurance payout. In addition, there is no need to take out any funds from this account for the strategy to work, it just provides additional value.

Exit

We assumed an exit at the end of 20 years to estimate the net distribution. At exit, the total distribution would be $5.0 million. The remaining payments after the annuity include the loan’s interest ($2.9 million) and tax liability (for the purpose of this analysis, we assume that the cost basis was $25,000 – resulting in a large tax liability of $995,000).

At exit, the trustees would receive the net distributions plus the BTC. Assuming the mechanics above and no growth in BTC, an additional $1.1 million would be added to the value of the estate.

Exhibit 5: Exit Waterfall4

Sensitivities

I sensitized the performance of the investment strategy based on growth rates of BTC. Assuming a decline in the value of BTC, the portfolio outperforms given the uncorrelated hedge built into the life insurance policy. Furthermore, the tax liability would be reduced. The net benefit of the strategy works better as we sensitized lower performance. In a worst-case scenario where BTC goes to $0, the insurance policy is still fully paid for.

Assuming an increase in the value of BTC, I note that the portfolio return is greater due to the tax-free distribution from the life insurance policy covering a portion of the increased tax liability. The gains are diminishing if greater rates of return are achieved, without performance drag as a result of the policy.

Exhibit 6: Sensitivity Tables

Conclusion

The wave of crypto-investing we all experienced the last couple of years will need to be monetized in some fashion as investors consider their exit strategies or look to diversify their portfolio. The structure described above can be combined with other mechanisms to either increase the hedge or increase exposure to the underlying crypto. We note that improvements in crypto liquidity in futures markets may one day enable a low risk hedging option for investors that want less asset volatility but still wish to participate on the upside. Additional liquidity would also enable dynamic tactical hedging strategies informed by burgeoning asset management services in the crypto space.

Any strategy focused on providing liquidity to crypto holders should consider optionality for repayments. The approach above considers 4 sources of liquidity: (i) growth in the BTC asset, (ii) cash value principal + growth, (iii) annuity stream, and (iv) deferring a large tax liability5.

Footnotes:

  1. Source: https://bitinfocharts.com/top-100-richest-bitcoin-addresses.html
  2. Source: https://termlifeadvice.com/single-premium-life-insurance-the-pros-and-cons-2018/
  3. The annuity was “back-solved” so that the resulting annuity distribution equals the interest on total debt.
  4. Interest after annuity represent the remaining interest payments on debt. We assume they would be paid lump-sum on exit but note they would be paid periodically over the life of the loan. No PIK options currently exist on crypto-based lending platforms.
  5. No transaction fees were considered in the analysis (except the large haircut required for the annuity stream).

Disclaimer: I am not a financial advisor, none of the information contained in this blog post should be considered investment advice.

The Bitfinex / Tether Controversy: Bitcoin Pricing in an Era of Crypto Fraud

It should come as no surprise that Tether’s structure has now garnered the limelight of the NY AG. Previously, Bloomberg reported that the US CFTC sent subpoenas to both parties, a Tether hack back in November 2011, Tether dissolved its relationship with its auditor, a UT study revealed Tether being used to manipulate BTC prices, and so forth. Despite the negative news for the industry, the underlying community remains strong and resilient to such occurrences.

We are now witnessing a “run-on-the-exchange”, a unique test case for Bitcoin Hodlers to prove that the sum of its parts can push through greed’s hold on using crypto for quick, scammy gains. As I type this out, a reported $185 million in BTC and ETH has been removed from Bitfinex’s cold storage wallets – about 20.0 percent of their total total balance. While additional losses (in terms of crypto pricing and faith in the industry) are expected over the short run, I remain confident that the industry players will find ways to effectively manage the risk of these illicit activities.

The history of our community demonstrates powerful forces pushing forward, working collectively on unique solutions that bring us closer to the goal of blockchain entrepreneurs – to create trust and accountability in the digital world. After Mt. Gox, crypto security providers become more popular, a renewed focus on security culminated in the popularity of cold storage solutions, multi-sig authority, and updated private key protocol. Large companies like IBM and Fidelity took the opportunity to release their own technology solutions for crypto custody.

We have also observed the shakeout of ICOs in favor of a more measured, standardized approach to fundraising on the back of blockchain-enhanced infrastructure. ICO deal flow has experienced significant losses over 2018 and the first half of 2019, favored by a variety of STO projects that use blockchain solutions to go to market more efficiently. Scam artists, like those responsible for Centra Tech, are being brought to justice – clearing the way for focus to turn to real projects.

However, progress has all proven to take time and work in volatile cycles. The direct impact on the crypto community has yet to be seen; however, prior fraudulent activity and hacks have lead to negative BTC performance over the subsequent 30 days after an event. The average max drawdown over this period, net of S&P 500 returns for the events listed below, has been about 25% – indicating that we may be in for a bumpy second quarter.

However, after all of these prior events: Bitcoin mining hash rates continue to climb year after year and adoption marches on via new, exciting platforms that demonstrate the potential of crypto technology.

