Q2 2018: Material Development in a Bear Market
The industry of token-based projects in 2018 Q2 saw development along a variety of axes, as projects continued to raise funds, build their applications, and work within regulatory regimes.
Token Sale Funding
In Q2 2018, 202 projects raised over $4.8 billion through token sales for a diverse array of projects in the cryptoasset space. This figure represents a decline from the $6.7 billion raised in Q1, likely reflecting a broader cooldown in cryptoasset markets and several developments within the blockchain industry. Despite this, more funding has been raised through token sales in the first half of 2018 than in 2013-2017 combined. In examining the token sale data, live versions of which can now be viewed with the Smith + Crown ICO Tracker, several trends are notable.
A small number of projects captured considerable portions of the total funds raised. In Q2, this surfaced most clearly with EOS, which raised $1.9 billion in the final three months of its year-long token sale for a scalable smart contract platform with a Delegated Proof of Stake architecture. As illustrated below, EOS represents over 40% of the total funds raised in the quarter. EOS raised nearly $4.2 billion in total over the course of its year-long sale, of which $1 billion has been allocated to various ecosystem funds to promote development of auxiliary applications and services. Additionally, TaTaTu raised $575 million in a June private sale for a video entertainment CDN with a tokenized rewards system, accounting for over half of the funds raised in June.
While the concentration of funds raised is notable, arguably even concerning, the full array of projects conducting token sales–not only those capturing mainstream headlines with 9-figure raises–demonstrates the breadth of opportunity and scale of development, suggesting a token sale market surprisingly robust within a broader bear market that has characterized the first two quarters of 2018. Q2 saw a variety of such promising projects that arguably flew below the radar of many observers, developing at the protocol, infrastructure, and application layers of the blockchain technology stack. Amongst noteworthy projects Smith + Crown examined, examples include FIC Network (a listing and exchange platform for fixed income financial instruments), Virtue Poker (a smart contract-based online poker site), and RightMesh (a wireless internet mesh network). Each of these projects raised between $5-$30 million, a substantial sum granting significant runway for development without the intense public scrutiny often associated with projects with the largest raises. The chart below considers the number of sales in each raise band for the previous three quarters, illustrating the continued strength of this ‘mid-tier’ market segment relative to the total number of sales. Given that token sales bore the brunt of criticism in the blockchain industry over the past year, one might have expected the practice to dwindle significantly or disappear entirely.
Token Sales by Sector
Projects working in a wide variety of sectors raised funds in Q2, though a large percentage of the funds were concentrated to only a few sectors. Beyond the aggregated funds raised data, it is also illustrative to consider the distribution of funds and number of projects in Q2 grouped by the Smith + Crown Industry and Sector classification.
The difference in sectoral distributions between funds raised and number of projects is notable. While total funding is fairly concentrated in a few sectors, the number of projects conducting successful raises is relatively distributed across the entire landscape. In terms of the number of projects, Q2 saw a variety of projects in the gaming, exchange, and advertising sectors complete successful funding rounds. The total amount of funds raised was much less equally distributed across sectors, with just four sectors accounting for over half of all funds raised. Total funding for particular sectors was also very concentrated, such as EOS accounting for over 90% of the smart contract platform sector and TaTaTu for nearly 80% of the entertainment sector. The contrast in distribution between the above charts suggests that entrepreneurs are continuing to find and explore varied use cases for blockchain technology and that token sale participants continue to willingly fund such projects, but that this opportunity is not evenly distributed across the entire sectoral landscape nor within an individual sector.
Beyond new projects raising funds for development, a variety of early token sales are beginning to launch initial versions of their application. Notable examples include Basic Attention Token, Open Simple Token, 0x, and Aragon, each of which has made meaningful progress in their development roadmaps after conducting token sales in 2017. Further, the Augur prediction market platform, which raised $5 million in a 2015 token sale, launched in early July. While many have decried the apparent lack of working products stemming from token sales, Augur serves as a reminder that the range of challenges in launching cryptoeconomic systems extends beyond expected areas such as creating a business model, writing smart contracts, and marketing. For instance, a core issue in actualizing a blockchain-based prediction market is that of designing an oracle to report and verify information about events external to the blockchain. In creating a platform for user-generated prediction markets, Augur needed to consider various game-theoretic design challenges and incentive mechanisms to promote accurate reporting of these events through an oracle system. While Augur’s specific challenges and innovation, which are still under active development, are of course not uniform across all projects, they do remind onlookers that the industry is still in its early days and that hard technical and design problems abound. Many projects raising in mid 2017 – early 2018 are still in their relative infancy and will take time to develop, though meaningful progress and iteration is apparent.
Such existing projects coming online will have implications for new projects, both as they devise architecture for their own functionality and as they compete in a crowded marketplace for funding. Projects may aim to integrate the existing functionality of certain infrastructure-layer projects in particular, such as Augur’s oracle system or the 0x decentralized exchange protocol, into their own design, leveraging and extending this to build further applications and use cases. As more projects function, particularly at scale and with robust mechanisms for interoperability, the conceivable design space for other projects multiplies. This is not a new phenomena in the broader technology space of course, but it does represent a development in the cryptoasset space, which is still in its relative infancy. Product launches may also have implications for other projects as they seek funding, as potential investors will have a more robust set of reference points and opportunity for greater understanding of the components necessary to bring a blockchain-based venture to fruition.
This idea of iterating upon existing approaches that are already functional, at least to some degree, is hardly new, of course. Ethereum as a decentralized alternative to perceived shortcomings in Bitcoin’s structure, Litecoin emerging as the ‘silver to Bitcoin’s gold,’ or the search for scaling solutions that attracted considerable attention throughout 2017 show that this process did not emerge in the first half of 2018. But an acceleration of this trend, and a widening of the realms throughout which it can be identified does appear to be observable lately. For example, Q2 2018 saw what can be termed iteration in the realm of stablecoins, where Tether’s existing functionality, measured by its market cap and setting aside the various associated concerns, has not prevented the emergence of a wide variety of stablecoin attempts.
Diversification of Smart Contract Platforms & Token Swaps
Q2 saw further development in the smart contract platform sector in particular, as projects begin to offer differentiating features from Ethereum. As noted in Smith + Crown’s discussion of EOS, some new offerings have responded to the Ethereum network’s continued issue of scaling by releasing smart contract platforms designed to address this problem. Projects concerned that Ethereum’s current design cannot scale to meet the needs of the various applications building upon Ethereum are beginning to consider moving to other platforms that offer increased transaction throughput. This open problem in the industry manifests both in application layer projects considering which protocols and platforms to build upon, and as an increased incentive to develop new scalable protocols to support current and future applications. Notably, Kik aims to utilize a fork of Stellar as its consensus layer. Other notable smart contract platforms under development in 2018 include Tezos, Dfinity, and Aeternity. Many of these protocols utilize a Proof of Stake or Delegated Proof of Stake consensus mechanism, the latter of which introduces a tradeoff of decentralization for increased transaction throughput that results from fewer nodes confirming the chain state. The trend of smart contract platform diversification and competition bears watching, as Ethereum has been the dominant platform thus far and outlasted a wave of proposed alternatives in 2016 and early 2017.
Also notable in Q2 was how a number of emerging projects have utilized Ethereum solely as a fundraising platform, with plans to shift development and token holdings to a native or alternative smart contract platform at a later stage. There is a certain degree of irony in this – raising funds through a platform in order to build a direct competitor to that platform. Projects such as ICON, Zilliqa, and EOS issued ERC-20 tokens under this plan throughout the past year, and have launched main networks this summer. Through a ‘token swap’ process, the tokens used for fundraising purposes are simply placeholders, with holders allocated an equivalent number of tokens when the main network launches. This launch is not always a smooth process, as evidenced by the uncertainty and phishing attempts surrounding EOS’ launch in early June. While this token swap process is not necessarily more difficult than maintaining a token economy on the original sale platform, it does illustrate one way in which projects may leverage certain advantages and network effects of existing infrastructure, particularly Ethereum as a fundraising platform, to develop future iterations and competitors.
Registered Offerings and Regulation D
Another trend in the token sale market over the past three quarters is the emergence of US-based token sales registering with the SEC under a Regulation D exemption, which enables companies to raise from accredited investors without completing full securities registration. Many such projects are raising funds under a Reg D exemption through instruments such as the Simple Agreement for Future Tokens, or SAFT. A SAFT is an investment contract whereby accredited investors fund development of a pre-launch blockchain network or application, in exchange for tokens deliverable upon launch. Established by Filecoin developer Protocol Labs and Cooley LLP, the SAFT aims to provide a compliant framework for token sales, particularly in the United States within the context of the Howey test. By offering the SAFT as an investment opportunity to accredited investors exclusively, projects may avoid the cost of providing full financial disclosures to the SEC and related entities (or the regulatory risk of raising money from non-accredited investors without doing so), reducing a considerable burden on what are typically early stage ventures. Once the token is functional on a network or application, it is distributed to SAFT investors and can be resold to non-accredited users on secondary markets, on the grounds that the token’s newfound utility to users within the network render it a commodity, instead of a security. While particular aspects of the SAFT framework are under development and have yet to be recognized or verified by the existing legal structure, it does represent a key step in integrating the rapidly evolving token sale space with existing securities law practices.
Some of these sales are hosted through compliance focused platforms such as CoinList, which facilitated the first SAFT offering in September 2017 with Filecoin. At least 43 projects have completed similar offerings to date, cumulatively raising over $2.9 billion, including $1.7 billion for Telegram. The chart below illustrates the prevalence of SAFTs and SAFT-like instruments since late 2017, defined broadly as projects who register a token offering through a Reg D exemption and file a form D publically available through the SEC EDGAR database. It includes cases such as Telegram, whose Form D specifies a “Purchase Agreement for Cryptocurrency” for a pre-functional network, perhaps similar in spirit to the SAFT.
At least 18 projects completed Reg D offerings in Q2, raising over $278 million. Notable offerings in Q2 included Basis, a stable cryptocurrency with an algorithmic central bank, Orchid, an ongoing sale for a distributed internet bandwidth marketplace, and TrustToken, an ongoing sale for an off-chain asset tokenization platform. Each of these projects raised or is raising funds primarily or exclusively through accredited investors or various VC funds. Indeed, there is a certain degree of irony here – token sales ostensibly could democratize access to early-stage venture investing opportunities, though increasingly access to top-flight projects is limited to a familiar, entrenched set of VCs and institutional investors. Alternative options such as a Regulation A offering, which allows non-accredited investors to participate, could provide a more inclusive route, though the practice broadly is new and has not proven to be a popular option to date.
While this trend of registered offerings emerged in late 2017 and is not exclusive to Q2, the continued breadth and quality of many of these offerings represents an unfolding trend in 2018, and one that may expand in scope as further regulatory clarity emerges. Indeed, the willingness of projects to either work within or seek to influence developments in the off-chain realities of regulation and state control is a core tension of the industry observed in the Smith + Crown discussion of Etherisc, which will likely continue to influence and motivate projects in the coming months. As both popular and regulatory attention on the cryptoasset space increased dramatically in late 2017, projects perhaps faced an increasing pressure to integrate into the larger financial and technology spheres and their associated rulesets, motivating the development of instruments such as the SAFT, which represents an innovative mechanism to conduct potentially compliant token sales within the existing Reg D framework. In any event, the willingness of projects to work within existing institutions and registration processes – SAFT, Reg D, Reg A, or otherwise – will continue to shape and signal the status of the blockchain space as a maturing industry.
Reviewing regulatory news, an official statement from the SEC Director of Corporate Finance William Hinman that current ETH transactions are not securities transactions represents the most notable development in the US. Crucially, this statement leaves open the possibility that the original token sale of ETH was an unregistered security offering, clarifying that a cryptoasset’s securitization status can change over its lifetime. Hinman emphasized that the Ethereum network’s current degree of functional decentralization was a key determining factor: “[i]f the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract.” This statement did not illuminate a strict guideline or test for this metric of functional decentralization, which will likely be the subject of extended legal debate and opinion. This is a notable development for the space, both because it clarifies a widespread uncertainty about a core protocol of the current Web3 technology stack and because it suggests a dynamic interpretation of existing securities law by regulators.
Expanding to international markets, the quarter saw a number of key regulatory developments, primarily demonstrating governments’ increasing willingness to facilitate innovation by developing clear, local frameworks to attract and retain cryptocurrency-related businesses. Notably, Malta unveiled a national regulatory framework for blockchain technology and related businesses, a first globally. Following this announcement, leading cryptoasset exchange Binance extended its operations in the country, aiming to form a regulated bank after previously moving its core trading operation there in late April. In South Korea, regulators are considering cryptoasset exchange security with tightened AML requirements and a proposed self-regulatory framework, after major attacks on Coinrail and Bithumb in June.
While initial examination of the aggregate funding trend in Q2 suggest a challenged market, a closer look reveals a number of trends pointing toward a maturing market with a range of project development and iteration on incumbent structures. Certain trends from the beginning of the year continued in Q2, such as the concentration of funds raised to a small number of projects, particularly smart contract platforms, and the registration of offerings through Reg D and the SAFT framework. Other trends, such as the emergence of token swaps, burgeoning competition among smart contract platforms, and regulatory developments suggest new ideas that will continue to shape the market moving forward in 2018.