Cryptoassets The Financial Metaverse

NICHOLAS WATTS FINTECH 5 AUGUST 2021 About the team

Nicholas Watts Nicholas re-joined the Redburn Financials team from Barclays where he covered African Banks. Prior to this, he spent six years at Redburn covering Investment Banks. He started his City career in Citigroup’s Equity Markets team. Nicholas is a chartered accountant and has an MBA from the University of Cambridge.

T +44 20 7000 2187 M +44 7557 316 531 E [email protected]

Charles Bendit Before joining Redburn, Charles was an Insurance analyst at Berenberg. He started his career at Nomura. Charles graduated from the University of with a BSc in Economics and .

T +44 20 7000 2171 E [email protected]

Russell Quelch (Specialist Sales contact) Russell joined Redburn from Bank of America Merrill Lynch where he worked in Equity Trading and subsequently as a Financials Specialist Salesperson. He holds an BEng in Mechanical Engineering from the University of and is a CFA Charterholder.

T +44 20 7000 2116 E [email protected] Cryptoassets / 5 August 2021

Cryptoassets The Financial Metaverse

Money is a social construct. The idea of open, borderless and permissionless money is an anathema to some and a foreign concept to the vast majority. The concepts contained in the original white paper and the technology behind it have powered the rise of cryptoassets, which now are starting to alter perceptions of money and how value can be transferred. A financial metaverse is being created that holds potential to be applied into the real world. For public sector guardians of the traditional monetary system, this is an uncomfortable time. Rather than shaping events, they are responding to them. For the financial sector, which extracts an annual toll of c7% of global GDP, radical change may be afoot. Interest in cryptoassets and the associated technology are broadening from retail into institutional and corporate markets. The concept of Decentralised Finance (DeFi), which envisages a financial world shorn of centralised intermediaries, is garnering growing interest and investment. Real-world complexity will act as a handbrake on wilder technology ambitions. However, history has repeatedly shown that technology-fuelled change usually meets resistance, its impact is almost always underestimated and significant unintended consequences arise. We do not think disruptions in the technology of money and value transfer will be any different. Investment opportunities will abound for those with a high risk tolerance. We assess , a leading crypto exchange with over 10% of global crypto assets held on its platform, as being well positioned to benefit from the coming change and rate the stock a Buy.

Nicholas Watts +44 20 7000 2187 [email protected]

Important note: see regulatory disclosures on page 123 of this report. 3 Cryptoassets / 5 August 2021

Redburn 3D: Coinbase

Fundamentals

Coinbase (price: USD230.18, market cap: USD48.0bn) summary financials and valuation Y/E December (US$m) 2020 2021E 2022E 2023E 2024E Revenue 1,277 5,942 5,990 6,839 8,341 EBITDA (adjusted) 527 2,922 2,676 3,045 3,902 Pre-tax profit 409 2,466 2,251 2,548 3,341 Net profit 322 1,922 1,733 1,962 2,573 EPS (US$, diluted) 1.57 7.31 6.51 7.29 9.46 Consensus EPS (US$) 8.08 5.00 6.21 7.60 Price/EPS (x) 31.5 35.3 31.6 24.3 EV/EBITDA (x) 19.5 20.5 17.2 12.6 DPS (US$) - - - - Dividend yield - - - - BVPS (US$) 14.1 21.9 30.5 41.5 Price/BVPS (x) 16.3 10.5 7.5 5.5 FCF yield per share, adjusted 0.6% 4.1% 3.5% 3.9% 5.0% Net debt/(cash) (adjusted) 954 3,293 5,424 7,860 10,981

Source: Redburn, company

IDEAS Charts Score: 30/100 Value (implied change) 33 1m 3m 12m Growth 4 Relative performance -4.4% -23.1% -12.3%

Ests. Mom (EPS) 91 Ests. Mom change (3m) -2 Quality (returns) 39

Relative Estimates Momentum Price relative 100 100

80 95 90 60 85 40 80 20 75 0 70 Sep Oct Nov Dec Jan Feb Mar Apr May Jun 11 12 13 14 16 17 18 19 20 21 Ests. Mom. EPS Ests. Mom. Sales Price Rel (RH)

Note: see redburnideas.com for an explanation of The IDEAS Wave, The IDEAS Note: Coinbase vs S&P 500 since listing. Data correct as at 4 August 2021. Please see Score and Estimates Momentum. Data correct as at 4 August 2021. Please see www.redburntoday.com/charts for live information www.redburnideas.com for live information

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Contents

The idea ...... 6 01/ A new way to transfer value and record transactions ...... 18 Distributed technology – the underpinning ...... 19 DLT and ...... 21 The Blockchain layers ...... 22 Investment and applications ...... 24 02/ The money debate and regulation ...... 26 The fragmentation of money ...... 27 The emergence of Central Bank Digital Currencies...... 30 Regulation – critical, but likely to lag ...... 34 03/ The crypto landscape ...... 43 Digital numismatics ...... 44 The emerging crypto infrastructure ...... 61 Use cases and institutional engagement ...... 63 04/ DeFi ...... 67 An overview ...... 68 The current status ...... 70 The opportunity ...... 73 05/ Crypto exchanges ...... 78 Spot and markets ...... 79 Exchange rankings ...... 82 06/ Coinbase ...... 84 Overview ...... 85 Developing a broader crypto offering ...... 86 Development and growth of the overall crypto market...... 91 Fade rate of retail transaction margins ...... 93 Benchmarking and valuation ...... 98 Coinbase financials ...... 102 Appendix 1 – Key ideas in Bitcoin ...... 106 Appendix 2 – Bitcoin mechanism ...... 107 Appendix 3 – 2.0...... 112 Appendix 4 – Altcoins ...... 117 Appendix 5 – Glossary ...... 119

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The idea idea

“A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.” Extract from ‘Bitcoin: A Peer-to-Peer Electronic Cash System’, , 2008

Satoshi Nakamoto’s Bitcoin paper published in 2008 has led to the development of an entirely new asset class and conceivably a new way of operating a financial system. Or has it?

“The rule is that financial operations do not lend themselves to innovation … The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version” Extract from ‘A Short History of Financial Euphoria’, John Kenneth Galbraith, 1990

As framed by Galbraith, the financial system does have a long history of false dawns. The Nakamoto/Galbraith comments usefully frame thinking about the cryptoasset industry. Nakamoto, a shadowy figure(s) who briefly existed in the ether, before disappearing. Galbraith, every inch an establishment figure. In assembling this report, we have been mindful of this dichotomy between the new and the established.

Digital numismatics The market for cryptoassets has exploded in recent years in both number of assets (CoinMarketCap listing over 5,700) and the value thereof (Fig 1). Interest in the sector continues to be led by Bitcoin and Ethereum, which together account for over 60% of cryptoasset market capitalisation (Fig 2).

Bitcoin remains the flag-bearer of the crypto industry, despite its dominance falling. Its role has changed from that originally envisaged in Nakamoto’s white paper of a peer-to-peer payment network. The lack of scalability around the (which processes around three transactions per second) has led to markets rethinking the rationale of Bitcoin. Its constrained supply (in an era of rampant global money supply expansion), global reach and portability allied with the computing power that backs its consensus mechanism has led to a strong view in some quarters of the financial markets that it could be a significant store of value.

This could change. The Lighting Network, a layer-2 network, built on top of the Bitcoin blockchain could conceivably support Bitcoin functioning as a payments system. The pending upgrade (known as Taproot) to the Bitcoin network, the first in four years, may enhance Bitcoin’s appeal in the area of smart contracts, currently dominated by Ethereum.

Considerable criticism has been levelled at Bitcoin given the prodigious level of electricity consumption demanded by its proof of work consensus mechanism. This mechanism underpins Bitcoin’s security and its decentralised nature. Given the

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The idea

economic incentives and flexibility around Bitcoin mining (evidenced recently by Bitcoin mining shifting away from China following a crackdown there on energy consumption concerns), we anticipate a degree of immunity to this criticism, although over time we expect Bitcoin energy consumption to be shifted to more renewable sources, while the efficiency of the mining process will continue to improve.

Fig 1: Crypto market cap, 2013 to date Fig 2: Major cryptoassets by market cap, 30 July 2021

3,000

2,500

2,000

1,500

1,000

Market capitalisation(U$b) 500

0 Oct-13 Oct-14 Oct-15 Oct-16 Oct-17 Oct-18 Oct-19 Oct-20 Apr-13 Apr-14 Apr-15 Apr-16 Apr-17 Apr-18 Apr-19 Apr-20 Apr-21 Bitcoin Ethereum Total Excluding BTC Coin Cardano XRP USD Coin Other Source: CoinMarketCap, Redburn Source: CoinMarketCap, Redburn

Ethereum has emerged as the workhorse of the crypto industry, despite it not (currently) offering dramatically better transaction processing capacity than Bitcoin. Reflecting its design, it is the network of choice for running decentralised applications (DApps), digital applications that run on decentralised networks. Growth of the Ethereum network has led to severe capacity constraints, and in order to solve this (as well as to try to resolve what is known as the blockchain trilemma – the inability of to simultaneously deliver security, decentralisation and scalability), a reboot of Ethereum is currently under way. Known as Ethereum 2.0, this upgrade is a series of interconnected projects expected to run into 2022. Collectively they are expected to massively increase the scalability of Ethereum (Fig 3), as well as switching from a proof of work consensus mechanism to a less energy-intensive .

Fig 3: Ethereum, theoretical transaction throughput Basic ETH transfer ERC-20 token transfer Theoretical throughput on Ethereum 1.0 54 TPS 23 TPS

Ethereum 2.0 Theoretical throughput before sharding 6,293 TPS 4,720 TPS Theoretical throughput after sharding 146,626 TPS 109,976 TPS

Source: Redburn, vitalik.ca

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The idea

The past few years have seen a proliferation in the number of assets across the crypto industry. Away from Bitcoin and Ethereum, the most important has been the emergence of , a subset of the wider cryptoasset industry, designed with the goal of improving the traditional fiat currency model by using a scalable and price-stable intangible digital asset as a medium of exchange. The most common stablecoins are fiat currency (usually US dollar-backed). Originally conceived as a utility token pegged to fiat currencies at a 1:1 ratio offering the benefit of cross-border payment facilitated by blockchain technology, stablecoins rapidly gained popularity as a location to park funds in a ‘safe haven’ in the highly volatile crypto market. Tether and USD Coin are the two largest stablecoins.

The rapid growth of stablecoins whose value now exceeds US$100bn and questions around the backing thereof (notably that of Tether, the largest ) have led to a considerable degree of regulatory scrutiny. Despite these questions, stablecoins are likely to remain an important part of the crypto industry, albeit we expect this part of the industry to be subject to certain regulatory standards, especially around backing assets. For example, a recent Bank of England discussion paper on digital money specifically considers allowing for the creation of stablecoins, albeit with certain regulatory requirements wrapped around them.

To support the operations of individual cryptoassets as well as the broader crypto ecosystem, a broad crypto market infrastructure has developed in recent years (Fig 4). In terms of construct, it exhibits a strong resemblance to the wider global capital market infrastructure.