The Blockchain Industry’s Next Catalyst: Video Games

By: Daniyal Inamullah

Since the introduction of Spacewar! in 1962, technological progress has had an intimate relationship with the growth of the video game industry. In the “Diffusion of Innovation: How the Use of Video Games Can Increase the Adoption of New Technologies,” the authors research the influence of video games on adoption of this tech, they note1:

“it is the degree of acceptance of the innovation that determines its success or failure … it should not only be accepted because it improves efficiency or quality, but it should be able to be integrated into society’s culture.”

Communication channels are a critical component of how fast technological innovation can be absorbed by society and become ‘normal’ in our daily lives. Drawing from the Spacewar! story, several technological revolutions occurred in the 1960s – all of which had a profound impact on revisions to the Spacewar! software code, applications in game console manufacturing, and expanding a programmer’s vision as they look to implement their next idea. These monumental innovations in the 60s include the first computer mouse, the BASIC programming language, LED, DRAM, and lasers2. Video games made innovation sexy (at least for certain segments of the population), and society demanded more following Spacewar!’s viral response.

The growth in popularity of cryptocurrency assets, prompted by the ICO craze at the end of 2017 opened the door for capital and talent to start seriously thinking about blockchain technology as a distinct asset class. I contend that the success of blockchain-based video games and media applications will be a critical driving force in mass adoption of the underlying technology. Let’s start.

A Short History of Video Games and Technology

The Spacewar! story presents the diffusion of innovation via the world’s first digital video game. One of the initial problems with the game includes the lack of computing power to model gravity’s affect on weaponry; however, programmers rushed to update the initial game software code and made improvements like adding the effect of inertia, scoring, explosion graphics, and even an application for games to be played on a VR headset3. The introduction of the game at MIT was observed, studied, and tested in computer labs all over the world. Games like Space Invaders and Missile Command became increasingly popular as people began interacting more with computers and assimilating them in their culture4. Play Spacewar! here.

Spacewar! Screenshot

Pong was a successor in the video game timeline. It was the first system to demonstrate that computers could be used by the average Joe. The game distinguished itself with its competitive element, breaking previous breakthroughs such as Lunar Lander, Mathematical Games, Oregon Trail that were focused on individual achievement. The game was an immediate commercial success and gaming consoles were shipped to bars, computer labs, and retail markets around the world. The success, however, did not come overnight. One of the creators, Nolan Bushnell, had previously built a coin-operated video game named Computer Space, which flopped due to its complicated controls. Pong was the first to combine the critical elements of a simple interface, amusing play, and easy to manufacture technology5. The success of the platform also motivated the release of the home game console in 1975; a hot Christmas item that pioneered a new industry. Play Pong Here.

Commodore 64 (“C64”), released in 1982, was one of the most successful home game consoles in history. The C64 boasted 64 kb of memory, had a large rolodex of games, a high-quality audio system, and was sold at a whopping price tag of $595! The C64 became a gateway for people to the world of computers, it enabled users to “play many games and … learn the programming language of computers …” by changing the way users interfaced with the gaming systems6.  The distinguishing feature with C64 was that you were able to control the processor directly, allowing users to garner an elementary understanding of software and hardware protocol languages. Another difference was with the marketing strategy. The prior norm was to sell video game consoles in computer stores, the C64 was also sold in discount stores, retail outlets, toy stores, and college bookstores. The natural trend from initial adopters spread to the general public – a sign of acceptance, excitement, and increased diffusion of gaming technologies.

Shatner Pitching Commodore

The US introduction of the Nintendo Entertainment System (“NES”) in September 1986 (which followed the 1983 success of Nintendo’s Famicom model in Japan) illustrates how the mass success of prior video game consoles created industry economies of scale for future iterations. The NES retailed for about $90 (plus $10 if you wanted Super Mario Bros). Even the action set (including the duck hunt gun, a controller, and the legendary dual Super Mario Bros and Duck Hunt game pack) retailed at $150, materially lower than C64’s $595 price tag. The Nintendo value offering, not too different from today, was to offer affordable, high-quality gaming. Nintendo imposed strict controls on its branded games and products in order to avoid the pitfalls of Atari’s relatively low quality games7.

In 1989, Nintendo made another splash releasing its 8-bit handheld video game system. What buoyed Game Boy to be one of the most successful products was timing – the late 80s exhibited the first generation of mobile technology (such as the introduction of CDs, the Walkman, cell phones, etc.) and a new generation of media entertainment (cable television, answering machines, personal computers, etc.)8. In just 27 years, the video game industry trended from a small class of individuals (programmers / scientists) to an almost $5 billion (equivalent of ~$9 billion today) global market9.

Since the Game Boy, the industry grew by expanding connection between players, improving graphics processing capabilities, introducing new types of gaming devices, and increasing the speed of game play. Doom’s release in 1993 improved visuals and game play leaps and bounds past its predecessor Wolfenstein 3D10. The catalyst for Doom’s adoption was a feature to play others in a co-op / deathmatch modes over a network. This also coincided with the release of the world wide web in the early 90s; gaming became an incredible bridge to future network architecture.

