The below is summary of the market and outlook commentary we sent to investors in Digital Asset Fund and DAF ICO Fund in late-May and early-June. It provides our perspectives regarding the recent significant market moves and structural changes in the digital asset primary capital markets.
Digital Asset Market Update
There has been a significant improvement in the digital asset trading environment since late-March as, first bitcoin, and more recently alt coins rally significantly. The chart and table below details the year-to-date (“YTD”) performance of some of the largest digital assets and highlights that bitcoin has been one of the best performing assets globally:
So, what has driven this turn in sentiment and surge in price? In our opinion the timeline can be summarised as below:
- Bitcoin’s tumble below the mid-$6,000 level in November 2018 can now be seen as a classic capitulation phase. Sentiment had turned almost universally bearish, press of the imminent death of bitcoin was prevalent, cries of conspiracy theories and manipulation were everywhere and we saw several of our investment manager peers either leave the sector or move away from a previous long-bias investment strategy;
- Prices continued to fall to mid-December lows as most non-crypto specialist investors (e.g. investors not tied to the sector by their investment mandate) and some previously crypto-focussed investors exited and the capitulation of retail investors who had bought at significantly higher levels continued. However, as this selling exhausted and the lower prices reduced the USD “overhang” created by bitcoin and ethereum’s constant block reward issuance, we saw a price floor found in the mid-to-low $3,000 level. Alt-coins continued to weaken and underperform bitcoin through this period. We believe at this price level there were enough fundamental bitcoin investors willing to commit new capital to balance the rapidly diminishing supply of capitulating sellers and ongoing mining reward issuance to finally create a robust demand/supply balance — the first time this had existed for any sustained period since 1Q2018;
- The market found support through January and February 2019 and bitcoin, in particular, started to strengthen into the end of March and move through the $4,000 level near the end of the month. February and March were the first consecutive months of gains for bitcoin (and the sector) in over a year and broader sentiment started to improve;
- As the market passed through $4,200 on 1 April 2019, we saw it surge to around $5,000 in a matter of hours and bitcoin’s price has continued to strengthen since — currently trading around $8,700, a gain of around 132% YTD. We believe the $4,200 level saw significant new, non-crypto-specific capital re-enter the sector. This new, material net-inflow, led to a step-change in the trading levels of, and sentiment towards, bitcoin. We believe it also caught several crypto-focused funds off-guard who found themselves underweight, or with little exposure to bitcoin in a digital asset market where bitcoin was making all the gains. This added to the buying pressure, and along with ongoing incremental new inflows to the sector, has helped carry prices to their current levels. We have also more recently seen the alt-coin market outperform as relative valuation gaps became extreme — this saw a modest reduction in bitcoin’s “market dominance” (bitcoin market cap/sector market cap) from a high of just over 60% to the current levels of about 56%;
So why was $4,200 material? Our team has over 50 years of market experience and when markets turn from such a seismic trend, as bitcoin saw through 2018, it’s always difficult to pick the exact event that changed that trend. Often there isn’t one and it’s more a confluence of different news flow and valuation factors that ultimately combine to turn sentiment.
From many years working across volatile asset classes, we have often seen material inflows from deep-pocket investors once they have confidence a “bottom” has been formed. Whilst every rally is different, in our experience these inflows typically materialise 20–30% above lows. These deep-pocket, multi-asset-class investors are happy to “give away” that initial return to the higher risk takers and traders buying falling markets and wait until they have confirmation sentiment, and price trends have reversed. Bitcoin and digital assets are a different market with a very distinct investor-base but we don’t think its pure coincidence we have seen a material rally from over-sold levels when this 20–30% “buy-zone” was reached.
The above focuses on the money flows but we think bitcoin’s and the broader digital asset market’s rally is more fundamental than just opportunistic traders playing price trends and momentum. The underlying sector-specific news flow has been very strong. We have seen the continued build-out of trading infrastructure with ongoing progress from Bakkt (I.C.E. sponsored bitcoin exchange) and Fidelity as well as E-Trade and TD Ameritrade working to make bitcoin ownership accessible directly to their vast retail client bases. Futures volumes have surged and the options market has grown 400%+ YTD — the ability for sophisticated investors to hedge their investments has improved immeasurably which is a pre-requisite, in our opinion, for a number of new investors in an asset this volatile.
On the user adoption side, Facebook released detailed plans regarding its digital asset strategy, which made it clear some form of native cryptocurrency is a central part of its future growth. Whilst the technology is unlikely to be decentralised like the assets we buy, we believe this is a significant endorsement of blockchain’s use-case and relevance by one of the world’s leading technology companies with over 2.3 billion users. We think the market is under-estimating what this signifies both in terms of broader corporate adoption and bringing the wider population closer to the decentralised assets we believe hold so much value. Facebook’s move is very likely to force other global tech leaders to develop their own blockchain strategies to stay relevant and competitive.
