VCs Poured $41 Billion Into Crypto in the Past 18 Months. Is There Any Hope for a Profit?
It’s a throwaway line, a piece of boilerplate, the disclaimer every investment firm slaps on promotional material: “Past performance may not be indicative of future results.”
And yet it’s a lesson venture capitalists may want to revisit after plowing billions into the cryptocurrency market during the past two years.
Hindsight is 20/20, of course, but it’s long been clear that crypto, inflated by the quantitative easing of the Covid-19 period, was careening out of control. In 2021, the value of digital assets multiplied six times, to $3 trillion, even though the technology had yet to demonstrate mass-market adoption or utility. Bitcoin couldn’t even fulfill its basic purpose as an inflation hedge as it followed the S&P 500 index into a rates-driven bear market.
Still, VCs invested more than $25 billion in blockchain companies in 2021, and then a further $16 billion in the first six months of 2022, according to data from CB Insights. Moreover, venture capital outfits amassed a mountain of dry powder: Earlier this year, Silicon Valley stalwart Andreessen Horowitz closed a $4.5 billion crypto fund, its fourth, and former a16z partner Kathryn Haun raised $1.5 billion for her new firm’s maiden fund. Coinbase Ventures, Sequoia Capital, and Chase Coleman’s Tiger Global are also among the many VCs committed to deploying hundreds of millions of dollars to crypto start-ups in the near future.
With the sensational failure of FTX, a crypto derivatives exchange, comes an uncomfortable question: How can VCs ever hope to deliver the sizable returns their limited partners expect?
Crypto proponents aren’t going to be able to explain away the FTX disaster as just another crack-up in a lawless industry. This one is going to hurt. Much like Enron, the Texas electricity company that committed mass fraud 25 years ago, FTX has instantly become a byword for an era of hubris and recklessness.
The reason doesn’t have much to do with scale, although FTX was handling about $10 billion worth of trades a day, according to CoinGecko, a market data provider. Rather, it’s that FTX was supposed to be the responsible grown-up in an industry filled with irresponsible, nerdy kids. Yes, crypto was rife with silly Bored Ape NFTs and joke tokens such as Dogecoin. But digital assets made up a serious asset class worthy of institutional investors’ trust and capital. That was FTX’s message and brand identity. FTX raised a ton of cash from the likes of Sequoia Capital and Dan Loeb’s Third Point Ventures, for a valuation of $32 billion, which is what the Nasdaq is worth in terms of market capitalization.
Led by Sam Bankman-Fried, a 30-year-old entrepreneur with an MIT degree and a stint as a trader of exchange-traded funds, FTX carried itself like a traditional finance firm. It lobbied lawmakers just as Wall Street does, bought Super Bowl commercials, slapped its name on sports arenas, and tapped celebrities like Tom Brady to sling its services. Earlier this year, Bankman-Fried co-hosted a splashy crypto confab in the Bahamas with Anthony Scaramucci, the impresario of SALT, a prestigious forum for institutional investors. With his just-woke-up look, SBF, as he likes to be called, played the boy genius role to the hilt. He even had the cheek to wear a T-shirt and cargo shorts when he moderated a panel discussion on global affairs with Bill Clinton and Tony Blair.
Yet behind the scenes, Bahamas-based FTX was little more than a black box. Its financials were kept under wraps instead of being publicly “on-chain,” as most decentralized finance, or DeFi, companies are, with data available online. And FTX operated in tandem with a proprietary trading firm called Alameda Research, which Bankman-Fried also controlled.
What FTX did do may go down as one of the most brazen acts of legerdemain in modern finance: It minted its own digital token, FTT, then used it as collateral in Alameda’s $7.4 billion loanbook, according to a report in CoinDesk published on November 2. Indeed, 40 percent of Alameda’s balance sheet was composed of FTX’s digital scrip. Reports from the past week indicate that FTX transferred at least $4 billion to bail out Alameda as the market tanked this year.
