Weekend Reading #18

Photo by  Alireza Attari  on  Unsplash

This is the eighteenth edition of our weekly newsletter, Weekend Reading, sent out on Saturday 25th May 2019. Sign up here and receive a copy each week direct to your inbox.

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Is this crypto's first blue chip company?

Binance is by far the world’s largest crypto exchange by volume, known for its extensive variety of altcoins (over 200 at last count). Earlier this month, one of the exchange’s hot wallets was hacked to the tune of 7,000 Bitcoin. That’s $40mn. 

Most CEOs would panic, dither, obfuscate or simply lie in the face of such an existential crisis. But the response of crypto celebrity Changpeng Zhao ( 赵长鹏 or “CZ” to his army of Twitter fans) was exemplary. It’s worth unpacking what happened, as it has positive implications for the broader crypto industry.
The rise and rise of Binance.

In order to understand CZ’s path to success we need to dig into his story, courtesy of a Forbes article written last year.  
“CZ was born in Jiangsu, China. Both of his parents were educators; his father, a professor, was labeled a "pro-bourgeois intellect" and temporarily exiled shortly after CZ was born. The family eventually emigrated to Vancouver, Canada, in the late 1980s. As a teenager, CZ pitched in to cover the household expenses, flipping burgers at McDonald's and working overnight shifts at a gas station.
After studying computer science at Montreal’s McGill University, CZ spent time in both Tokyo and New York, first building a system for matching trade orders on the Tokyo Stock Exchange and then, at Bloomberg’s Tradebook where he developed software for futures trading. But even after the 27-year old coding whiz was promoted three times in less than two years to manage teams in New Jersey, London and Tokyo, CZ became impatient. So in 2005 he quit and moved to Shanghai to start his Fusion Systems, a company known for building some of the fastest high-frequency trading systems for brokers.

Then, in 2013, CZ learned about Bitcoin from a venture capitalist with whom he played poker. He began bouncing around prominent crypto projects. He joined Blockchain.info as the third member of the cryptocurrency wallet’s team. As head of development for eight months, he worked closely with well-known Bitcoin evangelists like Roger Ver and Ben Reeves. He also worked at OKCoin as chief technology officer for less than a year, a platform for spot trading between fiat and digital assets.
All the while, CZ was thinking about starting his own pure play digital asset exchange that would not touch fiat currencies. Without the connection to financial institutions, the risks and regulatory complications that his former colleague Ver warned him about would be lower. But it wasn’t until 2017 when the ICO boom gained steam and volume began to soar, that he decided to make his move.  The $15 million he raised in Binance’s 200 million token crowd-sale in July 2017 caught Bitcoin’s breathtaking ascent perfectly.”

Binance exploded onto the scene, seemingly from nowhere, in 2017. The company was founded in China but soon moved to Japan (and later Malta) in response to the Chinese government’s ban on crypto trading in late 2017. In the 3 months after launch it generated $7.5mn in revenues, and it did $200mn the quarter after. 

Since then, the market has been through a full cycle. Crypto bulls and bears have come and gone and things are starting to settle into a semblance of normality – albeit with much greater volatility than “established” markets. Despite the bursting of the ICO bubble and increased competition from a host of freshly minted exchanges, Binance still managed to do $78mn in revenue in Q1 2019. It has taken market share from established exchanges that have struggled to compete with its much-vaunted security standards, user interface and range of tradable coins. 

Until recently, Binance has been crypto-to-crypto, meaning it didn’t offer fiat-to-crypto trading. This meant that during the 2017/18 bull market, competitors like Coinbase and Gemini benefited from being a gateway for traders buying bitcoin using fiat currency. For their part, the established fiat-to-crypto exchanges didn’t provide a wide range of altcoins, so many more relatively obscure altcoin pairs were traded on Binance. A core part of the exchange’s appeal is in the highly curated approach – CZ insists he won’t allow “sh*tcoins” on his platform, regardless of the financial rewards.