Along with the expanded network, PlayStation and Nintendo began their war over control of the console market. The competitive decisions from each side demonstrated differing opinions of value on how the technologies could be utilized for a competitive edge. Nintendo built a technically superior machine, boasting a 64-bit CPU chip and 4MB of RAM. PlayStation, by comparison, had a 32-bit system with 2MB of RAM. Below is a comparison of each console’s value offering11:

N64 vs PlayStation

N64 PlayStation
Cartridge CD
Limited storage / shorter games Longer load times
Struggles with texture and CGI Pixelated images
Terrible controller but included an analogue stick + rumble pack add-on More comfortable grip and sturdy
Super Mario 64, The Legend of Zelda, Goldeneye 64, Perfect Dark Tekken, Metal Gear, Tomb Raider, Gran Turismo, Final Fantasy

 

The debate between the two consoles was shaped by various business models, technological improvements, and game theory. The market’s invisible hand pushed the industry forward by rewarding consumer research and pushing capital towards innovation.

Today, the market is expected to grow $16 billion each year and gamers from around the world will spend an estimated $138 billion during 201811. Given the sheer size of the industry, niche markets can blossom and companies in the space can earn their investors a solid return given the pace of industry growth. Microsoft’s entrance in 2001 emanated a new battle with Sony over who will be crowned king of the home entertainment system market. The competition started with the rush to achieve dual capabilities – play video games and DVDs (this is also the predecessor to the popular adage – Netflix and Chill). This morphed into competing to which system can play Blue Ray, use Netflix, XBOX Live versus PlayStation Network, TV offerings (PlayStation VUE), motion-based gameplay (WII), VR capabilities, mobile gaming (PSP vs new generation Game Boys), and so on.

While I have certainly missed some evolutions in between, one of the current trends is a shift to an online-only model. Games such as Fortnite, BioWare, and Fallout exemplify a shift where gamers have a more intimate relationship with developers. BioWare’s general manager Casey Hudson noted in an interview with The Verge “We thought, what if we have a game where the whole point of the experience is for everyone to talk about what’s going on right now?12

This model also necessitates a re-thinking of a video game business’s economics. The following questions demonstrate how technological breakthroughs can propel businesses to adapt to innovation. How do companies make money when they need to pay for constant updates? How do they keep coming up with new ideas? Does that mean they need to hire a new team, and do I need to structure their compensation differently? Is the world ready for subscription models for the video game industry? What would be the impact of a single bad release? How do we evolve? Will Fortnite’s free user model continue to work in the future or will they also need to adapt? What technologies will emerge in the future that may displace current projects?

The Future of Gaming Technologies

Given the intimate history between technological progress and video games, a short examination of some of Gartner’s top 10 strategic trends may point us in the right direction for the next generation of gaming13:

  • AI – Gamification may enable AI to learn in different ways, researchers at Open AI used a rewards-based system to study the impact of intrinsically-motivated deep learning14.
  • Augmented Analytics – Just as Netflix initially catered to common TV shows / movies and then moved on to produce their own shows by data mining consumer taste and size, these capabilities will likely be implemented to produce better games and interface design for next generation tech.
  • Immersive Experiences – Evidence of this trend is illustrated by the move to VR headsets such as the Oculus Rift.
  • Blockchain – There exist many applications for video games using distributed ledger technologies such as security for servers, digital id applications, and establishing transaction protocol in digital environments. As a result of blockchain technologies, the economics between gamers and developers may start to converge.

How Blockchain Technology Fits

Today’s most popular crypto-related games include Blockchain Game and Alien Run – any of these applications would also work perfectly without any type of blockchain tech. Ultimately, there are three applications of blockchain in video games15:

  • Rewards;
  • Promotional / marketing; and
  • Gameplay modifiers.

The third category – gameplay modifiers – may be a key catalyst for mass adoption of blockchain tech in the video game industry. Dragon’s Tale is a great example of how cryptocurrencies can be tied in to modify gameplay. Dragon’s Tale presents an array of games to the player (some more gambling than puzzles); winning the game earns the gamer a BTC reward. The founder of Dragon’s Tale was quoted on his vision for the MMORPG16:

“What if there were a … world where everything that you see … that you touch … was in fact some sort of game. No traditional slot machines, card games, dice, but an RPG where your character advances by success at games of chance. Bitcoins rekindled that idea…”

Although the game essentially adds a digital poker chip to the equation, it was an early demonstration of how cryptocurrencies can be tied into gaming.

The success of CryptoKitties after its release during December 2017 shows us another example of how blockchain can be added as a gameplay modifier to improve the user experience. The game allows users to breed and trade digital kittens, like Tamagotchi meets Facebook meets E*Trade. By early December, the most expensive cryptokitty sold for 600 ETH (which was worth $170,000 at the time), although the median price was $917. Why? Ask people that bought Beanie Babies or Pokemon cards. More than 41,000 kitties have been sold and the game at one point accounted for almost 15% of Ethereum’s network power usage18. Based on their 256-bit genome, there are over 4 billion possible variations of cryptokitties. This proof of concept demonstrates the power of blockchain – digital identification tech merged with limits built into a game’s protocol opened the door to a new market.