When word got out about FTX’s and Alameda’s reliance on the homegrown token, crypto exchange Binance said it planned to sell $500 million of FTT, which it had accumulated as an early investor in FTX. The rest played out like a classic bank run: The market panicked, FTT cratered, and customers bombarded FTX with more than $5 billion in withdrawals in a single day. By November 11, FTX had filed for Chapter 11 bankruptcy protection in the U.S. In a nice bit of rhyming history, John Ray, the corporate turnaround artist who managed postcrash Enron, replaced Bankman-Fried as CEO of FTX.
The gravity of the situation for the entire crypto proposition was plain to see. “I’m really trying to control my rage,” tweeted Jesse Powell, the highly regarded CEO and co-founder of Kraken, a San Francisco–based crypto exchange. “The damage here is huge. An exchange implosion of this magnitude is a gift to Bitcoin haters all over the world. We’re going to be working to undo this for years.”
The truth is the industry was confronting existential questions long before FTX collapsed. Like any software play, blockchain technology is predicated on adoption, and 13 years after the mysterious Satoshi Nakamoto introduced Bitcoin, there’s been some implementation on the margins — shipping companies are using blockchain software to manage supply chains here and there, and museums and auction houses have found nonfungible tokens to be useful tools for recording the provenance of art. Yet crypto has failed to reinvent financial industries such as cross-border payments, securities clearing, commercial lending, and banking, each of which was supposed to have been well into a decentralized transformation by now.
“The question has always been, ‘What is the use case?’” says Eyal Malinger, a partner at Beringea, a venture capital firm based in the U.S. and the U.K.
Like many VCs, Malinger admires the inventiveness and elegance of blockchain design. The ability to reliably transfer assets between parties without the need for intermediaries and to record transactions on tamper-proof public databases is a bona fide breakthrough in computer science. Yet Malinger, whose firm doesn’t invest in crypto, says it may be hard to justify raising VC funds down the road when the market was so unhinged in 2021 and the first half of 2022.
“It was easy to raise money, but what is going to happen with all that money?” he says. “There’s few places where crypto can be interesting and add value.”
Venture capitalists have the luxury of investing over a duration of ten-plus years, and they’ve long been happy if one out of ten investments is a blockbuster. When it comes to crypto, a16z and its ilk are making the epochal-level bets their clients expect of them. Ali Yahya, a general partner in a16z’s crypto practice, says Ethereum, the top cryptocurrency after Bitcoin, provides the basis for nothing less than the next iteration of the internet.
“Blockchains are a new computing architecture,” he asserts in a podcast with The Defiant, a news site that specializes in DeFi. “They are not just about payments; they are computers.”
Likewise, a16z’s Haun says the “dawn of a new web” is primarily an infrastructure play and will change “every industry from transportation and commerce to fashion, sports, music, and more.”
Such ambition is right in character for the denizens of Sand Hill Road, and in the months to come, crypto VCs are bound to argue that FTX was an aberration that shouldn’t distract investors from the innovation of blockchain technology. Yahya, for one, says now is a time to build and “filter out the noise.”
Yet after FTX, it’s hard to see how institutional investors, save those with the highest tolerance for risk, will ever see crypto as more than a haven for Ponzi schemes and self-dealing. Moreover, the decentralized finance sector has proven so vulnerable to hacks that more than $760 million worth of cryptocurrencies was stolen in October alone, according to PeckShield, a blockchain security firm. If that wasn’t enough, Ethereum won’t have the capacity to be the financial substrate its believers truly desire until it implements a series of upgrades.
“There are fundamental limitations to the scalability of blockchain-based technologies, and every use case is better served by simpler technology except for crime, ransomware, extralegal gambling, and sanctions evasion,” writes Stephen Diehl, a software engineer and author, in an online essay.
That may be harsh — and perhaps unfair. But FTX just made sure the perception of crypto among institutional investors hews closer to Diehl’s critique than to the thesis promoted by venture capitalists. Maybe Sand Hill Road will decide to return capital to its clients rather than chase a prize that seems more out of reach than ever.