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The Value of Verification

To our Valued Investors:

Did you know how a trading card game from almost thirty years ago would come to influence the multibillion-dollar cryptocurrency exchanges of today?

Released in 1993, Magic: the Gathering was created by Richard Garfield. The game, which shares motifs and moods with the older and highly successful Dungeons and Dragons, boasts more than thirty-five million players. The period between 2008 and 2016 saw a viral surge in popularity, and more than twenty billion Magic cards were printed then. With its complex system of rules and its tendencies toward competition and expandability, the game’s followers took on a cultish persona. Naturally, this crowd had a strong yearning for a digital version of their passion, so the video game Magic: the Gathering Online went live in June 2002. It replaced the exchanging of physical cards with a “virtual economy”, and the online Magic community ballooned into the hundreds of thousands in a predictably short time.

Seeing an entrepreneurial opportunity, computer programmer Jed McCaleb created a platform upon which Magic: the Gathering Online participants could easily trade their hard-earned cards with one another. The site, unimaginatively dubbed “Magic: the Gathering Online Exchange”, or “Mt. Gox” for short, set up a marketplace of bids and offers for the digital assets. Apart from acting as a precursor to today’s NFT exchanges, Mt. Gox held the undisputed distinction of being the nerdiest stock exchange in history. Hilariously, after about three months of operation in 2007, McCaleb decided that Mt. Gox was no longer worth his time, and he folded up the tent to pursue other endeavors. In 2009, McCaleb took the Mt. Gox domain name out of moth balls to advertise a card game of his own invention, called The Far Wilds. This project was also short-lived, and once again Mt. Gox became a mere placeholder waiting for McCaleb’s next inspiration.

In 2010, McCaleb read about a two-year old digital currency called “Bitcoin”, which thrived on something known as a “blockchain”. He was completely enthralled by the concept, and he decided that Bitcoin could use a platform upon which people could buy and sell the fascinating tokens. This time, McCaleb was really on to something. Naturally, as it was the quickest and most efficient way to get the ball rolling, McCaleb simply blew the dust off of his old Mt. Gox setup and geared it up for Bitcoin trading. Two years later, again citing not having “enough time” to commit to Mt. Gox, McCaleb sold the newly successful project — by far the largest cryptocurrency exchange in the world at the time — to a French developer named Mark Karpelès. Instead of focusing on Mr. McCaleb’s seemingly inadequate time management skills, perhaps we should see him as a guy who knows how to dodge bullets. Three months after the sale of Mt. Gox, a series of sophisticated hacks and outright thefts caused the loss of thousands of Bitcoins and millions of dollars. Things only went downhill for Mt. Gox from there. In the years that followed, a litany of system glitches, chronic transfer delays, and the resulting tsunami of customer complaints culminated in 2014 bankruptcy filings in Tokyo and in the United States. By then, a total of about 850,000 of Mt. Gox’s Bitcoins, then worth approximately $473 million and representing about 7% of all Bitcoins that had been created up to that point, had somehow disappeared. Karpelès was arrested by Japanese police in 2015, charged with fraud and embezzlement. Trustees overseeing the bankruptcy said that, although Mt. Gox had recently claimed over $500 million in assets, only $91 million could be located for distribution to claimants.

The moral of this story is not as simple as “if those hobbyists stuck to old-fashioned, hard-copy Magic: the Gathering cards, none of this fiasco would have happened”. After all, without Mt. Gox, some other entity would have stepped in to be the first real Bitcoin exchange. No, the lesson that we should draw from this is that an exchange should have a layer of third-party verification. The distributed ledger structure of blockchain protocols makes their transactions “trustless”, meaning that the user needn’t trust institutions or individuals as the system maintains unerring integrity. Repeated verification makes it impossible to corrupt the official record of crypto transactions. Still, when an exchange is proclaiming to hold in its custody a large amount of assets, then that exchange itself needs to be trusted. After Mt. Gox, it’s easy to understand how this trust might sometimes be elusive. What’s more, the Mt. Gox horror story is only part of a larger issue. It’s estimated that in the thirteen years since the Bitcoin debuted, more than $23 billion in digital assets have been lost to hacks and other forms of misbehavior.

