Tag - bitcoin

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On Being Early and Being Right
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The Real Reason Bitcoin Startups Are Struggling to Fundraise
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Why Mt. Gox May Be Headed for Bankruptcy
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Dear Bitcoin: Patience is a Virtue. Love, Poker

On Being Early and Being Right

Over the past ten years or so, I have been relatively early to three highly nascent, wild wild west style industries: online poker, daily fantasy sports and bitcoin. In two of them – poker and bitcoin – I experienced significant professional and financial successes. In the other, daily fantasy, I lost my shirt. With bitcoin’s recent rise I figured it could be instructive to briefly explore the analogies between the three and develop a framework for spotting the emerging markets of the future.

On Being Early and Being Right

Jeremy Liew, General Partner at Lightspeed Venture Partners has repeatedly said that if one wants to spot emerging modes of communication and behavioral change, look to the products and services teen and tween girls are adopting. Similarly, I would argue that when it comes to emerging professional industries or financial markets, one should look towards how college aged kids are spending their time as well as the long-tail of the internet’s forums (including Reddit).

I believe this is the case for two primary reasons: (a) college aged kids have a substantial amount of disposable time and some variable amount of disposable income and (b) they are highly incentivized to increase their amount of disposable income – at a time in their lives when losing what little they have is not a significant loss. This combination pushes college students towards higher risk, higher return opportunities, some small percentage of which will materialize into mainstream markets and industries.

For example, although I’d played poker with my friends in high school, I found my way into online poker in a professional capacity my Sophomore year of college as the World Series of Poker was beginning to expand. It was the ideal format for a college student: success demanded thousands of hours of gameplay and continual learning and discussion via online forums. Very few adults with either part-time or full-time jobs could afford that much disposable time. My first startup, Cardrunners, where I ran marketing, had thousands of college students as customers, and many of the site’s pros were poker players who had made their millions during college.

You’re seeing a similar evolution in the world of professional gaming, or eSports; except that in eSports, the pros are often even younger, some still in high school. It is for the same reason: an adult with a full-time job, even one who loves gaming, will struggle to put in the tens of thousands of hours it requires to become great. These industries that demand obsessiveness are highly biased towards youth.

I discovered bitcoin in 2012 after the poker industry’s Black Friday as it was one of the few mechanisms to deposit and withdraw money from online poker sites. From there, I gradually became more interested in the technology, and began actively writing about bitcoin in 2014 in publications such as the WSJ and Recode as well as attending and speaking at Bitcoin conferences. I was also the first mainstream writer to publicly predict Mt. Gox’s insolvency, although, by that time, it was largely too late for most customers to withdraw their money.

During my poker years, I spent hours each day learning and communicating through the Two Plus Two Poker Forums. I still frequent them occasionally although only lurk at this point. They have a thread, over 850 pages long, all about bitcoin (there is an additional long thread about altcoins). You can watch the discussion evolve throughout the years. If you’d been paying attention to the forums back then, April 2011, and made even a small investment in bitcoin, you’d surely be a millionaire by now. [I love the first response given that it’s the same thing, verbatim, that bitcoin minimalists say now, even though it’s now trading at $3,400.]

On Being Early and Being Right2

There are other gems of niche industries and markets hidden throughout the Two Plus Two forums, although none have become as mainstream as bitcoin. You’ll likely find similar insights if you scour Reddit. We all know that one day another technology market will emerge that rivals or leapfrogs the attention and excitement given to cryptocurrency. I have a strong suspicion that early adopters will discover it through forums such as Two Plus Two or Reddit. I do worry that if that discussion moves to Slack or Telegram that it will be harder for the average person to find. I wrote about that concern here.

Daily fantasy sports, where I struck out both professionally and financially, was an industry where I simply wasn’t as personally passionate. In retrospect, I feel that my interest was a bit opportunistic. I still remember discussing at length with my friend Chris, who at the time was building the first ever Daily Fantasy site, Instant Fantasy Sports (in which I invested), about how we could port the functionality from the online poker sit-n-go format into fantasy sports and make an equivalent sit-n-go draft. I thought there were a lot of parallels, but I ultimately wasn’t excited by watching sports games all day nor obsessing over player statistics. This made it difficult to be credible either as a player (gamer) or an operator. I suspect that’s the reason I failed.