Fortnite’s success demonstrates the potential for digital asset trading being commonplace – about 69% of Fortnite players (a free game to download and play) have spent an average of $85 to purchase in-game content19. The trading of rare items, unique avatars or gaming skins, in-game currencies, and even in-game private lounges illustrate just some of the unique applications yet to be discovered. Establishing a scarce resource with utility will be one of the fundamental drivers of crypto adoption. Imagine the ability to create your own weapons on Call of Duty, design soccer balls on FIFA, breeding a Pikachu that can Kamehameha, and trace cheaters through application of an immutable ledger. Open source software would allow users to create their own digital assets and sell them – forever changing the relationship between developer and gamer.

Why Gamers will be Critical for Blockchain Adoption

Gamers have historically been the first adopters for technological advances, I see no difference for the growth of the blockchain industry. The popularized monetization model takes advantage of bourgeoning demand for in-game items to an almost $50 billion industry20. There were an estimated 2.1 billion gamers worldwide and forecast to grow to 2.7 billion by 202121. The next generation is spending more and more time on their phones for communication, gaming, and business. As discussed in the history section, gamers are a lightning rod for technological progress and facilitate innovation shaping our culture.

Creating digital assets eliminates the need for a middleperson. GameCredits demonstrates how developers could get paid more and exponentially faster compared with traditional payment models. The idea of the project is to accelerate widespread adoption of decentralized cryptocurrency assets and empower game developers. This process can be replicated in a variety of industries such as legal, accounting, and supply chain. Gaming can be an important test case of how users will interface with the technology and how growth will be cultivated in terms of monetization strategy and user experience.

Who Should you Pay Attention to?

The following is a list of interesting crypto projects in the video gaming space. Disclaimer: This is not investment advice.

  • CryptoKitties: Discussed above
  • Enjin Coin: Platform to empower users with true ownership of their video game development project, fraud prevention, and marketing tool.
  • Spells of Genesis: Magic (the card game) on the blockchain.
  • MobileGo: Incentive / rewards system.
  • GNation: GameCredits above.
  • XAYA: Gaming platform to help games scale, prevent cheating, and eliminate fraud.
  • Ethbet: Old fashion gambling platform without house bias and instant awards.
  • FirstBlood: Competing in daily tournaments with an automated experience.
  • Refereum: Allows gamers to earn rewards for completing quests.
  • GTCoin: Allows gamers to buy game titles, hardware, and in-game content. Their Game Tester platform aims to close the gap between players and developers.
  • Loom Network: An application platform for developers to create scalable games and user-facing DApps built on the Ethereum network. Cryptozombies was a fun couple of days.

Conclusion

Catalysts for the next stage of the blockchain industry’s growth will be driven by both gamers and developers. As some of the above projects and others begin to take off, it will be interesting to see how the platforms interact with one another – will we have another Sony versus Microsoft versus Nintendo battle? Will power and resources be re-distributed to developers and the creative artists of our day rather than the brokers? I certainly hope so. In the words of Amir Taaki:

“Bitcoin was created to serve a highly political intent, a free and uncensored network where all can participate with equal access.”

Sources:

  1. Hernández, J. F., Cano, P. y Parra, M. C. (2017). Diffusion of innovation: How the use of video games can increase the adoption of new technologies. Sphera Publica, 1 (17), 25-46.
  2. Oxford, Tamsin. 6 Technologies to Thank the 1960s For (2009). https://www.techradar.com/news/world-of-tech/6-technologies-to-thank-the-1960s-for-650980
  3. Brandom, Russell (2013). ‘Spacewar!’ The story of the world’s first digital playing game. The Verge. https://www.theverge.com/2013/2/4/3949524/the-story-of-the-worlds-first-digital-video-game
  4. Spry, Jeff. Firsts: Spacewar! Was the World’s First Video Game. Syfy Wire. https://www.syfy.com/syfywire/firsts-spacewar-was-the-worlds-first-video-game
  5. Montfort, Nick. The Sweet Pong of Success (2000). MIT Technology Review. https://www.technologyreview.com/s/400695/the-sweet-pong-of-success/
  6. Mihelich, Peggy. Commodore 64 Still Loved After All These Years (2007). http://www.cnn.com/2007/TECH/ptech/12/07/c64/index.html
  7. Lupton, Jonny. A Brief History Of: The Nintendo Entertainment System (NES) (2018). https://www.funstockretro.co.uk/news/a-brief-history-of-the-nintendo-entertainment-system-nes/
  8. Brain, Marshall. 12 New Technologies in the 1980s. How Stuff Works. https://electronics.howstuffworks.com/gadgets/other-gadgets/80s-tech.htm
  9. Shapiro, Eben. Market Place; Differing Views on Video Games (1991). The New York Times. https://www.nytimes.com/1991/06/19/business/market-place-differing-views-on-video-games.html?sq=video+game+industry+1995&scp=4&st=nyt
  10. McCauley, Jim. A Brief History of Doom (2015). Prima Games. https://www.primagames.com/games/doom/feature/brief-history-doom
  11. Ell, Kellie. Video Game Industry is Booming with Continued Revenue (2018).
    https://www.cnbc.com/2018/07/18/video-game-industry-is-booming-with-continued-revenue.html
  12. Webster, Andrew. Fortnite has the Most Interesting Video Game Story in Years (2018). The Verge. https://www.theverge.com/2018/7/2/17525200/fortnite-storytelling-rocket-launch
  13. Garfinkel, Jennifer. Gartner Identifies the Top 10 Strategic Technology Trends for 2019 (2018). https://www.gartner.com/en/newsroom/press-releases/2018-10-15-gartner-identifies-the-top-10-strategic-technology-trends-for-2019
  14. Greene, Tristan. Researchers Gave AI Curiosity and it Played Videos Games All Day (2018). https://thenextweb.com/artificial-intelligence/2018/08/23/researchers-gave-ai-curiosity-and-it-played-video-games-all-day/
  15. Chandler, Simon. Video Games and Blockchain: New Experience for Players or More Profit for Developers (2018). Coin Telegraph. https://cointelegraph.com/news/video-games-and-blockchain-new-experience-for-players-or-more-profit-for-developers
  16. Sagar, Yayanand. Dragon’s Tale: Vision that Became More than Just Bitcoin Gambling (2017). News BTC. https://www.newsbtc.com/2017/05/11/dragons-tale-vision-became-just-bitcoin-gambling-platform/
  17. Chong, Nick. World’s Most Expensive CryptoKitty Sold for 600 ETH ($170,000) (2018). Ethereum World News. https://ethereumworldnews.com/worlds-expensive-cryptokitty-600-eth/
  18. Cheng, Evelyn. Meet CryptoKitties, the $100,000 Digital Beanie Babies Epitomizing the Cryptocurrency Mania (2017). https://www.cnbc.com/2017/12/06/meet-cryptokitties-the-new-digital-beanie-babies-selling-for-100k.html
  19. https://www.statista.com/statistics/748044/number-video-gamers-world/
  20. Curran, Brian. Blockchain Games: The Current State of Blockchain Gaming Technology (2018). https://blockonomi.com/blockchain-games/
  21. SingularDTV (2018). https://medium.com/singulardtv/how-video-games-helped-pave-the-way-for-cryptocurrency-f930521eef55

 

Santa’s Workshop: Accelerating Operations with Blockchain Technology

The growth of the world’s population and impact of globalization trends has increased the demand on Santa’s primary production facility in the North Pole (“Workshop”). The advent of new toys and their underlying technologies increases the need for a more flexible supply chain, smarter elf force, and high-quality production to meet the annual deadline. Accomplishing all of this without being attacked by Jack Frost or his henchman has forced Santa to raise the bar with the Workshop’s analytical and strategic initiatives.

Below we discuss some of the partnerships the Workshop has entered into with blockchain companies to help meet the demands of the next generation. The essential components of the Workshop are broken up into 4 core segments: Snogistics, ER Management, Sleighportation, and Predictive Naughtylitics.

Solutions for Santa’s Operations

Snogistics

The complexity of supply chains due to globalization of production has made it more difficult to obtain critical raw materials and other inputs. This dilemma is only made more cumbersome with the addition of incentives to cheat for illegal or unethical practices due to the opaque nature of expanding to new markets. To solve these issues, Santa partnered with a few tech-minded companies.

On one occasion, Santa needed to source soccer balls from Sialkot, Pakistan for children in Mexico City, Mexico. The issues with Asian soccer ball production and sourcing include (i) disputes of transfers between entities, (ii) systems and records management being subject to errors / manipulation, and (iii) the use of child labor.

To combat these obstacles, Santa partnered with Halotrade to improve verification and product tracking. Upgrading their software enabled real-time tracking of goods from production to delivery. The protocol also included an automatic P/O facilitation and financing instructions that automatically trigger at each step of the production process. This reduced burden allows Santa to use that time more effectively, such as training junior elves for the next generation of toy technologies, adding elf-power to help reduce the effect of bottlenecks, and beginning FY19 planning a bit earlier.   

Recording the data also improved knowledge of when he needs certain elves to be ready to go. When the junior sized soccer balls were close, he was able to wake up the dwarf elves and optimize the workplace for packaging and distribution. When the professional soccer balls came in, Santa needed to make sure the athletic moon elves were available for additional testing before going to the dwarf elves.

Recording data at each stage also let Santa know where the hiccups were.  It informed him of what partners got the job done, if the Workshop needs to diversify production in any one area, and to help identify declines in quality over time.

Santa also partners with Provenance to get a better idea of who the supplies were coming from. Were payments being made to money laundering opium producers? Were certain individuals cheating the supply chain to smuggle illegal goods? Were the diamonds he acquired from the Venetia mine in South clean? Provenance gave the Workshop team additional confidence that they would not ironically find themselves on the naughty list next year.  

