Arcane Crypto — Gradually making progress on its agenda

Arcane Crypto reported a Q221 net loss of SEK7.1m (c £0.6m, see Exhibit 1), higher than the net loss of SEK1.6m in Q220, mostly due to the full consolidation of the Norwegian spot crypto broker Kaupang Krypto which, like most of the businesses in Arcane Crypto’s group, is yet to break even. The acquisition was completed on 26 March 2021, but while Kaupang’s balance sheet was already included in Arcane Crypto’s consolidated accounts in Q121, its income statement was consolidated in the group’s P&L for the first time in Q221. This was also the main driver of the significant increase in Arcane Crypto’s revenues to SEK100.3m in Q221 (versus SEK0.2m in Q220 and SEK2.1m in Q121), which now include Kaupang’s trading volumes (c SEK97.0m), ie the value of digital assets brokered to customers, with the corresponding acquisition costs (SEK94.8m in Q221) reflected in cost of goods sold. The acquisition of the remaining 66% stake in Ijort Invest, which operates the Swedish retail crypto exchange Trijo, was completed after the reporting date (2 July 2021). Consequently, Ijort Invest’s results were still accounted for under share of profits from associates in Q221.

Arcane Crypto posted a positive SEK0.1m impact in the personal expenses line in Q221, which came from a SEK6.9m reversal of social charges associated with warrants issued to employees (in Q121, the company recognised a SEK7.5m one-off cost including an accrual of social charges related to these warrants). Their value has been adjusted to reflect the decline in Arcane Crypto’s share price during the quarter. Adjusted for the above, Arcane Crypto’s EBITDA loss stood at SEK8.3m (versus the reported EBITDA loss of SEK1.5m), which is c SEK4.8m below Q121. Excluding Kaupang’s consolidation in Q221, underlying EBITDA would be SEK3.0m below Q121. Arcane Crypto also posted a loss from participation in associated companies at SEK3.1m in Q221 (versus a profit of SEK0.5m in Q121 and a negligible result in Q220), see Exhibit 1 for details. Moreover, it booked depreciation and amortisation including write-downs on intangibles of c SEK1.0m, which we understand (based on our discussion with management) largely includes regular amortisation of Kaupang’s goodwill. Finally, the group posted net interest and other financial costs of SEK1.4m in Q221 (versus net costs of SEK0.2m in Q220).

During Q221, Arcane Crypto’s net cash outflow from investment activities stood at SEK17.2m, of which €1.5m (c SEK15.2m) was spent on acquiring an additional 9% stake in ITOAM (LN Markets), bringing Arcane Crypto’s total stake to 16%. The remaining balance represents a minor investment in IIjort Invest ahead of the acquisition of the remaining stake. The company’s cash and bank balances at end-June 2021 stood at SEK33.5m versus SEK53.9m at end-March 2021. Furthermore, on 30 August 2021, the company completed a directed equity issue to a group of qualified investors (including Morten Klein, one of its major existing shareholders) raising SEK61.1m of gross proceeds at an issue price of SEK0.203 per unit (each unit consisting of one share and one share purchase warrant), resulting in the issue of 300.9m units. The additional funds will be largely used to fund the setup of crypto mining operations (see details below). Each of the issued warrants allow the holder to subscribe to one newly issued share between 1 September 2021 and 28 February 2022 at a price of SEK0.2436 per share. The directed issue will, upon full exercise of the warrants (representing SEK73.3m of additional proceeds), translate into a total dilution of 6.85%.

Kaupang’s trading volume rose to c SEK97.0m (c £8.2m) from c SEK40.0m in Q121 despite the sell-off in crypto markets in Q221. We understand that this was assisted by the broker’s increased focus on larger clients (primarily family offices and high-net-worth individuals, HNWI). The company recently launched its premium OTC offering and partnered with Fireblocks to provide custody solutions (a crucial part of the offering for institutional investors). We note that Fireblocks is one of the top players in terms of assets under custody and recently attracted a strategic investment from Bank of New York Mellon.

Kaupang’s gross profit on sales stood at c SEK2.0m, which implies an average spread achieved on its brokerage activities of slightly above 200bp. This may be viewed as quite healthy compared to, eg Voyager Digital, which recently disclosed its average spread as +100bp. While average spreads achieved by Kaupang’s local competitors (eg Safello or Goobit) are even higher, they seem difficult to sustain in the long run. We note that Kaupang’s current focus is on larger clients which, going forward, is likely to push the average spread down. At the same time, however, this should stimulate further growth in trading volumes and, in turn, gross profit. The average spread will also be determined by the mix of digital assets brokered, with cryptocurrencies other than bitcoin and ether likely offered at higher spreads.

Arcane Assets increased its revenue by 52% q-o-q to SEK2.7m, despite the decline in assets under management (AUM) to c SEK120m at end-June 2021 from c SEK170m at end-March 2021 (average AUM was still up in Q221 by c 25%, according to our estimates). Based on our discussion with management, we understand that the increase in revenue was assisted by performance fees and the hedge fund did not attract any meaningful new funds during the quarter. This may be somewhat disappointing given growing investor interest in crypto assets recently. The lack of new funds inflow may be largely due to the fact that the fund cannot be marketed directly (see our initiation note for details). Focus in Q321 is on distribution following the recent onboarding of a new head of business development. We note that on 16 June 2021, the company signed an LoI with Valour Structured Products to explore the issue and listing of an exchange-traded product (ETP) based on the hedge fund. Valour has so far issued four single-asset ETPs (traded on the Nordic Growth Market) tracking bitcoin, ether, Cardano and Polkadot. According to the original release, both parties are working on a definitive partnership agreement and a plan for the issue, which should be finalised later this year. We believe the launch of such an ETP would provide Arcane Assets with an important distribution channel supporting its AUM growth. However, we note that the design of such a product will likely be more complicated compared to existing digital asset ETPs (which are mostly passive products), given the active strategy of the hedge fund.