When it comes to being early and being right, I believe that passion is the ultimate insight. We humans have a lot in common. If you are passionate about an emerging industry, odds are that many other people are equally as passionate, or have the potential to become passionate if awareness is raised. Not all passions will materialize globally like bitcoin, but niche industries matter – even cosplay has developed into a $5-10 billion market. These emerging interests, industries and professions will continue to accelerate as the internet increasingly democratizes communication and awareness. It’s a fun time to be alive, and if you bet on your passions, odds are that you will discover others who feel similarly.

The Real Reason Bitcoin Startups Are Struggling to Fundraise

If you’ve read my blog over the years, you know I’ve written extensively on bitcoin in the WSJ, re/code, and Coindesk. And yet, a couple of years after my initial interest in the bitcoin sector, neither myself nor my firm Chicago Ventures is yet to make an investment into a bitcoin tech startup. And that in spite of my taking a large personal stake into bitcoin itself, and many “altcoins” such as Ethereum, Maidsafe and Factom.

Let me be clear: I am an unequivocal bitcoin bull. I believe that bitcoin may well represent the greatest transfer of wealth in my generation. I also believe that bitcoin itself, as the fuel underlying the blockchain, is exceedingly vital – as very clearly outlined by my friend Nick Tomaino in The Blockchain is Important and so is Bitcoin.

For the past 12-18 months I have intentionally passed on nearly every early stage bitcoin related business because of what I believe to be a systemic funding gap that is not easily reconcilable. Simply put: given the macro level of consumer adoption within bitcoin (below) it is exceedingly difficult for most new entrants to reach a level of traction compelling enough to warrant follow on capital. And because the majority of these businesses are not generating substantial revenue, availability of continuation capital is a pre-requisite to any current funding round.

So where is consumer adoption of bitcoin? One of the better breakdowns I’ve seen is by Tim Swanson on his blog Of Numbers – where he chops the data multiple ways and finds at best 2x year/year growth: A Brief History of Bitcoin “Wallet” Growth (whereas most VC-backed consumer companies are shooting for 5-10x+ Y/Y growth).

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EARLY STAGE CONCERNS

My hesitation towards investing in the sector comes from the following analysis (the data behind my analysis, as well as copied graphs are via Coindesk). Here’s the data as I’ve assessed it –

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2015 saw a nearly 50% decline in total bitcoin related VC deals from 99 to 57. Though that reflects a macro-level hesitancy on the sector (or perhaps over-exuberance in the 2014 bull market), that – in and of itself – is not debilitating.

But the two disconcerting trends to most early stage investors are:

  1. Of the 78 newly funded companies in 2014, only 21 raised follow on funding in 2015 (6 of the 27 follow-on rounds in 2015 were for companies who had first been funded in 2013).
  2. Funding is fast consolidating quickly around “platform” investments (as expressed by the graphs below) – which I characterize as either “universal” or “infrastructure” focused. These are the startups least exposed to the short-term volatility of consumer adoption as they touch multiple parts of the ecosystem.

The evidence appears in these two charts:

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Universal and Infrastructure related investments now make up nearly 50% of all bitcoin funding, but more importantly, are the buckets into which all of the year’s largest funding rounds fell into: Coinbase, $75M (Universal), 21 Inc, $116M (Universal), Circle, $50M (Universal), and Chain $30M (Infrastructure).

With that in mind, let’s unpack those two points –

(1) With 57 of the 78 funded companies in 2014 not raising publicly disclosed follow on funding round in 2015 that means that there are either (a) a lot of likely zombie bitcoin startups or (b) a large number of non-disclosed bridge/extension rounds.

Though bridge rounds are a sub-optimal situation for founders and investors alike, they are a reality and we’ve done our share of them at Chicago Ventures. The problem here is that an extension is fundamentally a “bridge to an outcome” – and in the case of most of these bitcoin startups, neither the market nor macro adoption has converged to the point where a meaningful “outcome” is achievable in 6-18 months.

