Arcane Crypto — A play on the digital asset revolution

Arcane Crypto positions itself as an investment company acquiring and developing early-stage businesses focused on the blockchain-powered digital assets sector as part of a ‘buy-and-build’ strategy. It aims to leverage the local prominence of its major shareholders and its CEO (see below) to act as a ‘centre of gravity’ in the Nordic countries by attracting projects with a clearly defined business model and monetisation strategy, and with a committed team to execute them. Importantly, Arcane Crypto prefers business models that have proven successful in traditional financial markets and could be applied in the digital assets industry. A good example here is Puremarkets, which is developing a platform for spot trading of bitcoin (BTC) and other digital assets for tier 1 investment banks based on the experience gathered by one of its founders from the ParFX project (see details below) and the management team’s extensive experience at top tier banks, in the FX business in particular. Moreover, it favours investments that offer synergies with Arcane Crypto’s existing projects and portfolio companies. The company’s due diligence process involves standard procedures, such as a SWOT analysis, synergies quantification and a risk assessment covering financial, regulatory and reputational aspects.

Arcane Crypto acts as a business incubator with extensive involvement to support the development of its portfolio companies, which can utilise internal personnel resources of Arcane Crypto. For instance, at Puremarkets, Torbjørn Bull Jenssen (Arcane Crypto’s CEO) holds a director position, while Eva Lawrence (Arcane Crypto’s COO) acts as an advisor. The company may be represented on the board (eg in Puremarkets and ITOAM) or just maintain close relationships with the company’s management (eg Alphaplate).

Arcane Crypto aims to generate income from 1) direct revenue from subsidiaries, 2) dividends and capital gains from portfolio companies and 3) return on capital deployed as trading capital in Alphaplate and/or invested with the hedge fund of Arcane Assets (see below for details). Below we present a timetable of Arcane Crypto’s investment activity since the adoption of its current strategy in 2018.

Until end-March 2021, Arcane Crypto spent a total of NOK93.3m to acquire 100% stakes in Ijort Invest and Kaupang Krypto and invest in its minority-held businesses (c €9.1m based on the current €/NOK rate), see Exhibit 2. Below we discuss the company’s major investments in 2021 ytd:

The listed Arcane Crypto AB in its current form was established as a consequence of the reverse takeover of Vertical Ventures (listed on the Nasdaq First North Growth Market) performed by the private company Arcane Crypto AS, initiated in August 2020 and approved by Vertical Ventures’ EGM in January 2021. The business of Vertical Ventures, founded in 2004 and listed since 2008, involved running its own projects as well as being an active co-owner in companies in diverse market verticals within loyalties. The company sold its sole operating business, the loyalty platform Wifog, in autumn 2019 and at the time of the reverse takeover did not perform any operations. The reverse takeover was carried out as an acquisition of all shares in Arcane Crypto AS by Vertical Ventures in exchange for a directed issue of 7,258,931,122 shares in Vertical Ventures to the owners of Arcane Crypto AS (resulting in an increase in total shares outstanding to 7,799,003,523). Arcane Crypto AS was founded in 2009 but was initially a holding company with none of its own operations until 2018 when its current business lines started to be developed. The rationale behind the stock listing was, among others, to provide capital markets access to help pursue the company’s investment strategy.

Given that a number of Arcane Crypto’s portfolio companies are utilising the Bitcoin Lightning Network (Teslacoil and LN Markets in particular, but also Kaupang), we introduce this open-source technology in more detail.

By eliminating the need for trusted intermediaries, blockchain technology (with the Bitcoin network launch in 2009 being its first live implementation) addresses the complexity and inefficiencies of existing legacy payment systems used by banks (which in turn lead to elevated costs), most notably in cross-border payments. Having said that, while the Bitcoin network was originally designed as a peer-to-peer payment system to address the shortcomings of legacy payments systems, it has shortcomings of its own. Its throughput in terms of transactions the network can handle proved to be quite limited and stands only at around seven transactions per second (TPS), which compares to the Visa network at c 1,700 TPS implied by the company’s statement that it processes 150 million transactions per day on average (it also claims that it can handle more than 24,000 TPS). Moreover, with the growing appeal of BTC as an investment asset and the resulting increase in transactions, average fees charged by miners (who take part in the transaction validation process) soared visibly above US$10 per transaction this year (and for a brief moment they recently even reached more than US$60 according to bitinfocharts.com).

