The Wallet Stack

1. User Interface

2. Authentication - confirm ownership

3. Transaction Formation - contract, parameters, gas

4. Transaction Verification - confirm that this is what you want to do

5. Transaction Signing

6. Node Infra - submitting the tx to the chain

In the past, you could only transfer and hold cryptocurrencies. You could only interact with balances and transfers. When ERC-20s came about, we could support multiple assets, and we got Metamask. But then in the latest crypto boom, we now support several DeFi use cases and NFTs and have even more wallet options.

Modern Wallet Examples

• Vertical specific wallets e.g. supporting certain Dapps

• Wallets that integrate into protocols for specific functions e.g. NFT purchases

Wallets are specializing left and right, the great unbundling and rebundling trend that we've seen in Web2 tech. This means that crypto is expanding outside of the early adopters and entering the realm of the "rest of the world". What will be most accessible to mainstream users though? Is this the first rebundling we are seeing in crypto? Are the lower infra layers mature enough to support a solid application layer?

I'll explore MPC and AA, two separate ideas that have arisen in the latest wallet innovation.

MPC

"Not your keys, not your coins" has resulted in $100bn+ lost / stolen for a decade now. Lost seed phrases or private keys is super stressful and inhibits mainstream adoption. The tech itself is actually many years old, but applying the tech to crypto wallets is a new phenomenon.

Fireblocks is the "gold standard" for MPC cryptography and custody, but they serve institutions. Coinbase also announced support for an MPC-powered Dapp browser insider their wallet. But the littler businesses and everyday users deserve the same security and simplicity!

The status quo for the rest of us is either to 1) self custody with private keys, using an on chain wallet or 2) custody in a CEX, giving up control and on chain access for someone else to manage the security.

MPC is a bit of a hybrid. The concept is that 2+ parties jointly compute a function without revealing their inputs. In crypto, this means being able to manage keys without a single point of vulnerability (e.g. losing a seed phrase), where multiple parties (like a phone or server) can perform all the cryptographic calculations necessary (like tx signatures / verification), without any of them revealing their secrets. Even if there is an attacker, they can't access all your "secret shares" at the same time. There are no private keys / seed phrases involved with MPC.

MPC enables on chain asset management systems without a single point of failure, increasing security for self custody options (no private keys can be stolen) and overall key loss (each party can back up their secrets individually without sharing or compromising the system).

Benefits:

• Easy to recover - no more lost or stolen seed phrases

• No single point of failure

• Off-chain cryptography

• End user has no costs

• Chain agnostic (multi sigs do not support every blockchain) - operates in the mathematical layer and therefore can be applied across many different blockchain

Cons

• More computational overhead - could be slower and more expensive. Harder to do atomic transactions.

• Hard to pre-fund transactions programmatically on-chain

If MPC goes more mainstream, people can have many different wallets to store their assets instead of putting all your eggs in 1 basket.

Sample MPC wallets

• Fireblocks

• Coinbase

• ZenGo - consumer facing

MPC vs Multisig

Multisig wallets are NOT protocol agnostic (or rather very difficult to do so) and are inflexible from an operational standpoint e.g. transferring digital assets. Multisig is more about multiplying your keys and giving everyone a set while MPC is about giving everyone a different key.

AA

Issues with Self Custody

There are 2 types of Ethereum accounts

1) External Accounts

External accounts cost nothing to create, can initiate transactions, need a cryptographic pair of keys, and typically only move money in ETH between externally owned accounts. For example, MetaMask is an EOA.

2) Contract Accounts

Because you are using network storage, there is a price to creating a contract account. You can only send transactions in response to receiving one, and there are no private keys as the account is controlled by code.

I'll focus on external accounts because it is what is relevant to AA.

When a transaction is executed by the EVM, the first account touched must be an external account, and the corresponding amount must pay a fee to the miner for the execution. The account's address is derived from the signer's public key for authorization. When the transaction and signature is received, the EVM will verify the validity, the nonces, and then deduct the transaction fee from the balance.

The issues with this are that the process relies entirely on your private key because your account = your private key. And hardware wallets are not scalable. Hence, the key needs to be decoupled from from the account.

Account abstraction increases flexibility of wallet accounts by turning the accounts into smart contracts, to determine with their own logic, what a valid transaction is.

Historical state of affairs

Firstly, Ethereum is already scaled to the point that it's not so easy to just implement any protocol change. Think about how long it took to get the Shapella upgrade! Smart contract wallets live on chain where the native account is the EOA, and putting smart contracts on L1 requires a heavier lift to emulate account abstraction. The entire Ethereum ecosystem is built around EOAs, so smart contract wallets are definitely the irrelevant little sibling. Few dApps are compatible.

In 2020, there was EIP2938 which enabled smart contracs to act as top level accounts. But this was still rather simple and couldn't incorporate nonce abstraction. Furthermore, it did not replace / remove externally owned accounts.

EIP3074 then came along, making existing EOA accounts act more like smart contracts because users could delegate control of their account to a contract. There were also 2 new opcodes, where the target smart contract invoker sends transactions as if it was the EOA. In this situation, users of external accounts could benefit from AA features without transferring their assets. However, there were security tradeoffs, and still, it did not fix the fact that it was still inherently an EOA.

EIP4337 is the most recent amendment and the most favored one. It makes writing and operating smart contract wallets on Ethereum much simpler because users don't make transactions. Rather the instructions are bundled to miners, and then sent to a contract for execution. Any developer can write custom smart contract wallets. However, still no protocol changes.

Benefits:

• On-chain

• Atomic transactions - Bundle multiple transactions into 1, and then execute a sequence of operations in 1 atomic transaction. For example, instead of approving 2 tokens to swap on Uniswap with multiple approvals, now you can just approve once and have 1 transactions. Reduce fees, increase speed, and increase security!

• Can pre-fund to do gasless transactions

• Social Recovery - With no more seed phrases, now people are more protected if their account is compromised or they lose their account. Now you can authorize a new key as the legitimate wallet owner e.g. a trusted contact or third party service.

• MFA - require signatures from multiple keys. Whereas in multi sig wallets there lacks the ability to customize, now you can define a spending parameter and add governance

• Flexible fee payments - pay in any token

• Session Keys - pre-approve rules for interacting with a dApp e.g. how much can be spend in what amount of time. No more needing to sign each transaction separately! The user experience improves and risk declines.

• Additional signing schemes - right now the status quo is ECDSA. Other options can include secure enclave such as using your phone as a hardware wallet. Increase efficiency and reduce gas on signatures.

Cons:

• Still limited to Ethereum / EVM ecosystem, not applicable to Bitcoin -> Not chain agnostic; implementations are on a chain by chain basis

• New architecture requires all wallets to send transactions to a global entry point contract, which means that this point contact better be well protected

• On chain costs can really rack up due to the cost to deploy and upgrade

• Logic upgrade processes = smart contract upgrade processes

The same fruit basket

So really as you can see, MPC and AA are apples and oranges that belong in the same fruit basket. As an example, you can create a wallet. Use MPC to decompose the keypairs, and distribute. AA can then permit an external service to automatically withdraw funds without every single person signing off. Set daily limits and parameters.

