2018: The Year of Crypto Funds

【2018-08-30】

Weiyu "Wanye" Zhu, Founding Partner of NGC


The year of 2017 witnessed a jaw-dropping increase in the market cap of cryptocurrencies, and the crazy money effect that followed has attracted an influx of funds at an unprecedented velocity. While individual-oriented financing activities in this space, often referred to as Initial Coin Offerings or ICOs, are facing more and more pressure from regulators, institutional investors of cryptocurrencies, or “crypto funds,” have come to dominate this emerging financial market.


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Three Factors Giving Rise to Boom of Crypto Funds

The rise of crypto funds seems inevitable, but several factors, in particular, have contributed to how rapidly these funds have sprung into existence.

Firstly, with cryptocurrencies becoming increasingly sophisticated in terms of their technological and economic designs, it requires in most cases strong technical and financial expertise to evaluate the projects properly — an area where institutional investors can best demonstrate their strengths.

Secondly, there are a growing number of governmental authorities looking to define many cryptocurrencies as securities, which would outlaw a lot of ICO activity. In the interim, no current regulations ban institutions from participating in cryptocurrency offerings outright. This is one of the key reasons that many crypto funds have been set up over the last 12 months.

Lastly, the prospect of making handsome financial returns has surely enticed more than a few traditional venture capitalists, traders, and mutual fund managers. The most natural transition for these traditional investors would be to become institutional investors in a cryptocurrency environment.

Crypto Funds Still Require Traditional Thinking

While some view cryptocurrencies as not conforming to incumbent economic theories, conventional financial wisdom may actually be of vital necessity when treading the dangerous waters of the cryptocurrency market today.  When it comes to cryptocurrencies with security-like underlying mechanisms, investors should still check out their implied future cash flow and profitability. For most others, a comparative analysis on the valuation and competitiveness of projects within the same vertical would definitely help understand the risk-reward ratio of your potential investments.

There are a few other practices that crypto funds could borrow from traditional financial institutions from an investment standpoint. For example, many VCs find it of paramount importance to thoroughly investigate the leading member or members of a startup, or the alpha leaders of the pack. In many cases, the experience, entrepreneurship, and vision of these team leaders might dictate how far the venture could go. Team cohesiveness is another key contributing factor to a firm’s success. These are both theories that crypto funds could make use of in their due diligence processes.

It might also be instrumental for funds to deepen the understanding of secondary market cycles, as most cryptocurrencies invested will go on to get listed on exchanges quite soon. Additionally, crypto funds should dedicate more resource to post-investment operations to provide more value-add to their portfolio.

From compliance and risk control perspectives, there is also much to learn from the traditional financial institutions, e.g. the mechanisms used to avoid conflicts of interests and those used to avert risk. Many crypto funds have grown too quickly to give any serious thought to these issues yet. If they are in it for the long haul, these funds must be fully compliant and sufficiently risk-aversive in near future.

Security Tokens - The Next Big Thing?

The advantages of blockchain technology, and the incredible hype surrounding it have led to a rising number of businesses to issue their own cryptocurrencies. However, very few of them are registered securities, which would make them the most compliant form of cryptocurrencies for those seeking financial returns.

This may change with the upcoming security token regulations, which will provide a compliant way for businesses to issue cryptocurrencies as registered securities without filing for numerous reports. It is anticipated that a great number of security tokens will be registered and issued when these regulations are put in place, which will present both opportunities and challenges for crypto funds. The importance of institutional investors will be emphasized now more than ever, and a clearer regulatory environment will also mean fiercer competition between funds, as traditional VC elites are not quite ready to give up this market to the budding crypto funds just yet.

Trends and Challenges for Crypto Funds

With more traditional venture capitalists striding into the market, the competition between funds to secure allocations from the best deals will intensify. Traditional VCs, or crypto funds established by these former VCs, typically have more real-world business resources and post-investment management capacities, and this gives them an edge in competition. Since they are often better funded than most crypto funds today, these funds tend to gobble up a large share of the allocations, leaving less available for smaller funds. In this increasingly crowded space, it is advisable for crypto funds to pay attention to the adoption of best practices from the realm of traditional finance in order to stay competitive.

Other challenges may also arise from compliance requirements. Some funds have been suspected or accused of market manipulation, insider trading, front running, or other wrongdoings. The whole crypto fund industry might come under closer regulatory scrutiny in the coming months and to create a sustainable, thriving industry, funds must come together to effectively combat these illegal activities, with both technical and non-technical measures. Ensuring compliance may increase the operational expenses in the short term, but would prove vital for funds in the future.

As the crypto ecosystem continues to mature, the most successful crypto funds will be those that evolve in parallel. By adopting the best practices and strategies from traditional financial institutions, and focusing on promising projects with far-reaching potential, it’s fair to say that the reign of crypto funds will last far beyond 2018.