In the words of the Workshop’s Director of Snogistics Frosty the Snowman, “Our partnerships have improved the transparency of our blockchain and made our operations more predictable. In an industry troubled with elf shortages and increasing demand, our partners give us confidence that the choices we make are founded on the best data.”

Elf Resources Management

As elves began working more and more from their homes around the world, the complexity of implementing efficient payment systems reduced the ability to recruit from emerging markets. Also, as we all know, about half of all elves lie on resumes. The certification of skills was a difficult task. Understanding the range of toy-making abilities is essential in the planning and design of the Workshop’s processes. As the ER Management’s Director Buddy the Elf Jr. notes “capability without strategy and strategy without capability are meaningless. Our partnerships help us bridge gaps in our organization.”

What partnerships? The Workshop recently entered into an agreement with Bitwage to find remote elves all over the world, set up payment terminals for their location, and receive invoices in any currency. The platform gave Santa access to almost 20,000 potential workers with sophistication in all parts of the toy making business.

To make sure they didn’t make the wrong decision, the Workshop also partnered with Vottun to create unique certificates applicable to the toy making world. It made sure they were hiring highly-skilled elves at a fraction of today’s recruiting costs.

Sleighportation

As reindeer gather all over the world to help with global coordination, maintenance of communication infrastructure, and, if they are lucky enough – fly Santa’s sleigh – the challenge of flying to everyone’s house in one night seems daunting. The now-retired Comet said, “you would think Christmas Eve is the busiest night, but setting up information architecture to understand weather patterns, conflicts around the world, condition of the sleigh, etc. are just as difficult.” 

Santa recently partnered with the Blockchain in Transport Alliance to create unique solutions to the tasks at hand. Working in coordination together, they were able to create a dashboard of real-time information for Santa to navigate during his night ride. The staff brought unique solutions from some of the top companies in the world – check out the list here – as well as the unique perspective and the technological advantage of blockchain. Safety has always been a priority of the Workshop, having delivered presents without injury for the last 10,000 years.

Predictive Naughtylitics

The ability to track and forecast naughty children to quantify the optimal level of coal necessitates advanced computers constantly slicing and dicing data structures. Santa, who takes pride in his leadership at the analytics department, spoke of the importance of applying next generation technology. He said “the complexity of right versus wrong, the impact of coal, and estimating how awesome the gift should be all require a deep understanding of statistics. Using blockchain tech, we get access to better information at an efficient price to run the right models.”

The Workshop recently partnered with the Golem network to increase accessibility to advanced computing power. They also partnered with Filecoin to buy the exact amount of storage units they need and add flexibility to their IT infrastructure in case they need to scale quickly. With all the information they created, a critical component of right sizing operations was establishing the ability to interpret the data and actively monitor when people move back and forth across the naughty/nice equilibrium. To gain further comfort in delivery success, Santa partnered with Chainalysis to make sure they are delivering coal to naughty kids, mediocre gifts to children that were mostly good, and the best gifts ever for nice children.

Summary

While many of these projects are still in their pilot / testing phases, 2019 should be an interesting year as blockchain becomes more normalized as a business tool. The recent blockchain hangover in the media related to the precipitous price declines of cryptocurrencies only masks the value generation we are beginning to see at a micro level.

(Yes, this article is satirical)

Merry Christmas and a Happy New Year!

Top 5 Historical Cryptocurrency Performers Over the Last Year

The top 5 monthly performers have changed quite bit over the last 3 years, we analyzed 30-day returns for the current top 200 cryptocurrencies (by market capitalization) and analyzed some of the top performers 

A notieable change since the 2017/2018 bubble is the decrease in the average traded volume. Looking over the past three years, we observed that both the top 200 cryptocurrencies (blue) and the top 5 (orange) have experienced roughly a 50% drop in average daily volume since last year. The chart also demonstrates that the popping of the bubble began the process of cleaning out crappy / fraudulent protocol (note, I said started, still a long way to go). The top 5 crypto’s percent of total trading volume crept back up since last year, indicating money was moving out of riskier assets due to increased investor attention to detail, regulatory pressure, and other industry factors.

While it is too soon to call a bottom to the issue of volume, the average figures seem to indicate some trading stability is returning . It is also the first time that the average trading volume increased relative to the last quarter. While this could also be associated with trading behavior exhibited towards the end of the year, exchanges are fighting tooth and nail to avoid looming interest rate hike implications and competing to be the best offering.

The table below shows the top 5 performers on a monthly basis for the same period:

Based on the chart above, the top 10 performers were as presented below. The top performer was defined as any monthly ranking in the top 5 chart above.

