Why we double down on Sheeldmarket's series A

Digital assets are booming

An asset class once seen as risky and confusing became an area of opportunity. More and more companies have begun allocating cash to digital assets and crypto-currencies, as Phong Le, Chairman and CFO of Microstrategy, did after investing on aggregate $2B in Bitcoin, not in a risky bet but in a new way to put its corporate cash. As he said : “[bitcoin] provides the opportunity for better returns and preserves the value of our capital over time compared to holding cash".

Many reasons are pushing corporates and institutional investors to dive into crypto-currencies. It's either a way to compensate for FIAT fluctuations in the mid / long term or a way to contribute to a new digital breakthrough for payment, control and traceability. As a matter of fact, a study realised by BitPay shows that offering Bitcoin payments attracts up to 40% of new customers.And to a lesser extent an investment in crypto can be a way to take advantage of an evolution of the value in the long run. As of February 24, 2021, Microstrategy holds an aggregate of approximately 114,000 bitcoins, acquired at an aggregate purchase price of approximately $2.171 billion. As of 21/09/2021, these 114,000 bitcoin are now worth $3.915 billion...

Deep diving into an institutional strategy, there are two distinct uses of crypto-currency investment: 1/ a willingness to be exposed to a new asset (trading firms, asset managers, Family offices) 2/ a cash investment to seek a minimum return (especially in a low or negative interest rate environment) while safeguarding the capital (corporate strategy). In both strategies, risk tolerance is absolutely opposite but the maturity of the actual crypto-world allows them to find architectures, custodians, prime-brokers, that offer solutions which suit them all. Also risk tolerance may be adjusted in setting up a wide range of cryptos in their portfolio (more stablecoins vs exotic coins).

To fit with these needs, startups had to deal with facing the same revolution as the banking system did in the early 80s : provide digital exchanges, custody, counterparts without taking aside security, liquidity and risks.

We can easily draw a parallel with the digitalization of the banking sector when we talk about digital assets for institutions. Nevertheless, if it took 35 years for a strong and reliable banking ecosystem to emerge (from Swift's launch in 1977 to 2015), it only took less than 8 (from Bitgo's creation to today) for crypto startups and VCs to rebuild it using blockchain technology, reaching a $2.17 trillion market cap in October, just below its highest peak of $2.52 trillion in May.

The crypto-fund push and the need for institutional grade solutions

According to the 2021 PWC Crypto Hedge Fund Report, there are currently around 200 active crypto hedge funds in the world (roughly 1.5-2% of total), compared to an estimated 150 for last year. 81% were created between 2017 and 2020, in the aftermath of the explosion of the bitcoin price in Q4 2017, which accelerated its democratization.

The total AuM of crypto hedge funds nearly doubled to US$3.8 billion in 2020, from US$2 billion in 2019 and US$1 billion in 2018. Global AuM of hedge funds has reached 3,826 billion in 2020, which means that 0.01% of all hedge funds' AuM is dedicated to crypto. It might not look impressive, but it's growth rate is skyrocketing.

Moreover, investors are now becoming more educated about non-traditional assets, with more than 20% of hedge funds already invested in digital assets, and 85% of them considering an increase of their capital deployment in this sector in the next months. The recent crashes and well-known high volatility of the crypto markets didn't affect their investment and risk management policies. Thus, the fit between the crypto space and institutional investors seems to be here to last in the long term.

The best example would be Blackrock, the world's biggest asset manager, which included in January bitcoin derivatives in its list of eligible assets for two of its investment funds, paving the way for potential future investments in the number one cryptocurrency. And coincidentally, in July, it increased its position up to 14.56% in Microstrategy, whose CEO Michael Saylor has been following a "buying bitcoin over gold" strategy for several months.

Another example of this rising demand coming from investors and high-net-worth individuals is the recent announcement of Wave Financial, which just crossed $1Bn AUM, doubling its amount under management in only 100 days!

More importantly, reports show EU investors seem to have a more favorable perception of digital assets relatively to their US counterparts. Reportedly, 6 out of 10 EU investors feel like digital assets have a place in investment portfolios. And yet, the largest and most high-profile digital asset investments are still taking place in the US, as EU institutional investors point to security concerns, underdeveloped market infrastructure, and regulatory classifications as the biggest obstacles to digital asset investment. In this context, there is an opportunity for a crypto fund and regulated prime broker to solve all three issues.