Overall you can see that there is increased security, speed, and customization when you combine AA and MPC!

https://blog.usecapsule.com/unpacking-the-wallet-stack/

https://zengo.com/mpc-wallet/

https://www.argent.xyz/blog/part-3-wtf-is-account-abstraction/

https://support.apple.com/guide/security/secure-enclave-sec59b0b31ff/web#:~:text=The%20Secure%20Enclave%20is%20a%20dedicated%20secure%20subsystem%20integrated%20into,Application%20Processor%20kernel%20becomes%20compromised.https://zengo.com/aa-and-mpc-frens-with-benefits/

Tradfi > Defi: Summer 2020 aka Crypto Bull Market

Trading

Integration between TradFi and DeFi mainly happened on the trading front. On-chain trading infrastructure was created to accommodate the volumes e.g. Jump Crypto.

Asset Management

Many products moved on chain leveraging smart contracts and crypto native nonlinear yields such as DOVs (DeFi Option Vaults). Example vaults include Ribbon finance and Antimatter. Retail investors could see option premiums yielding almost 40% of returns. Institutional options market makers would buy vaults of options and sell on exchanges. However, volumes have greatly declined since due to macro reasons.

Lending / Credit

Companies such as Celsius, Blockfi, Genesis issued almost $50 billion in loans in just one quarter for institutional traders, who paid double digit APYs for liquidity. Of course, we saw these companies also implode… As they deleveraged, it created a liquidity gap in the market and DeFi solutions such as M11 Credit, BlockTower, came to light. They provide direct lending on other businesses such as Maple Finance, to market makers such as Flow Traders, to draw USDC at high single digit % and wETH at mid digit %.

The Shift: Defi > Tradfi. The Holy Grail, Real World Assets.

Rising Rates

As FFR increases, the DeFi spread has dropped significantly. With lower yields, real world players are less interested in investing in Defi. Time for Defi to enter tradfi. This is the best time!

Benefits of RWA

• Better pricing models and discovery

• Transparency – DLT

• Efficiency – instant settlement

• Automation – smart contracts

• Fractionalization

• Democratized access to various asset classes and risks

• Programmability

Why it is difficult

• Regulatory framework not there yet - PE funds even have liquidity caps. and what about KYC / AML?

• Liquidity issues – potential lockups, illiquidity premium can be deterring

• Communication - oracles face their own reliability issues. It needs to be perfect for RWA tokenization and payments to work. RWA tokens sit secondary to the lgal asset and thus, token holders need to be promptly notified of relevant real world issues that could affect their token. This doesn't exist right now. Asset quality needs to improve and standardize.

• Custody is hard

• Tradfi banks are threatened

• Market adoption is not there

Target Audience for RWA

Emerging markets, just as crypto's strongest use case always was. They have the most to gain in terms of efficiency, transparency, and speed. The most suitable assets to tokenize would be stable ones such as ones representing US treasuries. Retail and SME investors could diversify their holdings in this new store of value. Trade finance, private debt, etc. are examples of ones that are very suitable because it is currently very manual and can be packaged together. Thus, smart contracts and automation would bring a lot of value to investors.

Main Players in the Ecosystem

Protocols

Centrifuge

Centrifuge bridges real world assets into Defi in order to lower the cost of capital for SMEs and provide stable uncorrelated yield. It brings the entire structured credit market on chain and provides liquidity providers legal recourse, and is fully collateralized and asset class agnostic. It has a Tinlake product to allow SMEs access to finance by creating pools of loans backed by collateral. The sector is appealing due to the high cost of capital and low default rate. Centrifuge is a PoS blockchain built on Polkadot. Users can bring assets on chain as NFTs.

https://tinlake.centrifuge.io

Tinlake | Centrifuge | Decentralized Asset Financing

Businesses can originate assets and finance RWAs by tokenizing them into NFTs and using them as collateral. Users can invest in TIN, the junior tranche and high risk/high return token, or DROP, the senior tranche, or yield token with lower defaults and returns.

Centrifuge launched an RWA market on Aave, so that the Centrifuge RWA token could be used as collateral to borrow USDC.

Goldfinch

Decentralized loan underwriting protocol for anyone to issue loans on chain as an underwriter, with KYC/KYB. Goldfinch relies on its backers (investors who supply USDC to borrower pools) to monitor and provide liquidity. Goldfinch gave funding to a Latam fintech called Divibank ($5

TrueFi

Offers on-chain capital markets. It is owned and governed by TRU holders. Traditional funds can move their lending portfolios on chain. It has portfolios facilitating loans to Latam fintechs, other EMs, and crypto mortgages.

Maple Finance

Launched in 2021, Maple offers undercollateralized loans to big companies like Framework Labs and Alameda (RIP). Maple offers 2 tokens to participate in governance, share in fee revenues, and provide cover.

Oracles

Oracles are bridges between blockchains and the real world. Oracles are key to RWAs to facilitate proper and timely communication between on chain and off chain events.

Chainlink

Chainlink is a decentralized oracle network. It is known as one of the most reliable, and proves core infrastructure for on-chain RWAs. For example, it helps verify that assets exists off chain and their values. It potentially could also verify collaterals, and share data on weather, etc.

Masa Finance

Is a decentralized credit protocol to connect traditional and crypto accounts. It offers decentralized credit reports as NFTs. It has 10k+ data sources across 70+ countries and has many tradfi integrations.

Stablecoins

Circle

Circle issues USDC, a multi chain stablecoin backed by US dollars. It offers a Circle Yield product, and is overcollateralized against borrowers' BTC.

MakerDAO

It charges significantly lower rates than credit risk premiums for high quality bonds and has become increasingly more attractive given rising rates. Real world players are borrowing on MakerDAO to seek yield.

MakerDAO issues DAI, which is an Ethereum backed stablecoin backed by both crypto and RWA pools. Users can mint DAI by depositing assets as collateral (overcollateralized though). When loans are issued, DAI is minted. At repayment, DAI is destroyed.

MakerDAO started off partnering with Centrifuge in 2020, and then has since onboarded many other RWA pool originators such as New Silver, Huntingdon Valley Bank, and Societe Generale.

https://makerburn.com/#/rundown

MakerDAO's RWA balance grew to 681 million DAI in January, up from 640 million in December and up from ~$335mm in November 2022. 4 lending pools are from Centrifuge, with collateral including loans to RE investors, revenue based financing assets, freight, etc. another is 6s Capital, that lends to RE developers, Huntingdon Valley Bank, and Societe Generale, a French bank.

Maker

@MakerDAO

RWA at its finest.

The latest MakerDAO Real-World Asset Report has been published by the Strategic Finance Core Unit!

How is the +$600 million MakerDAO RWA balance doing?

Let's investigate ↓

77

10:44 AM • Feb 24, 2023

Let's look into MakerDAO's RWA pools a bit closer.

Monetalis Clydesdale: US Treasuries

500 million Dai vault collateralized by short term US Treasury ETFs. 70% collateral is allocated to treasuries maturing <1 year.  

Through this implementation, MakerDAO currently holds ~$501 million worth of US treasury short-term bonds ETFs, up from an initial ~$497 million allocation. In January, the investment contributed ~$2.1 million in yield to MakerDAO.

Huntingdon Valley Bank: Private Credit

100mm Dai loan participation facility with a public commercial bank. Expected 3% net yield annally.

As of the end of January, the mentioned loans contributed 695,174 DAI of life-to-date fees to MakerDAO.

Blocktower S1-4: Private Credit

4 revolving credit facilities totaling 150mm Dai debt ceiling, collateralized by asset backed facilities, forward flow agreements, loans, structured credit.

With Blocktower as the arranger, four RWA Maker Vaults have minted over 40 million DAI to fund senior secured, real-world credit assets. As of the end of January, the mentioned vaults contributed 79,731 DAI of life-to-date fees to Maker.

