Coinbase Ventures Q2 Investment Summary: Optimistic about Blockchain Games, User Experience is Everything
Written by: Connor Dempsey, Coinbase Ventures
Translated by: PANews
Outline
- Coinbase Ventures' Q2 transactions saw a quarter-over-quarter decline of 34%, reflecting the overall pace in the venture capital space, but transaction activity maintained a year-over-year growth of 68%, indicating stable growth in risk business compared to last year.
- Among the key trends observed, we believe that Web3 gaming will usher in the next wave of crypto users, with experienced founders from Web2 gaming continuing to flood into the space.
- We are excited that Web3 user applications can disrupt the "forced model" of Web2 and allow users to control their audiences and communities.
- The Solana ecosystem continues to show impressive momentum and appeal to developers.
- The crypto industry is making significant improvements to user experience, which will eliminate complex operations and provide experiences comparable to Web2.
- The United States remains the home to the majority of companies in our portfolio, while Singapore, the UK, Germany, and India have established impressive innovation hubs.
- CeFi lenders have underperformed this year, while DeFi lending platforms have shown resilience.
- Setting aside the current price trends, we still firmly believe that the opportunities in crypto and Web3 are far greater than most people realize.
The first half of 2022 was tumultuous for all markets. The Dow Jones and S&P 500 experienced their worst first-half performance since 1962 and 1970, respectively. The Nasdaq saw its worst quarter since 2008. Bitcoin experienced its worst quarter since 2011, and DeFi TVL dropped 70% from its peak, with NFT sales in June plummeting to unprecedented levels within a year.
The chaos in the crypto market was largely triggered by the $60 billion collapse of the Terra ecosystem in May. This led to the implosion of a $10 billion crypto fund (Three Arrows Capital). Additionally, it was revealed that Three Arrows Capital had borrowed heavily from some of the largest centralized crypto lenders, and some of these lenders were forced to go bankrupt due to the inability to recover those loans.
The macro market downturn also seeped into the venture capital space.
Venture Capital Market Situation
The broader venture capital market began to show signs of cooling in Q1, with total funding declining for the first time since Q2 2019. This trend continued into Q2, with total venture capital down 23%, marking the largest decline in a decade. This quarter also saw late-stage companies like Klarna raising funds (Note: Swedish fintech company Klarna completed an $800 million funding round at a $67 billion valuation). This is a further sign of the times.
Crypto venture capital still set records in Q1, but as we noted in our previous article, we began to see signs of a slowdown that we expected to manifest in Q2. Indeed, data from John Dantoni at The Block shows that crypto venture capital funding decreased by 22%: the first decline in two years.
In Q2, Coinbase Ventures continued to be one of the most active investors in the crypto space, but the pace of transactions slowed, with the total number dropping 34% from 71 to 47. Despite this slowdown compared to the frenzied pace at the end of 2021 and the first quarter of this year, our Q2 activity still grew 68% year-over-year; indicating overall growth in our venture capital business.
The decline largely reflects the overall market conditions—amid market volatility, we see many founders reconsidering or pausing their fundraising, especially in later rounds. We observe that many companies are opting out of fundraising unless absolutely necessary, provided they are confident they can demonstrate the necessary growth to justify a new round of funding.
Setting aside the bleak macro environment, there are still many high-quality founders raising funds in our most active seed stage. Ignoring the price trends in our investment space, we can see a range of actual utilities being built, painting a hopeful picture for the future: a vibrant array of Web3 user applications, improved user experiences, a robust DeFi market, scalable L1/L2 ecosystems, and all the tools developers need to build the next killer application.
Here is a breakdown of our activity in Q2.
Now, let’s look at some standout themes. (* indicates a Coinbase Ventures portfolio company)
The Upcoming Era of Blockchain Gaming
With the rapid rise and subsequent decline of Axie Infinity, many experts have "gloated" and quickly dismissed blockchain gaming as a fleeting trend. As we wrote last September, Axie was experiencing a positive feedback loop, which could turn negative if the enthusiasm driving the game waned, and that ultimately happened. Regardless, Axie achieved nearly $1 billion in sales within a month and attracted 2 million daily active users with almost zero marketing budget. This caught the attention of the entire gaming world regarding the power of this new vertical.
It is estimated that there are over 3.2 billion gamers worldwide, and we firmly believe that Web3 gaming will usher in the next wave of mass crypto users. Web3 gaming remained a significant investment area in Q2, with The Block estimating that the sector raised over $2.6 billion. The activity we've seen over the past few quarters only strengthens our belief.
As we saw in Q1, founders with a strong track record in Web2 gaming continue to embrace this category. For example, Azra Games* is created by the makers of the mobile game Star Wars: Galaxy of Heroes, valued at over $1.4 billion. Their goal is to build a combat RPG with a strong in-game economy that can still attract mainstream appeal. The space has also attracted Justin Kan, co-founder of the game streaming platform Twitch, which was sold to Amazon for $1 billion. Kan's new company, Fractal*, is building a marketplace for NFT game assets.
Companies like Venly* are providing a suite of tools to help Web2 game developers seamlessly transition into Web3. Established gaming giants are even beginning to emerge, such as Epic Games, the creator of Fortnite, now allowing NFT-based games into its game store.
The industry will take time to mature, but it is becoming increasingly clear that blockchain gaming will become a massive category in the future. Coinbase expects to focus more on sustainable economies and gameplay, injecting a more familiar Web2 gaming experience into NFTs.
Rewiring Web2
Beyond gaming, the next generation of Web3 user applications is striving to disrupt the forced model of Web2 and empower users to control their audiences and communities. One company we are particularly excited about is Farcaster*: a fully decentralized social network founded by Coinbase alumni Dan Romero and Varun Srinivasan. Their early product resembles Twitter, but the key difference is that it allows users to own their relationships with their audiences.