Fig 4: Crypto capital markets overview

Pre-trade Trading Post-trade

Data & Analytics Exchange (centralised) - Spot -Coinbase -CoinMarketCap Clearing & Settlement -Binance - Cryptocompare -ErisX -Skew Exchange (centralised) - Derivative -Arwen -CME Indices -Binance - Solactive/CoinMarketCap Investor - Bloomberg/ Exchanges (decentralised) Investor Custody - -Paxos Research Lending -Coinbase - Investment banks -Genesis - Boutique providers

Technology services (Fireblocks)

Regulatory and compliance services (Chainalysis)

Prime brokerage (Coinbase Prime; Galaxy Digital)

Interface with payment rails (Silvergate, Clearbank)

Source: Redburn

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The idea

However, despite the extremely rapid growth in value of cryptoassets and the infrastructure supporting them in recent years, it remains to a large extent a self-contained universe with still limited connectivity to the traditional finance industry and a finite number of real-world use cases. The largest potential opportunity for the crypto industry is whether it can disrupt or exert a material influence on the global financial services industry.

Decentralised Finance We estimate financial services account for c6.6% of global GDP, or cUS$5.6trn based on 2020 global GDP. Potentially the greatest opportunity for the crypto industry lies in the area of Decentralised Finance (DeFi), which envisages a world of finance shorn of centralised intermediaries. Fig 5 shows the potential addressable market size for DeFi in 2030 if value starts to leak from the traditional finance sector towards DeFi. While any shift will be messy and is unlikely to be linear, it underscores that the prize for any shift in finance towards a decentralised model is enormous.

Fig 5: DeFi addressable market assuming share shift Fig 6: Total value locked in smart contracts on from mainstream finance markets, 2030E* Ethereum network, 2017 to date

U$ bn 100 2,000 1,800 80 1,600 1,400 60 1,200 1,000 40 800 600 Total value locked in (U$b) locked value Total 20 400 200 0 0 5% 10% 15% 20% Dec-17 Dec-18 Dec-19 Dec-20 Apr-18 Apr-19 Apr-20 Apr-21 Aug-17 Aug-18 Aug-19 Quantum of shift from CeFi to DeFi Aug-20

* Based on 2030E global GDP and assumes financial services account for 6.6% of Source: Defi Pulse, Redburn global GDP (i.e. consistent with current levels) Source: Redburn, OECD, IMF

DeFi has seen exponential growth over the past year, albeit largely within the confines of the crypto industry. Ethereum is the bedrock of DeFi, with the value of smart contracts locked in Ethereum rising from a negligible amount in early 2020 to a peak of around US$90bn in May 2021 (Fig 6). The planned upgrade of Ethereum is expected to provide further support to the potential growth in DeFi.

DeFi aligns with the concept of the Web 3.0 which is expected to be built on new technology innovations: edge computing, decentralised data networks and artificial intelligence. Critically, it envisages the individual as a sovereign on the Web operating

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The idea

in a decentralised manner with a much-reduced need for third parties (Fig 7), although this concept is likely to meet strong resistance from current centralised incumbents.

Fig 7: The second inning of tech decentralisation

App explosion Trigger, iPhone, Apps

High Android, SaaS

App & data decentralisation Trigger, AI, Apps Technology (DLT), Blockchain, Smart Contracts, Bitcoin, GS

Initial internet Data Apps Data

decentralisation Data concentration Scale and impact of App Data Trigger, Cloud computing, Trust IaaS, Visualization, AI/ML AI AI AI AI AI Apps/data 1 2 3 ... 1Google 5Tencent 2 Facebook 6 Alibaba Data 3Amazon 7Microsoft 4Apple 8 ... Today Low

Web 1.0 Web 2.0 Web 3.0 Birth: 2004 Birth: 2004-2020 2008- Source: Philipp Stauffer, FYRFLY Venture Partners

Factors behind crypto’s emergence While the rapid development of the crypto industry seems to have almost emerged from nowhere, the ideas that form its underpinning, notably digital ledger technology (DLT), have a long history dating back to 1983, when David Chaum first published on the idea of anonymous electronic money. These ideas percolated in academia and the movement for a quarter-decade; technology issues were considered and addressed. However, it was not until Nakamoto developed a solution to the double- spend problem that the idea of a trustless payment system would become a reality.

However, this on its own would arguably not have been enough to trigger the growth the crypto industry witnessed over the past decade. Critically, the Bitcoin proposals coincided with the coming of age of millennials, the first technology-native generation. It also coincided with the global financial crisis and the start of an extraordinarily interventionist era in the functioning of the global financial system by central banks that continues to this day (Fig 8).

While not broken, harder questions are being asked of the fiat money regime in developed markets than at any time in the past half century. Development of the crypto market has seen the emergence of private currencies as a potential alternative to the two current dominant forms of money – cash and commercial bank deposits (Fig 9). The allergic reaction of regulators, politicians and central banks to Facebook’s original

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The idea

Libra proposal is a recognition of this challenge to sovereign formalised control of money.

Fig 8: Central bank balance sheet evolution, 2000 to date Fig 9: The fragmentation of money U$bn Government Commercial bank Private 35,000 CBDC b-money Cryptocurrency e-currency e-currency i-money 30,000 (reserve-backed) (deposit-backed) (asset-backed) 25,000 e-currency (asset-backed) 20,000

15,000

10,000

5,000

0 Jan 00 Jan 05 Jan 10 Jan 15 Jan 20 Sep 01 Sep 06 Sep 11 Sep 16 Sep May 03 May 08 May 13 May 18 May US Federal Reserve SNB ECB BoJ BoE PBoC

Source: central banks, Bloomberg Source: Redburn

CBDCs and regulation In response to this challenge, central banks globally have ramped up efforts around the development of central bank digital currencies (CBDCs – a digital version of currency plus reserves, potentially extending the ability to hold reserves at the central bank to households and corporates). Depending on design features, CBDCs hold the potential to significantly alter the financial architecture of countries in which they are introduced. For example, if implemented at a retail (rather than wholesale) level, central banks could usurp key roles played by commercial banks, notably around deposit taking. Despite the uncertain implications of introducing CBDCs, based on initiatives under way we assess a degree of inevitability around their ultimate introduction, although there are varying degrees of urgency across countries.

Regulation of crypto markets has been nascent, reflecting their formative state and the small size of cryptoassets relative to credit, equity and derivative markets (Fig 10). However, the strong growth seen in crypto markets, the concept of private currencies and the challenge embedded in various ideas in the crypto industry to the traditional finance industry has triggered a surge in regulatory interest and myriad related proposals over the past couple of years.

We expect regulation around the crypto industry to largely follow well-established principles, notably: (1) maintaining financial and economic stability; (2) maintaining appropriate standards of investor protection; and (3) guarding against illicit activity. What is likely to complicate regulatory development is the ‘chameleon’-like nature of cryptoassets, which do not neatly fit traditional financial definitions. As an example, in

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The idea

the US, certain blockchain-based cryptoassets such as Bitcoin and Ether are not considered securities and as such do not fall under the purview of the Securities and Exchange Commission (SEC), while other cryptoassets that have more security-like characteristics do (note: in this report we use the term ‘cryptoasset’ rather than ‘’1). The regulatory environment and development will also be impacted by the borderless nature of the crypto industry and that it operates 24/7, neither characteristic sitting comfortably with the way in which traditional financial regulation is constructed.

Fig 10: Size of global credit, equity, gold, derivative and cryptoasset markets, 2020

U$trn U$trn 180 800

160 700

140 600 120 500 100 400 80 300 60 40 200 20 100 0 0 Credit Equity Gold Crypto Crypto Crypto Derivative markets**** markets markets (end markets markets markets (RH 2020) (peak)* (current)** Scale)***

* 10 May 2021 ** 30 July 2021 *** Notional value of outstanding in OTC and exchange-traded derivative markets **** Government, corporate and financial sector bonds Source: Redburn, BIS, IMF, World Gold Council, CoinMarketCap

Crypto exchanges Crypto exchanges have been among the prime beneficiaries of the growth in interest in crypto markets in recent years, benefiting from rising volumes and cryptoasset prices. Historically dominated by spot markets, the past two years have seen explosive growth in derivative markets, which industry data suggest now exceeds spot markets in volume. This development is one factor underscoring growing institutional interest in cryptoassets.

Lacking the strict regulation of the mainstream exchange operators, questions exist about the veracity of data from some venues; this view is underscored by industry surveys showing there is considerable variation in the quality of exchanges, a dynamic that hampers assessment across exchanges. Given the tighter regulation likely to be

1 The terminology used in the crypto industry can often be conflated. We view cryptocurrencies as a subset of cryptoassets. The primary types of cryptoassets are cryptocurrencies, utility tokens, security tokens and stablecoins.

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The idea

applied to the crypto industry as it grows, quality as well as strength of regulatory/legal framework under exchanges operating will become more of a differentiating factor.

Fig 11: Crypto exchange volumes (spot and derivative), Fig 12: Top-tier exchanges – monthly spot volume, November 2018-June 2021 November 2018-June 2021

12,500 90% 3,000

2,400 10,000 78% 1,800 7,500 66% 1,200

5,000 54% 600

Monthly volume traded (U$b) traded volume Monthly 0 2,500 42% Monthly volumetraded (U$b) Feb-19 Feb-20 Feb-21 Aug-19 Aug-20 Nov-18 Nov-19 Nov-20 May-19 May-20 0 30% May-21 Binance Coinbase Jul-19 Jul-20 Nov-18 Nov-19 Nov-20 Mar-19 Mar-20 Mar-21 OKEx Global Derivatives Spot % spot BeQuant LMAX Digital

Source: CryptoCompare Source: CryptoCompare

Coinbase Founded in 2012, Coinbase is one of the largest crypto exchanges globally. It is a top five player in volume terms on spot markets where it plays an integrated role acting as an exchange, brokerage and market-maker on behalf of retail and institutional clients. 85% of its revenue is generated by the trading activity it facilitates. It also operates a wider crypto infrastructure including custodial services, where it holds over 10% of global cryptoassets on its platform.

Growth has been exceptionally strong, fuelled by both retail and institutional activity in cryptoassets (Fig 13). While institutional trading activity on Coinbase has grown more rapidly than retail, from a revenue (and profitability) perspective, the engine room is the retail business given its much higher (Fig 14).

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The idea

Fig 13: Coinbase – quarterly trading volume, Q1 2018- Fig 14: Coinbase – retail and institutional transactional Q2 2021E revenue as % of trading volume, Q1 2019-Q1 2021

U$m 1.60% 450,000 400,000 1.40% 350,000 1.20%

300,000 1.00% 250,000 0.80% 200,000 0.60% 150,000 0.40% 100,000 50,000 0.20% 0 0.00% Q1 20 Q2 20 Q3 20 Q4 20 Q1 21 Q1 18 Q1 18 Q2 18 Q3 18 Q4 19 Q1 19 Q2 19 Q3 19 Q4 20 Q1 20 Q2 20 Q3 20 Q4 21 Q1 Q2 21E Retail Institutional Retail Institutional

Source: company, nomics.com Source: company

As a result, a pivotal question in the short to medium term around the investment case is how this margin evolves. In the long term, we expect retail transaction margins to fall, fuelled by more intense competition from both crypto exchanges and mainstream financial participants moving in the crypto trading arena. However, a variety of factors argue for a degree of persistence of retail transaction margins at higher levels than the market perceives. These include: (1) a degree of pricing complexity that favours incumbents; (2) the importance of quality and liquidity in unregulated markets; (3) security (which takes on a different dimension in crypto markets); (4) branding; and (5) the technical complexity of connecting building infrastructure for new cryptoassets. Relative to the broad crypto exchange universe, on multiple of these measures, Coinbase screens as best in class or in the top handful.