Sheeld : a top notch team to solve a big issue

That's why we bet on Sheeldmarket's team in late 2019. We thought this was the right moment to help institutional investors to get exposure with this new kind of asset (digital one) and offer them to trade large amount with best execution. As a matter of fact, crypto exchanges tend to operate very independently from each other, with differing onboarding requirements, varied KYC processes and separate order books. Additionally, they each have their own funding requirements, meaning for example your $1M on Kraken are not available on Coinbase. Consequently, liquidity fragmentation and low volumes can end up leading to wild price movements. Thanks to their core technology, a smart order router and an automatic cross-exchange inventory management system, institutional investors are now able to deal with a broad range of trades over the largest trading venues, all through a single account.

‍The unique combination between Jacques' track record in the banking industry and Oliver, Simon and Arnaud's, sum of expertises in the blockchain and crypto industries led us to back them from (almost) Day 1. To be very humble we didn't anticipate the bull run of mi-2020 and we thought the company would have time to test its offering and develop the product with their first customers, like every other startup does. Sometimes in VC you have an addition of market momentum + stellar execution, and this was the case with Sheeldmarket.

Of course this is just the begining but we can't wait to see the next chapter (and the release of the next products :) ) . Today, we are proud to double down on one of the best crypto-teams in Europe (100% humility but 100% non-partial).

Let's go forward : next stop -> Enablers vs Trust Providers

Beyond game changer protocols such as Eth2, Cardano, Solana, Avalanche, CasperLabs, Angle etc., institutions and corporates are in need of solutions to help them enter the cryptocurrency market. The first step of the institutional crypto wave has been made thanks to the 'enablers': architecture, exchanges and custodians. Those fields could be seen now as mature, enhancing difficulties for newcomers blocked in front of these dominant players. That being said, newcomers and VCs should take into account the next wave of 'trust providers' which will provide better liquidity, and enable better transparency (data and KYC process) and compliance.

Custody

Custodians are like ‘vaults’, holding investors’ assets, and charging them a fee in exchange for maintaining them securely. Custodians harness their market expertise to minimise the risk of fraud, theft or loss to those assets. Unlike custodians in the old fashioned banking system, custodians of digital assets are only holding the private key on behalf of the asset holder.

As more money is flowing into digital assets, individuals and institutions begin to consider safeguarding as a growing priority. From an investor's perspective, it's safer to store your asset with a custodian as the online nature of a cryptocurrency (or token) increases the cyber risk. Besides, the combination of an exchange + a custodian (like in the retail with Bitpanda or Coinbase) is a greater risk as hackers often concentrate on these high value targets.

That's why, even in 2021, the custody market is heating up like never before.

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Confidence is "key" (:)) in the safety of digital assets, and today institutional investors have a broad range of choices to find relevant solutions for their storage (tech-provider or third party). In terms of maturity, custodians now include many well funded companies even if sometimes they are not very old (Fireblock and Anchorage have been there for up to 4 years vs 8 years for Bitgo). Fireblock raised a total amount of $489M , NYDIG $409M, Anchorage $137M and Copper $82M. Moreover, successful exits have already been made, showing first concentration in the market, with for instance the acquisition of Curv (ISR) by Paypal in March 2021.

A lot of custodians have now grown into full-service financial platforms and infrastructure providers, adding services like asset management, mining services, fiat to crypto swap...It shows two things : 1. fierce competition in depositary solutions urge them to find differentiating features but also 2. customers want to have one full-stack service provider. For instance, NYDIG is currently offering on top of their custodian platform a mining service where customers could finance their mining machines and power infrastructures.

Prime Brokers

Now that institutional custody is a more mature market, prime brokers are emerging to provide hedge funds and institutional investors more complete services regarding their will of investments. SheeldMarket, Tagomi (exited ; Coinbase 2020) or FalconX could be referred to as pioneers when it comes to prime brokerage for cryptocurrency.

One of the main pain that those brokers are targeting is the access to the deepest liquidity pools. Indeed, the market is fragmented with around 6,900 coins distributed on hundreds of exchange platforms. This distribution leads to a fragmented liquidity so that the large positions taken by institutional investors (compared to retail positions) require advanced execution algorithms to fill in the orders without significantly impacting the market (low liquidity increases market variations). That's what SheeldMarket is offering. They blend liquidity from exchanges, OTC desks and their own dark pool with advanced order execution algorithms to ensure deep liquidity for institutional investors.

Some custodian companies are following the trend of prime brokers. Coinbase, one of the pioneers when it comes to trading crypto, recently announced the launch of their prime crypto brokerage solution for all institutional investors, after a beta launched in May 2021.