The revenues of Arcane Research tripled versus Q121 from c SEK306k (exact Q221 figure not disclosed). This was driven by an increase in the subscription base of its existing products (which for the weekly report went up by 29% in Q221), as well as other products developed with recently added clients and partners (eg the regular report for BlockFi’s institutional investors). While some of the projects were one-off in nature (eg the industry report on the Bitcoin Trading Ecosystem published with LMAX Digital), they are likely to be used as a ‘door opener’ for attracting new customers (institutions in particular).

The result from participation in associated companies (a SEK3.1m loss in Q221) includes the share in the results of Ijort Invest (Trijo), Puremarkets, Alphaplate and ITOAM (LN Markets). Puremarkets (37.5% owned by Arcane Crypto) is gradually approaching the platform launch, with the first test trade initially planned in August 2021 (now scheduled for September 2021). On 2 July, the company announced that it had signed an LoI with Bank of New York Mellon, which joined a consortium of tier one investment banks alongside State Street (the names of the banks behind the other four LOIs have not been disclosed yet). The consortium is working with the company’s interbank wholesale marketplace Pure Digital to develop a platform to support the entire digital asset life cycle. Alphaplate reported a loss of SEK1,554k in Q221, compared to a SEK3,171k profit on market making and other trading activities in Q121. Around SEK700k of the Q221 loss is attributable to Arcane Crypto, given its 45% stake in the business. Alphaplate focused on development and third-party integrations during the quarter, including integration with the Pure Digital platform, on which it will operate as a liquidity provider. The derivatives platform LN Markets saw a 22% q-o-q decline in trading volumes to US$69m, which management believes is due to broader market sentiment amid the Q2 sell-off. At the same time, however, the number of user accounts increased by 41% versus Q121. We note that Arcane Crypto has recently increased its stake in ITOAM (operator of the platform) from 7% to 16%. Finally, Trijo’s trading volumes increased slightly in Q221 versus Q121 to c SEK40m (by c 5% according to our estimates), but the exchange is still not charging trading fees (only deposit and withdrawal fees) and is in the process of transitioning to a brokerage model based on spreads. It has recently announced a collaboration with the payment service provider Trustly (which is the latter’s first collaboration with a crypto company) and has already implemented the option to deposit funds through the latter. According to the management, this triggered an uptick in investor activity lately.

Arcane Crypto continues to develop a cloud-based platform that will provide access to all products offered by several of its entities, including Kaupang Krypto, Trijo, Teslacoil, Arcane Assets and Arcane Research. This is being implemented by the team behind Arcane Technology, the business unit responsible for developing Teslacoil’s payment software. We understand that Arcane Crypto continues to face difficulties in partnering with external providers of on- and off-ramp solutions for Teslacoil (we flagged this as a potential risk in our initiation note). This suggests that the project is unlikely to generate any meaningful revenues in 2021, as discussions with potential business clients and payment processors have likely been put on hold. As a result, Teslacoil is now putting more emphasis on integration with Kaupang, which will provide its users with the functionality to make payments directly to and from their regular fiat bank accounts using the Bitcoin Lightning Network (described in more detail in our initiation note). Consequently, the Arcane Technology team will serve different businesses within Arcane Crypto, rather than operating as a separate business unit.

In June 2021, Arcane Crypto signed a lease contract for hosting bitcoin miners, marking the first step into the bitcoin mining business. Total hosting capacity covered by the contract stands at 2.5MW, which will be gradually unlocked between August 2021 and Q122 (half of the hosting capacity will be available from this year and the other half from next year). The duration of the contract is 3.5 years with an option to extend it for a further two years. Meanwhile, Arcane Crypto has started the process of ordering the required mining equipment (application-specific integrated circuits, ASICs), with the first batch expected to be delivered in September 2021 and the second in December 2021. Importantly, the energy used in the mining operations will be renewable (hydropower). The business will be operated by Arcane Green Data, a fully owned subsidiary of Arcane Crypto.

Arcane Crypto is launching its mining operations in the aftermath of the Chinese ban on crypto mining introduced in recent months, which initially reduced the total computing power in the Bitcoin network (so-called hashrate) by close to 50% from its peak in May 2021 at c 200 Exahashes per second. This in turn triggered a reduction in the difficulty of mining a block (and receiving a reward in the form of newly minted BTC and transaction fees) as part of an automatic update carried out periodically by the Bitcoin network’s protocol. This, in conjunction with the recent rebound in BTC price to the current c US$51,500, has significantly improved business economics for non-Chinese miners, which continue to operate on the Bitcoin network. Moreover, we understand that the Chinese ban also resulted in a decline in the price of new ASICs and a shortening of delivery times. This all works in favour of Arcane Crypto’s new business line. We also appreciate that the company’s mining operations will be based on renewable energy, with Bitcoin’s carbon footprint recently in the spotlight again. Based on current Bitcoin network parameters (total hashrate, block reward, average block time, transaction fees, etc) and the current BTC price, we estimate that full utilisation of hosting capacity would represent mining revenue of c US$10m (c SEK86m) pa for Arcane Crypto. Having said that, this figure may change significantly depending on development of the above-mentioned factors.