Blockchain: Ethereal frontiers

Two recent PE investments indicate that Asia's blockchain space may be on the cusp of a new development phase driven by a migration of talent and ideas from West to East: a $5 million Series A round for Coins led by Quona Capital, and a $60 million commitment to Circle from a group of international investors including China Everbright.

The companies have different target markets - Coins is focused on the Philippines while Circle wants to boost its presence in China - but their fundamental attractiveness is rooted in their US credentials. Expertise in blockchain is hard to come by globally, and Asia is understood to be behind the curve in knowhow development. The funding for Coins and Circle suggests that the region's increasingly crowded ecosystem of blockchain-supported financial services start-ups is ripe for diversification.

This influx of Western leadership is setting the stage for an expanded range of business models that fall under the Asian blockchain umbrella. In the US and Europe, blockchain start-up activity already stretches beyond financial services, but the technology's initial boom in Asia has remained anchored in banking and payments. The rationale is that by building up a competitive environment of similar companies, some will eventually sprout branches into other sectors.

"A year ago, blockchain wasn't something the young, hungry entrepreneurs were after in Asia, but now you're starting to see the talent here," says Scott Likens, PwC's emerging technology lead in Hong Kong. "Because of the draw of financial centers like Singapore and Hong Kong, fintech is going to lead the way on investments, but the VCs see industries that are not financial services as quicker and less regulated with fewer companies at play. There are hundreds of blockchain start-ups around payments and currency, so it becomes a more difficult question of where to put your money."

Bitcoin beginning

The ongoing emergence of blockchain technology is commonly promoted as representing an opportunity similar to that of the internet in the mid-1990s. As the internet allowed for the secure, free and instantaneous exchange of data, so does blockchain promise to revolutionize the exchange of assets.

Information has always been intangible, and therefore well suited to this style of networked medium, but stores of measurable value - like bills of lading for cargo shipments or documents relating to property titles - have become digitized only relatively recently. The dawn of blockchain accordingly offers a means of re-writing rules on the distribution of wealth while simultaneously intersecting political, financial and industrial structures in ways yet to be clarified.

Any technology with this level of vaguely alluring disruption potential deserves a good creation myth, and blockchain certainly delivers. The system was first developed as a ledger for bitcoin transactions, and as such, was mysteriously invented in 2008 by Sathoshi Nakamoto, the pseudonym for one or a number of programmers who remain unknown.

This esoteric backdrop fueled a culture of libertarian thinking and idealism among early adopters who were eager to avoid repeating the economic missteps that led to the global financial crisis. It also set up the proliferation of one of the more misunderstood technologies to attract institutional funding.

The core interest of blockchain is not so much its free-to-use, dis-intermediated computational resources as its emphasis on cryptography. The technology validates transfers by authenticating a chain of timestamped units of data that increases in complexity with each transaction. "Often when people say they're building a blockchain, they really just mean they're building a secure database that makes use of many of the characteristics that bitcoin has proven to work," explains Leonhard Weese, mentor at SuperCharger Fintech Accelerator and president of the Bitcoin Association of Hong Kong.

Since its inception, blockchain has only attracted about $1.5 billion of investment. At first, activity focused on digital currency mining, wallets and exchanges, with VC funding for bitcoin start-ups topping out at just over $200 million in early 2015, according to CB Insights. This surge of interest precipitated a dramatic drop-off to $25 million of investment by mid-2015, which has been interpreted as an inflection point in the industry's natural hype curve.

"I think that we are on the slope of enlightenment," says Jeremy Liew, a partner at Lightspeed Venture Partners, which has backed China's largest bitcoin exchange, BTCC.

"The initial peak of inflated expectations was driven by the expectation that the primary use-case for bitcoin was to reinvent payments in the developed world, and for trading, and that this would happen fast. This has largely proven out to be wrong."

The second phase of investment has been characterized by a shift toward non-bitcoin financial applications of blockchain technology, which either tap into the original bitcoin system or exploit a separately programmed protocol. These investments have been led by corporates and financial institutions aiming to improve online and mobile transactions in fiat currencies.

The fastest growth area, however, has been the use of blockchain as a system for recording adjacent non-monetary transactions. Chainsmiths, an Ireland-based blockchain consultancy that already services half its client base outside of the financial sector, ties this evolution in part to the shortcomings of banks versus industrial players when it comes to commercializing prototypes.

"Most of what you read in the news about blockchain is just financial institutions playing around with the technology, but they don't have any hope of bringing that to the market," says Kevin Loaec, managing director at Chainsmiths. "It's very hard to bring innovation to finance because there's so much regulation. That has always been the case, and blockchain isn't going to change that."