The Bitcoin Lightning Network is being introduced to address the scalability issue through a so-called ‘layer 2’ solution, that is a system that ‘sits on top of’ the actual BTC blockchain. It relies on a network of peer-to-peer connections (called ‘state channels’), which can be opened between two parties to execute an unlimited number of transactions off-chain (ie without being validated on the main blockchain). Only the net result of all these transactions will be recorded on the blockchain once the channel is closed. At present, transaction fees on the Bitcoin Lightning Network are significantly lower compared to the main chain and for small payment amounts normally do not exceed a couple of cents per transaction. Importantly, the fee structure normally includes a minor fixed base fee plus a fee charged as a percent of the transacted amount rather than a lump sum per transaction (as is the case on the main BTC blockchain, which at current fee levels makes it unattractive for micropayments). Main blockchain fees are charged only upon opening and closing of the respective state channel.

The tech stack of the Bitcoin Lightning Network allows it to handle a much greater number of transactions per second than is possible on the main chain. The exact figure is difficult to quantify but in terms of the technological setup, the throughput seems to be limited only by the speed of internet connection between parties. This potentially makes it an attractive alternative to traditional payment systems. The main non-technological scaling limitation is the level of overall liquidity and its distribution throughout the network. This is because in order to send a certain amount of BTC on the Bitcoin Lightning Network, each of the peer-to-peer channels involved in the transfer needs to have sufficient liquidity to process it. At present, the network is still at a quite early stage of adoption, with around 1,404 BTC (currently worth c US$55m) locked in the channels according to bitcoinvisuals.com (representing only c 0.01% of the aggregate BTC free float market cap estimated by Coin Metrics). Some recent technological advancements, such as wumbo channels (which can be larger than the originally implemented cap of 0.1677 BTC, ie c US$6,500 per channel currently) and multi-path payments (which allow payments to be split into smaller amounts routed through different paths), should reduce the likelihood of a transfer failure due to insufficient liquidity. We also note that a small amount of BTC locked can process a much larger transaction volume if it has a high circulation velocity. Still, we believe the amount of BTC locked on the Bitcoin Lightning Network needs to increase significantly to allow it to become a more widely accepted alternative payment system.

The current state of the network allows for live commercial implementations, with some recent examples being Moon, Zap’s Strike and Lastbit. Moon launched its Visa prepaid card in March 2021, which can be used at any Visa-enabled US online merchant as a secure virtual card. Cards can be purchased through a browser extension, for example with a Coinbase account or a Lightning wallet with BTC, Litecoin, Ether or Bitcoin Cash, which then gets converted into fiat money on the prepaid card. Strike currently supports the remittance of money between users (performing the exchange on the backend and sending dollars to the recipient’s account) and is in the process of launching a Visa debit card for online shopping. The Lastbit Lite solution also allows to remit funds between users (sending/receiving euros or bitcoin via the Lightning network), while Lastbit Cards makes it possible to load BTC into an app to gain access to a digital debit card for making BTC payments at online or physical stores, with the merchant receiving fiat money. We also note that a number of large crypto exchanges have decided to integrate Bitcoin Lightning in order to lower withdrawal and deposit fees for clients when moving funds through exchanges. These include OKEx, OKCoin, Bitfinex, River Financial and Kraken (with the Kraken’s integration expected in 2021). Moreover, the Lightning Network’s popularity is growing in the gaming sector.

Arcane Crypto’s current portfolio offers exposure to diverse digital asset trends and covers six fully owned businesses (with the acquisition of the remaining stake in Ijort Invest in progress), as well as minority stakes in three further companies. Below we present a summary of Arcane Crypto’s holdings and discuss their business models in more detail. We note that a number of these assets (Trijo, Kaupang Krypto, Puremarkets, Alphaplate and LN Markets) have a revenue model which is dependent on the level of trading volumes and activity in the digital asset markets. Moreover, changes in cryptocurrency prices affect the value of assets under management of Arcane Assets, which in turn determines its fee income.

Given that these businesses operate in different parts of the value chain, there are a number of potential synergies between them, which we highlighted below. We note however, that some of them address different customer groups, eg Puremarkets focuses on tier 1 investment banks, Trijo serves primarily retail clients, while Arcane Assets mostly attracts investments from family offices and high net worth individuals (HNWI).

Arcane Research is a provider of research and analytics services covering cryptocurrencies and other digital assets, generating revenues from paid newsletters and reports (see www.research.arcane.no), white-label research, as well as sponsored reports and consulting. We note that it is a recognised player in the sector, and acts as a ‘brand builder’ and ‘door opener’ to initiate M&A and partnership discussions with traditional and crypto native companies. Arcane Research recently entered into partnerships with BlockFi, Bitstamp and LMAX to offer institutional-grade reports to their customers. Moreover, institutional investors using Arcane Research may request information about the hedge fund managed by Arcane Assets, which is important given that due to the regulatory environment it cannot be marketed (see below). Arcane Media’s main brand is Kryptografen, a leading news site in Norway focused on cryptocurrencies and blockchain. It generates revenue from ad sales, paid content marketing, as well as content production for other companies.

