The sudden and spectacular collapse of Sam Bankman-Fried’s cryptocurrency exchange FTX could put a chill on institutional investment in the Canadian crypto space for years, industry experts told BetaKit.
FTX, which achieved a valuation of $32 billion USD after just three years in operation, had attracted $2 billion USD in funding from seasoned venture capital firms and institutional investors including Sequoia Capital, Tiger Global, SoftBank, Lightspeed Venture Partners, and the Ontario Teachers’ Pension Plan (OTPP)—the latter of which is the third-largest pension fund in Canada. The exchange also had several additional ties to Canadian tech, including a pending deal to acquire Bitvo and backing from Kevin O’Leary’s WonderFi.
“This has likely set crypto back at least three years,” said Koleya Karringten, executive director of the Canadian Blockchain Consortium. “Institutional investors are going to have a very difficult time being willing to explore the industry. They won’t view this as an isolated incident…Everyone [will get] painted with the same brush.”
“This has likely set crypto back at least three years.”
One expert in the Canadian cryptocurrency industry, who requested anonymity to speak freely about investor sentiment, told BetaKit that “gone are the days of not doing full due diligence and having some of these regulatory red flags be seen as not more of a pressing issue.”
The expert added that some institutional investors in the crypto space have set aside proper due diligence questions due to a “hunt for yield” from a growing sector that promised significant returns. Crypto-specific due diligence could include assessing regulatory uncertainty and perhaps insisting the investee company talk with local regulators; reviewing evidence of ownership of assets and company financials; and getting a clearer understanding of a company’s crypto asset.
“Oftentimes there was a bit of clamouring to get into the deal, so regardless of how big the institution was they couldn’t use their weight as they would with other ventures and areas of industry to extract additional rights and protections because they just wanted in on the deal,” they said. “This is now coming back…as a bit of a concern for investors who didn’t do proper due diligence.”
Boris Wertz, a founding partner of Version One Ventures, which invests in early-stage cryptocurrency companies, said the recent tech and crypto bull markets “definitely created a bunch of FOMO,” particularly among later-stage VC firms.
“Obviously there’s much more competition at the later stages, and that has sometimes led to perhaps people moving too quickly, taking too quick an investment decision, and overlooking things in due diligence,” he said, speaking generally and not about FTX investors specifically.
Overdue diligence
Questions of due diligence have dogged the OTPP in particular, given its role as custodian of Ontario education workers’ retirement income. The pension fund revealed last week it had invested an initial $70 million USD in the now-bankrupt crypto exchange in an October 2021 funding round and an additional $20 million USD in January 2022. Both investments came through its Teachers Venture Growth platform, which launched in 2019 to “support emerging technology companies raising late-stage venture and growth capital.”
“We are disappointed with the outcome of this investment.”
Amid crypto volatility in September, OTPP CEO Jo Taylor stuck by its investment, telling Reuters it was performing well, and that FTX was “probably the lowest risk profile you can have in that it’s everybody else is trading on your platform.”
In an updated statement on Nov. 17, the pension fund said its underwriting process on the FTX investment “included working closely with third-party advisors and FTX to explore commercial, regulatory, tax, financial, technical and other matters. Recognizing that no due diligence process can uncover all risks, especially in the context of an emerging technology business, the investment in FTX was sized moderately in relation to TVG and the overall portfolio of the plan.”
OTPP said its investment in FTX represented less than 0.05 percent of its total net assets, and equated to ownership of between 0.4 per cent of FTX International and 0.5 per cent of FTX.US. It will write down its investment in FTX to $0 at year-end.
“The financial loss from this investment will have limited impact on the plan, given its size relative to our total net assets and our strong financial position,” the statement read. “However, we are disappointed with the outcome of this investment, take all losses seriously and will use this experience to further strengthen our approach.”
Other FTX investors have also addressed their own diligence processes in the past week.
In a Nov. 9 letter to limited partners in its Global Growth Fund III, under which it owned FTX.com and FTX US, Sequoia announced it had marked its investment down to $0 USD and said it had conducted a “rigorous diligence process” on the exchange before investing.