When investors consider making a new investment in the space, they are increasingly cognizant that bitcoin adoption will not explode overnight and that the funding duration for any consumer-facing company is likely to be 5-10 years before generating material revenue. Given the technical nature of these businesses – and the consequent requirement to staff expert engineers – it’s a very cash intensive proposition to take on and a tough hurdle to overcome.

Nevertheless, of the 30 newly funded startups in 2015, a full two thirds touched payment processing, financial services (transfers) or wallets – the exact categories that are hardest to generate outperformance in the current macro environment.

(2) Over the past two years, much investor commentary has focused on discovering and funding “bitcoin’s killer app.” It is unclear to me whether that was simply a nascent understanding of the ecosystem or intentional misdirection, but it is a misunderstanding. The inherent flaw in that thesis is that it naively assumes that bitcoin is missing a UI, whereas in reality, the blockchain – because it can be leveraged by existing experiences – already has millions of beautiful interfaces to tap into.

Given that, it makes sense that funding is converging around platform plays: those that are either the building blocks of the emerging blockchain ecosystem or those with demonstrable network effects. The struggle for early stage investors wanting to make platform bets is that being a laggard into a space where competitors’ network effects are already strengthening is a recipe for disaster.

Here’s what the funding shift looks like in graphical form as the smart money transitioned towards platform focused opportunities as opposed to discovering a “killer” front-end app.

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THE NEXT 24 MONTHS

At the time of this writing, bitcoin is once again buzzing: after nearly a year of price decreases and stagnation towards $200, bitcoin has been on a roll, surging past $500 and now holding strong in the mid $400s. In addition, both Wired and Gizmodo believe they’ve uncovered the actual Satoshi Nakamoto, an eccentric, iconoclastic, tax dodging entrepreneur: Australian Dr. Craig Wright, although those who’ve communicated with Satoshi in the past disagree.

It sure does seem likely that 2016 could be another boom year for the broader bitcoin ecosystem.

But the described concerns remain – without a discernable shift in adoption, the vast majority of bitcoin related opportunities, both consumer and b2b blockchain focused, are exceedingly difficult to fund by early stage funds. Consumer, because of largely stagnant adoption, and, b2b, because of the relatively small size of most pilot contracts signed for ledger-focused blockchain-related record keeping. The exceptions, of course, are Barry Silbert’s Digital Currency Group and Dan Morehead’s Pantera Capital, both of whom are committed to expanding the overall bitcoin ecosystem via early stage bets.

Naturally, this equation is also different for larger funds that are opportunistically investing downstream for the right entrepreneur or idea – in that case, they have the pockets to support a company throughout the funding gap. But that is the exception rather than the norm.

My estimation is that smart money at the early stage will largely stay on the sidelines in 2016, waiting to see if new platform opportunities emerge via the 21 Bitcoin Computer, or other decentralized networks, especially as incumbents such as Coinbase, Circle and Chain prove the strength in their networks and multi-faceted applicability.

Why Mt. Gox May Be Headed for Bankruptcy

This article was originally published on Coindesk on February 17, 2014

It has been a tough week for bitcoin: a freeze on withdrawals at Mt. Gox due to transaction malleability, multiple DDoS attacks across the exchanges, and a consequent plunge in price.

In my view, however, Gox should be everyone’s biggest focus. While their price spreads and cash-out delays have plagued the site for more than six months, I believe their current situation and recent statements belie transparency and suggest insolvency. Namely, that their business model and recent past raise a number of red flags that make comparing the company to now-bankrupt online gambling operators highly relevant.

Three weeks ago, I took to Re/code to describe how the evolution of online poker is likely to be correlated and instructive to bitcoin’s development. In it, I wrote: “I believe we could see a major exchange go under, especially if regulations and wire transfers become more complex, or if the cost of acquiring customers becomes more competitive.”