Arcane Assets manages an actively managed crypto hedge fund for professional investors, mostly HNWI and family offices launched in March 2020. The fund is managed by Eric Wall, who has eight years of experience in cryptocurrency trading (which is quite extensive given that the industry is only 12 years old) and was the head of cryptocurrency and blockchain at Nasdaq-owned Cinnober for over three years. He also acts as a cryptocurrency advisor to the Human Rights Foundation. As at end-March 2021, the fund had assets under management (AUM) of just under US$20m (SEK167.6m). Due to regulatory reasons (AIFMD Directive and EU Directive 2011/61/EU), the hedge fund cannot be marketed directly (even to professional investors), hence Arcane Assets relies mostly on inbound inquires, for example in response to brief information about the asset management services on Arcane Crypto’s website (www.arcane.no/investments), as well as ‘word of mouth’, which also comes from Eric Wall’s prominence in the crypto industry.

Arcane Technology has developed a software-as-a-service (SaaS) solution for online payments utilising the Bitcoin Lightning Network. Teslacoil differs from payment companies such as Moon, Lastbit or Zap (see above) in that it is a provider of a white-label software solution for payment processors rather than a payments processor itself (and thus does not have to obtain an e-money licence). Retail customers have the choice of using this service to pay for goods and services purchased online with BTC or with fiat money. The payment processor (ie Teslacoil’s client) will use the company’s service together with a fiat on- and off-ramp solution, which will be required in order to exchange fiat currencies for BTC (sent on the Lightning Network) and then convert it back into fiat currencies received by the online merchant. This may be executed by a third-party crypto broker/exchange but could potentially also be handled by Kaupang (Arcane Crypto’s fully owned crypto broker). Teslacoil features an instant hedging solution to eliminate the risk associated with BTC price volatility. We note that Teslacoil will be responsible for ensuring sufficient liquidity in the state channels to facilitate the transactions, which means that the company will ultimately hold meaningful amounts of BTC on its balance sheet (though it intends to fully hedge its exposure).

A first instance of Teslacoil’s minimum viable product (MVP) version of its solution (licensed and run by Kaupang) has already been integrated with the WooCommerce and Shopify platforms, and is being used by external ‘pilot’ clients such as Swifi, Naturens Apotek and sponsor.me. It does not generate any meaningful revenue for Teslacoil at present. We understand that Teslacoil is currently in discussions with 10–15 large potential business clients and payment processors, expecting first revenues to be generated towards the end of 2021 (with a larger expansion planned for 2022). The company plans to further develop its product in the near term, in particular to introduce a cloud multi-tenant environment.

Teslacoil expects to charge a 1–2% fee on the transaction value (with payment processors adding their own fee on top of this when charging merchants), which basically replaces the fees of the acquiring and issuing bank, as well as the card network fees, in case of a standard credit or debit card payment. Initially, Teslacoil will not charge any regular subscription fees, which should encourage payment processors to adopt its solution (given that they will incur costs only if the solution is being used by their clients). It will however charge a setup fee to cover the costs of implementation and integration.

Ijort Invest operates Trijo, a small Sweden-based spot crypto exchange (regulated by the Swedish financial supervisory authority) serving primarily local retail investors. It currently has a simple offering covering trading pairs in BTC, Ether and Litecoin vs the euro. It aims to provide a simple and secure onboarding process using BankID (a leading electronic identification service in Sweden) for identification and log in. The company’s business model generates revenues from trading fees (expressed as a percentage of trading volume), deposit and withdrawal fees, as well as profit split with the market makers. Trijo’s fiat on- and off-ramp options include Single Euro Payments Area (SEPA) transfers via a number of regional banks (subject to a 1.8% fee) and credit card payments (at a 5% fee). However, in previous years, Trijo did not charge fees to stimulate growth of the user base (although it charged its clients the equivalent of the payment provider fees for deposits and withdrawals). At present, it charges full deposit and withdrawal fees, though no trading fees. Trijo also operates a crypto news service (Trijo News), which derives revenues from sales of marketing space and paid content.

After adding 4,600 new customers in Q121 (vs 1,100 in Q120), it currently has 7,000 customers, who have all completed the know your customer (KYC) process. Trijo’s total trading volumes stood at €4.4m in Q121, visibly up from €1.1m in Q120 amid overall increased retail investor activity and their growing interest in cryptocurrencies.

Arcane Crypto’s strategy is to move Trijo to a broker model (similarly to Kaupang) with revenues based on spread (on top of deposit/withdrawal fees). Moreover, the plan is to rebuild Trijo’s tech stack to a cloud multi-tenant framework that can serve many brands (and bring Trijo and Kaupang over to one unified backend). This will lay the foundation for a European expansion covering acquisitions of local crypto exchanges that can operate under a unified tech setup. Additionally, Trijo plans to introduce lending and savings products, in particular BTC collateralised loans through partnerships with traditional financial institutions. Finally, it intends to integrate its platform with the Bitcoin Lightning Network to facilitate faster and more cost-efficient BTC transactions.