Some exchanges, immediately following the Mt. Gox implosion, established different means of verification as a way to reassure crypto investors. The practice waned, though, perhaps due to short memories, the receding and subsequent rebirth of Bitcoin trading activity, or other factors. Last week, Payward, Inc.’s Kraken exchange voluntarily revived the idea.

A “Merkle tree” is a data structure that generalizes a blockchain’s hash list. It has the same appearance as a family tree, in which each “leaf” node is a hash of a block of data, and each “non-leaf” node is a hash of its “children”. Typically, each node of a Merkle tree has up to 2 children. The “tree” related to a Bitcoin chain is, of course, quite large, and it branches out extensively. The auditors that Kraken has contracted are able to take an anonymized snapshot of all balances held on the Kraken platform and aggregate them into a Merkle tree encapsulating and accounting for all client balances. Stated less technically, Kraken has employed an unrelated entity to leverage Kraken’s own blockchain technology to produce undisputable evidence of the true value of its cryptocurrency holdings. The process is known as a third-party “Proof of Reserves (PoR)” audit, and if you hold assets on the Kraken exchange, it should help you sleep better at night.

The audit was conducted at the end of last year by accounting firm Armanino, and it found that Kraken holds $19 billion in Bitcoin and Ethereum. Other assets traded on the platform were not included in this first audit. Kraken’s Chief Product Officer Jeremy Welch asserted that the decision not only bolstered Kraken’s own image, but it also lays down an example that other crypto exchanges should follow. “We do hope that all companies in this space continue to take the kind of transparent and secure approach that we know is possible,” Welch said in a recent interview. “That’s the unique thing about this industry, right? It’s not even possible in the older financial system to do something like this.”

Welch’s assertion is quite correct. Not only does the audit eliminate a weakness that had been displayed at Mt. Gox and at other earlier passes at crypto exchanges, but it also leapfrogs the innate trustworthiness of traditional financial institutions. This is a version of what the gang at Iron Edge VC has been telling you for a long time. The emergence of fintech and efficient blockchain applications is currently providing a once-in-a-lifetime opportunity to take part in a seismic shift at the ground floor, or close to it. Kraken’s voluntary deep dive into new levels of transparency comes at a time when all crypto exchanges are doing everything they can to boost credibility as regulators focus more sharply on their activities. Kraken is widely expected to make an announcement about going public soon, and this development certainly looks like a preparatory strengthening of brand perception.

Kraken’s nearest competitor, the publicly traded Coinbase (Nasdaq: COIN) has plunged in value by more than 40% since last November, likely due to a dip in Bitcoin pricing and a selloff in the broader markets. Some would argue that this COIN selloff is irrational, being that they make commissions when cryptos go up or down, and regardless of what’s happening to the S & P 500. In any case, COIN has been beaten up a bit, but our stake in Payward, Inc., a.k.a. Kraken, is still valued at about 25% of Coinbase’s price tag. We feel that the relative price stability inherent in our second market works well to the advantage of those who believe in the future of these platforms, especially as they mature into more transparent and verifiable entities. Unfortunately for most, though, Kraken is a private company. As such, its shares cannot be bought on any public stock exchange. Iron Edge VC can, nonetheless, provide you with access to our Fund that has ownership interests in this company that stands to benefit nicely from the currently unfolding crypto resurgence. If you would like to learn more, or if you know anybody else who would, please don’t hesitate to contact us by clicking “Get in Touch” below.

If you have enjoyed this article, visit the Iron Edge Blog for past updates on our pre-IPO opportunities and for general commentary on investment in the private marketplace.

As always, shares of Iron Edge investment funds are available on a first come, first served basis.

All the Best,

Paul Maguire
Founder & Managing Partner

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Paul Maguire

Founder And Managing Partner