I have seen this story play out nearly a dozen times before during my tenure as an executive in the online poker world and, in this article, I want to set out why I think Mt. Gox is in big trouble.

Fund seizures

Mt. Gox had nearly $5 million in funds seized from its bank accounts in 2013. It’s unclear whether these were operating funds or customer deposits. This is highly reminiscent of seizures in the online gambling world, which deeply affected operators’ solvency.

These fund seizures, such as $115 Million from Full Tilt Poker, or $33 Million in a 2009 DOJ Seizure, were initially smoothed over by their operators. Players were typically reimbursed and withdrawals were honored.

What outsiders hadn’t realized at the time was the strain this placed on individual operators. In order to keep the business running, operators had to remove the ring-fence that protected customer deposits and borrow from customer balances to support operations.

While everyone believed that the poker sites were making billions, their overheads due to staffing and marketing was significant. More importantly, each new seizure forced the operators to move downstream to less and less reputable transaction processors and banks. These processors charged heavier fees because of the heightened risk, and often absconded with deposits, because, well, they could.

We see this with Mt. Gox as well: the company lost its relationship with reputable processors, such as Dwolla, and has never managed to integrate with Skrill or Neteller.

Phantom deposits

It appears that Mt. Gox has long known of, and suffered from, transaction malleability. As explained in this Coindesk post, if a user claimed not to have received their bitcoin (either truthfully or maliciously), Gox was likely to have re-sent the funds to avoid negative press as a result.

This process of fronting money – either in the hopes of recovering the initial transactions or to maintain positive perceptions – is a vicious cycle that depends on deposits outpacing withdrawals to be sustainable. Once that balance reverts, it’s an effective bank run, and the operator will eventually not have enough deposits to cover user balances.

It is highly analogous to the working capital model that caused the insolvency of Full Tilt Poker, once a billion-dollar industry leader. In their case, the black market ACH (automated clearing house) processors they had contracted to transfer player funds from bank account to virtual wallet struggled to convince banks to process those transactions.

Full Tilt, wanting to maintain a dominant image and not lose player liquidity to competitors, chose to credit attempted (but failed) withdrawals to player accounts, hoping to recoup those transactions as their processors improved. This backlog of ‘phantom’ deposits ultimately reached $130 million. Executives later admitted that it started small and spiraled out of control.

Although I have not seen any indication as to the scale of Gox’s equivalent phantom transactions, the ramifications are considerable – especially if malicious customers exploited the issue to their advantage.

Excuses, excuses…

Mt. Gox’s public statements have been only partially accurate, initially blaming bank/processor delays in June 2013, and now admitting a systemic technical issue. This evolution of excuses mirrors those of gambling operators who were quick to blame a difficultly in transaction processing before admitting internal issues.

Eurolinx was a popular poker site from 2006 to 2008. However, in 2009, withdrawals began slowing considerably. Initially, it claimed:

“The situation is only temporary because we have had an unusually high number of withdrawals that, in combination with increased security checks, have caused a backlog and delays throughout the system.”

Weeks later they admitted: “Most of the delays occurred due to payment processor issues we experienced in May and June. The problem has now been fixed, however, we have some withdrawal backlog to deal with.” And, months later, they filed for bankruptcy – leaving players millions of dollars the poorer – and ultimately admitting that they gambled player deposits in the stock market and lost, big time.

FullTiltPoker enjoyed market dominance from late 2006 until their DOJ indictment in April 2011. Soon after being banned from servicing US players, the DOJ gave them permission to repay all depositors, but they failed to do so.

On May 15th, FTP claimed: “Full Tilt Poker faced numerous challenges and hurdles to ensuring the smooth operation of its international business and the orderly return of US player funds. We are absolutely committed to making sure that US players are refunded as soon as possible. We apologize for the delay and the fact that we underestimated the time it would take to work through these issues.”

On May 30th, they repeated:

“We still do not have a specific timeframe for [paying back players]. There has been, and remains, no bigger priority than getting US players paid as soon as possible, and we have been working around the clock to get this done.”