That being said, the rise of prime brokers could cope with development barriers in the near future, as few of them are regulated for now and institutional investors may ask for it. In Europe, SheeldMarket is at the forefront of this new trend, as the company has already been registered to be a Digital Asset Service Provider, providing trust to institutional investors.

Market Analytics & Data

Price movements, volumes dynamics, order books... the increase of trades provided the market with huge volumes of data. Thus, the existing solutions of data analytics, rather dedicated to retail investors (e.g. CoinMarketCap), started not to be enough for institutional investors who need enterprise-grade analytic tools on which they can rely.

The field of data providers in cryptocurrency is crowded, as one of the promises of a decentralized system is that everyone can access the data freely. With the 2017s increase of ICOs, a significant amount of projects came on the market and investors started requesting more datas in order to better price cryptos (quantitative methods, but also analyse the differences of volume and trades between platforms).

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It is precisely where "Digital Assets Market Data for Enterprises" solutions such as Kaiko appeared. By providing enterprise-grade data analytic solutions, those companies allowed institutional investors to enter the market and better understand its evolution, enabling them to deploy investment strategies relying on real time data from hundreds of exchanges and instruments.

‍As the volume of data is correlated with the evolution of the cryptocurrency market, the need to aggregate and easily analyse is increasing sharply. Last year, Anchorage acquired Merkle Data, a leading provider of risk and data solutions for crypto institutions, with the will to better serve the needs of their clients while providing "quantitative analytics and sophisticated risk modeling capabilities".

Crypto tax management & bookkeeping

With the rise of cryptocurrencies, governments and regulatory authorities started to look at this "unregulated" market. In France, the 2019 financial law implemented a flat tax rate for crypto investors. The government declared that both the exchanges of digital assets for state currency and the use of a digital asset as payment were taxable operations. Those operations are to be taxed at a global rate of 30%.

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Here comes the problem: solutions for crypto tax management were missing. People had to consolidate their wallets, find out the pricing of each crypto and calculate the taxable capital gains. With the arrival of institutional investors, B2B crypto tax management and bookkeeping solutions started to emerge to fill this gap.

‍Lumina, based in the US, went out with a solution of portfolio management dedicated to institutional investors in which you could do your accounting and taxes. The company was acquired by BitGo in April 2020, with the aim to "provide institutional investors with data analytics, tax, and reporting capabilities". This exit demonstrates rapid consolidation on the market, with custodians willing to have a larger footprint on the value chain.

This trend keeps on going, as crypto taxes are still under development and vary from one country to another. Recently, democrats in the US announced that they wanted to raise taxes to fund the recovery plan of Joe Biden, with a focus on new taxes on cryptocurrencies. As institutional investors have not appeared to be deterred by the new US taxes, solutions such as Lumina (US), Cryptio (FR), Blockpit (AT) or CoinTracker (US) should continue to emerge in the coming months to meet this need.

However, there is a lack of clarity on where to classify cryptos regarding taxes. Indeed, all of this is driven by the global increase of public authorities' comprehension of cryptocurrencies, which is quite slow. For instance, there is currently no taxation on cryptos’ swaps for stable coins, since stablecoins are not considered as cash, so we can expect updates in the coming years.

Compliance, Risk Management & Security

Once the arrival of institutional investors on the cryptocurrency market has passed, solutions must be deployed to make them stay :we're talking about compliance, regulation & security.

• Compliance & Regulation

Even if some pure players in the blockchain and cryptocurrency fields want to stay in the dark, if the trend is massively adopted, there will be a pressing need for better solutions in terms of risk management and transaction flows (incoming and outgoing) monitoring.

‍Indeed, because some cryptocurrencies such as Monero are still anonymous and don't disclaim the identity of their users nor the amounts transferred, and because blockchain transactions in general are quite complex to interpret, institutional investors must find a way to ensure that they aren't involved in the financing of terrorism (4% of all transactions with cryptos), or that their AML policy remains efficient. This also concerns government agencies, with for instance the USA announcing in June that they would expand to cryptocurrency analysis to fight against ransomware-tied transactions, or South Korea which has been actively conducting a ban policy for privacy-focused cryptocurrencies since 2018.

To tackle this issue, financial institutions, governmental agencies and cryptocurrency businesses are in urgent need of cryptos-related blockchain data. That way, they could better understand their exposure to cryptos and the entities at the origin of each transaction, so that they could better monitor their customer activities and adapt their KYC policy. For instance, Chainalysis provides institutions such as Barclays, Square, Bitpay or Europol and the UN with investigation tools to analyze each blockchain transaction and assess its risk.