Kaupang Krypto is a Norwegian spot crypto broker founded in 2017 (regulated by the Norwegian financial supervisory authority) focused on over the counter (OTC) trades and higher-volume transactions. As opposed to Trijo, Kaupang offers prices from its own inventory to each customer and generates revenues primarily from spreads. It serves both retail customers (through its automated purchase widget) and professional investors such as HNWI and family offices, offering trading in around 40 cryptocurrencies. Its gross trading volume in Q121 was c SEK40m (vs c SEK12m in Q420 and close to null in Q120).

Going forward, its strategy will be to focus on larger and corporate clients to provide deep liquidity, a premium service and a payment functionality. Kaupang will serve as a regulated on-ramp in combination with an open banking integration and Teslacoil’s Bitcoin Lightning functionality to develop solutions allowing users to use the Lightning network for payments directly to or from their regular fiat bank accounts. The company is currently setting up a wallet service and is also developing its premium service for high net worth and corporate clients, as well as a custody solution. Kaupang will also fall under the multi-tenant framework mentioned above.

Puremarkets is a UK-based company operating with the trading name Pure Digital, which is developing an interbank marketplace for cryptocurrency price discovery and exchange of wholesale risk, to allow tier 1 investment banks to trade BTC and other digital assets similarly to how they execute traditional foreign exchange (FX) trades. This setup will allow them to choose with whom they want to be matched and use the credit lines they have with each other to improve capital efficiency. During the development of the platform, the management team has drawn from the experience with creating ParFX, a wholesale electronic spot trading platform for traditional FX designed by Tradition with a consortium of 12 banks. This has also helped initiate conversations with potential clients with two letters of intent with top-tier banks signed back in 2020. Based on our conversation with Arcane Crypto’s management, we understand that the development of the platform is largely complete and it is now in testing stage. Puremarkets will first test the platform with four to five banks before going live. The go-live could potentially be achieved later this year, though is dependent on the banks’ internal review and approval process, which can be lengthy in the case of large banks.

In April 2021, the company announced that it has partnered with Currenex, a multi-dealer FX platform owned by State Street, which will provide the trading infrastructure for the marketplace Puremarkets will operate. Puremarkets will pay some of the fees it will charge its customer banks (which will be based on the trading volume executed via the platform) to Currenex based on a US dollar amount per million schedule. This reflects similar fee structures Currenex applies in the FX industry. Puremarkets highlighted that together with State Street it intends ‘to further explore the digital currency trading space’.

The management team of Puremarkets consists of the company’s two co-founders Campbell Adams and Jan Ivar Strømme, as well as Lauren Kiley (CEO). Campbell Adams is the founder of ParFX, who prior to that held senior FX trading roles at Citibank, Morgan Stanley, Deutsche Bank, BP and ICAP. Jan Ivar Strømme worked at FX exchanges (EBS/ICAP, Refinitiv FXall), GSA Capital/XTX Markets and DNB in roles related to high frequency trading, liquidity and technology for banks and hedge funds. He was also the global head of eFX development at XTX Markets, where he created a solution providing liquidity directly to disclosed counterparties, enhancing a buy side firm’s ability to trade, hedge and interact with non-bank FX liquidity providers. Finally, Lauren Kiley held multiple roles in FX units at Morgan Stanley for almost 10 years.

Alphaplate is an early-stage London-based market maker and liquidity provider, specialising in pairs between cryptocurrencies and smaller fiat currencies (eg Swedish and Norwegian krone). It has applied a similar business model to traditional market making and high frequency trading to the cryptocurrency spot market. Alphaplate primarily acts as market maker on the Trijo exchange. It generates revenues from trading cryptocurrencies based on three strategies: 1) spread on market making, that is offering buy and sell offers on the same exchange, 2) arbitrage from cross exchange liquidity provision and 3) generating alpha from smart hedging, that is seeking to predict short-term price movements of cryptocurrency prices and delaying an offsetting trade to generate profit. The company’s reported P&L from its market making and other trading activities was c £273.7k (c SEK3.2m), as reported in Arcane Crypto’s Q121 report. Alphaplate is exploring partnering with Puremarkets as a liquidity provider and is working on integration with the Pure Digital platform.

The company’s management consists of Jan Ivar Strømme (the company’s CEO and co-founder), who is also the co-founder of Puremarkets (see above), as well as Dr Robert Crenian (COO and co-founder), who is a former CEO of Renaissance Technologies Europe. Prior to that, Robert Crenian headed the product management group at the London-based systematic hedge fund manager Aspect Capital. He also worked as a senior quantitative strategist at Citigroup Smith Barney and as a global quantitative strategist and equity derivatives risk manager at Dresdner Kleinwort Wasserstein.