“We are in the business of taking risk. Some investments will surprise to the upside, and some will surprise to the downside. We do not take this responsibility lightly and do extensive research and thorough diligence on every investment we make,” the firm wrote. “In 2021, the year of our investment, FTX generated approximately $1B in revenue and more than $250M in operating income, as was made public in August 2022.”
Japanese investment powerhouse SoftBank, which invested in FTX as part of its Vision Fund 2, marked down its $100 million USD investment to $0 last week. On Nov. 12, the company’s former chief operating officer Marcelo Claure, who resigned in late January, addressed the fallout in a tweet. “I have been reflecting personally on the whole FTX fiasco and it taught me one more time that we should NEVER invest because of FOMO and we should always 100% understand what we are investing in,” he wrote. “I totally failed here on both.”
George Bordianu, co-founder and chief executive officer of Balance, a Canadian digital asset custodian, speculated investors like the OTPP and the Caisse de dépôt et placement du Québec pension fund, which wrote off its $150 million USD stake in now-bankrupt crypto lender Celsius Network in August and put a pause on investing in crypto, may have “mistook an early-stage company in the FinTech space for a late-stage company.”
Referring to FTX specifically, Bordianu said that while the company had hit significant fundraising milestones, “you can’t grow a company from $0 to $32 billion in three years, regardless of the space or the industry. This is most definitely cutting corners, and it looks like plenty were cut [here].”
Wertz added that valuation and company stage have historically been aligned, but became disconnected in the past few years as bullishness in the tech space sent relatively immature companies rocketing to billion-dollar valuations. “When you build an organization over 18 months, the business is not that mature. The product is not that mature. Obviously, you still have way more risks that something blows up,” he said.
FTX’s own FTT token, which was marketed as a utility but was, in reality, an investment, should have been a red flag, Karringten said. Tokens with an investment function are unregulated securities, she said, and companies trafficking in them are fundraising from an ineligible group of investors under securities law. In Canada, companies can only raise funds from friends and family or accredited investors without a prospectus, but not retail investors.
The Canadian Blockchain Consortium has been “very conscientious” of which companies it brings on as members and has a strong vetting process, knowing that the organization is lending them its credibility. She said any firms that have held initial coin offerings in the past, or issued tokens that are marketed as a utility but are in reality investments, would “absolutely not” be welcome, though those that issue a token that is genuinely a utility are acceptable.
Wake-up call
Both Wertz and Bordianu said this should be a wake-up call about the risk of centralization in the crypto space.
“I want to make sure if I’m securing assets with someone, that someone doesn’t also provide a trading desk… that might be producing a conflict of interest. These distinctions in traditional finance are well-cemented and established. The exchange should not have custody over assets, the exchange should not be market-making and trading with clients’ assets. There’s a need for separate entities,” Bordianu said.
Balance CEO George Bordianu said there should be “consequences” for investors who participated in FTX rounds.
The Canadian Securities Administrators and Investment Industry Regulatory Organization of Canada had expressed concern about this type of centralization back in 2018, when they first started considering how crypto asset trading platforms should be regulated.
The CSA rolled out regulation for the sector in March 2021, requiring crypto companies to have mandatory insurance to cover the loss of clients’ assets, meet cold storage requirements, disclose risk to clients, follow know-your-client standards, and follow a two-year transition to registration with IIROC.
Karringten said the fallout from FTX will hit Canada’s crypto industry hard, despite the country having some of the strongest regulations in the world, and the consortium plans to step up its advocacy and public relations work in response.
“Canadian companies are going to have harder hurdles to overcome,” she said. “The ones that are fully registered with IIROC, are regulated by the securities commissions, are working with the top four accounting firms and the top five law firms to make sure they’re compliant, they’re going to have a harder time accessing institutional funding after this, because of a group of teenagers living in a Bahamas condo.”
But Bordianu said there should also be “consequences” for investors who participated in FTX rounds. “You shouldn’t be getting as much deal flow as you normally would be getting. It should have an impact on their reputation as well,” he said.
Feature image courtesy Unsplash.