Several players operate on this segment, of which Elliptic, CipherTrace acquired by MasterCard , or TRM Labs, founded in 2017, and which as experienced a 600% yoy growth of its business activities. Their rapid success highlights the growing need and demand for institutional compliance monitoring tools. Nevertheless, if some solutions are emerging to tackle the compliance around blockchain and Defi, there is still a blur between cryptocurrencies and the other financial assets, causing public authorities to be cautious, afraid and hesitant in front of big players that are now dealing with several billions dollars per year.

A most recent example showed that it's maybe the end of the "wild west". At the beginning of September, the SEC announced plans to sue Coinbase relative to an offering of yield product called "Lend". The SEC said Coinbase is not regulated to offer such a product as they guaranteed interests (4% APY). After having reacted strongly in public and showing their muscles without a clear defense, Coinbase decided to cancel the launch of Lend. Financial regulators are turning their sights to crypto businesses and pushing them to comply with the local regulations.

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France is definitively one of the best place in Europe to set up a crypto business thanks to the modern view of the AMF (the french SEC) and its DASP regulation, enhancing crypto-startups to emerge and access a clear regulatory rule. Beyond startups, the CDC (french depository fund) recently announced that they have registered to became a DASP, becoming the first public institution to obtain this legal recognition. This will allow the CDC to store crypto-currency on behalf of third parties.

‍We could also thank the ADAN initiative which wants to shake things and is pushing new tax rules to the french National Assembly for the next "Loi de finance 2022" (French finance act 2022), with proposals like the tax neutralization for crypto exchanges in an enterprise financing purpose, the carring-forward crypto and token losses for 10 years, or a better split between professional and non professional trading (same treatment as in financial markets). Overall, bills are currently being discussed with the will to equate crypto taxation with stock market transactions and thus bury the final entry of cryptos into the financial world.

All in all, we consider it’s a good thing to put an end to the "wild west" because regulation is the first step to see a massive adoption of crypto. Even if, of course, it will put somehow complexity, disagreements, adding process for launching new products, it's also the best way to strengthen confidence for users, borrowers, lenders and relationships between all the players of the value chain. In the startup field, every initiative, software providers, advisory firm will strongly benefit from this. On the regulatory side, international rules or at least a common view should be shared between organisations.

• (Cyber)Security

Even if one of the blockchain's advantages is security, cyber criminality is rising into the cryptocurrency field. In august 2021, hackers have stolen $600M on the site Poly Network, the biggest hack up to date. Other platforms such as QuadrigaCX, UPbit or Binance also suffered from hacks, resulting in millions of stolen cryptocurrencies. This lack of security may make some investors reluctant about the crypto market.

‍While traditional cybersecurity solutions could help, some companies are trying to innovate building solutions thanks to blockchain. Lossless, for example, is building a protocol able to "freeze fraudulent transactions based on a set of fraud identification parameters, and return stolen funds back to the owner’s account". Such solution could allow to automatically return funds following hacks or other frauds (money laundering etc) and to reduce cybercrime.

Conclusion

The hardest part is still to come. Even if some part of the B2B crypto fields are more mature than others, there is a lot of work to be done to spread full adoption of the market by institutions.

This virtuous circle shows that the will to enter the market is high and therefore many solutions should emerge in the next few months. Compliance and regulation could be the figurehead of this adoption. As Julian Sawyer, CEO of Bitstamp, said in an exchange with CoinTelegraph: “By separating good actors from the bad, building more trust with investors and holding companies responsible for their actions through clearer guidelines, regulatory interest means credibility and growth for the whole industry". Also, from a broader perspective, the cryptocurrency market will have to reduce its carbon footprint to be fully in line with long-term sustainable development.

The entry of institutional investors is a good indicator of a market maturing and becoming mainstream. And their needs in terms of compliance, security and regulation will drag others professional investors and retail players in the mid term.

In this game, VCs and startups are bound to live exciting and challenging times !Do not hesitate to comment, share or reach out to discuss about it with us 🙂

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‍Axeleo Capital I is our fund, dedicated to early-stage B2B digital startups. Only heroes make seed investments. We are convinced that extraordinary teams need first believers before the business scaling-up phase. We focus our analysis on product quality and team constitution to bring best-of-breed solutions to the market. Easy-to-use, adapted to customers’ IT ecosystem and beautiful products are what we seek.