ITOAM operates the LN Markets derivatives trading platform, built on the Bitcoin Lightning Network, which went live in March 2020 and derives revenues from the spread by providing both buy and sell offers on the platform. The Bitcoin Lightning Network is utilised for payment and settlement of BTC used as collateral for derivatives trading. This allows ITOAM to provide highly leveraged derivatives (up to 50x) with minimal counterparty risk for traders (given the instantaneous settlement on the Lightning Network). The company’s tech stack and APIs give most users the ability to trade derivatives directly from a Lightning-enabled BTC wallet. Major investors in ITOAM alongside Arcane Crypto include venture capital company Fulgur Ventures (which puts particular emphasis on the Bitcoin Lightning Network), as well as crypto exchange Bitfinex.

The gross trading volume (which represents gross derivatives exposure) on LN Markets in Q121 stood at US$94m compared to US$30m in Q420 and US$6m in Q220. LN Markets plans to expand its offering beyond BTC derivatives and eyes global expansion through partnerships to leverage the scalability of its solution.

Management

Arcane Crypto’s management board is composed of three members:

Torbjørn Bull Jenssen (CEO) was appointed Arcane Crypto’s CEO in 2018. Previously, he worked as an analyst and senior economist at Menon Economics for around four years. He has a master’s degree in economics and econometrics from the University of Oslo, where he wrote his master thesis on BTC. He specialises in digital assets topics and is a prominent public speaker in Norway.

Eva Lawrence (COO) joined Arcane Crypto in August 2020. Prior to that, she spent almost eight years at Morgan Stanley, where she was head of securities lending flow trading for EMEA after working in the FX prime brokerage unit. She is a UK qualified lawyer. Eva Lawrence specialises in contract law, digital assets, funds and financial services.

Per-Olov Östberg (interim CFO) has over 35 years of experience in managerial finance and held related positions in international companies, including Alfa-Laval, Apple Computer, Hitachi Data Systems, ASG, Pan Nordic Logistics, Nordea Bank, Xelerated, Mavshack, H&D Wireless and Qbrick. He joined Arcane Crypto in November 2020.

Arcane Crypto’s supervisory board consists of four members: Jonatan Raknes (chairman of the board), Viggo Leisner, Kristian Kirkegaard and Anna Svahn. Jonatan Raknes is an investment director at Middelborg (see more details below).

In Exhibit 4 we present the shareholder structure of Arcane Crypto as at end-March 2021. This includes in particular Kristian Lundkvist who is the co-founder of Arcane Crypto and holds a c 27.8% stake in the company through Middelborg Invest, an investment company focused on both public and private equities, real estate and financial derivatives, which he established in 1999. Other major shareholders are: 1) Ketil Skorstad, another co-founder of Arcane Crypto, who holds a c 25% stake (reflected in the exhibit below through brokers Arctic Securities and Skandinaviska Enskilda Banken, 2) Morten Klein (c 7.2% stake), a Norwegian poker player and investor active in media, entertainment, e-commerce, real estate and venture capital, who invested in the company in 2019 through the investment vehicle Klein Invest and 3) Modiola (c 6.7% stake), a company wholly owned by Jonatan Raknes, the chairman of the board. Torbjørn Bull Jenssen (CEO) held a c 2% stake in Arcane Crypto at end-March 2021. In January 2021, Arcane Crypto attracted the US hedge fund Lucerne Capital Management as a shareholder. We estimate that the current employee incentive programmes (covering warrants and stock options) represent a potential total dilution of c 6.0%.

Teslacoil aims to contribute to the disruption of the global payments market, which was worth c US$2.0tn in 2019 (and was expected to slightly decline to US$1.9tn in 2020 due to COVID-19), according to McKinsey’s Global Payments Report 2020 published in October 2020. This market has been growing by c 7% pa on average in recent years (except for last year), according to McKinsey.

In general, adoption of online payment solutions (such as Teslacoil) should be assisted by the accelerated shift to e-commerce triggered by the pandemic, with McKinsey forecasting a 22% CAGR in global digital commerce market sales from US$6.9tn in 2019 to US$15.3tn in 2023. In addition, there are some indications of a growing interest in crypto-based payment solutions. For instance, according to a recent online survey conducted by Mastercard, 40% of the c 15.6k respondents across 18 countries are more likely to try using crypto as a means of payment in the next year compared to a year ago. This has been accompanied by decisions of major payment companies (such as Visa, Mastercard and PayPal) to support certain cryptocurrencies as a payment method. Having said that, crypto payments will likely capture only a small proportion of the overall global payments market in the near term.

