Tesseract: Marvel of the digital assets space

Why we led Tesseract’s $25m Series A round

By Martyn Holman, Partner at Augmentum Fintech

Our digital assets thesis

Augmentum’s investment in ParaFi at the start of this year was made on the back of strong momentum in underlying crypto and blockchain markets in 2020, with significant inflows of institutional capital particularly in H2. In December 2020 the digital asset/crypto market cap passed the significant $1trn mark, and doubled to pass $2trn less than a quarter later. Despite a well documented period of retrenchment in Q2, the weight of institutional investment in the space has suggested that we have passed an inflection, and a point of “no-return” as a focus for institutional capital inflows.

Indeed market commentary now suggests that Bitcoin may be at a tipping point for becoming the preferred currency for international trade. In most weeks this year there have been similar declarations of interest from some of the major names in traditional financial services as they move to accommodate their customers’ desire to seek exposure to the space — even ahead of clear regulatory frameworks being adopted. Just last week for example, State Street the giant US custodian bank announced its intention to enter the space with a new digital division.

We have for some time now embraced this trend as our central thesis for crypto at Augmentum. As a consequence there are multiple opportunities as the infrastructure required to support the additional demands of regulated institutional activity undergoes fundamental change.

A consolidated evolution

The history of crypto is a short one. Bitcoin (BTC) originally launched its code in 2009, and Coinbase (perhaps the best known exchange platform) was founded in 2012. In this first “wave” of crypto evolution a number of exchanges appeared over the next several years including Binance (2017), Kraken (2011), Gemini (2014), and the futures exchanges such as FTX (2017) all focusing on the important on/off ramp fiat/crypto interchange that was the starting point on the crypto journey for most investors, and the interchange between new and emerging tokens.

The early adopters in this space were not institutions, but individuals and retail investors who not only needed somewhere to match their trades, but also a portal to the exchange itself, an assured settlement for their trade, and (generally) a place to store their assets post-trade.

In stark contrast to the world of traditional finance therefore, these exchanges all evolved as “full stack”, a walled garden of financial services providing end-to-end solutions for their growing retail-driven customer base. A large number of exchanges flourished, becoming unicorns almost overnight in the first crypto wave of 2017/2018, entrenching their dominant positions that crossed traditional financial boundaries and the norms of regulatory separation in the traditional finance world.

Fig 1. Simplified Tradfi vs Crypto

The infrastructure revolution

The entry of institutional capital has been enabled only by a bifurcation of this suite of services — the first requirement of money managers, market makers and traders being to have an independent, secure and trusted counterparty with whom to deposit their assets. This has given rise to a new wave of infrastructure incumbents providing “custodian” services to their customers.

These technologies have either been full service custody (controlling the private key and all processes around it) or non-custodial technologies (technology protecting the private key but giving the client control and/or generally allowing them to offer their own suite of services around custody to other third parties). Curv was amongst the early non-custodial winners, only to be snaffled recently by Paypal and recently Fireblocks raised $133m Series C aiming to roll out its underlying technologies to mainstream financial operators. Full service custodians such as NYDIG (recently raised $200m Series C), Anchorage ($80m Series C) and Copper ($50m Series B extended by $25m in June) seek primarily to host active market participants in high volume traded tokens, whilst others such as Finoa in Germany ($22m Series A led by Balderton) target long hold asset managers by providing a flexible platform more attuned to rapidly adopting new alt tokens and projects.

Access to trading capital

With custody normalising, the next layer of services are now at play. Despite the rapid early growth there remains a chasm in capital flows between the traditional and digital finance worlds driven primarily by continuing regulatory ambiguity on crypto (not yet defined by SEC) restricting bulge bracket entry. Additionally, due to structural differences in settlement (instant vs T+1/T+2) and expertise (requiring hiring) it is likely that any regulatory timeline is further increased for any traditional incumbents. Even alternative bulge bracket prime lenders do not currently take crypto as collateral.

Demand however is huge, and growing. Such demand is currently fulfilled by non-bank financial market participants, especially in the US. The exact market size is difficult to ascertain as most of the trades are done OTC, but industry experts estimate overall outstanding loans (all currencies) have grown to at least +$10 B in Q4 2020, with other commentators putting the figure as high as $40bn. At current volumes, crypto lending is significantly under-penetrated at <1% of total crypto market cap (c. $1.5tn, fluctuating daily). At fiat/traditional finance levels of lending penetration, crypto lending is set to become a potentially $1trn asset class in the next few years.

Fig 2. The evolving market opportunity

DeFi applications (Decentralised Finance) are also beginning to play a role here. DeFi applications offer a wide range of financial services using algorithms running on blockchains to create automated, enforceable agreements known as “smart contracts” — obviating the need for central financial intermediaries. Volume growth here from a relatively low start point, has been extreme — the total value committed through smart contracts reached $53bn at the time of writing, up from $1 billion in February 2020.

Enter Tesseract

Tesseract has built the infrastructure necessary to connect capital flows between traditional and digital asset finance. With core products in margin lending, OTC lending, partnerships with retail trading platforms, and DeFi, Tesseract’s unique margin lending platform improves capital efficiency for institutional clients ranging from hedge funds to market makers. Global retail trading platform partnerships allow consumer focused exchanges, custodians, fiat on-ramps, and wallet providers to gain a competitive edge through Tesseract-enabled yield solutions for their customers. In short, Tesseract enables the widely distributed base of digital asset owners to connect with and lend their assets via the Tesseract solution to borrowers looking to leverage their own capital position for trading purposes. As the market opportunity grows we believe Tesseract are optimally positioned to become a leader in the space.

Fig 3. The Tesseract value proposition

Founded in 2017, the company moved quickly to secure regulatory permission from the Finnish Financial Supervisory Authority (FIN-FSA), and was amongst the first companies to obtain a 5AMLD (Fifth Money Laundering Directive) virtual asset service provider (VASP) license in the EU. It is the only VASP with an express authorisation from the FIN-FSA to deploy client assets to decentralized finance (DeFi).

Tesseract have built a strong and profitable foundation with an outstanding product, a clear vision and an outstanding team led by co-founders Yichen and Ilkka, many of whom are clear thought leaders in the digital asset space. Based in Helsinki but building a truly global platform, Tesseract are an example of the global potential of fintech businesses originating in Europe. This investment marks Augmentum’s first investment in the Nordic region and we continue to execute on our pan-European strategy. Joining us in the round are an outstanding group of international co-investors — including Sapphire Ventures, Blackfin, DN Capital and Leadblock from the VC space, and leading names from the digital assets space including Coinbase and Wintermute and Woorton.

At Augmentum we are all very excited to be joining them on this journey, and humbled that they chose us to lead their round.

Learn more about investing in fintech with Augmentum here.

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Augmentum Fintech is the UK’s only publicly listed investment company focusing on the European fintech sector.