Pioneer RWA Vaults – Private Credit

Maker’s earliest attempts in the RWA space. 6s Capital (commercial real estate including Tesla), New Silver (real estate mortgages), ConsolFreight, Harbor Trade Credit, Fortunafi. 34mm Dai issued against this collateral, mostly in 6s and New Silver.

Societe Generale

In 2021, Societe Generale via SG-Forge (investment arm) raised $20mm in DAI to refinance their on-chain covered bond issuance. They used AAA rated bonds representing housing mortgages, with 0% interest as collateral. SG-Forge then borrowed Dai, swapped to fiat, and transferred to Societe Generale.

In Summary

Historically capital was pretty cheap and didn't make sense to invest in defi. However due to monetary policy, crypto explosions, we've been seeing literally negative defi spreads, thus incentivizing real world assets to be put on chain to gain yield. I expect RWA innovation to accelerate and their assets to outperform in bearish conditions as they retain their cash flows due to the RWA's predetermined loan agreements. RWA will be an exciting driver of defi innovation to come.

Sources.

https://forum.makerdao.com/t/real-world-asset-report-2022-12/19413

https://aqua-hollow-alpaca-520.mypinata.cloud/ipfs/QmUgJVqdws4MRfjcfvgKCoKVDxYoqgVLZjSyZN1Jcup7Qf

https://ngc.fund/post/defi-meets-tradfi-the-integration-and-challenges-faced

https://medium.com/centrifuge/rwa-market-the-aave-market-for-real-world-assets-goes-live-48976b984dde

https://research.thetie.io/real-world-assets/

https://docsend.com/view/u53utyp2j4ycg7r6

https://medium.com/bankless-dao/brick-and-mortar-banks-begin-to-build-on-chain-de0e78413fc2

https://medium.com/centrifuge/defi-2-0-first-real-world-loan-is-financed-on-maker-fbe24675428f

https://genesisblockpod.substack.com/p/rwa

Blockchain technology, with its decentralized and distributed digital ledger system, enables secure and tamper-proof tracking of transactions and assets, making it the perfect tool for managing carbon credits and emissions data. The benefits of blockchain in the carbon industry include:

• Transparency and Trust: Blockchain technology allows for the accurate and transparent tracking of carbon emissions and credits, ensuring that companies are held accountable for their environmental impact.

• Efficiency: Blockchain streamlines the trading and management of carbon credits, removing intermediaries and reducing transaction costs. This facilitates a more efficient carbon market.

• Security: The decentralized nature of blockchain ensures the immutability of data, reducing the risk of fraud and manipulation in the carbon market.

What Blockchain Platforms are Used

• Ethereum: Ethereum is an open-source, decentralized platform that allows for the creation of smart contracts and decentralized applications (dApps). Many carbon industry companies, such as Nori, Energy Web Foundation, and Xpansiv, use Ethereum as the basis for their platforms. Ethereum's smart contracts enable the automation of processes, improving the efficiency and transparency of carbon credit trading.

• Stellar: Stellar is a decentralized, open-source network designed to facilitate cross-border transactions and asset transfers. Poseidon Foundation and Veridium Labs use Stellar for their carbon credit trading platforms, taking advantage of the network's low transaction fees and quick processing times.

• Hyperledger Fabric: Hyperledger Fabric, a permissioned blockchain platform developed by IBM, is designed for use in enterprise settings. It offers a high degree of customization and privacy, making it ideal for carbon asset management applications, as seen in IBM's partnership with Energy-Blockchain Labs.

Walking through a Use Case from Credit Generation to Retirement

1. Carbon Credit Generation: Projects that reduce or remove greenhouse gas emissions, such as reforestation or renewable energy initiatives, generate carbon credits. Each carbon credit represents one metric ton of CO2 equivalent emissions reduced or removed from the atmosphere.

2. Verification and Certification: Independent third-party organizations assess the projects to verify their emission reduction claims e.g. Verra, Gold Standards. Once verified, the projects are certified, and the corresponding carbon credits are approved for issuance.

3. Carbon Credit Tokenization: The approved carbon credits are tokenized on a blockchain platform, such as Ethereum, Stellar, or Hyperledger Fabric. Tokenization involves creating digital tokens that represent the physical carbon credits. Each token is assigned a unique identifier to ensure its traceability and prevent double counting.

4. Carbon Credit Registration: The tokenized carbon credits are registered on a blockchain-based registry, which serves as a decentralized and transparent database of all issued and traded carbon credits.

5. Carbon Credit Marketplace: Tokenized carbon credits are listed on a blockchain-based marketplace, allowing buyers and sellers to engage in transparent and secure transactions e.g. Patch, Watershed.

6. Purchasing Carbon Credits: Companies or individuals looking to offset their emissions can purchase the tokenized carbon credits through the marketplace. The process typically involves creating an account, selecting the desired number of carbon credits, and executing the transaction using a digital wallet and the marketplace's native cryptocurrency or a stablecoin.

7. Carbon Credit Retirement: Once purchased, the carbon credits are "retired" to prevent their reuse. Retirement involves updating the blockchain registry to indicate that the credits have been used to offset emissions, ensuring transparency and accountability.

Companies in the Space

1. IBM (Public)

IBM has partnered with Energy-Blockchain Labs to develop a blockchain-based platform for carbon asset management, using Hyperledger Fabric. This platform aims to improve the efficiency and transparency of the carbon market, facilitating the trading of carbon assets and credits.

2. KlimaDAO (Private)

KlimaDAO offers their coin KLIMA to accelerate the speed at which the price of emitting arbon is going up. The business does this buy purchasing credfits from Verra, retiring them, and then minting the tokens via Toucan Protocol. The tokens become Base Carbon Tonnes (representing 1 tonne of carbon removed). KLIMA's are backed by at least 1 BCT, and owners of the token are supposed to grow their share of the coin through bonding more BCT or staking holdings for yield.

3. Toucan Protocol (Private)

Toucan is the infrastructure that helps crypto carbon projects like KlimaDAO eexist. It turns carbon credits into tokens to be used on a blockchain. They are retired from their source registry to prevent double counting, but haven't been claimed against emissions yet and thus are still viable. Their tokenized CO2 (TCO2s) are semi-fungible, meaning they are not all identical but can be fractionalized and grouped for trading. Toucan was the first platform to allow for the tokenization of carbon credits.

3. Nori (Private)

Nori's blockchain-powered carbon removal marketplace utilizes Ethereum to allow small farm based suppliers to sell to buyers, particularly those in regenerative agriculture. Nori focuses on soil carbon storage, with each carbon credit making up a Nori Carbon Removal Tonne (NRT). Nori will expand internationally and also tokenize their NRTs into NORI tokens to be deployed on Polygon and create a secondary market. Polygon has already partnered with KlimaDAO. Nori has also partnered with Bayer AG, one of the largest pharma / agricultural companies in the world to scale up their NRT supply.

4. Poseidon Foundation (Private)

The Poseidon Foundation's blockchain-based platform, built on the Stellar blockchain, empowers consumers and businesses to offset their carbon footprint by purchasing carbon credits. The blockchain technology ensures the transparency and traceability of these transactions.

5. Energy Web Foundation (Private)

Energy Web Foundation (EWF) has developed the Energy Web Chain, an open-source, scalable blockchain platform specifically designed for the energy sector. The platform, built on a customized version of the Ethereum blockchain, allows for seamless integration of renewable energy sources, carbon credits trading, and emissions data management.

6. Moss (Private)

Based in Brazil, Moss is a blockchain-based platform focused on tokenizing carbon credits, making them accessible and easy to trade. Moss has purchased parcels of land in the Amazon rainforest and focuses on credits generated from forest preservation projects. It then sells to companies and individuals with the goal of preserving the forest. It leverages the Ethereum blockchain.