Farcaster is an open protocol, similar to email (SMTP). While Farcaster has built the first social application on this protocol, other developers can build competing clients, just as we have Gmail and Apple iCloud. While you cannot take your Twitter followers to TikTok, someone could build a TikTok alternative on the Farcaster protocol, allowing Farcaster users to take their followers to a new differentiated platform. Users can not only better maintain ownership of their audiences but also open the door to more consistent monetization. Most advertising spend flows directly to social platforms like Twitter and Instagram, while Farcaster users with large followings can directly monetize across platforms through their audiences.
Another investment we are excited about is Highlight.xyz, which sits at the intersection of Web3 and the thriving music industry. Highlight will allow musicians to create their own web3-supported fan clubs/communities (no coding required), including token thresholds, access to NFT airdrops, merchandise, and more. Highlight joins other Coinbase Ventures portfolio companies like Audius, Sound.xyz, Mint Songs, and Royal*, all of which provide musicians with new ways to connect with and monetize their fanbase.
In summary, we remain excited about the potential of Web3 to reimagine established Web2 models in areas like social media and music, ultimately returning power to creators.
The Rise of Solana
Notable in our Q2 activity is the continued momentum behind the Solana ecosystem. While Ethereum and EVM remain the kings of developer traction and compatible applications, we have noticed a clear trend of early teams valuing Solana. Overall, we completed 10 Solana-based transactions in Q2.
Given that Solana smart contracts are programmed in Rust rather than EVM's Solidity language, founding teams typically choose one or the other. An increasing number of teams are choosing to support both EVM and Solana from the start—such as the recently added Coherent and Moralis. We have seen other companies start with EVM and choose to fully transition to Solana, while Fractal mentioned above chose to build on Solana from the outset.
Moreover, several large funds have publicly expressed support for the ecosystem, indicating that Solana's resilience is real. However, the vitality of the public chain (Solana's ability to stay online) remains a primary issue that the Solana team needs to address.
User Experience is Everything
For a long time, the overall clunky and disjointed crypto user experience has been a barrier for users. Think about what users have to do to execute a typical transaction: convert fiat to cryptocurrency, transfer cryptocurrency to a wallet, bridge the cryptocurrency to their chosen network, and finally execute the transaction.
In Q2, we invested in several teams (yet to be announced) dedicated to simplifying and verticalizing the entire retail trading process. Soon, developers building in crypto and Web3 will be able to deploy an entire transaction stack with just a few lines of simple code and a set of standard APIs.
Ultimately, the future outcome will be that, for example, users can execute DEX trades with a click, while in the background, fiat will be converted to cryptocurrency, transferred to a wallet, bridged to L1/L2, and then executed and held in their chosen wallet. All the complexity will be abstracted away, and we will have a user experience comparable to Web2—unlocking tremendous potential.
Where are the Builders?
This quarter, we examined the locations of the founding teams we invested in. While crypto is a global industry, it is no surprise that the largest concentration of our founding teams comes from the United States—64% of our 356 portfolio companies are based in the U.S.; regulators have more reason to promote rather than stifle this rapidly growing industry.
Singapore has become a hub for many teams building in Asia. Meanwhile, the UK and Germany are home to growing centers where policymakers are actively working to improve regulatory transparency. Founding teams in India have impressed us, and we expect them to play a significant role in future crypto technology applications (CBV portfolio company Frontier, which has 30 engineers in India, has built an excellent mobile-first DeFi aggregator supporting over 20 chains and more than 45 protocols).
This quarter, we were also pleased to support five teams founded by former Coinbase employees, including the aforementioned Coherent and Farcaster, along with three others that have yet to be announced. We are proud to continue supporting employees who received world-class crypto education at Coinbase and continue to create world-class companies and projects.
Conclusion
While there are many exciting things ahead, there are also many lessons to be learned now. The current crypto crisis is reminiscent of the crises we see in traditional finance. The opacity of centralized lenders and Three Arrows Capital's operations led lenders to be unable to accurately assess the risks of their counterparties. Lenders did not know how much others had borrowed from 3AC, nor did they know how much leverage and risk 3AC was taking on. Investors had no idea how much risk they were collectively facing. When the market turned against both lenders and 3AC, massive holes appeared on lenders' balance sheets, leaving investors powerless.
However, it is important to note that, in contrast to the centralized lenders facing bankruptcy, blue-chip DeFi lenders like Aave, Compound, and MakerDAO are operating smoothly. Each loan and its terms are transparently maintained on-chain for all to see, and when collateral levels fall below a threshold, collateral is automatically sold via smart contracts, and lenders are repaid. The same code also prompted Celsius to repay $400 million in loans to Aave, Compound, and MakerDAO—without the need for a court order (though over-collateralization played a role). In summary, it is a powerful testament to decentralized finance.
This is to say that it is easy to feel disheartened by the current price trends while forgetting how much progress we have made in the short term. The last time a bear market hit, the most popular user application was Crypto Kitties. Today, there are countless deeper and more impactful innovations. DeFi, NFTs, and a rich DAO ecosystem have all emerged in the past two years, even coming together to make a real impact on the world stage. Meanwhile, Layer 2 scaling solutions have finally emerged, taking us from the dial-up phase to broadband, capable of supporting rich user applications with simple UX to launch.
As with previous economic downturns, critics confidently declare that cryptocurrency is dead once again. However, from our vantage point in the industry, we see outstanding founders tirelessly pushing this technology forward, which is invigorating. As the entire financial system and the world digitize, we remain convinced that the opportunities in crypto and Web3 are far greater than most people realize.