Its transactional orientation results in Coinbase currently carrying considerable operational and financial gearing to cryptoasset prices. A core priority for Coinbase is to develop a broader crypto infrastructure offering, diversifying its revenue base and supporting its goal to serve as its customers’ primary financial account in the crypto economy. Initially, we expect the focus to be in three areas: geographic, service and asset expansion.

 Geographic expansion. Coinbase has steadily grown its number of verified users in recent years (Fig 15). The number of monthly transacting users has also grown, albeit this correlates more directly to cryptoasset pricing. We anticipate an effort to significantly expand presence and grow user numbers in other markets, especially outside its geographic areas of strength in the US, UK and Europe.

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The idea

Fig 15: Coinbase – verified users and monthly Fig 16: Coinbase – assets held on platform and as % of transacting users, Q1 2018-Q1 2021 crypto market cap, Q1 2018-Q1 2021

(m) (m) 250,000 14% 60 7 12% 50 6 200,000 10% 5 40 150,000 8% 4 30 3 100,000 6% 20 2 4% 50,000 10 1 2%

0 0 0 0% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 18 18 18 18 19 19 19 19 20 20 20 20 21 18 18 18 18 19 19 19 19 20 20 20 20 21 Verified users (LHS) Monthly transacting users (MTU, RHS) Assets on platform As % of crypto mkt cap

Source: company Source: company

 Asset expansion. Alongside geographic expansion, further expansion of unique assets offered on Coinbase’s platform will be an additional contributor to growth.

 Service/Product expansion. Of all the expansion areas, the most important in our view is service/product expansion. While Coinbase is termed an exchange, it effectively operates as a broker dealer, exchange, market-maker and custodian. The opportunity on the service/product side is to build out an infrastructure that the entire crypto infrastructure arena (Fig 4). Here, a key strategic advantage is that Coinbase already holds on its platform c11% of cryptoasset market cap with a strong presence in both the retail and institutional markets (Fig 16).

The expansion areas outlined above all effectively fall under the first pillar of Coinbase’s strategy – ‘crypto as an investment’ (Fig 17). The company’s ambitions are much broader than this, encompassing two further pillars:

 Crypto as a new financial system. This involves developing a much broader financial services offering built on crypto rails, including DeFi, payment, earning and borrowing/lending. The opportunity here will key off, in particular, development of DeFi. As a hypothetical example, if by 2030, per the analysis in Fig 5, 10% of financial services shifted into DeFi and Coinbase captured 5% of that (noting a c11% share of cryptoassets on its platform), it implies a US$45bn revenue opportunity.

 Crypto as an app platform. This is an even more formative area of investment, which involves driving crypto innovations and products beyond financial use cases.

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Fig 17: Three pillars of Coinbase’s strategy

Source: company

Valuation in the crypto arena is unequivocally more art than science given the limited track record and lack of listed comps. In framing thinking about Coinbase’s valuation to support our DCF valuation, we also benchmark against a group of fintech-oriented companies. Relative to this peer group on the basis of 2023E EV/revenue, Coinbase screens at the bottom end (Fig 18) and broadly in line with more established companies on 2023E P/E (Fig 19).

Fig 18: Coinbase vs selected comparators, enterprise Fig 19: Coinbase vs selected comparators, price/2023E value/2023E revenue EPS

50x >100x >100x 100x 90x 40x 80x 70x 30x 60x 50x 20x 40x 30x 10x 20x 10x 0x 0x Visa Visa Adyen Adyen Paypal Paypal Square Square Shopify Shopify Bill.com Bill.com Coinbase Coinbase Silvergate Silvergate Mastercard Mastercard

Source: Redburn, Visible Alpha (2 August 2021), Bloomberg Source: Visible Alpha (2 August 2021), Bloomberg

These relatively muted ratings, despite the promise embedded in the crypto industry, stem in part from the market assuming Coinbase generates little revenue growth between 2021 and 2023, reflecting a presumption that retail margins (and revenue) compress, offset by institutional and subscription revenue growth. Little allowance is being made for the substantial opportunity for the business to broaden its asset, client

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and infrastructure across the crypto industry as well as the potential vast opportunity around DeFi. We derive a DCF-based valuation for Coinbase of US$335 per share and rate the stock a Buy.

Five predictions Based on the work in this report, we make five predictions for the crypto industry:

1 Growth in DeFi. While still nascent, we forecast that over the next half-decade, value will start to leak out of the traditional financial industry into DeFi at an accelerating pace.

2 Crypto market cap will grow. Despite growth seen in recent years, the value of cryptoassets is tiny compared to other asset classes. Given the potential of the technology underpinning the crypto industry, we expect the value of cryptoassets to continue to expand, albeit with an ongoing degree of .

3 Crypto exchanges. We expect crypto exchanges will remain highly profitable. However, engine rooms of growth will likely emerge elsewhere – in offering infrastructure capability and DeFi services.

4 CBDCs and Stablecoins. CBDCs are likely to be introduced by some central banks within the next half-decade, with significant (albeit still unknown at this stage) implications for existing financial services architecture. Stablecoins are likely to become a more established part of the financial landscape although with a more comprehensive regulatory overlay.

5 Regulatory friction. We expect regulation around the crypto industry to gradually emerge, but it will significantly lag the pace of development of the industry. As a result, ‘grey areas’ will abound for the foreseeable future, as will a degree of friction between this industry and regulation. Crypto-native participants that can offer products and services that can compete in ‘grey areas’ while operating with legal and compliance standards closer to traditional financial services are likely to be the ones that build competitive advantage.

Returning to our opening debate and the comment that “the world of finance hails the invention of the wheel over and over again”, the difference this time perhaps is that the world of technology is imposing its innovation on the world of finance.

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01/ A new way to transfer value and record transactions

A new way to transfer value and record transactions

Most of the concepts underpinning Satoshi Nakamoto’s original Bitcoin paper were not, in their own right, new. What was groundbreaking was the way in which , computer science and economic incentives were stitched together to create an idea that challenges existing notions about money and value transfer. This holds the potential to significantly disrupt components of the global economy, notably the financial system. This chapter examines these underpinnings – Distributed Ledger Technology, blockchain and the layers that make up a blockchain.

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01/ A new way to transfer value and record transactions

Distributed ledger technology – the underpinning Distributed ledger technology (DLT) is a means of recording transactions and storing information. It has certain characteristics, as defined below.

“Distributed ledger technology is a decentralised peer-to-peer digital system for recording transactions between parties in multiple places at the same time. ‘DLT’ deploys cryptography and consensus mechanisms to allow participants to share an immutable replica of the same ledger. It gets rid of the need for a centralised store of data and dispenses with the requirement for a central authority to carry out administrative functions, as is necessary with traditional databases.” Risk.net

Historically, transaction recording (and value transfer) has been centralised with a single trusted entity (in the case of finance usually a bank) holding the master record. However, this is a system replete with problems, ranging from theft and error to risks around the trusted entity itself. The original Bitcoin white paper was published in 2008, two months after the failure of Lehman Brothers and a near implosion of the global financial system.

A conceptual alternative to challenges posed by centralised recording is to move to a distributed system (Fig 20) where information and records are maintained, administered and utilised by all members of that system. This gives rise to its own challenges, notably how to ensure consistency of records across the distributed system.

Fig 20: Different types of databases Centralised Centralised Decentralised (Master) (Master-Slave) (Multi-Master) Central

Distributed Distributed Distributed (Enterprise) (Private) (Public) (DLT) Distributed

Source: www.serokell.io

The original concepts underpinning DLT date back as far as 1983 when computer scientist and cryptographer David Chaum first published on the idea of anonymous electronic money. These ideas have been evolved over the subsequent decades (see Appendix A for a chronology). Core concepts were set out in a paper by Haber and Stornetta in 1991 (abstract below) in which they proposed mechanisms for

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01/ A new way to transfer value and record transactions

time-stamping digital data including introducing the idea of using cryptographically secure hash functions.

“The prospect of a world in which all text, audio, picture, and video documents are in digital form on easily modifable media raises the issue of how to certify when a document was created or last changed. The problem is to time-stamp the data, not the medium. We propose computationally practical procedures for digital time-stamping of such documents so that it is infeasible for a user either to back-date or to forward-date his document, even with the collusion of a time- stamping service. Our procedures maintain complete privacy of the documents themselves and require no record-keeping by the time-stamping service.” Abstract from How to Time-Stamp a Digital Document, Haber and Stornetta, Journal of Cryptography, 1991

A decade later, Mazieres and Shasha took these ideas further2, examining how blocks can store data, setting out the framework for blockchain. Much like the development of the building blocks of the internet, the emergence of DLT and blockchain had a long gestation (Fig 21).

1997 saw the Hashcash proposal by (proposed more formally in 2002), which introduced a cryptographic hash-based proof of work system originally intended to limit email spam and denial-of-service attacks. 1998 saw computer scientist Wei introduce the concept of b-money in an essay:

“The protocol proposed in this article allows untraceable pseudonymous entities to cooperate with each other more efficiently, by providing them with a medium of exchange and a method of enforcing contracts.” B-money, , 1998

Also in 1998, computer scientist Nick Szabo proposed ‘bitgold’, a new blockchain-like currency that proposed minimising dependence on trusted third parties. However, this proposal struggled to overcome the double-spending problem of electronic transactions, whereby holders could duplicate transactions and spend the currency more than once (a dynamic that is not an issue in a centrally controlled system).

Nakamoto’s Bitcoin white paper solved for this via a consensus mechanism (and incentivisation layer). This consensus mechanism is underpinned by miners who collect pending Bitcoin transactions, verify their legitimacy and assemble them into ‘block candidates’. The miners are not altruistic; their goal is to earn newly created Bitcoin units through this activity – this can be achieved by convincing all other network participants to add his/her block candidate to their copies of the Bitcoin blockchain. This is achieved by solving mathematically complex problems that demand high levels of computational power.

2 Building secure file systems out of Byzantine storage, David Mazieres and Dennis Shasha, NYU Department of Computer Science.

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This consensus mechanism is known as ‘proof of work’. In turn it allows the formation of consensus in a distributed manner in a way that had not previously been possible, effectively solving the double-spend problem. The success of Bitcoin has spawned an entire industry based on these underpinnings and has stimulated an enormous amount of innovation in related areas.