However, at this point, they admitted solvency issues for the first time, saying: “We are raising capital to ensure that the US players are paid out in full as quickly as possible.” The company admitted total insolvency three months later, on August 31st.

In these cases and more, the operators cited seemingly legitimate reasons for process delays. All were rooted in industry truths – difficulty of bank processing or technical complications of implementing a mass refund – but were ultimately covers for deeper issues.

Most worrisome is that in the weeks prior to nearly every major online poker bankruptcy, the operators marketed deposit bonuses and perks – a last attempt to buy solvency and time.

This was true in the case of Full Tilt Poker and Eurolinx, as well as Ultimate Bet, Absolute Poker, GoalWin Poker, Poker in Venice and more. Mt. Gox did the same – offering discounted trading fees as recently as December 19th – a curious move for an operator clearly aware they were facing transactional hurdles.

Tell-tale pattern

I am hopeful, along with the wider Bitcoin community, that Mt. Gox can overcome its difficulties and rebuild consumer confidence.

As Mt. Gox has struggled with both bitcoin and fiat withdrawals, it should be noted that, in a public ledger cryptocurrency, it is possible to certify the solvency of reserves with digital signatures showing the location of all deposits – although no exchange currently utilizes this feature of bitcoin.

While that would solve questions surrounding bitcoin solvency, it would leave fiat concerns unresolved. That said, my experience over the past decade has shown that insolvency tends to follow a pattern, that Mt. Gox clearly fits, and I feel the company is likely to fail unless outside capital comes to the rescue.

Dear Bitcoin: Patience is a Virtue. Love, Poker

This article was originally published on re/code on January 23, 2014.

Having spent much of the past decade in the online poker world — first as a professional poker player, then as an operating executive, and now as an investor/advisor — I have witnessed firsthand its extraordinarily volatile ride through hyper-growth, legal uncertainty, numerous frauds and emerging regulation.

When I look at bitcoin, I see many similarities to the Wild Wild West feel and uncertainty of the online gambling industry in its formative years. I am bullish on bitcoin, but I believe that it’s very early in its development and marketing life cycles, and I think that the parallels from online poker’s development could provide valuable lessons on what to expect and how to engage with the nascent industry of virtual currency.

The consumer doesn’t always win

Bitcoin is good for consumers and merchants, while disruptive to existing payment networks. Legalized, regulated online poker is also a net positive for consumers, would create jobs and would generate valuable revenues for municipalities.

Over the past 15 years, the consumer has watched disruptive companies greatly improve their buying power and choice. Whether via Groupon offering steep discounts or Netflix democratizing entertainment, we have become accustomed to industries ultimately tilting toward the benefit of consumers.

My experience in online poker suggests the principal is true, but is mired in “ultimately.” It is finally receiving formal legalization and legitimization, but that process is happening slowly — the first three states came in 2013, after six years of lobbying. During that period, the government willingly left billions in revenue on the table, while leaving constituents to take their chances with offshore operators — the consumer being the net loser. Just because bitcoin is good for consumers does not mean the government will see it that way in the short term.

The U.S. isn’t everything

November was a good month for sentiment on U.S. bitcoin regulation, with a positive Senate hearing as well as Ben Bernanke’s light endorsement that bitcoin “may hold long-term promise.” But online poker had many similarly positive hearings that were ultimately false starts.

Then, on April 15, 2011, the FBI and DOJ seized the domain names and servers of the leading online poker rooms PokerStars and FullTiltPoker, among others, demanding that they stop servicing U.S. players. The sites quickly complied, and many industry experts held that the loss of the U.S. player pool — between 30 percent and 45 percent of the total market — would crater the industry. They were wrong. In April of 2012, a full year later, traffic was down industrywide by less than 10 percent, and PokerStars had lost only 13 percent of its total player base.

While there may be multiple factors for PokerStars’ resilience (including FullTiltPoker’s bankruptcy, which orphaned countless players), experts believe it was their focus on emerging markets in Asia-Pacific and South America that enabled the growth to continue.