Teslacoil’s advantages versus traditional payment rails include cost efficiency, but also the instantaneous settlement on the Bitcoin Lightning Network, which compares with anywhere from 24 hours to several business days (or even weeks) for credit card payments and can thus potentially reduce the working capital requirements of merchants. We believe that Teslacoil’s solution may represent a viable option for smaller online merchants who utilise payment solutions of companies such as Square or Adyen (rather than having a direct payment setup with a bank) and whose customers mostly pay by credit card, in which case the merchants are normally charged a c 2–4% fee by the payment processor. This applies in particular to merchants with a geographically diversified customer base that accept a significant share of cross-border payments between regions (eg Europe to US), which incur the additional costs of FX spreads and do not allow the use of cheaper local bank transfer options, such as SEPA transfers. This market segment seems to offer the greatest opportunity in terms of providing cost-effective and efficient payment services. According to the above-mentioned McKinsey report, 39% of SME merchants would change their payment service vendor if offered a better price, while 34% would be encouraged to do so by a faster and easier-to-use technology. Teslacoil plans to target industries such as global aviation, gaming and media.

The company intends to approach the international remittances market, which we believe represents a significant opportunity for disruption. Global remittances to low- and middle-income countries (LMICs) alone were forecast to reach US$508bn in 2020 by the Global Knowledge Partnership on Migration and Development, down from US$548bn in 2019. At the same time, the average cost of sending US$200 to LMICs remained at a high 6.8%, visibly above the target of 3% by 2030 included in the UN’s Sustainable Development Goal 10.c.1.

We believe that digital assets (including cryptocurrencies) have emerged as a new, distinct asset class, with growing acceptance among both retail and institutional investors, as well as selected corporate treasuries (eg Tesla, Square). Some notable recent examples of financial institutions investing or authorising some of their funds to gain exposure to BTC (through an outright BTC purchase, investment in BTC funds or BTC derivatives) include MassMutual, Ruffer Investment Company, BlackRock and Guggenheim Investments. The increase in cryptocurrency market liquidity (with BTC trading volumes reaching more than US$10bn per day) allows larger institutional players to enter the market. There are also indications of BTC investments from top US university endowments (eg Harvard and Yale). Moreover, we note that the cryptocurrency narrative of major investment banks such as Morgan Stanley, JP Morgan and Goldman Sachs has changed dramatically over the last three to four years, shifting from calling BTC worthless, useless and fraudulent to (re)starting cryptocurrency desks and offering access to BTC investments to their wealthy clients. They also evaluate the option to offer cryptocurrency trading to their hedge fund and asset manager clients. BTC’s investment theme has recently been centred around its status as a scarce, decentralised, incorruptible, durable and easily transferrable store of value (‘digital gold’ and inflation hedge). At the same time, native cryptocurrencies of blockchains enabling smart contracts (Ether in particular) have been the foundation for the recent DeFi and non-fungible tokens (NFTs) boom. They are also a play on the asset tokenisation theme, which we discussed in our Blockchain adoption report.

Institutional adoption has been a key catalyst for cryptocurrency prices since last year, further supported by an overall pick-up in retail investor activity across asset classes, especially in Q420 and Q121. Consequently, the total market capitalisation of all the 4,000+ existing cryptocurrencies currently stands at c US$1.7tn (US$2.1tn at end-April 2021), according to coinmarketcap.com (of which BTC makes up c 42%). However, the market size of digital assets still remains small relative to other asset classes, such as gold (c US$12tn) or global equities (US$100tn+), and also around US$13tn in outstanding debt with negative yields (see Exhibit 5).

According to a PricewaterhouseCoopers report published last year, global AUM in the asset and wealth management industry were expected to be c US$112tn in 2020. Consequently, every 1% allocation of the industry to digital assets represents c 64% of the current aggregate cryptocurrency market cap (and exceeds the current market cap of BTC). A common view in the crypto industry is that investors should allocate c 1–3% of their wealth to cryptocurrencies to benefit from the additional return potential and portfolio diversification while remaining protected against heavy portfolio losses. Here, it is worth noting that several cryptocurrencies (including BTC) have a predetermined supply cap, while many others have a predetermined supply growth cap. This suggests that a meaningful increase in asset and wealth managers’ allocation would likely push prices of well-established and liquid cryptocurrencies further up. We also note that the size of the crypto derivatives market vs the spot market is disproportionately small in comparison to traditional markets (derivative trading volumes are c 3x derivative volumes according to Diginex which compares to >100x in the traditional FX markets), providing even more expansion headroom.

Below we discuss the different types of players competing for investor allocation to digital assets, though there is obviously some overlap as crypto funds also need an exchange and/or broker to execute their trades.

The aggregate AUM of all crypto funds globally (including hedge funds, VC/PE funds, hybrid funds, fund of funds and passive funds) stood at c US$57.5bn as at end-March 2021 according to the Q121 report published by Crypto Fund Research (of which we believe c US$40bn was attributable to Grayscale Investments). This represented a mere c 3% of the total crypto market capitalisation at end-March 2021, suggesting considerable room for growth through new fund inflows.