Fig 21: Timelines – internet and crypto Internet Crypto Ethernet (1974) Blind Signatures For Untraceable Payments (Chaum), 1983 TCP/IP* (1974) Digital Time-Stamping (Haber/Stornetta), 1991 HTTP** (1990) Hashcash (Back), 1997/2002 SSL*** (1994-96) Bitgold (Szabo), 1998 TLS **** (1999) B-money (Dai), 1998 Bitcoin (Nakamoto), 2008

Note: TCP/IP – Transmission Control Protocol/Internet Protocol; HTTP – Hypertext Transfer Protocol; SSL – Secure Sockets Layer; TLS – Transport Layer Security Source: MIT, Acunetix, Redburn

DLT and Blockchain Fig 22 set out some potential configurations of DLT ranging from a traditional single entity overseeing record keeping (and value transfer) to a much more open infrastructure more reminiscent to that used by Bitcoin. While the terms DLT and blockchain tend to be used interchangeably, blockchains are a sub-set of DLT (Fig 23) with certain characteristics that may not be present in other DLT (e.g. block structure). Fig 24 provides an overview of the main types of blockchains segmented by permission model. We would note blockchain purists would reject this view, arguing the blockchain term should only be used to describe a permissionless system.

Fig 22: Potential configurations of DLT arrangements Only approved entities Only approved can use the service (can entities can use the Any entity can use Description of One entity maintains be assigned distinct service (entities can the service and arrangement and updates the ledger restricted roles) play any role) play any role Operating of the ------Single entity ------Multiple entities ------arrangement Access to the arrangement ------Restricted ------Unrestricted Technical roles of nodes ------Differentiated ------Not differentiated ------Within a single entity or Validation and consensus Within a single entity ------Across multiple entities ------across multiple entities

Source: BIS

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Fig 23: Blockchains and distributed ledgers are subsets of distributed databases

Distributed databases 1. Adversarial Model Presence of malicious nodes assumed

Distributed ledgers (DLTs) 2. Data structure and diffusion Chain of cryptographically linked blocks, and/or global data broadcast

Blockchains 3. Permission model Read: public vs private Write/commit: permissionless vs permissioned

Permissioned blockchains

Source: serokell.io

Fig 24: Main types of blockchains segmented by permission model Read Write Commit Example Public Open to anyone Anyone Anyone* Bitcoin, Ethereum permissionless Public All or subset of Open to anyone Authorised participants Sovrin ---- Open ---- permissioned authorised participants Restricted to an All or subset of Multiple banks operating Consortium authorised set of Authorised participants authorised participants a shared ledger participants Private Fully private or Internal bank ledger permissioned restricted to a limited Network operator only Network operator only shared between parent

------Blockchain type ------Closed ------(‘enterprise’) set of authorised nodes company and subsidiaries

* Required investment in either mining hardware (proof of work model) or cryptocurrency itself (proof of stake model) Source: CCAF (Cambridge Centre for Alternative Finance)

The Blockchain layers Fig 25 presents one view of blockchain architecture from the hardware layer through the application layer. There is considerable nuance in the way blockchains and the constituent functions can be presented and a detailed review of industry sources underscores there is considerable terminology flex within the blockchain and crypto community.

Given the view of some market participants that DLT and Blockchain potentially form critical building blocks for the ‘Internet of Money’, there is some debate around where value will potentially accrue as this technology and its intersect with finance evolves. In this context, the development of the internet offers an interesting analogy – it is built on a series of open protocols, such as HTTP, TCP/IP, SSL, STMP etc, which allow different applications to communicate and work together – effectively facilitating

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smooth functioning of the internet. However, most of the value within the internet is captured by the applications that run on top of it (e.g. by companies such as Facebook, Amazon, Netflix and Tencent). This gives rise to the idea that the internet is composed of thin protocols and fat applications (Fig 26).

By contrast, in the blockchain stack, most of the value sits in the protocol layers with much more limited value in the application layer. Factors behind this are: (1) the operation of a shared data layer in blockchain (which constrains centralisation); and (2) the introduction of cryptographic tokens, which effectively ties success of the applications to the protocol layer. Decisions around where business logic is implemented also play a role (Fig 27). Whether the blockchain dynamic of ‘fat protocols, thin applications’ holds as technology and ecosystem mature remains to be seen; this dynamic is likely to be of importance in dictating where value accretes.

Fig 25: Blockchain architecture Fig 26: Value capture – internet vs Blockchain Application layer The Web Blockchain Smart Dapps Chaincode contracts Application layer

Consensus Layer Propagation protocol Applications layer

Mining protocol Protocol layer Value captured Consensus protocol Value captured Proof of Work Proof of Stake PBFT* DPoS**

Network Layer Protocol layer

Data layer Merkle Asymmetric Data blocks Trees encryption

Hardware / Infrastructure Layer

* Practical Tolerence Source: Union Square Ventures * Delegated proof of stake Source: Redburn

Fig 27: Advantages and drawbacks of implementing business logic at different layers Advantages Disadvantages Protocol layer - Smart contracts can self-enforce on the network - Larger attack surface - Smart contracts cannot be changed or stopped - Confidentiality and privacy issues - Deterministic outcome of computation is visible - Higher network burden in terms of data storage, to everyone transmission and processing (depending on data diffusion model) Application layer - Smaller attack surface - Smart contracts cannot be directly enforced by the - Bugs do not affect the entire network network - Greater confidentiality and privacy - Smart contracts can be potentially changed - Better scalability

Source: CCAF

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Investment and applications Although small relative to the wave of money that has swept into the broader cryptoasset arena, venture capital investment into blockchain technology has been increasing. Q1 2021 attracted more funding than the entirety of the preceding year, underscoring the growing interest in this area (Fig 28).

Fig 28: Venture capital funding in blockchain start-ups

U$m 3,500

3,000

2,500

2,000

1,500

1,000

500

0 2016 2017 2018 2019 2020 Q1 21

Source: CB Insights

The level of investment shown above likely significantly understates broader spend on this technology. The strongest use cases for DLT are expected to reside in the financial services area (Figs 29 and 30) and incumbents have become increasingly active in this arena. The activities of existing mainstream financial companies have included:

 Forming Blockchain consortia. One of the best known is R3, which developed Corda, a purpose built DLT application development platform focused on financial services. It was set up in 2015 and is backed by a number of the world’s largest banks.

 Small-scale experimentation with DLT technology. For example, in April 2021 the European Investment Bank (EIB) announced it had placed a €100m bond using blockchain technology. The transaction consisted of issuance by the EIB of a series of bond tokens on a blockchain with investors purchasing the tokens using traditional fiat currencies. The transaction used the Ethereum platform.

 Acquisitions. For example, Deutsche Börse announced in June 2021 that it will be acquiring a two-thirds shareholding in Crypto Finance AG, a financial group under consolidated Swiss FINMA supervision that “offers trading, storage, and

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investment in digital assets to institutional and professional clients”. The acquisition allows Deutsche Börse to extend its digital asset offering.

Fig 29: % of DLT service providers targeting different sectors/use cases Fig 30: Industries seen as leaders in blockchain*

Capital markets Financial services Insurance Industrial products & Trade finance manufacturing Payments Regulatory compliance/audit Energy & utilities Digital identity Healthcare Healthcare Public sector Government Supply chain Energy Retail & consumer Intellectual property Entertainment & media Other

0% 20% 40% 60% 80% 0% 10% 20% 30% 40% 50%

Source: CCAF * Response to question: Which of the following industries are the most advanced in developing blockchain today? Source: PwC Global Blockchain Survey (2018)

For financial service incumbents, the appeal of adopting DLT usually has its roots in the potential efficiencies and cost savings this technology can offer, albeit broader adoption of this technology will entail significant upfront investment, which means the process is likely to be evolutionary. This also reflects the regulatory scrutiny changes to the technology underpinnings of the financial system is attracting. These dynamics are discussed in depth in Chapter 2.

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The money debate and regulation

Distributed Ledger Technology marks a major innovation in the ‘technology of money’ and raises the spectre of private money competing with the dominant forms of money issued by central and commercial banks. A primary response to this challenge has been the development of Central Bank Digital Currencies, albeit with differing levels of urgency across jurisdictions. The rapid growth of cryptoasset markets has triggered varying degrees of regulatory response around the world, although the characteristics of these markets pose certain unique challenges in the regulation thereof.

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The fragmentation of money The rise of cryptoassets in recent years has triggered debate around whether these are ‘money’ (hence the phrase cryptocurrencies). To meet the generally accepted definition of money, the instrument in question should be able to fulfil three criteria, acting as: (1) a medium of exchange; (2) a store of value; and (3) a unit of account. The primary forms of money are cash and bank deposits, which together constitute the vast majority of money in most countries. Gold enthusiasts argue gold is the purest form of money and should be on the list given its track record through millennia. Central banks, the current guardians of the money system, are generally of the view that cryptoassets are not money as they effectively do not meet any of the criteria needed to function as money.

However, as discussed in Redburn’s recent economics report on globalisation:

“Distributed Ledger Technology marks a major innovation in the ‘technology of money’. It has opened up the possibility of ‘peer-to-peer’ payments outside the banking system and expanded the definition of ‘money’ beyond cash and bank deposits to incorporate myriad forms of ‘e-money’ and cryptoassets (Fig 31). ‘Fundamental’ money (bank reserves) now co-exists alongside not only ‘convertible’ money (bank deposits) but also ‘exchangeable’ money, including standalone crypto currencies and stablecoins.” The Arrow, Melissa Davies/Clemmie Elwes, 12 May 2021

Fig 31: The fragmentation of money Government Commercial bank Private Central Bank Digital Currencies (CBDCs) b-money Cryptocurrency e-currency (reserve-backed) e-currency (deposit-backed) i-money (asset-backed) e-currency (asset-backed)

Source: Redburn

As noted in that report, while bitcoin is often cited as the archetypal cryptocurrency, based on DLT, the seed of the idea for a decentralised currency came from a white paper written by Wei Dai in 1998 on ‘b-money’ (Szabo’s bitgold proposal echoing similar ideas). We quote it here as it captures the very essence of globalisation and the role digital currencies have to play in it, potentially greatly diminishing the role of the state in validating and facilitating the exchange of value:

“Unlike the communities traditionally associated with the word ‘anarchy’, in a crypto-anarchy the government is not temporarily destroyed but permanently forbidden and permanently unnecessary. It’s a community where the threat of violence is impotent because violence is impossible, and violence is impossible because its participants cannot be linked to their true names or physical locations.”

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The allergic reaction of regulators and politicians to Facebook’s original Libra proposal in 2019 suggests they recognise the potential embedded within DLT and the cryptoassets built thereon to disrupt the current monetary order.

“We write to request that Facebook and its partners immediately agree to a moratorium on any movement forward on Libra - its proposed cryptocurrency and Calibra - its proposed digital wallet. It appears that these products may lend themselves to an entirely new global financial system that is based out of Switzerland and intended to rival U.S. monetary policy and the dollar. This raises serious privacy, trading, national security, and monetary policy concerns for not only Facebook's over 2 billion users, but also for investors, consumers, and the broader global economy.” Extract of letter from US House of Representatives Committee on Finance Services to Facebook, 2 July 2019

Efforts by regulators in that case were successful, with many of the original Libra Association members withdrawing. The original proposals were significantly scaled back and the initiative has been rebranded ‘’. However, we argue the challenge potentially posed by private money to central bank and bank money is far from diminished and tension between the private and state sectors on the issue of money is likely to recur as cryptoasset markets develop further.