TickerTop 5Cryptocurrency NameMission
GRS9GroestlcoinInstant & private transactions
RDD8ReddcoinEasier to use for general public
PIVX7PIVXInstant & private transactions
XVG6VergeInstant & private transactions
NXS5NexusInfrastructure
UBQ5UbiqPayment + decentralized platform
BCN4BytecoinPrivate payments
DASH4DashInstant & private transactions
MONA4MonacoinPayments
REP4AugurDecentralized prediction market

Notably, some of the top performers include coins focused on instant & private transactions. The top 10 performers include only 1 crypto was not focused on payments or broad platforms – Jack Peterson and Joey Krug‘s Augur. As utility token companies begin to deploy the insane amount of capital raised for their projects, we may see the successful projects begin to creep up on these charts. Given the recent boom-and-bust raised the eyebrows of institutional players, we can expect decent market trials and venture-esque projects to provide further insight on future winners and losers. 

The often volatile nature of the industry may be quelled by current attention on fomenting stability. The market’s competition on establishing a stablecoin provides additional evidence that capital is getting smarter and key players are finding ways to take advantage of other emerging technologies (e.g., AI/ML, edge computing, virtual/augmented reality, etc.). The above charts illustrate investors may be consistently reward certain industry segments and protocol. However, as always, it is important to keep tabs on all of your names and keep a diversified portfolio – even historically successful names like Bytecoin may potentially be worth $0 at any time.  

With December 2018 Rate Hike Locked In, Headwinds Accelerate for Cryptocurrency Exchanges

CME’s Group FedWatch is currently assessing the probability of a 0.25% rate hike in the federal funds rate to be 82.7%. In the most recent FOMC minutes, the group indicated “Almost all participants expressed the view that another increase in the target range for the federal funds rate was likely to be warranted fairly soon.” Compounded with the accelerating hacker problem faced by the exchanges, the long popping of the crypto bubble, and an SEC tightening their grips on registration requirements, exchanges are looking at material headwinds to attract capital.

Major Cryptocurrency Exchange / Platform Hacks

Why do Interest Rates Matter?

The response of cryptocurrency asset performance after last 5 or 6 rate hikes (represented by the dotted black lines below) has had a negative impact on crypto price performance.  The chart below demonstrates that the collapse of the crypto bubble during Q1 2018 coincides almost perfectly with the December 2017 rate hike decision. All subsequent rate hikes had a negative impact on crypto asset performance.

Cryptos Versus Rate Hikes

The interest hikes hurt the exchanges in two ways. First, the exchanges are primarily comprised of non-interest bearing deposit accounts. As interest rates rise, traditional deposit accounts will become more attractive. Second, the lack of a futures / forward market for cryptos means the exchanges are forced to be long commodity / crypto volatility with limited choices for risk management. Another item that compounds the issue is that these exchanges lack cash flow diversification such as fee-based services offered by traditional banks.

One area still unexplored is the impact of an inverted yield curve on the price performance of cryptos. Will they become more popular for individuals given the signal of a future recession? Will retail investors try to avoid Federal Reserve exposure by shifting to more digital asset classes? Per the chart above, the 10-2 spread is now sitting at 0.11%. In the past two decades, the 10-2 spread has never reached this level without the yield curve becoming inverted in the near future. The answers to these questions are certainly not going to be answered in the near future; however, observance of these trends may signal future retail investor behavior – especially as regulatory, security, and customer service standards begin to mature.

Change May be Coming

The innovative spirit of the blockchain community has not turned a blind eye to the problem. Coinbase recently invested in Compound, a platform that enables cryptocurrency holders to earn ‘interest’ on their holdings. The goal of Compound is to created tokenized versions of fiat currencies (like the US dollar). Other players such as the Winklevoss brothers’ Gemini Coin, MakerDao, Tether, and other ‘Stablecoin’ projects recognize the importance of creating a digital asset replicating fiat currency. Key features of a winning technology will likely include a secure platform, low volatility, and corporate governance transparency.

 

Bitcoin Volatility: Evidence of Market Maturity After Cryptocurrency Craze

Since the inception of Bitcoin and the concept of ‘digital assets’, institutional and retail investors kept their distance (and rightfully so) given the extreme volatility in prices, uncertainty around regulation, and questions around consumer adoption. Not only was the concept of Bitcoin foreign, but potential opportunities surrounding the digital currency and its underlying technology were also quite nascent.

As investors and entrepreneurs increased attention and resources to trading, mining, and building tangential services around these digital currencies, we have witnessed a bumpy road to stabilization and maturity. A study of market cycles demonstrates the relative boom and bust of any new industry. A particular article in Hackernoon shows a great example of this by overlaying BTC prices on stock market performance during the inflating and pop of the dotcom bubble.

In order to attract capital and accelerate a new growth cycle, trading statistics of cryptocurrencies need to be more in line with traditional asset classes. Evidence of that trend has already been reflected in trading price data. Analyzing the trading data of the top cryptocurrencies (based on market capitalization), a decline in 30-day rolling volatilities and significant compression in the volatility spread between BTC with the S&P 500 and Russell 3000 indices were observed.

While there is certainly a long way to go until the industry begins to “mature” (with respect to long term cycles), the sharp decrease in implied volatilities points to certain tailwinds.