6. DevvStream (Private)

Devvio is an ESG blockchain platform and is the parent company of DevvStream. Devvio uses DevvStream to put the carbon credits it gets from its streaming agreements on-chain. On DevvStream, the credits gain distribution benefits. DevvStream also gets priority access to Devvio's commercial clientele who are already using the ESG platform, so that if they need credits, they will go to DevvStream. DevvStream is also partnered with Xpansiv, one of the largest voluntary carbon exchanges, to provide liquidity.

7. Xpansiv (Private)

Xpansiv is owned by CBL markets and uses blockchain technology to create Digital Feedstock, a data-driven digital representation of commodities, including carbon credits. The platform, built on the Ethereum blockchain, provides a transparent and secure marketplace for carbon credit trading and valuation.

Others: Filecoin Green, Flowcarbon

Honourable Mention: dClimate

How Does the Market Look

Carbon Market Growth

The global carbon market reached a record value of $272 billion in 2021, a 20% increase compared to 2020. The voluntary carbon market, where companies and individuals voluntarily purchase carbon credits to offset their emissions, has also experienced significant growth. In 2020, the market saw a transaction volume of 104 million metric tons of CO2 equivalent (MtCO2e), with a value of $320 million. The increased interest in voluntary carbon offsetting creates a demand for transparent and efficient blockchain-based solutions.

Carbon Pricing Initiatives

As of September 2021, 64 carbon pricing initiatives, including emissions trading systems (ETS) and carbon taxes, have been implemented or are scheduled for implementation. These initiatives cover approximately 21.5% of global greenhouse gas emissions, further emphasizing the need for efficient carbon credit management systems like blockchain.

Blockchain Investment in Energy and Climate

A report by PwC found that between 2017 and 2021, over $2.4 billion was invested in blockchain-based energy and climate projects. This investment demonstrates the growing recognition of blockchain's potential to address sustainability challenges, including carbon credit management.

Adoption Rate

According to a report by the World Economic Forum, 10% of global GDP is projected to be stored on blockchain technology by 2025. This widespread adoption of blockchain is expected to extend to the carbon industry, further enhancing the efficiency, transparency, and security of carbon credit transactions.

Conclusion

Blockchain technology has the potential to revolutionize the carbon industry by providing a transparent, efficient, and secure solution to managing carbon credits and emissions data. While blockchain technology solves many inefficiencies, ultimately it does not solve the "global climate crisis". However, I do believe that blockchain technology does have strong use cases here.

SVB Overview

• 209bn assets

• 175bn deposits

• 13-14bn market cap

• 16th largest bank

Financial Profile

• Heavily reliant on tech / VC companies - <10% deposits from stickier US domestic retail

• 90% deposits uninsured – very different form other banks (in a bad way)

• Low loan to deposit ratio – small lending book. Aka larger securities portfolio

• Large HTM investment portfolio, especially in higher yielding long duration USTs and MBS over Fed reserves and t bills

  • Huge interest rate risk exposure

  • 50%+ assets invested in fixed rate securities

  • Average maturity of HTM bond portfolio was 6+ years

• Mark to market losses

  • End of 2022: SVB had 15bn+ mark-to-market losses

What happened

• 2021 deposits doubled – concentrated in longer dated USTs

• Bank moved too slowly to shore up capital base, vulnerable to rapid deposit outflows

• ALM policy errors, mark to market losses exceeded equity base

  • Usually higher interest rates drive stronger earnings b/c loan rates rise faster than deposits

  • SVB had the opposite happen due to customer base

  • Why didn’t SVB manage the assets better, or raise capital sooner?

• Failed capital raise --> 42 billion deposit run on March 9

• Entered FDIC receivership on March 10

What the government did

• Yellen made FDIC make all depositors whole

• Bank Term Funding Program provides banks up to 12 months financing with qualifying assets used as collateral valued at par rather than mark to market

Prisoner’s dilemma

• A lot of SV investors banded together to ask companies to continue with SVB and support the bank

• Peter Thiel was the first to run away 

• Classic prisoner’s dilemma – once one starts, the rest will follow. How to get everyone to agree to stay with SVB? Impossible given human nature

What I am tracking now

• J Powell is supposed to hike rates again next week (week of 3/20/2023)  

• Which companies will benefit from this

  • Mercury deposits sky rocketed already and offered 3mm FDIC insured

  • Angellist launched custodial accounts to help startups

• Who will serve the large crypto institutions now that both Signature and Silvergate are dead

What will happen to startups now and the venture landscape

• Survival mode

  • Companies who were valuation sensitive will not be

  • Just get money to last 2 years

• Funders need to always have follow on capital reserved and strong capital providers around the table

Silvergate Capital profile

• 11+bn assets

• 6+bn deposits

• Market cap ~550mm

• Founded in 1988, pivoted to digital assets in 2013

• Large concentration in crypto – super risky

• 12 bn --> 4bn deposit run in Q4, post FTX

• Forced sale of security at huge losses

• Voluntary wind down and liquidation March 8

Then, big marketplaces entered and highly democratized e-commerce for both merchants and customers e.g. Amazon, Coupang, Flipkart, Alibaba. As time went on, more marketplaces joined the party, and merchants realized that they wanted to go solo and set up shop on their own to own more of the customer experience, lower CAC and increase LTV, and own more of the profit margin. The SMB/mid-market landscape exploded, and so did D2C. With this, became clear that investors should look further down the value chain beyond the application layer into e-commerce infrastructure such as banking, payments, cart conversion, logistics, etc. Many aggregators emerged such as Moonshot, Thrasio, etc.

Then, the pandemic hit. E-commerce topped $1 trillion in 2022 for the first time, a record high. Penetration was ~24% of total retail growth. It took 10 years for e-commerce to go from 6-16% of retail sales. But in 2020, in just weeks, it gained another 10%!

Now that we are living in a "post-pandemic" world, e-commerce activity has normalized to "pre-pandemic" levels. Also, interest rates have been rising, and we are potentially heading into a recession.

What does this mean for e-commerce?

Before COVID, D2C was already hitting a point due to the crazy saturation of the space leading to rising acquisition costs. Regular shmegular methods such as Google / SEO / Facebook were not cutting it anymore. Omnichannel was table stakes. Being on major marketplaces is table stakes too. With declining consumer spend, merchants were seeing excess inventory and selling it off at steep discounts. Every step of the chain from sourcing to customer to post-purchase is not only more competitive but more expensive, cutting further into their margins.

The vast majority of merchants aka the long tail, are still patch-working together point solutions, and overspending on fulfillment / logistics, mismanaging inventory and working capital, and creating liquidity issues, which is a death sentence. Those that can cut out what is not necessary, be agile, focus on the bottom line, will survive. Also, e-commerce enablement products will consolidate, and only those focused on increasing ROI will survive.

I'm excited about companies that help businesses better manage their balance sheets (working capital, logistics, etc.).

Other than that, I'm also excited about some of the themes below.