Growth looks set to continue with the news that Binance now accepts credit card payments and bank transfers, having bridged the regulatory gap in certain jurisdictions, including Singapore and Luxembourg. In doing so, it’s entered a new mass market category in direct competition with Coinbase, Bitstamp and other fiat-to-crypto exchanges. This means it can disintermediate fiat on-ramp platforms, allowing users to stay on its exchange for their entire trading experience. And the launch of Binance Chain – a custom blockchain that features a permissionless decentralized exchange (DEX) – means Binance can leverage its dominant position in the market to drive new blockchain projects and their tokens from the popular Ethereum blockchain to BinanceDEX. The ecosystem is in full ramp up mode. 

As a result of all this progress, Binance is now the world’s largest exchange, accounting for over 50% of the total volume traded – up from less than 10% in August 2017. Binance’s native cryptocurrency (imaginatively named “Binance Coin”) has been among the best performing altcoins so far this year, with a market cap north of $4.4bn. 

Then came the hack.

A short history of crypto exchange hacks.

Of course, crypto exchange hacks are nothing new.  

As bitcoin champion-in-chief, Morgan Creek Digital’s Anthony Pompliano or “Pomp” said after the Binance hack:

“There were over 3,000 bank robberies in the US in 2018 according to the FBI. No one wants to see hacks in crypto, but everyone calm down. This too shall pass"

The total amount stolen from exchanges now stands at $1.35 billion and the 10 largest hacks comprise 97% of the total stolen amount while the three largest (Coincheck, Mt. Gox and BitGrail) comprise 79% of the total. So the numbers are heavily skewed towards a small number of very large, high profile hacks, perhaps unfairly distorting public opinion against the wider crypto ecosystem.

This Binance hack was indeed a big one, the sixth largest ever recorded. 

On the 7th May, a group of hackers was able to gain control of a number of user accounts and made large withdrawal requests that bypassed Binance’s pre-withdrawal risk management checks. They “used a variety of techniques, including phishing, viruses and other attacks” to make off with 7,000 bitcoin, worth approximately $40 million, plus some user two-factor authentication codes and API tokens. It seems that hackers compromised several HNW accounts, whose Bitcoin was stored in Binance’s “hot wallet” (which is connected to the internet, unlike cold wallets which store Bitcoin offline).

In the aftermath of the incident, CZ took to Binance’s blog to take the community behind the scenes of what happened with a post-mortem of sorts, explaining what actions Binance had taken to address the hack and what they had learned from the experience.

A lesson in crisis management. 

After discovering the breach, Binance’s response was immediate. Withdrawals and deposits were suspended, but (somewhat controversially) trading was not affected. $40mn comprises just 2% of Binance’s overall bitcoin holdings and it pledged to cover the loss for all impacted customers by drawing down on its Secure Asset Fund for Users (SAFU) – a contingency fund financed through transaction fees. This shows great foresight and planning. 

Significant changes to Binance’s API, two-factor authentication and withdrawal validation are also being made and risk management and KYC procedures are being beefed up to fight phishing, among other back-end security measures. Apparently the team has been sleeping in the office in order to cram 3 months’ worth of work into 1 week. Whilst a “reorg” of the Binance platform was mooted by a Bitcoin core developer in order to undo the fraudulent transaction and recuperate funds, it was quickly dismissed as it would undermine the exchange and Bitcoin’s claim to security and immutability. 

Compare Binance's response to this incident to that of another, far more established fintech company.

In July 2017, credit scoring company Equifax discovered a MASSIVE data breach which compromised highly sensitive personal information of up to 143 million people. We're talking names, birth dates, Social Security numbers, addresses, driver’s licence numbers and 209,000 actual credit card numbers.

You'd think the company would hold its hands up and inform its customers so that they could take action to safeguard their finances. But unbelievably, Equifax waited until September to make a public announcement. That's two months! Then things got really ugly. Telephone lines were overloaded and people couldn't get through for weeks. 3 executives reportedly sold nearly $2mn of shares after the hack was discovered but before it was disclosed. Equifax then upped its estimate of how many consumers were affected, twice – by 2.5 million in October 2017 and 2.4 million in February 2018.