First, there have been a plethora of services and applications built with blockchain tech and successful companies in the space are now emerging. Payment services companies such as BitPay demonstrate various applications focused on consumer and business adoption. Ripple’s partnerships provides further evidence that there are tangible results that will disrupt status quo tech. The Zerocoin project has improved its capabilities and made meaningful progress towards secure transactions.

Second, investors are starting to reap rewards of their early investments in blockchain and recycle capital within the industry. The success of Coinbaseillustrates blockchain companies can attract significant investor attention and capital. Prior management teams that have exited these companies have been able to raise money for their own projects; their niches are focused on plugging gaps with current technology offerings.

Finally, large multi-national corporations are beginning to introduce new and specialized product lines for industry participants. For example, Samsung released a new chip to improve BTC mining profits. These new products will reduce the overall marginal cost to enter related markets, just as cloud computing decreased the capability gap between small and large corporations.

While we cannot ascertain where the winners will be (equity investors, miners, coin investors, etc.), there seems to be a long runway for investors and entrepreneurs to figure it out. What we can see is that the railroad is making its way to the wild west, both the numbers and trends point to opportunities for those paying attention.

 

4 Takeaways from SEC Registration Charge Settlements with Airfox and Paragon

First Takeaway: The SEC Means Business and is Polishing their Playbook

First, the recent settlement of SEC Registration charges against Paragon and Airfox on November 16, 2018 is likely the first of many civil penalties levied against cryptocurrency businesses. The ruling also represents an important legal precedent where the SEC applied guidance from the 2017 DAO Report of Investigation (Release №81027 / July 25, 2017). The guidance was used to charge both Airfox and Paragon for violating Section 5(a) and 5(c) of the Securities Act by “offering and selling these securities without having a registration statement filed or in effect with the Commission or qualifying exemption from registration with the Commission.” PRG and Airtokens were represented as “Utility Tokens” to present themselves fundamentally as glorified Kickstarter projects rather than securities.

The DAO Report set a framework to predict how the SEC would interpret securities law when applying them to ICOs despite labels as a security or utility token. Below are a few of the foundational principles of securities law from the DAO Report applied to capital raising via cryptocurrency offerings.

1) Determination of whether an investment contract exists. A key item distinguished was that the investment of “money” does not necessarily need to take the form of fiat currency. Using ETH to make investments was specifically cited (such as exchanges involving smart contracts). Tokens that fit the Howey test are determined to be securities.

2) Reasonable expectation of profits. Despite the focus on funding development projects, the tokens were presented and structured in a manner where a reasonable investor would have been motivated by the “prospect of profits on their investment.”

3) Benefit derived from the managerial efforts of others. The responsibility for shepherding the raised capital and generation of profit was assumed to be tied to the efforts of the management team. This increases in importance when considering management teams using cryptocurrencies to compensate employees and contractors.

4) Voting rights are a critical distinguishing factor. Based on the structure of these companies, there are a number of limiting items for the overall control of token holders. In addition, given that token holders are often widely dispersed and lack the ability to communicate with one another, there is an even greater burden placed on management to prove their efforts are not being relied upon for economic gain.

5) Information rights are important. Whether it is an unplanned hard fork or change in monetization strategy, it is important for token holders to have a reasonable amount of information to make an informed decision. This is likely to increase the burden on management teams to effectively communicate their results and general business plans in a more structured manner.

Second Takeaway: No Fraud Charges Levied

The SEC charged the two companies with a $250,000 fine and a cease-and-desist order until they can be properly registered. Notably, no criminal charges were applied in either case. This demonstrates that the SEC is focused on establishing registration requirements and enforcement mechanisms to create a more predictable ICO market. While these rulings may not establish a clear bright line on a number of other securities items pertaining to cryptocurrency markets, the blue prints for ICO compliance seem to be coming together.

Third Takeaway: Labeling it as a “Utility Token” Means Nothing

None of the defenses based on the label of a “utility token” were strong enough to avoid the categorization of each token as a security. A utility token is issued in order to fund development of a cryptocurrency and future marketplace where the token would be exchanged for a particular good or service. The legal defense of a utility token to avoid the label of a security is tantamount to comparing themselves to Kickstarter projects. However, the SEC determined that the promise and hope of asset inflation creates a fundamental point of distinction.

Fourth Takeaway: Investor Relations is Important

The SEC consistently discussed the promotional efforts on social media, email communications, blockchain communities / chat sites, and white papers in applying securities law. Similar to virtually every other asset class, the overall communication of the opportunity was evaluated in a legal vacuum to determine whether the tokens were securities and if they were exempt from registration.

Summary

While there are likely much more settlements in the SEC pipeline, we are starting to see the development of clear standards for ICO markets. This positive trend will culminate in more clear standards for asset monetization strategies using blockchain technology. Future guidance on the following topics are likely over the next few years:

· Equity compensation rules around distribution of cryptocurrency

· Trading rules surrounding secondary markets

· Liquidity requirements (for instance, escrow accounts held in ETH)

· Information rights

· Voting rights

· Governance structure

· Distributed ledger technology security

· Industry-specific applications (i.e., gambling, gaming, cannabis, etc.)