November 2018 - Market Update

November 1, 2018 Ikigai HQ

Monthly Update || November 2018

OPENING REMARKS

Greetings from inside Ikigai Asset Management1 headquarters in Marina Del Rey, CA. We welcome the opportunity to bring to you our second Monthly Update and hope these are helpful in better understanding what we’re doing and what we’re seeing. We have the privilege of deploying capital on behalf of our investors into a new technology and asset class that we believe will fundamentally change the world and create trillions of dollars of value in the process. We believe we are obligated to be shepherds of this technology – to help the world better understand the powerful potential of DLT and crypto assets, and to fund and be an ambassador for DLT projects that will change our lives forever.

To that end, we are heads down building a world-class crypto asset management firm and the results are showing. Our team of 17 in LA and two working remote are making daily progress on multiple fronts – news flow synthesis; qualitative framework architecting; narrative tracking and assessment; new valuation framework creation; quantitative analysis; sentiment analysis; trading tools construction; venture deal origination and diligence; Internal Ventures origination, execution and management; partnership exploration; exchange and OTC onboarding; driving operational excellence; hiring team members; speaking at conferences; and meeting with investors. We are making great strides and we are proud of that.

While building an outstanding organization is never a finished job, much of the heavy lifting has been completed. The slab has been poured and the framing has been erected. We are ready to drive superior risk-adjusted returns on a repeatable basis and we believe our timing is ideal. Put simply, we are ready.

1. Ikigai Asset Management is the trade name for a collection of advisory and consulting businesses operated by Travis Kling, Timothy Lewis, Anthony Emtman, and their team.

OCTOBER HIGHLIGHTS

• Yale endowment invests in crypto fund

• TD Ameritrade invests in institutional crypto exchange ErisX

• Circle acquires SeedInvest

• Ric Edelman invests in Bitwise

• Fidelity to offer crypto custody in early 2019

• ICE-backed Bakkt exchange sets December 12 launch date

• Binance receives investment from Singapore Govt-owned Vertex Ventures

• Coinbase obtains license from NY State to operate as a Qualified Custodian

• VanEck makes significant progress with regulators on a BTC ETF

• Coinbases raises $300mm at an $8bn valuation

TETHER

This is a saga that you’ve likely heard about for well over a year and has recently reared its head again. The details are vague and I could certainly be missing some things or getting some things wrong, but the story goes something like this - Noble Bank, the bank of Tether (USDT) had been trying to raise money at the operating level for months. Lots of folks took a look and there were no bidders, presumably due, at least in part, to the inability to get comfort around the co-mingling of funds between USDT and Bitfinex, which are essentially controlled by the same people, and who were customers at Noble, as was Jump (who is also an investor in Noble). About 8 weeks ago, Noble kicked USDT out as a client. Shortly thereafter, Bitfinex either quit or was fired by Noble. Bitfinex quickly got a new bank account at HSBC under a shell company, but was kicked out after about 2 weeks when HSBC found out who it was. Bitfinex has been kicked out of 5 banks in 8 months. Meanwhile, USDT got a shady bank in the Bahamas called Deltec to handle the impending redemptions. Noble may have found a buyer but the future is unclear there.

All of this came to head the night of 10/14 as there was a crisis of confidence in USDT. USDT prices plunged and prices of more trustworthy competitors like TUSD, USDC and PAX soared. Crypto asset prices became distorted as many are shown relative to USDT. As USDT price dropped, crypto asset prices appeared to rise, albeit artificially. This divergence is apparent when comparing fiat-onramps to USDT dominated exchanges. (see yellow line denoting Coinbase prices in bottom chart).

Source: TradingView. As of 10/30/18.

At the time, on Sunday night, it looked like we might be witnessing the real-time collapse of USDT, which has grown to systemic importance in the crypto ecosystem. With hindsight, as shown on the charts above, that Sunday night was peak USDT stress and well-informed market participants stepped in to close the arb by redeeming USDT for USD out of Deltec in the days thereafter. This was a very profitable, low-risk trade for individuals who knew the amount of USD collateral Tether had and could access that USD when redeeming USDT.

In total, $1,040mm USDT was “redeemed” out of circulation and into the USDT Treasury. Of that $1,040mm, $500mm was “destroyed”. We believe this is a meaningful market occurrence.

Source: Omniexplorer. As of 10/30/18.

In the meantime, the market caps of TUSD, USDC and PAX soared.

Source: CoinMarketCap. As of 10/30/18.

In aggregate, TUSD, USDC and PAX market cap has grown >$300mm recently. It is clear that fiat currencies are leaving USDT en masse and at least part of that has flowed into other, more trustworthy Stablecoins. Looking solely at the delta between the decline in USDT in circulation and the increase in competing Stablecoins’ market cap, it would appear that >$700mm moved into either fiat or other crypto assets. This large apparent shift has occured in the context of incredibly stable BTC prices. We struggle to make sense of this, and we may be missing something; or it may just be evidence of highly manipulated crypto prices. Where did all that USD go?

Source: TradingView. As of 10/30/18.

Going forward, it’s hard to say for sure but it appears the confidence in USDT may be permanently impaired and the ecosystem is quickly moving towards regulated, safer alternatives. USDT utilization was pervasive across the space, so it will take time to rejigger the system to use other Stablecoins. If what we’ve already seen was the max pain relative to USDT worries and now it’s importance to the ecosystem will fade, that was a GREAT outcome for the space, as it removes uncertainty. We will continue to closely monitor this situation.