ICO/Primary Market Update
How have the listed market moves impacted the ICO/primary capital market?
After a period of significantly reduced volumes there has been an encouraging increase in dealflow. We think this has been driven by two key factors:
- The emergence of Initial Exchange Offerings (“IEOs”): IEOs have become a popular structure used by exchanges and projects to introduce a retail/small investor allocation just ahead of listing a project for the first time on an exchange. The structure is simple: an exchange offers a relatively small, usually discounted allocation (typically sub-$2,000 per investor) of tokens exclusively to its client-base through some form of lottery/auction process and shortly thereafter lists the tokens on it’s exchange. It has proved a successful method for projects that have undertaken private/institutional rounds in 2018 to attract a new set of investors and create a marketing “event” to reintroduce the project to a larger audience around a liquidity event. The results have been mixed but exchanges Binance and Huobi have become the clear leaders in this area with higher profile projects and, to-date, relatively impressive returns for their customer bases. The success of some of these IEOs (some of which have produced 500%+ returns) have demonstrated the advantages to a broad group of investors of also considering newly listed assets and helped to encourage investors to search for other opportunities. Whilst the IEO is often conducted at discounted prices to institutional rounds, this development is generally beneficial at a broader level as the structure creates an additional path to liquidity instead alongside a straight exchange listing; and
- The strength of the listed market: its early days but the strength across the market has seen a wealth effect, of sorts, begin to incentivise investors to consider new opportunities and broaden their investment scope. A number of recently listed projects have also generated significant returns for seed investors — some of which is finding its way back to be reinvested in the ICO market. The equities IPO cycle generally displays a leveraged (both up and down) correlation to the underlying equity market performance and we believe we are starting to see this trend in the ICO market as well. As the chart below demonstrates, there has been a clear uptick in activity over the last two months as listed markets improved. This is partly given increased investor interest as discussed above but, particularly for the higher quality projects, the potential to receive more attractive pre-money valuations given the strength of listed comparable assets.
As the chart shows, volumes stabilised around the $200m — $300m level through the 1Q19 and have started to increase over the last two months. We believe the correlation of primary raisings to market conditions in the digital asset market will be higher going forward so would expect volumes to increase if market levels hold at current levels.
What other trends have we seen?
- Longer lock-ups: the Seed and Series A rounds we are seeing generally have longer lock-ups than we saw in early-2018. Whilst this means the period of illiquidity for investors, like our Funds, is longer (now typically 12 months+) it matches the reality that better outcomes for early investors will be received if projects are more mature at the time of listing. We see much fewer projects listed nowadays without a mainnet or, at a minimum, an advanced testnet to demonstrate a Projects progress and change in risk profile from when the initial funding was conducted;
- OTC market developing: somewhat as a result of the longer periods of illiquidity discussed above, a more liquid OTC market in Seed/Series A investments is developing and providing for the transfer of ownership ahead of listing between institutional/high-net-worth investors. This is a welcome sign and enhances investors’ ability to selectively manage portfolio risk or at least get market input into the value of illiquid assets; and
- Traditional legal structures: structures being used by vendors are maturing as well as the sophistication of disclosure documentation. We are seeing structures more defensible from a regulatory perspective and that have more traditional documentation and disclosure regimes than were generally offered in 1H18. This is clearly encouraging as it reduces the risks of investing in these projects — albeit it must be kept in perspective that they remain early-stage and high-risk investments
We think these developments are all positive and continue to believe early-stage ICO opportunities are one of the most exciting investment markets globally with compelling return possibilities.
Whilst volatility will be a significant part of the digital asset market for the foreseeable future, we believe the shackles of the bear market have finally been broken and there is much to be excited about. Innovation continues at a rapid rate, as do advancements in useability and adoption. Market infrastructure is light-years ahead of where it was only twelve months ago and includes the ability to securely trade and store assets. New investors continue to learn and enter the space as highlighted by a Fidelity/Greenwich survey published in May stating that 40% of US institutional and family office our open to future blockchain investment opportunities and 22% already have some exposure.
We believe broad corporate adoption of blockchain technology, which is underway, is a key step towards bringing mass-market users to the doorstep of the decentralised assets we own. The ongoing de-basing of the traditional fiat monetary base (we estimate 18 countries now have negative base rates) continues to highlight the appeal of a decentralised, deflationary alternative, and we believe this still isn’t being factored into the current prices of store-of-value alternatives in the digital asset space. Some of the world’s brightest coding talent continues to enter the sector, which we believe adds to the inevitability of its success.