Perversely, central banks themselves are arguably architects of the emerging challenge to their monetary dominance; more than a decade of ultra-low interest rates (Fig 32) and relentless money printing (Fig 33) has led to a disquiet around the implications for the fiat environment over which they preside as well as indirectly providing ample and cheap funding support to backers of DLT and the wider crypto industry.

Fig 33: Central bank balance sheet evolution, 2000 to Fig 32: The global interest environment, 1992 to date date

8.0% U$bn 35,000 7.0% 6.0% 30,000

5.0% 25,000 4.0% 20,000 3.0% 15,000 2.0% 1.0% 10,000 0.0% 5,000

-1.0% 0 Jul-05 Jul-08 Jul-11 Jul-14 Jul-17 Jul-20 Jan-04 Jan-07 Jan-10 Jan-13 Jan-16 Jan-19 Jan 00 Jan 05 Jan 10 Jan 15 Jan 20 Sep 01 Sep 06 Sep 11 Sep 16 Sep May 03 May 08 May 13 May 18 US Europe UK Japan China US Federal Reserve SNB ECB BoJ BoE PBoC

Source: BIS Source: Central banks, Bloomberg

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As governments draw on central bank support to fuel recovery from the COVID-19 pandemic and address myriad economic challenges, we argue central banks are likely to move further down the stimulus continuum rather than back up it (Fig 34) with the line between monetary and fiscal policy likely to blur further3. This will continue to facilitate a supportive environment for digital asset innovation and experimentation, including central banks’ developing their own digital currencies.

Fig 34: The stimulus continuum Fed BoJ ECB BoE Interest rates Corridor Floor Tiering

Forward guidance Duration Threshold Open-ended

Repos Bills Government bonds ABS/MBS Corporate bonds Loans Equities/ETFs

Quantitative Easing Bills Government bonds MBS Corporate bonds Commercial paper Loans REITs Equities/ETFs

Yield curve control Duration Threshold Open-ended

Cooperation with the Treasury Issuance timing Remittances Direct purchases and earmarked funds

MMT Monetary financing

Central Bank Digital Currencies No physical cash

Note: yellow = prior to COVID-19 crisis; grey = since COVID-19 crisis Source: Redburn

3 For a more in-depth discussion of the stimulus continuum please refer to: ‘Bankonomics - The Nationalisation of Risk’, 17 January 2020 (Melissa Davies/Nicholas Watts) ‘Economics – Inflationology’, 16 July 2020 (Melissa Davies) ‘Economics – The Arrow’, 12 May 2021 (Melissa Davies/Clemmie Elwes)

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One risk to cryptoasset markets, specifically the value thereof, potentially arises if central banks were to start raising rates most likely in response to rising inflation/inflation expectations. Our economics view around this is that deflationary structural pressures are stronger than inflationary ones, and as such a structural resurgence of inflation is viewed as unlikely (refer to ‘Redburn Economics – Inflationology’, 16 July 2020 (Melissa Davies) for more detail on this). Additionally, the burden of debt in most developed market economies is so high that central banks are likely to be significantly constrained in the extent to which rates could be raised. Finally, we would not expect interest rate shifts to significantly diminish the interest in and pace of innovation around crypto markets given the potential growth opportunities it offers.

The emergence of Central Bank Digital Currencies One core response of central banks to the challenges posed by digital innovation has been the development of the concept of Central Bank Digital Currencies (CBDCs) – activity in this area commencing in 2016-17 and ramping up in recent years (Fig 35). A CBDC is a digital version of currency plus reserves, potentially extending the ability to hold reserves at the central bank to households and corporates.

Fig 35: Timeline of central bank activities on CBDCs

Live CBDC Research report Speech Pilot Pilot report

Jamaica

2014 2015 2016 2017 2018 2019 2020 2021 1 Excluding activities of national central banks within the Eurosystem Source: BIS

Central banks have been exploring the merits and demerits of a CBDC, its potential impact on the financial system and ways to mitigate possible financial stability risks.

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Some within central banks advocate the introduction of a CBDC could enhance a central bank’s ability to conduct monetary stimulus for the following reasons:

1 A CBDC allows a central bank to overcome the ‘effective lower bound’ by opening up the possibility of implementing negative interest rates on digital cash (a replacement to physical currency) and reserves held by households and corporates as well as banks.

2 It would facilitate ‘helicopter money’ drops by allowing the central bank to directly credit individuals’ accounts at the central bank, reducing the reliance of the central bank on the commercial banking sector to transmit the stance of monetary policy. This dynamic has taken on greater importance given the effects and experiences in the COVID-19 pandemic.

3 More broadly, a CBDC could reduce the systemic importance of banks and their significance in transmitting the stance of monetary policy to the real economy, by removing their role in deposit creation.

Opinions among economists and market participant are understandably divided on multiple aspects of CBDC, notably point 3 above and whether it would be a desirable outcome, given it would transfer a substantial amount of risk out of the private sector financial system and into the public sector and potentially put the central bank in the position of a major financial intermediator.4

Much of the impact of CBDC will be dictated by the specific designs – Fig 36 providing an overview of certain of these. Decisions around design features range from whether they should be built on existing infrastructure or using DLT to whether account-based ledger to digital tokens should be used.

Fig 36: Key design features of CBDC --- Existing central bank money ------Central bank digital currencies ------Reserve and ------General ------Wholesale-only Cash Settlement balances Token Accounts token 24/7 availability ✓ × ✓ (✓) (✓) Anonymity vis-à-vis central bank ✓ × (✓) × (✓) Peer-to-peer transfer ✓ × (✓) × (✓) Interest-bearing × (✓) (✓) (✓) (✓) Limits or caps × × (✓) (✓) (✓)

Note: ✓ =existing or likely feature; (✓) = possible feature; x = not typical or possible feature Source: BIS

4 For a more detailed examination on the economic and monetary aspects of CBDC please refer to the following Redburn reports: Bankonomics – ‘The Nationalisation of Risk’, Melissa Davies/Nicholas Watts (17 January 2020) Economics – ‘Globalisation – The Arrow’, Melissa Davies/Clemmie Elwes (12 May 2021)

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Fig 37: CBDC pyramid

From consumer needs…Retail …to CBDC design choices Cross- or border wholesale payments interlinkages?

Accessible to all Account or token-based Ensure privacy in lawful exchange access technology?

DLT-based or conventional central

Resilient and robust operations Lower-level choices feed bank infrastructure? into subsequentdecisions

Convenient real-time payments Architecture: indirect or direct claims, and Cash-like with peer-to-peer functionality What operational role for central bank?

Source: BIS

One of the most critical decisions will be whether CBDCs should be wholesale (i.e. available to only to financial institutions) or retail based. Adoption of the latter approach would potentially be much more disruptive to existing financial system architecture. Depending on precise structures adopted central banks could usurp key roles played by commercial banks, notably around deposit taking. Pre-pandemic the weight of opinion was wholesale CDBC was more likely, however more recent surveys suggest retail CBDC’s are potentially more likely (Figs 38 and 39).

Fig 38: Likelihood of CBDC issuance – retail Fig 39: Likelihood of CBDC issuance – wholesale

90% 90% 2018 2019 2020 2018 2019 2020 80% 80%

70% 70%

60% 60%

50% 50%

40% 40%

30% 30%

20% 20%

10% 10%

0% 0% Likely Possible Unlikely Likely Possible Unlikely Likely Possible Unlikely Likely Possible Unlikely ------Short-term*------Medium-term**------Short-term*------Medium-term**------

* Short term = 1-3 years * Short term = 1-3 years ** Medium term = 1-6 years ** Medium term = 1-6 years Source: BIS Source: BIS

Timelines for potential CBDC adoption vary widely. Among the largest economies, the US has arguably been the slowest initial mover. While multiple speeches have been made on the subject, little substantive action has been taken, although work is ongoing behind the scenes.

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“Multidisciplinary teams at the Federal Reserve are investigating the technological and policy issues associated with digital innovations in payments, clearing, and settlement, including the benefits and risks associated with a potential U.S. CBDC.” Lael Brainard, Federal Reserve Board Member, 24 May 2021

The Federal Reserve is expected to publish a discussion paper this summer examining the prospect of a US CBDC.

The European Union has been active in this area at both a national as well as a supra- national level, although, as highlighted by the comment below, the timeframe for progression to a digital euro is likely to be a protracted one.

“If the Governing Council gives us the green light in July, we’ll start a formal investigation phase focusing on the design of a digital euro. After two years, we’ll get back to the Governing Council, and in the meantime we’ll interact with other European authorities and institutions – the Parliament, the Commission, the Council, the Eurogroup – all those who are involved, because the digital euro will require legislative changes. So at the end of these two years, ideally, we would have more clarity on the steps which would be necessary to issue a digital euro, if the decision were taken to launch it. Then we expect to have, by and large, three years to be able to implement what we have decided on.” Fabio Panetta, Executive Board Member of ECB, 20 June 2021

China is arguably most advanced. It has already trialled a CBDC, the Digital Currency Electronic Payment (DCEP), in mainland China and the Greater Bay Area (Fig 40). The ‘push’ factor for developing the DCEP has been as a response to the rapid rise of Chinese technology companies such as Alipay and WePay with their own payments ecosystems, which have drawn deposits out of the traditional banking systems. A key pull factor has undoubtedly been a desire to broaden RMB usage, although steps in this direction are likely to be carefully controlled given China’s relatively closed capital account.

Irrespective of the pace of development in different countries, it does appear that there is an air of inevitability around CBDCs. Despite financial market perception around the power of central banks and popular mantras like ‘don’t fight the Fed’, adoption of CBDCs would be an example of technology development imposing a significant change on central banks.

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Fig 40: China’s DCEP trials Number of Validity period of Year Location red envelopes Total amount red envelopes Application scenarios 2020 Luohu district, 50,000 10 million yuan 18h00, 12 Oct – 24h00, 20 Oct 3,389 designated businesses in Shenzhen Luoha district 2020 Suzhou 100,000 20 million yuan 20h00, 11 Dec – 24h00, 17 Dec Nearly 10,000 physical stores and JD.com 2021 Futian district, 100,000 20 million yuan 08h00, 7 Jan – 24h00 17 Jan Over 10,000 designated businesses Shenzhen in Shenzhen 2021 Longhua district, 100,000 20 million yuan 09h00, 1 Feb – 24h00, 9 Feb Over 3,500 designated businesses Shenzhen in Longhua district 2021 Beijing 50,000 10 million yuan 21h00 11 Feb – 24h00, 17 Feb Designated businesses on Wangfujing and JD.com 2021 Suzhou 150,000 30 million yuan 18h00, 10 Feb – 24h00, 26 Feb Over 16,700 designated businesses in Shenzhen 2021 Chengdu 200,000 40 million yuan 08h00, 3 Mar – 24h00, 19 Mar Over 11,000 designated businesses in Chengdu and JD.com

Source: https://forkast.news/china-dcep-digital-yuan-pros-cons/

Regulation – critical, but likely to lag The other major response from central banks (and other regulators) to the rise of digital assets is around regulation. While the pace has picked up recently, regulation around digital asset markets is nascent and significantly lags the pace of innovation and experimentation in these markets. This is typical of the emergence of new markets and technologies. As an example, in the US, although credit cards were first introduced by Bank of America in the late 1950s and usage grew rapidly through the 1960s, it took until the 1970s for the major pieces of legislation and regulation to emerge (Fair Credit Report Act 1970; Fair Credit Billing Act 1974; Practices Act 1977).