MARKET UPDATE – VENTURE CRYPTO ASSET INVESTING

Over the last month, our venture crypto asset investing business has been in full swing, averaging about a deal a day being assessed, and that pace is increasing. Our intake, assessment, diligencing and execution processes are in place and operating effectively. We pass on many projects within the first hour of diligence, as they do not possess the characteristics of a compelling investment opportunity. For others, the project may have compelling investment characteristics, but the valuation is too high. Currently, we are seeing this often. Many crypto funds have significant AUM tied up in illiquid investments that they don’t want to be publicly listed because of the imminent, immediate price decline relative to where these funds have these investments marked, which is at cost or in some cases even higher. Still, many of the top tier crypto funds that do have deployable capital appear to be willing to club up and invest in highly-valued venture crypto deals, justifying the prices being paid because “this is the next Ethereum” or “other smart investors are in”. In many cases, these funds are still playing a game of greater fool, with the expectation that returns will be insulated by a future fundraising round at much higher valuations than their investment, and that eventually the project will be listed publicly, and early investors will be able to unload on retail buyers. We find these justifications to be inadequate and the risk-adjusted return propositions to be broadly unattractive. This aspect of current market structure feels like it has another shoe waiting to drop. We believe venture crypto asset investing may have simply risen too far, too fast. Values of unused networks have been irrational. The ecosystem needs to build and deploy secure infrastructure before attracting network participation. This process is ongoing.

That being said, venture deal structures are evolving. Many raises are now leading with equity rather than a token. These equity raises may have SAFT’s attached to them, or in some cases the equity may convert into Utility Tokens at a later time. In other instances, we’re seeing capital raises via Security Token with a totally separate token distribution model for a Utility Token at a later date. In each case, there is acknowledgement, explicitly or otherwise, that the ecosystem does not currently know how to create a token structure for most types of Utility Tokens that will accrue value over the long term. As such, the strategy is to raise equity capital now and sort out the token structure later when the ecosystem’s understanding as a whole evolves further. We believe this is a step in the right direction from where we were in 2017 and early 2018, when the vast majority of ICOs had token structures that were fundamentally flawed in their ability to accrue value over the long term.

While we remain patient, the current venture crypto asset landscape is not entirely devoid of compelling investment opportunities. We are finding smaller deals, some under $15mm, that possess many characteristics of a compelling investment opportunity. In other cases, valuations may be >$50mm but the technology is fully functional, patent-protected, with a clear revenue model and a strong go-to-market strategy. We may be in a position to execute on several of these transactions before year-end.

Overall, we practice patience. We are planning on running Ikigai for the next 20 years. We believe we could miss 100 good venture deals and still produce outstanding returns for our investors, because there will be that many bites at the apple. In the current environment with so much uncertainty present in every corner of the market, our hurdle to make an investmentwhich, in many cases, we will be locked into for 12-18 months, is quite high. We believe this is the prudent approach to generating attractive risk-adjusted returns on a repeatable basis.

MARKET UPDATE – LIQUID DIGITAL ASSET INVESTING

Source: CoinMarketCap. As of 10/31/18.

October crypto markets were characterized by USDT fears and meaningful declines in trading volume, with the backdrop of significant stress in traditional asset classes.

Volume has gone from bad to worse. It is currently a small percentage of the volume from earlier this year. The volume shown below doesn’t even tell the entire story. A meaningful portion of this volume, perhaps well over half, is actually wash trading on unregulated exchanges. The depth of order books is very shallow. Despite about ~$5mm of daily volume on paper and a ~$150mm market cap, one could easily depress the price 20% or more attempting to sell $1mm of an asset outside the top 30, over a several day period on-exchange. This puts the market in a precarious position.

Source: TradingView. As of 10/30/18.

Dominance has stayed approximately flat in the low 50’s, while the Bottom 99 is leaking lower- currently 20% off the ATL.

Source: CoinMarketCap. As of 10/31/18.

Last month, we talked about a Bottom 99 that could trough as low as $40-50bn if not lower. We still think that could happen. However, we acknowledge the inherent flaws in this framework, like all crypto asset valuation frameworks taken in isolation. One of those flaws is the reliance on “paper” market cap, rife with wash trading, that is a distorted representation of actual capital deployed, the motivations of that capital, and the cost basis of that capital might be. Another potential flaw is the assumption that this current market is comparable to historical crypto asset markets. While we are acutely wary of the risks in assuming “this time is different”, we also acknowledge the drastically different market participants, structure, awareness and investor capital “in-play” at the current juncture relative to just one year ago.

Instead of relying solely on this Bottom 99 framework, we have constructed a set of scenario analyses based on what the next 1-6 months might look like. For each of the many scenarios, we have identified key, defining characteristics of each regime, which will be used to identify the specific regime as it unfolds in real-time. Different portfolio constructions will be applied depending on the specific regime observed.

Cross-Coin Correlations have generally increased over the last month from already-elevated levels.

Source: www.sifrdata.com. As of 10/31/18.

Volatility continues to collapse to new ATL’s. Even the USDT stress, which was a major event for the asset class, could do nothing more than slightly spike vol for a day before collapsing again. Volatility continues to make lower highs and lower lows into declining volume.