Livestream

Examples: Popshop Live, Talshop, Whatnot, Drip, Shops, NTWRK, Loupe, Yes (acq. by Pinterest)

• sellers drive traffic to the site and leverage existing platforms

• proven and MASSIVE in China ($550 billion market in 2022)

• leverage influencers and celebrities

  • Kylie Jenner, Jessica Alba, Hyda Kattan, Rihanna, Selena Gomez

• here in the US: Tik Tok, Instagram, Youtube Shorts

Fintech / Payments

Examples: Bolt, Rally, Catch, Accrue Savings, Ampla

• new financing methods for merchants to reduce intermediaries and customers to have a seamless no touch experience (one click)

• BNPL is under heavy scrutiny

• ways for businesses to get debt to sustain operations

Sustainability / Climate

Examples: Aspiration, Pachama, Patch, Everlane, Allbirds

• customers care about where their products are coming from, they care about their carbon footprint, and they care about the planet

• transparency is key and necessary

Wholesale

• 70% spend goes through some sort of b2b distribution at some point

• huge untapped market

Brick & Mortar

Examples: Leap

• helping e-commerce businesses set up a brick and mortar shop as people go back in person

• Some products are better sold with an in-person experience, and the way to do so has large barriers to entry

Web3 / Crypto

Examples: Lolli, Glow Labs

• NFTS - digital tokenized versions of the product you buy

• Shopify allowed merchants to list NFTs on their storefronts

• Metaverse brands such as RTFKT (acq. by Nike)

Post-purchase experience

Examples: Malomo, Kale

• retain customers, drive loyalty, drive repeat purchases, at a lower cost

Shipping / Logistics

Examples: Shippo, Okendo, Shogun, Shipbob

• I could go down every step of this so I don't want to go too deep, just mention it because it is obviously important

Micro-influencers / Everybody is an influencer

Examples: Grin (managing partnerships)

• influencer marketing market grew from $1.7bn in 2016 to $13+bn in 2021

• as the influencer market saturates, everyone needs to find a niche. In the niches, audiences trust those that lead in them. Democratization of power from big celebrities to the everyday person

• Microinfluencers have better engagement and economics, and are cheaper for merchants

• Glossier was a huge success story

Honourable Mentions

• Proptech (democratizing real estate investing) e.g. Pacaso, Arrived

• HR solutions given high number of part timers

• VR / AR / AI - rise of personalized recommendations

• What

  • Allows users to inscribe data e.g. images onto the Bitcoin blockchain

  • Basically NFTs except on the Bitcoin blockchain, not Ethereum

  • Has some limitations around size and functionality

• Why it matters

  • Bitcoin has historically only been used for P2P money transfers, a ledger of transactions on the network

  • It is up to time to see if this will be good or bad for the network, and if this functionality will last

  • Bitcoin purists obviously don’t support this new feature.

• There is no marketplace for ordinals right now, or even a website, or even ordinal friendly crypto wallet

Check Ordinal Count here:

https://dune.com/maloikka/ordinals

Stacks

• L2 built on Bitcoin that lest developers create and deploy smart contracts like Ethereum

• Has a native token: STX

Coinbase Base

• What

  • L2, can build dApps

  • Built using Optimism’s OP stack (open source code powering the L2)

  • Coinbase is the initial sequencer

• No plans to issue a token yet

• Launched Base Ecosystem, a new fund to invest in early stage projects

• Why it matters

  • Coinbase is the largest crypto exchange in the US

• Opinions

  • Good: Coinbase has millions of users, the potential valule generated from even a smaller percentage of adoption is huge

  • Bad: Flops like their NFT marketplace

Value locked in L2s:

https://l2beat.com/scaling/tvl

Largest NFT sell off:

• Jeffrey Huang / Machi Brig Brother sold 1,010 NFTs, worth $18.6mm

LIDO

• LDO has gone up 200% this year

• LSDs for all major cryptos

• If you don’t use an LSD you have to stake on a CEX with big fees and risk or stake on chain and move to a hot wallet, choose validators, lock up your tokens, and it's just really hard

• process: swap ETH token for stETH to stake. That is it

• Lido stakes for you and you get the change in value plus staking rewards. You can still use your stETH

• Unstake just via swapping on a major DEX

• LIDO is rising because

  • SEC cracked down on centralizing staking e.g. Kraken

    • Goodbye CEX options hello DEX

  • The merge made it impossible to unstake your ETH

    • Shanghai update coming in march

    • LIDO will roll out V2

  • V2 is coming Feb 7 to directly unstake from the platform instead of swapping on a DEX

    • Much faster ~2 hours

• LIDO now manages more than Coinbase, Kraken and Binance combine

Stacks (STX)

• Stacks Network is an L2 on Bitcoin’s L1

• Popularity reasons

  • It powers Bitcoin’s NFTs – Bitcoin only used to power monetary transactions

  • SEC approved

    • First over token to get SEC approval in 2019

    • Now legally traded on US exchanges

Google & Tezos

• Google Cloud to be the first major cloud computing platform to be a validator

• Tezos can now set up nodes (validates tx) using Google’s cloud platform

• Google gets good returns too as all stakers tend to

Hong Kong

See proposal here: https://apps.sfc.hk/edistributionWeb/api/consultation/openFile?lang=EN&refNo=23CP1

• Crypto trading platforms need to apply for a special license from the SFC (only 2 exchanges are licensed to trade)

• Exchanges may soon offer trading services to retail investors

• Investors can only trade large cap tokens e.g. BTC / ETH

• Why it matters

  • Hong kong is the gateway to China

Blur

• One of the two biggest NFT marketplaces next to OpenSea

• Popularity Is due to

  • No marketplace fees

  • Optional creator royalty fees

    • OpenSea maintains its royalty fees except for a LIMITED TIME

    • Pressure from Blur?

    • Lose creators?

• Recently released $BLUR token, airdropped $400mm worth aka free mulla for everyone

Do Kwon and Terraform

• SEC charged Do Kwon and Terraform labs with fraud

• What went down

  • Sold unregistered securities and security based swaps and a bunch of other stuff

  • Lost $40bn

  • Worked with a US trading firm Jump that bought TONS of the stablecoin when the peg hit 10 cents in May 2021

  • Lied and said Chai (Korean payments app) used their blockchain to settle payments and replicated the transactions ont its blockchain

  • Kwon transferred 10,000 Bitcoin from Terraform into a cold wallet and slowly moved funds from it to a Swiss Bank beginning May 2020. Since then $100mm+ fiat has been withdrawn

  • No one knows where Kwon is

Tokenized Bonds

• What is different

  • No paper

  • No central clearing

  • No bank middleman

  • Aka cheaper and faster

• Who is using

  • Siemens (German) and HK government

    • Siemens did it without Polygon even knowing, and already collected the money

    • HK gov’t worked with Bank of China and HSBC to use GS’s tokenization platform to issue $101mm one year GREEN bonds

Napster

• Blast from the past! It technically got shut down in 2001 and has been passed around from Roxio to Best By to Algorand etc.