In framing thinking around regulation, it is worth noting the size differential between the major components of global financial markets (debt, equity and derivative markets) and cryptoasset markets. Historically cryptoasset values have been extremely small relative to mainstream capital markets (Fig 41), and of little systemic relevance. The growth in the size of crypto market capitalisation, coupled with the spectre of private currencies competing with mainstream forms of money, has triggered a regulatory response we anticipate will intensify.

However, the approach to regulation is complicated by the ‘chameleon’-like nature of the crypto market. For example, are these instruments securities, currencies or commodities? How should a stablecoin be thought of and regulated relative to an unbacked coin? These markets are anchored in a virtual 24/7 world and operate in a borderless manner, an anathema to regulators whose focus tends to be largely domestic and anchored in traditional market structure thinking. Even where forums exist to try and achieve a degree of regulatory harmonisation (e.g. the Financial

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Stability Board), this concept is likely to be challenged by the desire of certain counties and jurisdictions to achieve economic competitive advantage by embracing this technology.

Fig 41: Relative size of global derivative, credit, equity, gold and cryptoasset markets, 2020

U$trn U$trn 180 800

160 700

140 600 120 500 100 400 80 300 60 40 200 20 100 0 0 Credit Equity Gold Crypto Crypto Crypto Derivative markets**** markets markets (end markets markets markets (RH 2020) (peak)* (current)** Scale)***

* 10 May 2021 ** 30 July 2021 *** Notional value of outstanding in OTC and exchange-traded derivative markets **** Government, corporate and financial sector bonds Source: Redburn, BIS, IMF, World Gold Council, CoinMarketCap

Discussions with digital asset industry participants underscore that a frustration in many quarters is the absence in multiple areas of a regulatory framework (or the existence of a very immature one). Ultimately, new regulatory frameworks will emerge, but it is likely to be a slow and relatively haphazard process, and we expect this market in coming years to be characterised by friction between the pace of innovation in this market relative to the pace of regulatory development.

While traditional frameworks may be more challenging to operate in this market for the foreseeable future, we anticipate regulators will frame and develop regulation around well-established principles, notably: (1) maintaining financial and economic stability; (2) maintaining appropriate standards of investor protection; and (3) guarding against illicit activity.

Financial (and economic) stability Given their mandate to maintain financial stability and the competitive threat posed by private money, much of the response on the part of central banks has been on developing CBDCs (discussed in the preceding section). However, perhaps in recognition that the challenge of private money will not disappear, the central banks have also been examining alternatives, notably around the concept of stablecoins. In a recently released discussion paper on digital money, the Bank of England in addition

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to a CBDC also allows for the possibility of stablecoins, although it stresses the need for public confidence therein:

“Like existing forms of money, new forms of digital money that are systemic could be publicly or privately provided. In this Paper, the term ‘systemic stablecoin’ – often referenced as ‘stablecoin’ for simplicity – is used to refer to those that are issued by private companies…New forms of digital money could be preferred by the public to commercial bank deposits, but they will endure only if they can be trusted as a store of value and as an accepted means of payment. This means that stablecoins must promise, credibly and consistently, to be fully interchangeable with existing forms of money. In other words, they must be anchored. This is essential for ensuring that users have the same confidence in stablecoins as commercial bank money.” Extract from ‘New forms of digital money’, Bank of England discussion Paper, 7 June 2021

In the US, regulators have underscored the need for a greater oversight of private sector stablecoins; some recent commentary around them has been relatively constructive (see comment below). This is not mirrored in all quarters, with certain politicians adopting a more sceptical stance. For example, Senator Elizabeth Warren in a recent Senate hearing likened stablecoins to ‘wildcat notes’ issued by banks in the US in the 19th century, which left many holders with large losses.

“In my judgment, we do not need to fear stablecoins. The Federal Reserve has traditionally supported responsible private-sector innovation. Consistent with this tradition, I believe that we must take strong account of the potential benefits of stablecoins, including the possibility that a U.S. dollar stablecoin might support the role of the dollar in the global economy.” Extract from speech by Randal Quarles, Federal Reserve Vice Chair for Supervision, 28 June 2021

One of the central concerns of regulators about private stablecoins is the backing thereof, a dynamic we discuss in more detail in Chapter 3. From a financial stability perspective, a central risk in the event of largescale adoption of stable coins would be the displacement of commercial bank money (a similar phenomenon could be seen in the event of a successful retail CBDC), with implications across the financial system, not least for credit formation (Fig 42).

“A large-scale displacement of commercial bank money by new forms of digital money could mean a higher fraction of money in the economy backed by high- quality liquid assets (HQLA) rather than by loans to the real economy. In that event, real economy loans could be financed instead by more stable, and expensive, sources of funding, reducing the efficiency with which commercial banks extend credit. As a result, there could be a greater reliance on non-banks for credit provision.

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Overall, there may be a trade-off between the optimal provision of transaction services – that is, payments – and intermediation services – that is, credit. On the one hand, the introduction of new forms of digital money may improve the range of transaction services available to people. On the other hand, it might reduce the efficiency of credit provision in the economy.” Extract from ‘New forms of digital money’, Bank of England discussion paper, 7 June 2021

Fig 42: Overview of implications of stablecoins for macroeconomic stability

Deposits migrate Commercial banks • Greater resilience of payments (✓) Stablecoins • Potential to enhance the transmission of monetary policy (✓) Replace deposits with long-term • Potential forlargerdepositrunsinstress debt () • Reduced chance of sharp fall in • Risk of short-term disruption in money bank credit conditions (✓) markets () • Potential to make it more difficult to ease financial conditions () Funding costs rise • Risk to confidence in money and payments if expectations not met (×)

Lending rates rise Provision of lending shifts Non-banks • Potential for more productive credit allocation (✓) • Some borrowers may find it too costly to borrow from non-banks () (✓) Opportunity Banks’ provision of credit falls () Risk in transition (×) Risk

Source: Bank of England

The use of CBDC and possible much more widespread use of stablecoins would potentially trigger changes to financial system architecture (especially banking) in a way that has not been seen before. This is usefully framed by the outgoing Bank of England Chief Economist:

“On financial stability, a widely-used digital currency could change the topology of banking fundamentally. It could result in something akin to narrow banking, with safe, payments-based activities segregated from banks’ riskier credit- provision activities. In other words, the traditional model of banking familiar for over 800 years could be disrupted. While the focus of debate so far has been on the costs of this disruption, largely in the form of disintermediation of existing agents, there are significant potential benefits to be had too.” Extract from speech by Andy Haldane, Bank of England Chief Economist, 30 June 2021

Given the importance of the banking system to financial stability, regulators are also in in the process of clarifying the regulatory treatment of cryptoassets for banks. In June 2021, the Basel Committee on Banking Supervision published its proposed prudential treatment of cryptoasset exposures. The high-level proposals are detailed in Fig 43.

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The proposed 1250% risk weighting of bitcoin garnered much attention, but the publication of the broader proposals is arguably more interesting and symptomatic of greater official acknowledgement being placed on an emerging asset class.

Fig 43: An overview of the prudential treatment of cryptoasset exposures Group 2 cryptoassets (not fulfilling Out of Group 1 cryptoassets (fulfilling classification conditions) classification conditions) scope Group 1b: Cryptoassets with Cryptoassets that do Prudential Group 1a: Tokenised stabilisation mechanisms not qualify as Group 1 requirements traditional assets (i.e. stablecoins) (e.g. bitcoin) CBDCs New guidance on application Capital requirements at New conservative prudential of current rules to capture the least equivalent to those of treatment based on a 1250% Credit and market risk risks relating to stabilisation traditional assets (with risk weight applied to the n/a requirements mechanisms (with further further consideration for maximum of long and short consideration for capital capital add-ons) positions add-ons) Other minimum requirements Application of the existing Basel Framework requirements with additional guidance where ( ratio, large n/a applicable exposures, liquidity ratios) Additional guidance to ensure that risks not captured under minimum (Pillar 1) requirements Supervisory review n/a are assessed, managed and appropriately mitigated (including through capital add-ons) New requirements for banks to disclose information regarding cryptoasset exposures on a Disclosure n/a regular basis

Source: BIS

Preventing illicit activity The second major area of regulatory focus is in guarding against illicit activity, which includes anti-money laundering (AML) measures and preventing terrorism financing. Fig 44 shows an estimate of illicit activity in the cryptoasset arena. Fig 45 shows a breakdown of this activity, which estimates show as being concentrated in four areas:

1 Stolen funds.

2 Darknet markets, the most notorious historical example being the Silk Road which was shut down by the FBI in 2013. Bitcoin was the currency of choice on this website.

3 Ransomware. This is the category of illicit activity that has seen the most rapid growth in recent years and holds the potential to be a source of intense regulatory scrutiny for crypto markets.

4 Scams. We discuss investor protection in the next section.

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Fig 44: Total cryptocurrency value sent and received by illicit entities vs illicit share of all cryptocurrency Fig 45: Total cryptoasset value received by illicit activity, 2017-20 entities*, 2017-20 U$bn U$m 2.50% 25 12,000

2.00% 20 10,000

8,000 1.50% 15

6,000 1.00% 10 4,000 0.50% 5 2,000 0.00% 0 2017 2018 2019 2020 0 Total illicit value (U$bn, RHS) 2017 2018 2019 2020 Share of total cryptocurrency transfer value (LHS) Darknet markets Ransomware Scams Stolen funds

Source: Chainalysis * Top four Source: Chainalysis, Redburn

Given the scrutiny and pressure regulators have bought to bear on the traditional financial sector in the area of illicit activity, it is realistic to expect a similar approach in the cryptoasset arena.

Fig 46 shows data compiled by the Financial Action Task Force (FATF), an inter-governmental body that sets international standards to prevent money laundering and terrorist financing. Its latest survey work, based on data from April 2018, found that out of 128 jurisdictions, 58 reported they had introduced legislations to implement FATF standards imposing AML/CFT (anti-money laundering and counter-terrorism financing) on VASPs (Virtual Asset Service Providers). This was up from 33 jurisdictions in the prior year.

We expect the number of jurisdictions wrapping prevention of illicit activity legislation around the cryptoasset industry to continue to climb. From an AML/CFT perspective, we also expect regulators to intensely scrutinise and exert pressure on fiat on-off ramps.

Inside the crypto markets themselves, notably in the DeFi arena (which we examine in Chapter 4), we anticipate AML and Know Your Customer (KYC) procedures to be an evolutionary process given the characteristics of these markets with a degree of friction with official sector proposals. An example of this evident in recent industry commentary on certain March 2021 issued FATF proposed guidelines of virtual assets and VSAPs.

