Venture Capital Investing in Crypto Assets

Venture capitalists were amongst the earlier groups to join the crypto bandwagon and have reportedly ramped up their involvement in the crypto industry. This is not surprising as the venture capital space seeks to be at the forefront of adopting and/or turbocharging new technologies and consumer behaviors. According to PitchBook, venture investors deployed a record $21.4 billion into cryptocurrency and blockchain-related startups across 1,196 deals through the first three quarters of 2021. This amounts to more than five times the money invested in the prior year.

For Illustrative Purposes Only

Source: Bloomberg, June 2021. “Venture Capital Makes a Record $17 Billion Bet on Crypto World.”

A large portion of this milestone comes from a single deal, in May 2021, Block.one, a blockchain software company backed by notable investors, Peter Thiel, Alan Howard, and Louis Bacon, invested $10B of cash and digital assets into Bullish Global, a new crypto exchange, representing the largest venture investment in the space at the time the deal was done.

VCs are investing in crypto assets to establish an alternative universe of finance, trade, communications, and entertainment on the internet, with the intent to revolutionize large portions of the global economy. Areas of opportunities for investing in crypto assets include gaming, finance, and social networks to name a few.

Source: New York Times, October 2021. “How Venture Capitalists Think Crypto Will Reshape Commerce.”

Investing in crypto assets has provided opportunities within gaming, specifically focused on applying blockchain technology to gaming and creating coins for users to monetize their experience. Ethereum, a popular blockchain platform, has been gaining market share for hosting games on their platform, providing a “decentralized platform” for users to build on top of games.

A blockchain can be described as a chain of “data blocks” which is run on a computer network and is accessible by all its users and outside parties. These data blocks keep a running tab of network activity, serving as a master ledger for the game. Because these data blocks are run on a computer network, which can be accessed by all, anyone is able to add to these data blocks and build on the blockchain. This is a key distinction with blockchain, as it means the platform is “decentralized”, meaning there is no central governing body.

For example, let’s look at a traditional gaming experience, like Call of Duty. The video game franchise is owned and managed by Activision. Activision serves as the controlling authority for the game. Players of Call of Duty can access the game, but they are unable to make significant changes to the game’s format or build upon the game; only Activision is permissioned to do so.

If a game is run on the blockchain, the game is built on a computer network that is accessible by all users. The users can add data blocks and build parts of the game, creating an ever-evolving immersive gaming experience for users.

Within the blockchain network, users are often rewarded with crypto assets after reaching certain levels of a game. These crypto assets can be exchanged for other coins, like Bitcoin and Ethereum, which can ultimately be exchanged for fiat currency.

Blockchain gaming has the potential to upend the gaming universe as its decentralized platform places more power with the users to control the game, creating a more engaging experience for players.

Sources:
Call of Duty, November 2021
Medium, June 2021. “Blockchain Games Will Revolutionize the Gaming Industry.”

Venture capitalists are applying blockchain technology to disrupt the notion that banks control the flow of money.

Investing in crypto assets within finance leverages the foundation of blockchain technology to hold the records of these transactions on the series of data blocks, which are controlled by users, not a central governing body. Running these financial transactions on a decentralized platform is also referred to as Decentralized Finance or DeFi.

With centralized systems, a governing body holds all the control behind the transactions, which impacts the speed and level of complexity, resulting in users having less control over their money.

In the example below, imagine that Bill uses a credit card to pay for a cup of coffee. When Bill swipes his card, the transaction gets sent to the credit card issuer. The credit card issuer needs to check that Bill has the requisite credit available for this transaction. Once the credit card company verifies that Bill has the necessary credit for his $5 cup of coffee, the transaction is then approved, and the barista can provide Bill with his coffee. All of this takes less than 5 seconds to review and is barely noticeable to Bill. However, this transaction is contingent on the credit card company’s ability to review the transaction. If this single governing body fails to review the transaction, Bill doesn’t get his coffee.

