The Start of Capitulation

Crypto doesn’t exist in a bubble. Investors who hold crypto also hold other assets, and as much as we’d love to believe “all you need is crypto” — we still live in a world denominated in US dollars.

The global macro environment matters a lot to what happens to the crypto asset class.

The forces that made crypto an attractive concept (centralized mega powerful corporations, political instability, trade wars, shift away from globalization, totalitarian regimes, etc) are the forces that are also creating fear and doubt in other asset classes and markets. In an environment where investors feel fear, their response is to de-leverage, or reduce exposure.

We are starting to see the fraying around the edges of the global investment community. Blackrock, the world’s largest asset manager with $6.4 trillion in AUM, just experienced its first quarter of net outflows in three years.

Stocks are awash in volatility — and investors are getting all of the adrenaline rush they need in traditional markets without reaching for that crypto fix.

However, a lot of investors *do* have exposure to crypto already, and we’re starting to see those investors hit the brakes on (1) injecting new capital into crypto and more importantly, (2) keeping current capital in crypto.

Inflows into crypto have all but stopped completely. Raising money through an ICO is so passé (and likely to get you enforcement action), and even private placements for ambitious new protocols are struggling to raise capital. Investors are questioning if the medium (selling tokens) is the best tool for the end means (building a useful — and maybe valuable — protocol).

More importantly, investors who already have capital in the crypto market have taken some money off the table. Investors spent most of 2018 waiting for another “bull run” — or an event several standard deviations outside of recent price movement — to pump the price of their portfolio and enable some selling.

See my business partner, Daniel Masters, take on history rhyming but not repeating if you need more convincing on why this wishful thinking isn’t sound.

Last week, as both issuers and investors starting gearing up for the end of 2018, many on both sides of the table called the game, took the loss, and removed a heavy burden from their conscience.

On the issuer side, many crypto projects that raised money through an ICO face massive challenges to stay relevant and create real purpose. This is what happens when you lack a true finance function, and unfortunately, “crypto finance” is still nebulous and undefined on the whole. Just look at this balance sheet below, which characterizes many crypto firms that raised cash through token offerings.

I can’t really fault projects for pursuing the ICO path. Looking at the cost of capital for equity versus tokens, it’s much more appealing to capitalize a company without taking dilution and without having any sort of legal obligation (see black box above).

Investors (not all, but far too many) signed away billions of dollars of their LP’s money in nebulous and questionable legal agreements and structures that defied the laws of this universe.

In reality, anyone who has been an investor for some time knows that eventually, the ledger must balance. There is real liability you incur when capitalizing a company, and eventually, the other shoe will drop. It probably looks a bit like this:

We’re seeing this play out in real time, as companies need to sell token inventory in their treasury to pay tax bills; need capital to fund legal bills and potential rescissions (refunds); and have to deliver on their community debt to token holders and other ecosystem members who gave them money, time, and energy.

More coming on the cost of capital in another post… corporate finance is one of my favorite topics and crypto finance needs a lot of help…

On the investor side, the people who funded the ambitious, multi-million dollar ICOs did so expecting a return in the form of appreciation in the value of the crypto assets they hold.

I love investors. They’re a critical part of the ecosystem, because new ideas often need capital, and crypto has a wealth of thoughtful investors. But investors are fiduciaries. They don’t sit around their office wanting to fund amazing ideas just because they can. They have to make money to ensure survival. Investors aren’t users. They are speculators.

Selling all of your tokens to financial speculators is a great way to ensure your tokens will have no real utility.

There are funds trying to experiment with hybrid speculator / user models, including CoinFund, who call this activity “network engagement.” I’m not yet convinced these models will work as intended.

As I’ve discussed in my writing on “The Tezos Experiment” — selling governance rights via tokens is a slippery slope. Crypto is still a small game, and the actors are still fairly congenial. As the crypto market grows, a new class of investors will emerge. And these aren’t so friendly. Once the real money shows up and the vultures figure out how to play, we’ll see a more ruthless set of investors swoop in to exploit any potential weakness in these systems to maximize profit.

For all of these investors holding tokens, most have accepted these ICOs they have sitting on their balance sheet will come to market at ‘cost,’ (traded token price = purchase price in ICO) in the best case; and there are still billions of dollars of tokens the market needs to digest. Those projects will delay coming to market as long as they possible can, and funds will try to hold those assets “at cost” or at “paper marks” as long as they can to avoid taking a hit on portfolio value.

I expect we’ll see 2019 shutter some funds, because living on 2 + 20 is challenging as is; and when your AUM finally gets marked down 50% and there is no 20 in sight, the juice just isn’t worth the squeeze.

Here’s my view on the next 12 to 24 months ahead in the crypto crisis:

So what’s an issuer likely to do?

Sell the assets they can and hoard cash like it’s going out of style.

What’s an investor likely to do?

Sell the assets they can, take the hit, and free up mental and emotional energy to focus on generating a return for their investors.

Add these two up, and we get capitulation — the action of surrendering or ceasing to resist an opponent or demand.

Acceptance is the final stage of grief.