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“Adan strongly supports the development of appropriate and proportionate guidelines which mitigates criminal and other illicit use of virtual assets. However, these proposed guidelines are at best impractical, at worst, impossible to implement for individuals and DeFi startups which neither have the competence, know-how or resources to perform due diligence on users with whom they have no point of contact. Indeed developers or deployers of smart contracts which enable the transfer of assets – such as decentralized exchanges, decentralized stablecoins or any number of DeFi applications – have no practical means to identify users or their operations. This broad and vague definition of VASP creates legal uncertainty for virtual asset users and developers participating in the DeFi ecosystem.” Extract from ADAN (Association for the Development of Digital Assets) publication, 21 April 2021

Fig 46: Progress in implementing AML/CFT* regulatory regimes for VASPs* FATF* FRSB* Total Jurisdiction has necessary legislation for AML/CFT regime for VASP Permit and regulate VASPs 27 25 52 Prohibit VASPs 1 5 6

Jurisdiction is in the process of introducing necessary legislation/regulations for AML/CFT regime for VASPs Permit and regulate VASPs 7 19 26 Prohibit VASPs 0 0 0

Jurisdiction has decided its approach on VASPs, but has not yet commenced the necessary legislative/regulatory process Permit and regulate VASPs 1 5 6 Prohibit VASPs 1 5 6

Jurisdiction is yet to decide what approach to take for VASPs Approach to VSAPs under consideration 1 31 32 Total 38 90 128

* AML/CTF – anti-money laundering and counter-terrorism financing; VASP – Virtual asset service providers; FATF – Financial Action Task Force; FRSB – FATF-Style Regional Bodies Source: Financial Action Task Force (July 2021)

Investor protection The other major area of regulatory focus around cryptoassets is investor protection. As highlighted in Fig 45, the largest area of losses in the cryptoasset arena has been around scams. The composition of cryptoassets, their borderless nature and high levels of innovation in these markets generate an usual set of challenges for regulators, as traditional investor protection frameworks are more challenging to fit cryptoassets and markets.

As with other areas of regulation, we expect adoption of investor protection around cryptoassets to be an uneven process, with this area potentially seeing the greatest variation in regulation across countries. For example, Canada has already authorised a

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range of cryptoasset exchange-traded funds (ETFs), while multiple developed market locations are still grappling with whether or not to authorise them.

A brief country-by-country summary There are myriad proposals around the cryptoassets and markets globally. Below we briefly summarise select developments in a few major economies.

US Within the US, while there has been significant engagement by a variety of regulatory agencies on the subject of cryptoassets, little formal rulemaking has occurred. At a federal level, regulation is complicated by differing mandates. For example, the SEC is responsible for securities regulation, including securities exchanges. However, crypto exchanges do not fall under its purview, with the largest cryptoassets Bitcoin and Ether not considered securities. The Commodities Futures Trading Commission (CFTC), which is responsible for the oversight of US derivative markets, does not oversee these markets either, although it does oversee crypto trading on the major US derivative exchanges (for example, CME’s Bitcoin futures & options products). How oversight of these assets and markets evolves is unclear, although in April 2021 the US House of Representatives passed a bill that would create a digital asset working group between the SEC and CFTC. Some pockets of guidance have been issued. For example, in July the Office of the Comptroller of the Currency (OCC) issued guidance allowing US banks to provide cryptoasset custody services.

State-level rules also exert an impact in the US. Here, there have typically been two approaches. Some states have been highly supportive of cryptoassets, passing favourable regulations exempting them from state securities laws and money transmission statutes. Others have adopted more restrictive approaches, although regulation at this level can shift. For example, in 2020, New York amended its ‘BitLicense’ rules, which were first introduced in 2015, the amendments aimed at making it easier for companies to undertake crypto business in the state.

EU Limited specific regulation has been passed by the EU that governs crypto activities. The EU’s fifth AML directive, which came into effect in 2020, specifies that crypto exchanges must follow the EU’s AML regulations. In September 2020, the European Commission (EC) published a new digital finance package, one component of which includes legislative proposals for an EU regulatory framework on cryptoassets.

UK Cryptoassets are considered property in the UK, but currently no specific cryptoassets laws exist and they are not considered legal tender. Firms carrying out specific cryptoasset activities (e.g. crypto exchanges) in the UK are permitted and are required to register with the Financial Conduct Authority (FCA) from January 2020. The FCA has granted temporary registration until 31 March 2022 to existing firms whose

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applications are pending determination. In October 2020, the FCA passed regulation, which became effective in January 2021, prohibiting the sale to retail clients of investment products (derivative and exchange-traded notes) that reference cryptoassets.

China Among the major economies, China is the most restrictive in its approach to cryptoassets, with the People’s Bank of China (PBoC) having banned financial institutions from handling Bitcoin transactions in 2013 and then outlawing Initial Coin Offerings (ICOs) and domestic cryptoasset exchanges in 2017. Crypto-mining activities are still permitted, with the majority of mining operations (as measured by Hash Rate) based in China. However, there has been a crackdown on such operations in recent months, partly influenced by energy consumption concerns.

Japan The Financial Services Agency (FSA) oversees all crypto trading platforms in Japan. In 2017 Japan made an amendment to its Payments Services Act and introduced a regulatory regime for businesses, making Japan the first developed market to do so.

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03/ The crypto landscape

The crypto landscape

The cryptoasset market has exhibited exponential growth in recent years, led by interest in Bitcoin and Ethereum, with the number of cryptoassets exploding. A broad crypto market infrastructure has sprung up to support growth of this industry, which has exhibited high levels of innovation. However, real-world use cases remain limited and the cryptoasset industry’s ability to mount a challenge to mainstream finance is unproven. Investment in the sector has primarily been retail-led, although the past year has seen a surge in institutional and corporate interest and activity in this industry.

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Digital numismatics The crypto landscape (as measured by the market capitalisation of the various cryptoassets) has grown exponentially, aggregate capitalisation reaching cUS$2.5trn in May 2021, before a sharp correction (Fig 47). The dominant assets accounting for over 60% of market capitalisation are Bitcoin and Ethereum (Fig 48). Bitcoin remains the highest profile currency, although its dominance has fallen (Fig 49).

Fig 47: Crypto market cap, 2013 to date Fig 48: Major coins by market cap, 30 July 2021

3,000

2,500

2,000

1,500

1,000

Market capitalisation(U$b) 500

0 Oct-13 Oct-14 Oct-15 Oct-16 Oct-17 Oct-18 Oct-19 Oct-20 Apr-13 Apr-14 Apr-15 Apr-16 Apr-17 Apr-18 Apr-19 Apr-20 Apr-21 Bitcoin Ethereum Tether Total Excluding BTC Binance Coin Cardano XRP USD Coin Dogecoin Other Source: CoinMarketCap, Redburn Source: CoinMarketCap, Redburn

Fig 49: Evolution of total crypto market capitalisation by major coin, April 2013 to date

100%

80%

60%

40%

20% % of global% marketcap 0% Nov-2013 Nov-2014 Nov-2015 Nov-2016 Nov-2017 Nov-2018 Nov-2019 Nov-2020 May-2013 May-2014 May-2015 May-2016 May-2017 May-2018 May-2019 May-2020 May-2021

Bitcoin XRP Dogecoin Tether Ethereum Binance Coin Cardano USD Coin Polkadot Others

Source: CoinMarketCap, Redburn

In the sections that follow, we examine Bitcoin, Ethereum, Stablecoins and other Altcoins in more detail.

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Bitcoin Bitcoin is the flag-bearer of the cryptoasset market, and despite a falling share of the total cryptoasset market, it currently exerts the greatest influence. Its proof of work consensus mechanism is fuelled by a level of computing power exponentially higher than that of other cryptoassets (Fig 50). The associated energy demand to support this has climbed (Fig 51), with estimates suggesting the energy consumption of the miners (who underpin Bitcoin’s consensus mechanism) rivals that of Norway. This has triggered a number of questions, especially from an ESG perspective, and has been a contributory factor in the fall in Bitcoin’s price from record levels seen in April 2021.

Fig 50: Bitcoin network Hash Rate, 2009 to date Fig 51: Bitcoin energy consumption, 2017 to date

200 150

120 160

90 120 60 80 30 Annualised energy usage usage (TWh) energy Annualised 40 0 Exahash per sec. (EH/s) = 1million TH/s 1million = (EH/s) sec. per Exahash Jul-17 Jan-20 Jun-20 Oct-18 Feb-17 Dec-17 Apr-21 Aug-19 Nov-20 Mar-19 0 May-18

Minimum Actual - Estimated Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 Jan-19 Jan-21

Source: Blockchain.com, Redburn Source: Digiconomist, Redburn

The rapid appreciation of Bitcoin’s value and subsequent awareness has resulted in an increase in the number of users (measured in Fig 52 as total active addresses), which is around all-time highs5. While originally conceived as a peer-to-peer electronic transfer system, the transaction throughput of the Bitcoin network is limited, averaging c3.5 transactions per second in recent years, a level that precludes it operating as a payment network given the vastly higher output of other networks (Fig 53). This lack of scalability has been an issue that has pervaded the Bitcoin network for years and a exemplifies the blockchain ‘trilemma’ (a term coined by Vitalik Buterin, the founder of Ethereum), a dynamic that forces blockchain creators to sacrifice one of three core characteristics – decentralisation, security, scalability – in order to achieve the other two. In the case of Bitcoin, its decentralisation and security are delivered at the cost of scalability.

5 There are challenges in gauging user and ownership numbers across the Bitcoin network. Many reports focus on the distribution of Bitcoin network address. This approach does not allow for certain important considerations: (1) an individual’s self-custody address will be treated the same as an exchange’s address, which may hold funds from hundreds of thousands of users; and (2) a single user may have multiple addresses.

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Fig 52: Number of active addresses used in successful Fig 53: Bitcoin transaction rate per second*, 2016 to transactions on Bitcoin*, 2009 to date date

1,500 5

1,200 4

900 3

600 2 Transactions per second 300 1 Number activeaddressesof (000)

0 0 Jun-16 Jun-17 Jun-18 Jun-19 Jun-20 Jun-21 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 Jan-19 Jan-21 Dec-16 Dec-17 Dec-18 Dec-19 Dec-20

* Seven-day moving average * Seven-day moving average Source: Glassnodes, Redburn Source: Blockchain.com, Redburn

Various proposals have been advanced to improve the scalability of the Bitcoin network, the most prominent being the , which effectively sits on top of the Bitcoin blockchain and is intended to be a decentralised system to facilitate instant, high-volume micropayments. The past 12 months have seen an increase in the Lightning Network’s capacity, although it remains relatively small (Fig 54).