With DeFi, smart contracts are processed on a decentralized platform with multiple users able to review the transaction, removing the need for a financial intermediary to review the transaction.

Source: CoinDesk, September 2020. “What is DeFi?”

DeFi looks to expand blockchain’s original use of value transfer to more complex financial transactions. It is estimated that about $235B has been invested in DeFi, whereby consumers can trade, borrow, and purchase digital assets on a decentralized platform. Thanks to DeFi, consumers are rethinking the need for traditional banking intermediaries and embracing new ways to manage their digital assets. With DeFi, the technology seeks to eliminate the need for regulators to oversee financial transactions by leveraging the “trust” system with blockchain.

This technology, however, is still ironing out its kinks. Already there have been instances in which algorithm bugs have sent funds to the wrong counterparty, proving costly to investors. A report conducted by crypto intelligence firm, CipherTrace, found that DeFi-related crimes continue to grow, amounting to losses of $329 million by the end of the second quarter of 2021, compared to $106 million in the first quarter of 2021.

Source: Fortune, November 2021. “DeFi is creating a two-tiered market where insiders reap rewards and retail investors get burned, warns SEC’s Crenshaw.”

Investing in crypto assets within social networks looks to solve some of the common problems associated with traditional social media companies. Companies, like Facebook/Meta, have been under fire recently for, among other things, data privacy concerns, content ownership disputes, and having a single company controlling the shape of how we communicate. The aim of crypto asset investments in social networks is to run a social network on blockchain’s decentralized network. With a social network running on a blockchain, the users can build upon the network via data blocks and in doing so, maintain the rights for their data and content.

Blockchain investments in social media networks are referred to as DeSo or Decentralized Social because social networks are not controlled by a central governing body. For example, on Facebook/Meta, users are subject to the rules of the company and any data inputted into the platform is owned by the company. With DeSo, the social network is run on a series of data blocks and is not owned by a central governing body. With a decentralized platform, any user can access the social network and build upon the data blocks. Most importantly, the user adding to the data block owns that series of information. This ultimately gives the user more control.

BitClout is an example of a decentralized social network, which enables users to post their content on the blockchain and provides content creators the ability to monetize their social media presence via Creator Coins. These Creator Coins represent the content creator and function like stocks in that these coins are purchased by their fans who believe the perceived value in the creator will increase. As more users pile into a Creator Coin, the price of the coin goes up. The Creator Coins can ultimately be later exchanged for another cryptocurrency, like Bitcoin, which provides content creators the ability to make money from their popularity on the platform.

Sources:
Bloomberg, June 2021. “Venture Capital Makes a Record $17 Billion Bet on Crypto World.”
New York Times, October 2021. “How Venture Capitalists Think Crypto Will Reshape Commerce.”
Medium, September 2021. “Introducing DeSo: A Blockchain for Social Media.”
CMI Media Group, August 2021. “Are BitClout and Blockchain-Based Social Networks the Next Generation of Social Media?”

As with any investment, important risks and limitations must be considered, especially when investing in crypto assets. One risk, namely, is lack of regulation. While the lack of regulation offers an opportunity to explore market inefficiencies, this can leave the door open for fraud. Blockchain technology is based on not having a central governing body, which allows users to control the transactions. However, if a transaction goes awry, which inevitably happens, there is no regulating body to recover recourse.

Additionally, considering the nascency of the asset class, there is much that is still unknown. Increasingly, countries have been adding more regulation to crypto assets and blockchain. In fact, China recently announced in September 2021 that the country will make all cryptocurrency transactions illegal. Swift legal actions, such as potential regulatory decisions, have the ability to upend this sprawling asset class.

Source: BBC, September, 2021. “China declares all crypto-currency transactions illegal.”

Venture capital has long been at the forefront of technological innovation, often funding new companies that transform the paradigms in which we see the world today. As such, it is no surprise that the venture capital space is providing investors with access to innovations in the digital asset ecosystem. Venture capital is on track to deploy record amounts of investing in crypto assets, seeing opportunities in gaming, finance, and social networks for future investment.