Comparing the second half of 2017 with the second half of this year, we see two important trends in the market that lay the foundation for a more healthy blockchain market. One is the outflow of retail capital combined with inflow of professional capital. The second is the emergence of security tokens. Let’s dive into both to see why these trends will contribute to a more healthy market looking forward.
MORE PROFESSIONAL MARKET
Most of the capital that left the market since the start of this year is retail money. These private investors often entered the market during the bull run of 2017, panicked during downward spikes early 2018 (caused by events like the MtGox trustee having to sell $400M worth of BTC in two months) and took their losses during the first months of this year. After this happened, more professional capital dedicated to blockchain/DLT has gradually been entering the market through new crypto funds and existing family offices. Apart from this, research indicates that projects which raised significant amounts of BTC or ETH during their ICO are mostly holding on to their digital assets even though we’re in a bear market.
This leaves us with a significantly larger percentage of professional investors in the market now than half a year ago, which impacts the dynamic of investing in this industry. The most noticeable way the larger percentage of professional investors impacts the market is in the structure of early funding rounds. During the second half of 2017 almost all projects were funded primarily with ICOs targeting retail investors. The last two quarters we see a lot more private rounds aimed at VCs. We think this is good for the market as a whole for two reasons. Firstly, professional investors tend to have more steady hands and a longer investment horizon in general than the “get rich quick” retail investors that were typical late 2017. Secondly, VCs are more adept in valuating projects properly than retail investors. The result of this is that projects are more realistically valuated on average now than they were during the bull run in the second half of 2017.
More steady hands combined with more realistic valuations in early funding rounds means the foundations are being laid for a more stable market with more potential upside.
THE RISE OF SECURITY TOKENS
A second fundamentally good development is that security tokens and the infrastructure around that asset class are starting to emerge. To explain the impact of security tokens, we should first explain the difference between utility tokens and security tokens.
Currently, almost all tokens that projects sell (and have sold) to participants during their ICO are utility tokens. These tokens have a use (utility) in the platform the project is building, like preventing spam or creating an internal currency. Utility tokens never pay dividends to the holder, because that would cause the token to be flagged as a security by financial authorities, which is a risk for the project because most ICOs are not organised in compliance with security issuance regulation. The downside of utility tokens is that for a majority of projects a share structure that pays dividends would just make most sense for its investors. But because the projects want to circumvent security regulation, they instead resort to utility tokens with far-fetched use cases that are uncertain to ever become valuable for its holders. This is not to say all utility tokens are bad, to the contrary some are in fact very useful and part of our portfolio. It’s just a model that’s not the best fit for many projects.
The solution for these projects is security tokens: tokens that are backed by a tangible asset, being shares in a company and/or predefined profits of a project. Security tokens also result in the executives of projects being legally responsible for running the projects responsibly, just as is the case with directors of companies with traditional shares. Security tokens are more easy to valuate using traditional valuation models than utility tokens and give investors an asset with a clear legal status. Reading this, one might ask why security tokens haven’t been issued more often in the past. There are two reasons for this. Firstly, regulators didn’t yet know what to think of security tokens so they didn’t approve them. Secondly, issuing a public security token, like a traditional IPO, is a lot of work and comes with high legal advisory costs, which is hard to bear for a young project that is low on funding.
Security token standardisation
Both these issues are on the verge of being solved, which paves the way for security tokens becoming mainstream. First of all, we see regulators like the SEC approving the first few companies to issue security tokens. Examples are blockchain companies like NEX and Securitize, but also more traditional companies like lottery.com and Overstock. Next to regulators approving security tokens, we see the necessary infrastructure around these tokens develop. Several companies are developing standard frameworks for issuing security tokens. An example is abovementioned Securitize, which is a platform that makes creating and listing security tokens easy and affordable to projects by standardizing the technical and legal aspects of the process of issuing security tokens. Their legal team has developed a framework for security tokens that is legally compliant in 22 countries (and counting) and Securitize has partnerships with several exchanges in order to make the process of listing tokens on those exchanges relatively straightforward for their clients.
Security token exchanges
Speaking of exchanges, several exchanges are in the process of acquiring legal approval to trade security tokens, and some are close to concluding this process. An example is Coinbase, one of the most prominent US based crypto exchanges, which they aims to start offering security token trading pairs early 2019 according to their own press release. Another example we like to mention is NEX. We think NEX is well positioned to take a leading role as trading platform for security tokens. Not only because of their very strong team and the fact that they have already gotten legal approval to launch their own asset as a security token, but also because it is the first decentralised exchange to do so. In an industry that is focused around decentralisation, it makes total sense to decentralise exchanges as well, thereby eliminating the very real risk for users of losing their assets when an exchange gets hacked or corrupted.
We are actually so enthusiastic about NEX that we have actively pursued to get a stake in it. On top of reasons mentioned above, the NEX security token is in very low supply. This is the result of the NEX team structuring their token sale in such a way that no single investor can invest more than $10k in the sale (bar a very select number of exceptions). They did this to make sure the token is well distributed among investors. Because $10k is not a significant ticketsize for institutional investors, they have to buy NEX tokens after they get listed, potentially resulting in a multiple on the STO (Security Token Offering) price soon after listing. Due to the very good relations Balder has built with the NEX team over the past year, Maven 11 is one of very few institutional investors to have secured a significant ticket during fundraising.
Impact of security tokens
The emergence of security tokens will impact the market in in several ways. The most important impact will be an influx of institutional investors entering the market that were until now on the fence because they were either not convinced of the value of utility tokens, or because they perceived the uncertain legal and fiscal status of utility tokens as too big a risk.
In short, even though there are still projects in the market that are overvalued, and the general bearish sentiment might not be over overnight, we see fundamental developments that lay the foundation of a healthy market: More steady hands, more realistic valuations, regulators starting to approve security tokens and infrastructure for security tokens and other digital assets is being built by prominent players.
It’s hard to predict when exactly the market will recover, but as we see strong fundamentals indicating a healthier market, Maven 11 is now in the process of positioning its portfolio for eventual recovery of the market. We do this by allocating a higher percentage of funds to relatively liquid assets that have been punished hard during the bear market, and have historically shown to bounce back strongly during upswings (mainly Ethereum). Next to that we increase the percentage allocated on early stage deals in promising projects that are not listed on exchanges yet (like NEX) that we think should show upside regardless of market sentiment.