• Recently acquired Mint Songs, letting artists turn music into NFTs and integrate with Napster

FTX

• 7 former FTX employees got subpoenaed

• Nishad Sing, Former FTX engineering director, pled guilty to wire fraud and various conspiracies

• FTX gave a LOC to Alameda as high as $65 billion, with cover being the staking program FTX offered for the Serum exchange on the Solana blockchain

• FTX investors and partners got lawsuits e.g. Silvergate Bank, Sequoia, Paradigm, Thoma Bravo

• JPM is giving away millions of SMF’s money from Modula Capital, SBF’s small hedge fund

• A charity affiliated with an FTX executive made $150mm from an insider deal (Polaris Ventures)

Staking

• SEC shut down Kraken’s staking service, saying it was offering unregistered securities

• Brian Armstrong said the SEC’s 4-rule security template does NOT apply to staking

  • Staking is not an investment of money b/c you don’t lose the principal

  • Staking does not have common enterprise value – stakers are chosen randomly

  • There is no profit expectation – stakers want to validate transactions, not necessarily b/c they think they can make money

  • Staking rewards are not dependent on others – rewards are randomly automated

• Fact:  Coinbase charges customers 30% of rewards

Shopify blockchain tools

• Merchants can build tokengated apps using NFTs to give discounts and benefits to customer

3AC

• Launched new crypto venture called OPNX (open exchange)

• FLEX = native token

• Let people trade crypto bankruptcy claims against FTX, Celsius, 3AC (lol)

• First marketplace for trading crypto claims

• Banned in the US

SEC

• 2/9 SEC said it would close down Kraken’s staking service and fine them 30 million

Gemini & Genesis

• DCG to converted IOU to Genesis into convertible preferred stock

• Refinance term loans pay out $500mm to creditors

• DCG to sell equity in Genesis’s trading arm

• Pay up $100mm to Earn users

Digital Currency Group

• Selling shares in trusts operated by Grayscale, at a huge discount  

Twitter

• 200-300mm daily users

• Developing in app payments function first for fiat then crypto

Meta

• $13.7bn put into metaverse last year

• Quest 3 VR headset coming this year

• VR apps starting to make money

• 100mm+ WhatsApp users created animated avatars

Celsius debacle

• Eligible users will soon be able to withdraw 94% of assets given certain parameters, net tx and gas fees

• Open AI

• Google Brain

• DeepMind

• Meta AI

And we have seen some incredible ML models come to life

• Stable diffusion

• Multilingual machine translation

• GPT3

Is there an application within fintech?

The natural next thought is around chat bots / customer service / customer experience.

However, we’ve seen some pretty bad applications where chat bots don’t fully understand subtle inflections and latent context, which is kind of the whole point of that department in a company. Everyone gets mad, from customer to agent.

The fundamental building block of any form of generative AI is data. But not only is ChatGPT not trained on financial data (rather it is an expert on everything on the internet and programming), data in finance is very unlike data in computer vision or NLP. Financial data is extremely rich, but organized in an inconsistent way, with inconsistent rules, to encode lots of implicit information. Basically, the data structure is not easy to navigate, and financial data doesn’t have the absolute nature that physics does because all the rules around it were created by us wonderful humans.

Also, a mistake with financial data can cost a LOT of money. The legal ramifications are extremely high.

So is it even worth it with such large potential downside? Well, yes. We aren’t there right now but there is (obviously) huge opportunity in better data & analytics for financial institutions, from fintechs to insurtechs, the latter of which is completely dependent on risk modeling.

Some successful surface level opportunities already exist, primarily in the lead gen space and sentiment analytics e.g. Gong, Observe, etc as well as algorithmic trading e.g. Renaissance Technologies and asset management portfolio construction. And perhaps another lower hanging fruit is generating insights from transaction data, as it can help humans do their job better.

I've been following Square for a number of years, due to my fairly obvious interest in fintech and particularly payments. Square is considered one of the "new" players in SMB commerce payments, after Global Payments, TSYS, FIS, Fiserv, etc.

In December 2021, Square rebranded to Block, with Block being the name of the corporate entity, and Square being synonymous to its seller business only. Since then, Block has also grown to encompass not only Square, but also Cash App, and other emerging ecosystem players such as its acquisition of TIDAL, and new bitcoin products/teams, Spiral and TBD.

TL;DR Block is cool af, a behemoth business that continues to grow rapidly year over year, and one that I don't think will actually become obsolete and clunky in the years to come (it will actually be the opposite...). Particularly I am interested now in Cash App and the new crypto offerings in the pipeline, and I also personally identify with their mission of economic empowerment and increasing accessibility to financial products.

Square

Square has been around since 2009, and now has 30+ software and hardware products that are primarily self-service and supposed to create a seamless experience across business, customers, employees, etc. Monetization occurs via recurring and transactional fees.

Cash App

Cash App was founded in 2013 but really only expanded beyond its common use cases of grooming in 2015 / 2016. Since then, it has refines its product to become competitive to similar products such as Venmo (and surpassing it), launching several new products, and creating a whole culture / community around it.

Functions

• Send: Fiat & Crypto. Even hold your funds

• Bank: Direct Deposit (the ultimate game changer for any fintech), taxes

• Spend: Cash App Debit Card

• Invest: Stocks and Bitcoin, even fractional. Cash Boost, a rewards program.

• Save: Savings program, can round up as well

• Lend: Up to $500 loans

Monetization

Inflows for Cash App occur via checks, deposits (fiat & crypto), taxes, physical money, and outflows occur via instant deposits, the Cash App debit card, P2P transactions, ATMs, bitcoin, and stocks. Cash App monetizes on paper deposits, instant deposits, ATM transactions, bitcoin transactions, P2P transfers, and their Cash App debit card.

Cultural Movement

So how did Cash App suddenly become so relevant? The origins of its popularity explosion started really in the South, particularly Atlanta, where it really engrained itself in hip hop culture. In fact over 200 artists have mentioned Cash App in its lyrics. Since then, Cash App has partnered with influencers and celebrities to embed itself into communities of fans and users.

In 2020, Megan Thee Stallion gave away $1 million in Bitcoin, and then $1 million in stock in 2021. Lil Nas X also gave away $1 million in 2021. Cash App also sponsored the 2022 Bitcoin conference, and has an incredible presence on Tik Tok partnering with influencers.

Network Effects & the Organic Flywheel

When Cash App launched its #cashappfriday giveaway, it immediately took off. These giveaways exponentially increased user adoption and engagement. Furthermore, Cash App has created a sense of community where you can see what your friends and others are spending on (I am guilty of this...). Inherently, people want to use fintech products and apps that their friends are using, otherwise there is no point in being the sole user of an app. Thus, it is clear that for Cash App, these marketing tactics, partnerships, and community building has created tremendous network effects, with dividends paying off year by year. In fact, Cash App's CAC is around $5 whereas the average bank's CAC is several hundred, if not a couple thousand dollars.

Given how each generation is increasingly digitally native, the need for a formal bank account is reducing year by year, and the desire to have a flexible and easy to use digital wallet increases (to be clear, Cash App is NOT a bank). All of the points above help Cash App maintain and improve its differentiation all while scaling. And above all, remain in line with its mission of economic empowerment and improving financial literacy.

And all of this shows up in its financials. Excluding all bitcoin-related revenue, Cash App revenue increased 50%+ YoY due to increasing number of Cash App accounts, related transaction fees, and BNPL.

Spotlight on Cash App Bitcoin:

It started off in 2018 as an exchange and custody solution aka on and off ramp. Since then, they now provide features such as custom limit orders, automatic buying, converting direct deposit paychecks, and rewards.

Given Block's investment into a whole team called Spiral and TBD (see below), they're clearly bullish on the bitcoin network and bitcoin as an asset. They integrated with the Lightning Network last year, an L2 that helps enable bitcoin transactions with Block to be extremely fast, with very small to no fees. All of this in line with their mission...

In 2021, 56% of Block's revenue was solely from Bitcoin, and in 2022, it is looking to be the largest revenue line as well. While this number is heavily impacted by market and price volatility, it is nonetheless proof that the demand exists, will grow into the future, and should be treated as almost its own product line and a major top line contributor. One thing to keep in mind is that while the top line is very large, the gross profits were only 3-5%. Given the low margin profile, I presume Block will continue to grow their bitcoin revenue as a driver for other more high margin portions of their business, and/or eventually pursue a way to increase the margins.