By comparison, Binance’s response to its hack has been exemplary. It’s made customers whole, taken measures to improve the security of the exchange, and kept everyone updated throughout the process. 

Crisis management is an industry. Consultants get paid huge amounts to help companies prepare crisis management plans. But it's not something that startups tend to think about. Perhaps they should? The Binance hack teaches us that the key to crisis management is what you do to protect your customers before the crisis, not just after. It also demonstrates the power of brand. Binance has built an identity more akin to that of an indie gaming studio than a financial services company, with a following of passionate and highly informed early adopters. Durable brands built on consumer-centric propositions can weather big storms and the erosion of goodwill they inevitably bring – but only if they are honest with themselves and their customers.

What doesn't kill me, makes me... richer. 

Companies can emerge from huge crises stronger. Binance certainly has done, drawing praise from the crypto community for its transparency and communication. Regular updates on social media and honest long-form blogging helped to allay customers' fears and those of the broader market. CZ explained that he hoped to create “a new benchmark for how project teams communicate with their users, during both the good times and the tough.” He’s done that. 

Ultimately though, money talks. The clearest measure of the success of Binance’s progressive crisis management isn’t what people are saying on Twitter – it’s the price of BNB, which dropped a bit on the initial news, but soon made a strong comeback and has now hit all-time highs (in USD and BTC terms). The price of Bitcoin also held up well, demonstrating its ability to weather hacks much better than it has in the past (in fact we saw a rush to bitcoin as a safe haven from others in the midst of the hack news breaking).

The crypto story has a long way to run and we believe we are still close to the beginning. There is a generational opportunity to embrace what is happening in the space and we continue to monitor and research the opportunity set. The changes that this industry promises to bring – not only to the financial sector (and the disaster it spells for most incumbents), but many aspects of our lives, from identity to engagement – are happening faster than most people think.

This is not intended to be a full blown analysis of Binance Coin as an investment idea. Our thoughts are still emerging and if you would like to chat to us about how we see the crypto space evolving, or get your hands on some first-rate reading material, please get in touch!

What we're doing.
This week we attended the BGC Partners’ Turkey investor conference at Andaz hotel in London. Despite the political turmoil unfolding in the background (in both Turkey and the UK) everyone was in good spirits and we had a series of productive meetings with a bunch of impressive people from companies that represent everything that Turkey has to offer. We’ve been traveling to Turkey and doing business there for many years (we recently blogged about one such trip) and we remain big believers in the long term prospects for the country and its economy. We can't think of a better place to invest in transformation over the long-term. Thank you BGC for putting on such a great show!
What we're reading.

A book about human rationality (and irrationality), Daniel Kahneman's Thinking, Fast and Slow is well worth your time. It's been around for years and remains an important influence on our entire approach to portfolio management, particuary loss aversion and the behavioural element of investing. The author is a psychologist and economist notable for his work on the psychology of judgment and decision-making, as well as behavioural economics, for which he won the Nobel prize in 2002. With this book he's produced a compulsive read and one that will give you fresh insight into how your mind really works – and how you can help it to work better. This is self-help on steroids, far richer and more credible than the superficial, rehashed blog posts that seem to be doing the rounds these days. Buy it, if you haven't already.

What we're watching.

Have you come across Chinese novelist Liu Cixin? He won a Hugo Award for The Three-Body Problem, which has been (somewhat reductively) described as Asia’s answer to Star Wars when it fact, it’s more complex, challenging and provocative. We liked it – and the ideas around exponential change and transformation it raised – so much we named our business after it! This week we sat down to watch The Wandering Earth, the sci-fi hit based on a short story collection by the same genius author. The elevator pitch on Netflix says it all – “A looming collision with Jupiter threatens Earth as humans search for a new star. The planet's fate now lies in the hands of a few unexpected heroes.”If you think it sounds far-fetched, grandiose, perhaps even preposterous, you’d be right. That’s what makes it so watchable!