Looking ahead, we consider Arcane Crypto an appealing (although early stage and high risk) option on the disruption of traditional financial services by digital assets. While adoption of digital assets has just started, the above analysis shows a sizeable addressable market already exists for Arcane Crypto’s businesses. Consequently, capturing a marginal market share would potentially translate into a multiplication of existing group revenues. The group’s 2025 ambition, which we understand is the first milestone in its growth plans, is to process SEK150m of daily transaction volume (c US$6.6bn annually). This covers both payment volumes processed using Teslacoil’s solution, as well as trading volumes on the Trijo, Kaupang, Puremarkets and LN Markets platforms. At the midpoint of Teslacoil’s targeted 1–2% fee, the entire volume level translates into just 0.005% of the global payments revenue in 2020 as per McKinsey’s estimates presented above. As an example, this compares with a gross payment volume processed by Square in 2020 at c US$112bn. Alternatively, the 2025 ambition constitutes a mere 0.03% of the global crypto spot trading volumes in 2020.

Arcane Crypto’s 2025 ambition is for the hedge fund managed by Arcane Assets to reach an AUM of c SEK10bn (c US$1.2bn), that is, c 2% of the current crypto funds market (or c 32% of the crypto hedge fund AUM at end-2020 according to PwC, Elwood and AIMA estimate). The average size of a crypto hedge fund at end-2020 was US$42.8m, according to PwC, Elwood and AIMA. Here, we again note the crypto funds market is still in its infancy and is likely to capture a far greater share of the overall crypto market in the coming years. As an additional reference point, the c US$1.0bn AUM is comparable with a traditional mid-sized alternative investments fund.

The above suggests that Arcane Crypto’s portfolio companies may, on successful (further) commercialisation of their projects, experience a strong growth trajectory. This is illustrated by a plethora of successful fintech stories in recent years, ranging from payment companies such as Square (revenues ex-Bitcoin up 24x between 2012 and 2020) to native crypto businesses like Coinbase (with revenues of US$1.28bn in 2020 despite being founded just eight years earlier). We note that all Arcane Crypto’s commercial-stage businesses are largely local players in the Nordic market, whose size is a fraction of the global market. Having said that, Arcane Crypto’s long-term strategy in the brokerage business (Trijo, Kaupang) is to expand into Europe through acquisitions of local exchanges. Moreover, the Pure Digital platform is designed for investment banks, including tier 1 global players and it is worth highlighting no such dedicated crypto trading platform for banks exists at present. Finally, as discussed above, Teslacoil as a software provider does not require an e-money licence. which should facilitate its international expansion in the longer term.

Below we present Arcane Crypto AB’s results for Q121, as well as the Q120 and FY18–20 results of its predecessor, the private company Arcane Crypto AS. So far, the company has generated limited revenue and has been loss making since the adoption of its strategy back in 2018. Historically, its top line (which in Q121 stood at SEK2.1m vs c SEK118k in Q120) included only revenues from Arcane Research and Media, and since FY20 also Arcane Assets. Teslacoil has not generated any meaningful revenues yet, while the results of Arcane Crypto’s minority holdings (Trijo, Puremarkets, Alphaplate and ITOAM) are booked under profit from participation in associated companies (SEK447k profit in Q121). Kaupang’s P&L was not consolidated in Q121 as its acquisition was completed on 26 March 2021. The acquisition of the remaining stake in Ijort Invest (Trijo) is in progress. We note that a number of projects within Arcane Crypto’s portfolio appear to be close to commercial stage and more extensive rollout (eg Teslacoil, Pure Digital). Building critical mass will be key to benefit from the scalability of its businesses (as revenue for most of them is based on percentage fees/spread on transaction volumes) to realise the solid EBITDA margins its management expects in the long run (‘well north of 50%’).

Arcane Crypto’s operating costs consist primarily of personnel expenses, which in Q121 stood at SEK8.8m (vs SEK2.1m in Q120). Management indicated that the company continues to be active on the hiring front, with new employees joining closer to the summer time. This includes an additional fund manager and client relationship manager at Arcane Assets, new team members at Arcane Research and two new tech hires for the Teslacoil project (including a new Arcane Crypto group CTO). Moreover, Kaupang’s personnel expenses (five full-time employees and one part-time employee) will be reflected starting from Q221. Other external expenses stood at SEK4.4m in Q121 (vs SEK0.9m in Q120).

We note that the company’s operating expenses in Q121 include SEK7.5m of one-off items, including an accrual of social charges related to warrants in Arcane Crypto AS being transferred to Arcane Crypto AB, as well as additional legal and other fees incurred in connection with potential M&A. After adjusting for these items, the group EBITDA loss in Q121 stood at c SEK3.6m. Even more importantly, its financial result was distorted by a SEK126.9m one-time effect associated with the reverse takeover. As Vertical Ventures had no operations at the time of the transaction, the goodwill on the transaction could not be recognised on the balance sheet but was instead booked as other financial costs in the P&L. After adjusting for this item, Arcane Crypto’s net loss was c SEK9.1m in Q121 (versus a SEK2.9m loss in Q120), broadly in line with management expectations.