Statistics

• 51 million + MAU across US and Europe

• #1 finance app in iOS App Store and Google Play, something that has held for a couple years now at this point

BNPL / Afterpay

In January 2022, they also acquired Afterpay, a BNPL platform, uniting Block's Square ecosystem and Cash App ecosystem. Now, Cash App customers can pay merchants online and offline, with some Square sellers able to use Square hardware to accept cash app. Given how COVID-19 propelled the trend of contactless payments forward quickly, it's incredible that Square / Cash App actually were able to adopt and execute upon it (clearly I have a low bar with American businesses and innovative payments technology...).

TIDAL

The TIDAL acquisition was completed in 2021, with the similar purpose of economic empowerment, but for artists. Purchased from Jay-Z, TIDAL offers a catalog of 90+ million songs and 450k+ videos, with listeners across the globe, and extensive relationships with labels and distributors.

Bitcoin Ecosystem

All Bitcoin related projects align with Block's goal of economic empowerment, but via a decentralized world. As a crypto believer and advocate, I absolutely love that they are doing this, and believe that now is actually a great time to really build in the space. Given Block's resources and the "crypto winter", investing time into this now with the world moving into a direction of greater decentralization will position Block very well once another crypto boom hits.

Spiral

Cash App offers the ability to transact in bitcoin, but Block also includes Spiral, an independent team focused on bitcoin open source work.

TBD

Block also includes TBD, a bitcoin focused business, established to build an open developer platform for non-custodial, permissionless, and decentralized financial servics.

It's clear that the rebrand into Block was to create a sense of an ecosystem, or become a complete financial OS for the user. I am sure there are many more applications, products, and features down the line, and I am so excited to see what the company comes up with.

I was very bullish on Real time payments. I still am, especially with FedNow on the horizon for 2023.

We are already seeing real time rails like RTP, FedNow and Interac and Pix. Startups like Orum are also working to re-route payments to speed them up. Perhaps the answer is also stablecoins but I am less well versed in that arena and believe mass adoption of that for banks and large financial institutions would come later.

Early October it was the 50 year anniversary of ACH. A bit mindblowing to think about - it’s been around half a century and nothing that drastic has improved since then.

The payments sector is saturated full of players owning a piece of the stack, orchestrating the stack, or building software on top. Of course owning more of the stack is valuable, but also providing several payment methods beyond ACH, push payments, cards, etc. is critical. Businesses want faster payments at the very least as an option. And they want it to work, not be patchwork. RTP by TCH (launched in 2017, consortium of 25 largest banks/tech companies, with most smaller FI’s not participating), Zelle (P2P debit payments, NOT settled in real time), Same day ACH, fintech bandaids from large companies like Apple or Google have already been around but what companies are really waiting for I’ve found, is FedNow.

As a quick primer, FedNow will be the first new payment rail since ACH. It’ll actually be instant, all hours of the day, all days of the year. Payments will be received and settled instantly. Funds have to be available instantly. And given certain compliance and fraud measures, funds should be able to be recovered. Similar to RTP in that it’s 24/7 and instant. However it’ll include clearing functionality aka recover funds from failed payments, as well as offer accessibility into 10,000+ financial institutions. It’ll be the first new payment rail since ACH!

Pertinent given how cash focused companies now are, faster payments will be a growing theme, and likely a new embedded feature instead of full-fledged new product.

Vertical Payments has and will continue to be an important theme of mine. I’m seeing the beginning of the J curve of more vertical fintech softwares broadly now.

Of course we have big players like Lightspeed POS or Toast or Kindbody that have really succeeded in the vertical payments spaces. However I’m seeing more in verticals like healthcare or specific geographies like MENA now which is very exciting, given how old the infrastructure there is and how difficult it is to penetrate doctors, insurance companies, hospital systems, care providers, etc. There are many moving parts and building a successful network will be a great moat.

Some I have in mind are Nitra and Mercantile. Those two have emerged in the past quarter in the healthcare payments/expense management space (Q3-Q4 2022) and I expect to see a lot more me-too players. I’ve also seen Pluto, the MENA version or Mendel in Latam. I think what will really differentiate will be the same logic as what made Ramp stand out from Brex, Airbase, etc. Better product, better value proposition for customers, monetizing on multiple fronts (although I will say the business models of existing large expense management companies has yet to move towards profitability, but I’d like to think that they know what they’re doing and are going to explode out of nowhere with a crazy product suite like Figma did).

I thought a lot of M&A was going to happen. I change that thought to M&A AND partnerships/collaboration.

I thought big companies were going to swallow the smaller companies that had great technology but were at risk of being swept away with the market downturn, running out of runway, and decline in VC funding, especially as fintech has been experiencing a lot of unbundling and so many “me-too” companies popped up.

As companies work together more closely, it becomes harder to differentiate who actually owns the tech and if it is the network that holds the value or what the company has built itself. As industries become saturated with more me-too companies and we see increasing commoditization, being able to differentiate that will become key.

While I still believe in that and it has already happened, I’ve come to realize that it’s not just about 1 company versus another, but rather about one company’s products and features versus another. Perhaps sometimes it is strategic to acquire a whole startup. But more often than not, as fintech is unbundled and the space becomes more saturated, the smartest fintechs will learn to collaborate and partner with others on some products/features and then compete on others where they believe they have an edge. Especially when it comes to particular customer segments, or incumbents who cannot move as quickly as smaller companies but have the market share. This is already an active theme in crypto given the decentralized nature of the industry, but we have yet to see the communal nature proliferate intro centralized industries.

Of course though, M&A still will continue to persist. However, what I am keen on seeing is if major players will acquire companies more for their tech or book of business. It seems like many are interested more in the former, to cross sell existing customers, especially as many startups in the past couple of years have really just built features, and overall industry saturation has led to commoditization.

Either way, the power law holds true and a handful of companies will hold the vast majority of the pie eventually.

Crypto is suffering right now in the wake of FTX and general market downturn. Thus, regulators are cracking down on the space. 2023 will be a year to see who can hold out the longest and navigate this changing regulatory landscape with the greatest finesse.

Within the broader tech markets, many companies will die as funding becomes more scarce and entrepreneurs don’t manage their cash properly. This holds even more true within crypto, as it was one of the most volatile and noisiest (if not holding #1 place) of 2020-2022. With what happened with FTX, many crypto companies will become easy collateral.

I’m interested to see which infrastructure players will suffer and which ones won’t - as regulators crack down even more aggressively, I’m sure many providers will start turning away crypto customers or stop onboarding until this wave “passes”. This will create a domino effect throughout the industry as most topple (probably within defi and applications) and few survive (probably within more core functions). The ones that survive I’m sure will survive many crypto cycles to come.

Either way, I am fully confident the industry isn’t going anywhere in the long run, but that it will suffer some pretty casualties in 2023.

The market did indeed take a big downturn, forcing companies to focus on profitability and extending runway. The world is so noisy for founders right now. What is the right answer? Growth or profitability? I seriously do not know.

Some of my friends are starting companies. Actually, more and more - I haven’t really seen desire to be a founder drop even though the market took a downturn amongst my demographic at least. But on one hand, you’re hearing from venture capitalists that you should optimize for profitability and reduce burn as much as possible. Advice, I believe worthy or a founder already in the growth stage with moderate amount of funding. But then you hear how Figma got acquired by Adobe and became one of the biggest SaaS acquisitions to date. And they didn’t even start making money until 5 years post launch. The past doesn’t predict the future, but what does hold true is that if you sell a half baked product too early, before finding product-market fit and before truly understanding the problem you’re solving, it’s very hard to turn around after you’ve started selling. I feel for founders right now who are faced with tons of conflicting opinions and noise.