Non-financial applications

Early signs from the West that the future of the technology is in non-financial industries also include the diversification of specialist VCs such as US-based Blockchain Capital, which backed BTCC alongside Lightspeed but now counts a third of its portfolio outside of banking services. For example, the firm has invested in Wave, an Israeli company that uses blockchain to allow cargo vessels to send highly sensitive inventory titles across a decentralized network.

"We see a lot of interesting start-up activity around reimagining the bitcoin blockchain as an immutable record," says Bart Stephens, managing partner at Blockchain Capital. "Many people tend to think of the blockchain industry as part of fintech, but we really see it as an evolution in computer science that will impact and alter not just financial services but government services, healthcare, legal services, international trade, shipping and logistics. We see a lot of our future activity in those areas."

Although Asia has not yet followed this lead, it is expected to catch up quickly on the back of a number of technocratic drivers. Digital transfers of any kind in Asia remain subject to foreign exchange and border-control complications that have already been resolved in the US and Europe. Countries in the region must also contend with a much broader range of technological competency in cross-border trading, adding appeal to the simplifying architecture of blockchain.

The primary driver of Asia's potential, however, remains its massive and fast-growing consumer markets. As such, the scaling upside of blockchain business models related to payments and remittances cannot be as easily dismissed by bureaucracy-wary investors.

"Blockchain has very diverse applications, but if we make another investment in the technology, it's definitely going to have some connection with fintech," says James Pan, a member of China Everbright's management decision committee. "Blockchain is not the only technology for coming up with payment solutions - which is the clear trend - but based on our due diligence so far, it's the most reliable."

The performance standard of this type of database is difficult to overstate. The most robust blockchain is the original bitcoin system, which is said to have up to eight times more computing power than the world's top 500 supercomputers combined. In the context of Asia's large population trends, this resource is increasingly seen as an indispensable settlement solution.

"Asia is a very exciting and robust market, and we're bullish on the developing economies and their adoption of blockchain technology," Blockchain Capital's Stephens adds. "There are about three billion consumers with a smartphone in their pocket who can essentially leapfrog the paper, plastic and physical branch-based products you see in the West into bleeding-edge financial services that are ultra-secure and ultra-cheap."

Finding value

As investment targets in this space multiply, one of the key challenges for GPs is identifying viable use-cases. One rule of thumb is to focus on monopolies such as insurance or taxation on controlled goods. This is because businesses in these fields are dependent on a single point of failure and become more secure when a decentralized network diffuses the trust and risk.

Another point of consideration is to avoid business plans that are attempting to apply the technology as a solution for non-technical problems. For example, Chainsmiths' Loaec cites a common investment thesis related to using a blockchain to streamline electricity payments - a concept that does nothing to solve the underlying problem of customers illegally tampering with their meters.

"Blockchain can be applied to all industries but most of the use-cases don't work," he says. "Probably 95% of all the people that talk to us shouldn't be on a blockchain because they don't have the right approach to the technology. Most of the time, the problem is about physical elements in the real world and has nothing to do with blockchain."

Due diligence should otherwise focus on confirming the expertise of the targeted technical team, especially in light of the supply-demand imbalance for top-notch blockchain talent. For China Everbright, the decisive factor in its decision to back Circle was the company's status as the New York Department of Financial Supervision's first "BitLicense" recipient and the only digital currency play to receive an e-money issuer license in the UK.

"The technology is new and unfamiliar, so investors don't usually have much experience in the space. This makes it more difficult to assess a team's credibility and whether their product has any real value," says Josh Stark, head of operations at Canada-based blockchain consultancy Ledger Labs. "Investors need to have a clear thesis on where they believe the technology and market is heading. That's true of any investment, but in this space, credible answers that get beyond the hype are much harder to come by."

Both the financial and non-financial service angles in blockchain are relatively well understood by PE investors with experience developing enterprise software for clients. The value proposition at the cryptocurrency end of the spectrum, however, is less immediately recognizable. In this area, it is harder to plot the future evolutions of the market, how bitcoin will perform as a currency, what trends will redirect its exchange platforms and in which countries.

Investors may overcome this lack of visibility through exposure to wallets, which monitor digital currency transactions across different geographies in real time. Keeping company burn rates low is also essential to ensuring there will be enough dry powder available to react when the inevitable black swan event starts moving the market.

"Bitcoin companies are like surfers. You can't make a wave - you have to wait for it to come," says Lightspeed's Liew. "But when it comes, you can make sure that you're pointed in the right direction, well positioned, and you can paddle hard. And if you get it just right, you can catch a really great ride."

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• Topics
• Greater China
• North America
• Europe
• Financials
• Technology
• Venture
• Early-stage
• China
• Philippines
• USA
• China Everbright
• Lightspeed Venture Partners