Powered by high valuations and mainstream adoption of blockchain, dealmaking in the crypto industry is moving rapidly, opening an uncharted lane for traditional corporate finance.
In the past year, banking powerhouses started to lend financial support to innovative companies in the crypto sector looking for fundraising and consolidation, overcoming their initial skepticism about a volatile and mostly unregulated industry.The total value of crypto M&A deals in 2021 grew over 50 times the total of 2020, with each of the top 10 deals valued at over $1 billion, according to a PwC report. The average M&A deal size more than tripled to $179.7 million in 2021 from the prior year, while the total value of crypto fundraising deals soared by 645%. Momentum will continue in 2022, the report also states.
“The increased demand we see coming from our clients shows that institutional investors are becoming more and more interested in entering the digital asset market,” Drew Forman, head of Cowen Digital, tells Global Finance.
Blockchain lawyers are guiding firms through a regulatory maze. “Digital assets are unlike debt or equity and therefore represent a new frontier in terms of working out financing structures and valuations,” says Timothy Spangler, partner at law firm Dechert. “Lawyers working on these transactions today must anticipate what positions regulators and courts will take in the coming years.”
Lending to crypto companies is the next step for traditional financial institutions already offering custody and management of digital assets. This was unthinkable only a few years ago when decentralized finance (DeFi) and traditional finance had firm boundaries.
In March, New York-based financial firm Cowen launched a digital asset division to offer trading and custody solutions for institutional investors. The company said it spent 15 months building the institutional-grade, fully integrated platform. Cowen Digital says it plans to offer lending capabilities this year. “There is increasingly a recognition that digital assets are here to stay and that institutional clients want safe exposure to them,” Forman says. “During 2022, we plan to offer lending capabilities and also aim to launch swaps and derivatives.” Cowen also intends to roll out algorithmic technology and plans to expand in the U.S., Europe, and Asia.
After launching its bitcoin desk last year, Goldman Sachs in March became the first major investment bank to execute an over-the-counter cryptocurrency trade. The bank says it recently extended a secured lending facility where they lent fiat collateralized on bitcoin owned by the borrower.
“The interesting piece for us was the structure and the 24-7-365-day risk management,” a Goldman spokesperson says.
The Collateral Issue
Traditional financial institutions with institutional-grade platforms claim an advantage over DeFi lenders when it comes to financial risk. “In the past, the challenges for regulated firms have always been around making sure there is robust custody, and that they can access this new asset class in the same secure and seamless way as they would access any other asset,” says Cowen Digital’s Forman.
Collateral, however, remains a concern due to the volatile nature of crypto assets, as seen with the selloff that followed the collapse of the TerraUSD stablecoin and its twin coin Luna in May.
“Recent drops in crypto asset prices will lead many to approach this with caution and set high collateralization requirements,” says John Garvey, leader of PwC Global Financial Services. Traditional players will monitor any high-profile liquidations and margin calls from borrowers that took loans during the bull market and face a downgrade in the value of their collateral, he explained. “For some this could also be a time to build and refine models and collateral levels, so when market conditions turn, they are prepared and stronger than ever,” he adds.
The Bank of International Settlements (BIS) in its latest Annual Economic Report warns against the “deeper structural limitations” of crypto and DeFI “that prevent them from achieving the levels of efficiency, stability and integrity required for an adequate monetary system.”
Dealmaking will move to geographies where regulation is more advanced and friendlier than the US, experts say. The US has been a catalyst for crypto M&A deals, accounting for 51% of transaction count in 2021, up from 41% the previous year, PwC shows. However, Europe, the Middle East and Africa recorded the highest M&A deal value last year, helped by SPACs including the $8.1 billion Bullish deal.
“I know for a fact that very large investors, some of the largest family offices, have invested in the United States, in bitcoin and bitcoin mining, and have started to pressure the regulators to leave them alone,” says Ralf Kubli, a Switzerland-based executive specializing in blockchain, cryptocurrency and decentralized technology.
Kubli sounds confident that globally there will be more clarity in future regulation. “The problem in the US is that you get clarity by litigation,” he says. Countries like Switzerland are attracting the parents of crypto exchanges like FTX, which opened its European headquarters there.
“We are seeing a number of jurisdictions establish specialist regulatory regimes with the objective of providing better regulation but also attracting internationally mobile crypto businesses,” says Garvey. Market players are actively establishing a locally regulated presence in the markets where they expect to get larger customers, like the US, parts of Europe and Japan. “We expect this trend to continue with more and more locally regulated entities being established,” he adds.
The Risk Factor
Fresh money is flowing into crypto and blockchain deals from traditional and crypto-focused venture capitalists and funds, which combined became the largest source (38%) of M&A activity in 2021, according to PwC.
Kubli warned that there may be a problem of overvaluations as venture capital and funds must deploy large amounts of cash.Last year, the average size of the top 10 M&A deals in the crypto industry was $3.3 billion, over nine times larger than Binance’s $400 million acquisition of CoinMarketCap in 2020, PwC shows. “The reason why there is so much chaos and so much risk in finance is because the cash flows of these financial instruments are not properly defined and standardized,” says Kubli, a board member of the Casper Association, which oversees the Casper Network, a modular blockchain designed to issue and manage crypto-based financial solutions.
Kubli believes that the digitization of traditional finance requires standardized, digital, algorithmic financial contracts that define the cash flows between parties. Without such contracts, it won’t work: “We’re building capital markets the right way, from ground up again.”