In Exhibit 7, we present Arcane Crypto’s historical balance sheet and cash flow. Most of its assets of SEK85.0m is in cash and bank balances (SEK54.0m) and goodwill from investments in associated companies (SEK21.2m). It also has some minor short-term investments of SEK6.0m, which we understand includes BTC held to facilitate liquidity in the Lightning channels in addition to BTC held on the balance sheet after receiving it as payments from clients of Arcane Research.

In January 2021, Arcane Crypto raised SEK49.5m through a directed issue of 99m shares to Lucerne Capital Management and Klein Invest. The proceeds are earmarked for general corporate purposes, growth investments and M&A. We note that after the reporting date, Arcane Crypto had already spent €1.5m on the additional 9% stake in ITOAM.

Moreover, the company issued 49.5m warrants to the above investors (each entitled to one Arcane Crypto share) which, on full exercise until 16 February 2022, would translate to SEK24.75m in additional gross proceeds for the company. Management highlighted earlier that the company’s cash position (SEK54.0m at end-March 2021) allows it to fund the development phase of all of its portfolio projects. We note that in 2020, Arcane Crypto AS raised a total of SEK48.5m through equity issues and debt conversion.

Arcane Crypto’s portfolio consists of companies at an early stage of development that either generate no sales or have relatively limited revenue and are yet to break even. Consequently, we refrain from providing a detailed valuation of the group. We note that the subscription price for the new shares negotiated with investors in the directed issue in January 2021 discussed above was SEK0.50 per share. Furthermore, the subscription price as part of the Kaupang and (March 2021) Trijo (April 2021) deals stood at c SEK0.11 and c SEK0.27 per share, respectively. From a longer-term perspective, we believe it is instructive to look at current multiples at which similar though more mature businesses trade to understand how Arcane Crypto’s portfolio companies could be valued by investors once they grow and mature.

There are a number of listed payment processors, including Adyen, FIS, Fiserv, Global Payments, PayPal, Square and Worldline, which at present trade at EV/sales multiples based on Refinitiv consensus estimates for revenue in the current fiscal year of c 5–12x (except for Adyen, which trades at a much higher ratio), which after two years narrows to c 4–8x. However, given that Teslacoil is a software provider rather than a payment processor, we consider recent private transactions of payment software companies as more relevant. For instance, EML Payments recently acquired Sentential Group (SG; see our recent update note for details). The majority of SG’s business is currently derived from providing direct debit, credit transfers and instant payments for major European banks via its SaaS platform. The maximum consideration payable (including the potential earnout payment) values SG at 3.1x CY23e sales and 8.4x CY23e EBITDA.

Given that Kaupang is a crypto broker while Trijo plans to migrate at some stage to a broker model based primarily on revenues from spreads, we also examine multiples at which both traditional and crypto brokers are now traded. In the crypto space, we consider the listed Swedish crypto brokers Safello and Goobit Group as good comparators, which are currently trading at an LTM EV/sales ratio of c 14x and 20x, respectively. Again, we note that the significant increase in crypto trading volumes in recent months likely had an influence on how investors value these companies. In terms of traditional listed players, we look at IG Group and CMC Markets, which trade at LTM EV/sales multiples of c 3.0–3.5x (and LTM EV/EBITDA multiples of 9–12x). While the average spread offered by Kaupang has not been disclosed, we note that the crypto broker Voyager Digital reported an average spread per trade at 90bp, while Arcane Crypto’s CEO recently stated that spreads at Nordic exchanges (Trijo’s and Kaupang’s competitors) stand at c 150–300bp. If we conservatively assume an average spread of 100bp, every €1.0m of average daily traded volume may translate (based on a 3.0–3.5x EV/sales multiple and excluding any fee income) into c €11.0–12.8m value for a well-established business.

Amid the lack of publicly traded pure-play crypto asset management businesses as peers for Arcane Assets, we look at valuations of traditional asset managers as a broad reference point. We acknowledge that these may have more limited AUM growth prospects compared to the crypto assets industry, which may thus command a certain valuation premium. Asset managers such as Ashmore Group, Azimut Holding, Jupiter Fund Management, Man Group, Impax Asset Management and Lloyd Fonds trade on average at 4.7% of their last reported AUM (with the ratio ranging from 2.4% to 6.5%). This may provide some indication with respect to the potential growth in the value of Arcane Assets alongside AUM expansion (management eyes c SEK10bn by 2025).

We have identified the following sensitivities influencing Arcane Crypto’s business: