Has The Space Gone In Winter Sleep Mode?

US exchange Coinbase lays off 18% of its workforce in June, crypto lenders Celsius

CEL
, Voyager, and BlockFi and crypto hedge fund 3AC file for bankruptcy, Tesla sells 75% of its Bitcoin

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holdings, DeFi protocol Terra

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Luna collapses, Bitcoin drops to $16,000, the FTX bankruptcy gives the crypto industry its Enron moment, and the crypto market capitalization is down more than 60% in the last 12 months. For the crypto scene, 2022 was a bust at first glance. Therefore, the question is whether we are in the midst of a crypto winter or even a crypto ice age. Blockchain Founders Group (BFG) is at the forefront of the Web3 revolution, and in this article, we highlight the current trends in the crypto space and explain what the “crypto winter” is all about. BFG is a venture capital firm and company builder with a track record of over 35 investments in early-stage blockchain startups. Through its BFG Superstars incubation program, it co-founds about 10 crypto startups per year in 2 cohorts with ambitious and talented entrepreneurs in areas including decentralized finance, NFTs, metaverse, and carbon offsets. – Author: Prof. Dr. Philipp Sandner

What is a crypto winter?

A crypto winter is a period when the prices of all cryptocurrencies fall sharply and the apparent investor sentiment is extremely bearish. This usually happens whenever there was previously extreme euphoria and exuberance in the markets and the prices of Bitcoin & Co. have risen to a disproportionate extent. Within the crypto market, this phenomenon is relatively common. In 2018, for example, such a market collapse occurred after the ICO hype turned out to be a false promise, causing losses of many billions of dollars, especially for private investors. The current price drop can be attributed to the macroeconomic environment on the one hand, and the poor choice of some institutions and protocols on the other hand. The collapse of the Terra Luna ecosystem set off a wave of bankruptcies among crypto financial service providers, which sent the markets into crisis mode.

However, it should be noted here that such a “purge” of the ecosystem of highly leveraged and speculative players, painful as it may be, should not be seen as exclusively negative, but represents important learnings for future players.

And even if the enormous price drops of the well-known cryptocurrencies are material for attention-grabbing headlines, they majorly reflect the public investor sentiment, and therefore mainly characterize the term “crypto winter” (to differentiate – a crypto ice age would, in our eyes, take on even more drastic proportions and would accordingly be much more threatening to the existence of the crypto industry, as not only would prices fall and funding volumes drop, but also fundamentally and operationally there would be extreme pessimism and virtually no activity. This is not to say that the latest bearish event, the demise of FTX, will not have highly detrimental effects on the entire industry. There will undoubtedly be a wave of affiliated companies declaring bankruptcy, and many projects with weak finances will fail. Simultaneously, however, the lessons learned can ultimately strengthen the industry, e.g. by introducing healthy regulation, better risk management, liquidity requirements, and reserve policies, and overall, lead to more scrutiny and less greed).

Instead, let’s look at some developments in venture capital that underpin that the current phase can also be seen as an opportunity for sustainable growth and innovation and show that price drops and bankruptcies are part of the “noise”.

Developments in Q1, Q2, Q3 2022

Concerning the first half of the year, the amount of venture capital funding increased by 323% on average, and the number of funding deals increased by 118%, compared to H1 2021. Similar bullish developments can be observed in the crypto fund universe – venture crypto funds raised USD 25.9 billion in 116 rounds in the first six months to drive developments in Web3 & Co. And more and more “traditional” venture capitalists are also starting to look at the crypto market and managed to raise as much as USD 10 billion. While Q1 continued the bullish trend of the previous year, Q2 hinted at a potentially strong market turnaround in Q3, despite overall solid but flattening numbers. And indeed, the figures now released confirm those fears – total VC funding fell by nearly 70% from around $15 billion to $5 billion – and FTX’s bankruptcy means that this figure is strongly expected to fall even further for the coming quarters, as the multi-billion dollar crypto holding group was a strong influencer within the overall crypto and venture capital space, with more than 100 affiliates and numerous other partner companies.

Nevertheless, there were also positive events that caused a stir. One of the most prominent examples is heavyweight a16z, known for investments in Facebook, Airbnb, or Skype, which opened a USD 4.5 billion fund in May to take advantage of low market prices. It is also worth noting that while in 2021 and Q1 2022 the ten most active venture capitalists accounted for 65% of deal volume, in Q2 they were involved in only 42% of deals. This indicates a larger number of active capital providers and increased competition among them, which is fundamentally beneficial because it counteracts the buildup of too much market power. And even though the total value of deals has hardly changed in the first two quarters, the composition and distribution of deals have changed. Deal volume increased from 543 to 656 rounds between Q1 and Q2, although the average deal value declined from $27.5 million to $23.43 million, suggesting that VCs are becoming more risk-averse in their investment decisions and are further diversifying their holdings. Most of all deals in Q3 took place in the pre-seed and seed stage (even if it does not generate the largest volume at just under USD 1 billion), which can be seen as a positive sign: Despite the current market environment and the risk aversion of many market participants, especially young and risky crypto startups were able to raise capital. This is possibly also related to the mindset that those startups that survive the current market phase will have a clear competitive advantage over competitors afterward.

Figure 1: It can be seen that both the number and value of deals are increasing significantly year-on-year in the first 6 months, with Web3 and NFTs showing the largest gains.

Figure 2: Until the beginning of the year, there was a strong quarterly increase in the value of VC deals over the last few quarters, followed by stagnation and most recently a sharp drop in the accumulated deal value.

Selected trends in the cryptoverse

DeFi, short for “Decentralized Finance,” is a movement that strives to move financial services to the blockchain using smart contracts. In the first 6 months of this year, the DeFi space has raised more funding than 2021 as a whole, nearly $1.8 billion. In June this year, DeFi funding jumped from USD 224 million in May to USD 624 million (+179%), possibly due to the fatal collapses of several CeFi players (“Centralized Finance”). Despite Ethereum’s
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bottleneck and scaling issues, it dominated DeFi funding deals – both to address the aforementioned issues and in anticipation of the Ethereum Merge, the switch of the consensus mechanism from proof-of-work to proof-of-stake. The main focus of funding was on decentralized exchanges, asset management and yield farming protocols, and stablecoin projects. From July to September, 14% of the nearly 340 funding rounds were in the DeFi sector. Solid growth can still be expected in the long term, as only the recent liquidity and insolvency crises of several CeFi players have exposed the downside and “contagion” risks of a profit-driven single point of failure – with crypto exchange FTX as the latest example.

At the beginning of the year, CeFi investments were in extreme demand. The goal was to get as many users into the crypto space as quickly as possible. Due to their ease of use and wide range of services, centralized crypto exchanges and yield farming platforms lower the barrier of entry for many (new) crypto users, bridging the gap between the crypto world and “TradFi” (traditional finance). CeFi has accordingly amassed the highest investments in the first six months of this year, with over USD 10 billion, mainly targeting exchanges, payment providers, and market makers (>50%). The highest relative share (47%) of financing rounds with a value of more than USD 10 million can also be found in the CeFi sector. After several CeFi fiascos we mentioned earlier, CeFi players were only involved in less than 40 deals in Q3, and we expect similarly low deal volume in the coming quarters.

Another popular trend is NFTs, short for “non-fungible tokens,” which allow the ownership of digital assets to be unique, traceable, transparent, and identifiable. Although they already gained massive popularity in 2017 through CryptoKitties, it was only last year that the enormous potential of NFTs beyond digital art became clear. Here, gaming was by far the dominant deal category, with $4.1 billion in inflows in the first 6 months – about four times as much as marketplaces, which raised just under $940 million. While Ethereum remains the dominant ecosystem in the DeFi space, the tide appears to have turned for NFTs, with alternative blockchain ecosystems (e.g., Solana
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, Algorand
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, Arweave
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, Polkadot, or Avalanche
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) receiving nearly three times as much investment as Ethereum in Q2 ( $2.9 billion versus USD 1.1 billion), although Ethereum still had the higher transaction volume (125 deals versus 72 deals), i.e. more investments but with lower amounts. As NFTs are among the most speculative of all investments within the crypto market, and we are in an extremely unfavorable environment for riskier assets, NFTs were the clear losers in Q3 this year with the fewest deals ever (excluding GameFi projects incorporating NFTs, which remained among the best performing niches in Q3).

The infrastructure sector, which is the backbone of the crypto scene, raised nearly $10 billion in the first two quarters, up 3.5 times from H1 2021. Smart contract platforms as well as mining and data-centric companies enjoyed the most interest. Polygon
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, for example, raised $450 million in Q1 to advance its research and development of zero-knowledge proof technology, a novel method for scaling Layer 2 blockchains while maintaining a high level of privacy. About one-fifth of the 1199 VC rounds in H1 were focused on the infrastructure niche. Similarly, in Q3. 20% of the nearly 340 deals were in the infrastructure space.

The Web3 space enjoyed the most deals in Q3 (>44% of all deals), with a focus on GameFi and Metaverse projects. GameFi is a niche within the Web3 Space that seeks to rethink video games. Users should be able to own the in-game items themselves, which is achieved through the use of NFTs. Tokenization creates incentives for users and the foundation for what is called “player as owner” (instead of the classic “player as consumer”). The metaverse, although a very vague term, refers to virtual worlds that are supposed to provide their users with numerous opportunities and, at least in theory in terms of the decentralized ethos, ownership rights. How decentralized and egalitarian The Sandbox, Decentraland
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, and co. will ultimately be, however, remains to be critically observed.

“The current shakeout in the ecosystem will lead to consolidation, in our view. We expect Ethereum including its Layer 2 ecosystem to increasingly dominate the Layer 1 smart contract platform competition – the high number of active developers, the extensive DeFi ecosystem, the decentralization, the reliability, the successful merge, Polygon’s onboarding of numerous companies, as well as upcoming scaling progress and high Layer 2 activity are strong arguments for this thesis. Last but not least, Bitcoin’s halving is coming up in 2024, which could be a catalyst for the next crypto summer, given the overall circumstances are more favorable than currently.” — Elias Mendel, Research Analyst (Blockchain Founders Group)

Why we are in the middle of a crypto winter, but not necessarily in a crypto ice age

Although the current market environment seems extremely bleak at first glance, the numbers, at least temporarily, present a different picture at a second glance. Even though the turmoil in the markets leaves few untouched, the motto #BUIDL continues to be consistently followed, financial resources permitting, and funding and development behind the scenes continuously reached all-time highs, at least in the first half of the year. Speaking from our own experience, there remains confidence among the creators and founders of the decentralized system that DLTs have the potential to positively change many areas of our daily lives. However, the macroeconomic environment makes it extremely difficult to continue funding and deal volume at the pace of previous quarters. The days of VCs handing cheap money to projects en masse are over. In the current growth and nascent phase, the Web3 sector is still heavily dependent on the traditional financial sector and is thus also strongly affected by the consequences of quantitative tightening and other external shocks, such as the European energy crisis. Finally, it should be mentioned that after FTX’s spectacular collapse, large capital inflows can only be expected again once the new regulatory uncertainty has subsided. One of the largest trading venues lent billions of USD worth of tokens to its trading subsidiary largely unnoticed, ultimately causing a bank run and spectacular insolvency. The resulting losses in the millions for many investors and the “contagion”, the consequences of which are still not fully foreseeable, are unacceptable. This circumstance will initially weigh heavily on the crypto industry. Numerous VCs had stakes in FTX, and FTX Ventures, the VC subsidiary of the trading venue, had invested in more than 250 crypto startups together with Alameda Research. Even if existing startups continue to work diligently on their visions, more (crypto-friendly) legal certainty and more favorable macroeconomic conditions are needed before the next crypto summer can be expected. Until then, it’s best to dress warmly.

Disclaimer

The article is written for educational purposes only. The author does not provide financial advice on investing in any cryptocurrencies or other securities.

References

[1] Messari, Dove Metrics, 2022, H1 2022 Crypto Fundraising Report.

[2] Cointelegraph Research, Keychain Ventures, 2022, Venture Capital Report: 2021 Overview.

[3] Cointelegraph Research, Keychain Ventures, 2022, Venture Capital Report: 2022 Q1 Report.

[4] Cointelegraph Research, Keychain Ventures, 2022, Venture Capital Report: 2022 Q2 Report.

[5] Cointelegraph Research, Keychain Ventures, 2022, Venture Capital Report: 2022 Q3 Report.