The lesson for bitcoin is that the U.S. isn’t everything — it can survive without U.S. legitimization, or even China’s reported heavy volume. Bitcoin as financial currency has a much wider market appeal than online poker (which has no formal penetration in China), and could find real growth and stability even if only legitimized and liquid in Europe or Africa.

With fast money comes fraud

My circle of friends used to endlessly needle recreational poker players who believed that online players could see their cards or were cheating them. Until one day, my roommate David, a highly successful professional player, came into my room and said, “I’m convinced I just played against someone who could see my cards.” He was right. And the ensuing investigation uncovered the largest online poker ring in history, even landing him on “60 Minutes.”

Over the years, there were multiple cases of intermingling player funds with operating funds, leading to the bankruptcies of smaller operators and even FullTiltPoker, at one point a billion-dollar industry leader. High-stakes poker players have reported hundreds of cases of finding Trojan horses planted on their computers — the most recent scandal involves room break-ins at a five-star hotel in Barcelona.

Some poker sites chose to simply shutter without warning, absconding with player money. One site, JetSetPoker, is notorious for issuing a pop-up at 11:55 pm to all players, informing them that the site would cease to exist at midnight, while offering no options for withdrawals.

The lesson is that these now-bankrupt sites were “regulated” by offshore regulatory agencies, who were ultimately proven powerless. And much of the interpersonal fraud was perpetrated by individuals with stellar reputations in online communities, or even by recognizable television personalities.

We have already seen bitcoin wallets disappear into the night, and history would suggest that more will follow suit — I believe we could see a major exchange go under, especially if regulations and wire transfers become more complex, or if the cost of acquiring customers becomes more competitive. Further, because bitcoin is supported by its community, numerous alt-coins are trading in early development cycles based off the reputation of their developers, many of whom are anonymous forum personalities. Some of these will be scams. And although online poker never had a “cold storage” equivalent to protect players, the rapid rise in price of bitcoin has left billions of value unsecured. Fortunes will be wiped away by poor security.

Exchanges rule, but opportunities abound

As with the poker industry, the biggest opportunity for bitcoin will be as a marketplace. Gaming operators such as PokerStars and FullTiltPoker generated billions in annual revenue.

Conversely, two of my businesses, CardRunners and Hold’em Manager, were each the leaders in their respective niches. CardRunners was the premier educational/training community, while Hold’em Manager was the most popular software analytics suite for players. These businesses topped around $5 million in annual revenue.

It’s therefore not surprising that venture interest in bitcoin to date has focused on the exchanges, such as Coinbase, and BTCChina or its underlying protocol, with Ripple and Circle. But although the bitcoin industry is maturing quickly, mainstream consumer penetration is in its infancy — so there’s real potential for new exchanges to emerge and become dominant. My precedent is that online poker leaders in the early 2000s, such as Paradise Poker and Planet Poker, were displaced in 2004 by PartyPoker, with its superior marketing. PartyPoker’s market dominance was then displaced by PokerStars and FullTilt in 2006, as legal regulations changed and as those companies made huge investments into television advertising and original sponsored programming.

Outside marketplaces, there are still big opportunities. One example is affiliates — a large poker affiliate, PokerStrategy, was recently acquired for $50 million in cash. As the bitcoin audience grows and competition between exchanges heightens, affiliates will increase in importance — and will ultimately be larger than a $50 million price tag. CoinDesk and ZeroBlock are well positioned with their engaged audiences and strong SEO.

A last area for opportunity are SaaS/PaaS plays, which have only recently started to emerge in the online gaming world with companies such as Betable. I see similar opportunities for KYC (Know Your Customer) bitcoin platforms or bitcoin-specific securitization as service businesses. Given the likelihood that bitcoin will soon need to integrate with everything from trading desks to personal tax forms, an aggregated API clearinghouse could also be a big opportunity.

(Disclaimer: The author owns Bitcoin, Litecoin, and Primecoin. They make up less than two percent of his diversified holdings.)

Ezra Galston is currently a VC at Chicago Ventures, and was director of marketing for CardRunners Gaming, the parent company of CardRunners, Hold’em Manager and DraftDay. Reach him @EzraMoGee.

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