So growth or profitability? Ultimately a question for smart and lucky founders who raised early and have the runway to even contemplate this question. If most companies that become big don’t really get there for at least 5 years, I do believe the market will make a correction before the half decade is up (sorry being hypocritical that past market behavior does predict future behavior here…). So really, optimizing for the long term seems like the best play, again, if you are in the position to do so. Being too short sighted can be your downfall.

Apple Card users can move Apple rewards and more funds into a Goldman Sachs savings account and earn interest. Interest pending due to rapidly rising rates.

Context:

Apple has been expanding its consumer financial services offerings. Apple has a payments network with Apple Pay and a credit card, all mobile. Goldman Sachs has been the chosen one partnering with Apple for its infrastructure and lending.

Relevance:

• With interest rapidly rising to bring down inflation, interest rates haven’t really moved for savings accounts. Goldman could offer a more competitive interest rate (national average around 0.1-0.2%). With Apple’s network they get an easy distribution pipeline

• With this new offering Apple will own more of the consumer’s wallet and financial OS, which they’ve already done with all our computers and phones and iCloud. Apple is / will be the first big tech company to foray into financial services.

• Goldman is winding Marcus down. Good timing for Goldman to partner with Apple and gain a whole slew of deposits.

• Implications for data, KYC, undewriting/credit, and identity. Apple wallet could be the gatekeeper.

What it is:

Apple Card users can move Apple rewards and more funds into a Goldman Sachs savings account and earn interest. Interest pending due to rapidly rising rates.

Apple has been expanding its consumer financial services offerings. Apple has a payments network with Apple Pay and a credit card, all mobile. Goldman Sachs has been the chosen one partnering with Apple for its infrastructure and lending.

• With interest rapidly rising to bring down inflation, interest rates haven’t really moved for savings accounts. Goldman could offer a more competitive interest rate (national average around 0.1-0.2%). With Apple’s network they get an easy distribution pipeline

• With this new offering Apple will own more of the consumer’s wallet and financial OS, which they’ve already done with all our computers and phones and iCloud. Apple is / will be the first big tech company to foray into financial services.

• Goldman is winding Marcus down. Good timing for Goldman to partner with Apple and gain a whole slew of deposits.

• Implications for data, KYC, undewriting/credit, and identity. Apple wallet could be the gatekeeper.

The reason to prefer it to consumer technology to me is clear, as I don’t enjoy or understand the fickle nature of consumer dynamics.

But why I really prefer core tech in fintech isn’t because the valuations have been crazy high the last couple of years, and I’m a momentum and hype chaser.

It goes back to why I am passionate about fintech to begin with - because it solves real problems with core players, and pushing these large boulders forward can help power generations of technology on top. It’s mission critical, and most fintechs rely on these “core” institutions.

It’s freaking hard because it involves heavy regulations, decade long contracts that are incredibly sticky, valuable and high margin businesses, massive stakeholders that move at a snail’s pace, and a certain level of scale that most companies don’t end up reaching.

Overall I have learned a lot but have so much more to learn. It’s so exciting! I am so excited.

I believe that the past does not predict the future, but understanding the past is key to building the future.

The market is huge ($30bn+ TAM) and can be segmented in many different ways.

• By industry

• By size of customer

• By geography served

• Vertical vs horizontal (point solutions vs suites e.g. talent acquisition or accounting)

• PEO, ASO, HCM, etc.

The market is fragmented.

• 5 largest vendors (INTU, Gusto, ADP, PAYX, iSolved) control well over 50% of the US SMB payroll market

  • Besides the large vendors, small players have almost negligible market share (<1%)

  • Big opportunity here

  • Many product expansion opportunities here. Can the large players keep up?

People are thinking more than just simple payroll.

• HR / payroll providers are getting bundled up depending on their target audience

  • Bundling examples

    • HR + payroll

    • HR + benefits

    • HR + expense management

    • HR + insurance

  • Rise of services and tech-enabled services

• Excel is out!

• Tailwind in digitizing everything and having 1 clean UI to manage it all

  • Focus on digitization and automation

Macro Tailwinds.

• Rise of the remote workforce makes it even more important to have fewer digital platforms to maintain a consistent culture and reporting

💡NEED TO HAVE, not a WANT TO HAVE anymore for SMBs. Critical to stay competitive.

• Relatively lower switching costs as more move into the space

  • Important to make the experience as seamless as possible

• It is easier to access data

  • Rise of embeddable offerings

  • Rise of white label offerings

  • Payroll data, employee data, etc. Verticalized Plaid.

Consolidation.

• The larger players have spent years building integrations but the newer ones understand trends and customers better - and there is a very long tail of them. Not a new theme, but one that will hit even harder as the market takes a downturn.

• Merging point solutions

• Enterprise + SMB —> expand offerings and client base

Overall increasing number of SMBs and segmented offerings creates opportunities to bundle and create a better, tailored product.

Well Known Players:

• Gusto

• Rippling

• Hibob

• BambooHR

• iSolved

• Bambee

• JustWorks

• Namely

• Homebase

• PrismHR

What is a PEO?

• You outsource your entire HR function to 1 partner and enter into a co-employment relationship

• The partner does all HR stuff while clients just focus on their business

• HR service that includes insurance

• The PEO becomes the EOR (employee of record) under 1 federal EIN when it comes to taxes. Essentially they become the umbrella.

• PEO helps with payroll and benefits, compliance, workers comp, other insurance, software, etc.

• Benefits

  • Cost and time savings

  • Support

  • Getting more bang for your buck because as an SMB it can be hard to get access to what a PEO already has access too

• Will this space grow?

  • Previously was just used for outsourcing and saving time / money

  • Now even more important given the macro trends of distributed workforces, having 1 united HR front, and engaging / retaining employees

• Largest players

  • ADP

  • TriNet

  • VensureHR

  • Paychex

  • Also fragmented and concentrated! Major players own ~50%

ASO Model

• Administrative Service Organization

• Similar HR services but NO insurance coverage or direct access to benefits, NOR EOR (client has to handle payroll tax)

• Why ASO and not PEO?

  • Businesses think they can get insurance / benefits elsewhere for cheaper

  • Risk of the business is unattractive for PEOs because PEOs bear insurance risk

• Largest Players

  • ADP

  • PAYX

  • NSP

  • TNET acquired Zenefits

Common Business Models

• Consider:

  • Client Count

  • Client Size

  • Offerings Per Client

  • Pricing per revenue

• Common pricing models

  • PEPM

  • Fixed fee + PEPM

  • Transaction + subscription

  • A la carte

  • Various bundles + discounts

• Revenue composition

  • Recurring is 90%+ of revenue, non-recurring usually around 1 off implementation, extra sales, etc.

    • higher margin

  • Float revenue too

    • volatile and dependent on many factors

• Seasonality

  • Q1 is heavy and declines throughout the years

    • Lots of clients going live

    • Annual form filings

• Sales and Distribution

  • Direct

  • Resellers

  • SEO

  • Referrals

• Margins

  • GM

    • Payroll lowest and is susceptible to employee turnover

    • HCM > PEO

      • PEO is more service heavy and involves insurance (they take on the risk, faces regulations too)

      • HCM tends to be more software

  • EBITDA

    • ~30% Adj. EBITDA is a good target, some are operating much above such as PAYX

    • Critical to achieve revenue scale as costs stay rather flat (focus on cost efficiency)

    • PEO is different

      • low double digits or single digit margins are reasonable

• Common risks

  • Client churn - especially as they scale or go bankrupt

opportunity for expense management providers to move into benefits?