Less well known is that the Bitcoin network currently supports smart contracts, albeit with limited functionality. In June 2021, the first Bitcoin upgrade in four years was approved by miners that underpin the Bitcoin’s consensus mechanism. Known as Taproot, it is expected to take effect in November 2021 and allow for competitive smart functionality. Key changes planned as part of this upgrade are: (1) a switch from Elliptic Curve Digital signatures to Schnorr signatures, a change that will afford greater privacy and, crucially, make transactions more data-lightweight (more specifically, Schnorr signatures forego the current need to record the individual participants in a multi-signature transaction and instead uses a single ‘combined’ signature); (2) modifying the data structure of the network, through the implementation of Merklized Abstract Syntx Trees, to enable users to write more complex conditions and further increase user privacy; and (3) swapping to a new, less- restrictive, network programming language called Tapscript. All in, Taproot holds the potential to improve the Bitcoin network appeal as a venue for smart contracts, an area where Ethereum (discussed in the next section) dominates.

The constrained supply of Bitcoin (supply is capped at 21 million, Fig 55), the computing power deployed behind the network, and its global reach and portability have given rise to the idea that Bitcoin could function as a store of value – effectively digital gold. The conservative approach adopted by the Bitcoin development

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03/ The crypto landscape

community, analysis that suggests much of Bitcoin is being held for the long term, supports this idea (Fig 56), although unsurprisingly the official sector view differs sharply:

“Unlike gold, however, which has industrial uses and aesthetic attributes quite apart from its vestigial financial role, Bitcoin’s principal additional attractions are its novelty and its anonymity. The anonymity will make it appropriately the target for increasingly comprehensive scrutiny from law enforcement and the novelty is a rapidly wasting asset. Gold will always glitter, but novelty, by definition, fades. Bitcoin and its ilk will, accordingly, almost certainly remain a risky and speculative investment…” Extract from speech by Randal Quarles, Federal Reserve Vice Chair for Supervision, 28 June 2021

Fig 54: Lightning Network – total daily capacity in Bitcoin and US$, January 2018 to date*

1,875 75 Capacity in BTC (lhs) Capacity in U$ (rhs) 1,500 60

1,125 45

750 30

375 15

0 0 Jul-18 Jul-19 Jul-20 Jan-18 Jan-19 Jan-20 Jan-21 Sep-18 Sep-19 Sep-20 Nov-18 Nov-19 Nov-20 Mar-18 Mar-19 Mar-20 Mar-21 May-18 May-19 May-20 May-21

* Seven-day moving average Source: Bitcoin Visuals, Redburn

Fig 55: Bitcoin inflation vs time

Year 2009 2013 2017 2021 2025 2029 2033 2037 100% 20 90% 80% 70% 15 60%

50% 10 40% (millions) Bitcoins 30% Inflation rate (annualised) 5 20% 10% 0% 0 0 210 420 630 840 1050 1260 1470 1680 Blocks (thousands) Inflation rate Monetary base

Source: StackExchange

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Fig 56: Bitcoin – liquid and illiquid supply

Illiquid Liquid Highly liquid Price ($) $20,000 17.5m $8,000 $4,000 15m $1,000 $600 12.5m $200 $80 10m $40 $10 7.5m $6 $2 5m $0.80 $0.40 2.5m $0.10 $0.06 0 $0.02 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Source: Glassnodes

Ethereum First proposed in a white paper by Vitalik Buterin in 2013, Ethereum has evolved into the second largest cryptoasset, currently accounting for c20% of the crypto market, having experienced a meteoric price rise (Fig 57) since the project was formally launched in 2015. The thinking behind Ethereum, articulated in the comment below, was much broader than Bitcoin, with some framing it as the world’s computer.

“The concept of an arbitrary state transition function as implemented by the Ethereum protocol provides for a platform with unique potential; rather than being a closed-ended, single-purpose protocol intended for a specific array of applications in data storage, gambling or finance, Ethereum is open-ended by design, and we believe that it is extremely well-suited to serving as a foundational layer for a very large number of both financial and non-financial protocols in the years to come.” Extract from Ethereum white paper

Although it currently uses a proof of work (PoW) consensus mechanism, similar to Bitcoin, Ethereum’s is far less energy-intensive (Fig 58), its PoW algorithm being memory-intensive, a step that penalises application-specific integrated circuits (ASICs), which dominate Bitcoin’s PoW mechanism. A switch of the Ethereum network from PoW to Proof of Stake (PoS) is planned as part of the Ethereum 2.0 project (discussed in the next section and Appendix 3), which will dramatically lower Ethereum’s energy consumption.

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Fig 58: Number of Petahash per second (PH/s) Fig 57: Ethereum market price, 2015 to date performed by the ETH network*, 2015 to date

4,500 0.75

3,600 0.60

2,700 0.45

1,800 0.30 Average daily price (U$) price daily Average 900 0.15 Petahashsec.1,000 per (PH/s)TH/s =

0 0.00 Jul-15 Jan-19 Jun-18 Oct-20 Sep-16 Feb-16 Feb-16 Feb-17 Feb-18 Feb-19 Feb-20 Feb-21 Apr-17 Aug-19 Nov-17 Mar-20 Aug-15 Aug-16 Aug-17 Aug-18 Aug-19 Aug-20 May-21

Source: Etherscan, Redburn * Seven-day moving average Source: Etherscan, Redburn

The transaction rate on the Ethereum network, while higher than that of Bitcoin, is a fraction of that of payment networks (Fig 59). Reflecting Ethereum’s orientation, it is the network of choice for running Decentralised Applications (DApps), digital applications that run on decentralised networks (Fig 60).

Fig 59: Transaction rate per second on the Ethereum network, 2015 to date Fig 60: Decentralised apps built on Ethereum

25 150 3,000

120 2,400 20

90 1,800 15 60 1,200 10 30 600 Transactions per second 5 No. newDApps addedpermonth 0 0

0 Dec-15 Dec-17 Dec-19 Apr-15 Apr-17 Apr-19 Apr-21 Aug-16 Aug-18 Aug-20

Ethereum platform (lhs) Total DApps (rhs) Feb-16 Feb-17 Feb-18 Feb-19 Feb-20 Feb-21 Aug-15 Aug-16 Aug-17 Aug-18 Aug-19 Aug-20

* Seven-day moving average Source: StateoftheDapps, Redburn Source: Etherscan, Redburn

Pivotal to the functioning of Ethereum is the widely used ERC-20 tokenisation standard, which is defined below.

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“The ERC-20 standard outlines the common set of criteria and technical specifications an Ethereum token must follow to function optimally and interoperably on the Ethereum blockchain. It enables the creation of tokenized assets that can be bought, sold, and exchanged alongside cryptocurrencies like bitcoin (BTC) and ether (ETH). The ERC-20 standard utilizes smart contracts to issue tokens that can be exchanged on the Ethereum network as well as used interoperably between Ethereum-based dApps. It is the most commonly used Ethereum token standard, and has been used as a framework to create many notable digital assets.” Extract from cryptopedia

Daily transfer of ERC-20 tokens hit a record high in H1 2021, reflecting growth in the Ethereum network, in particular its use as a base for DeFi. This is also reflected in the exponential growth in value locked in smart contracts on the Ethereum network (Figs 61 and 62). We discuss DeFi dynamics in Chapter 4.

The growth of the Ethereum network has resulted in capacity constraint and surging transaction costs (Fig 63). To improve the scalability of the network, a prerequisite if Ethereum is to take on a bigger real-world role as many in the crypto industry hope, a significant upgrade of the Ethereum network is in progress.

Fig 61: Daily number of ERC-20 tokens transferred on Fig 62: Total value locked in smart contracts on ETC network, 2017 to date Ethereum network, 2017 to date

1,250 100

1,000 80

750 60

500 40

250 in (U$b) locked value Total 20 Numberof tokens transferred (m)

0 0 Jul-18 Jun-21 Oct-16 Sep-19 Feb-19 Dec-17 Apr-20 Dec-20 Dec-19 Dec-18 Dec-17 Aug-15 Nov-20 Apr-21 Apr-20 Apr-19 Apr-18 Mar-16 Aug-20 Aug-19 Aug-18 Aug-17 May-17

* Seven-day moving average Source: DeFi Pulse, Redburn Source: Etherscan, Redburn

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Fig 63: Ethereum – average transaction fees, 2015 to Fig 64: Ethereum, average price for a single unit of gas date on the Ethereum network, 2015 to date

50 450 0.0010

360 0.0008 40

270 0.0006 30 180 0.0004 20 Gwei = 10^-9 Ether 90 0.0002

Average transaction (U$) fee transaction Average 10 0 0.0000

0 Feb-16 Feb-17 Feb-18 Feb-19 Feb-20 Feb-21 Aug-15 Aug-16 Aug-17 Aug-18 Aug-19 Aug-20

Gas price in ETH (lhs) Gas price in $U, rhs Feb-16 Feb-17 Feb-18 Feb-19 Feb-20 Feb-21 Aug-15 Aug-16 Aug-17 Aug-18 Aug-19 Aug-20

Source: Etherscan, Redburn Source: Etherscan, Redburn

Rebooting Ethereum We previously mentioned the blockchain trilemma in the context of Bitcoin and, as discussed above, the situation for Ethereum is near-identical: decentralisation and security of the network is achieved at the cost of scalability. Demand for constrained network resources has led to an unwanted growth in fees (Figs 63 and 64), whilst the popularity of the network has rapidly increased the disk space required to participate in securing the network – in consequence, centralising the network. Ethereum 2.0, or Eth2 or Serenity, is Vitalik Buterin’s solution to these issues, a reboot of the network with improved architecture that sustainably solves the Blockchain trilemma.

The upgrade itself is the launch of several interconnected projects expected to finish in late 2021/early 2022. Scalability improvements will come from: (1) sharding the transaction database and (2) integrating layer-2 solutions, specifically rollups. Sustainability and security are addressed by the same project – a movement from an energy-intensive PoW consensus mechanism towards a more energy-efficient PoS consensus mechanism coordinated by the Beacon Chain. Security improvements will come from a random staking algorithm provided by the Beacon Chain.

The Beacon Chain is the lynchpin of the Ethereum upgrade, responsible for coordinating communication in the sharded database and successfully implementing a PoS consensus mechanism. We discuss these constituent parts of Ethereum 2.0 in more detail in Appendix 3, as well as the hard which will help bridge the current version of Ethereum to Ethereum 2.0.

In Figs 65 and 66, we show the impact on transaction throughput of upgrading the current Ethereum infrastructure to version 2.0. The first column (respectively second

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03/ The crypto landscape

column) shows transaction metrics for the transfer of ether (transfer of ERC-20-based tokens) between two users. Throughout, we assume that (1) each block contains a single type of transaction (either ether- or ERC-20-based token transfers) and (2) each block is maximally filled or, equivalently, the miner is aware of the true gas cost of each transaction in the network and exhausts the entire gas limit of the block. This is optimistic. Indeed, it is unlikely that a block would only contain a single type of transaction and be filled maximally. Nevertheless, the modelling below provides useful insights into the capability of next-generation blockchain networks.

Fig 65: Ethereum 1.0 (current version), theoretical transaction throughput Basic ETH transfer ERC-20 token transfer Gas limit per block 15,000,000 15,000,000 Gas cost per transaction 21,000 *50,000 Transaction ceiling, per block 714 300 Theoretical throughput on Ethereum 1.0 **54 TPS **23 TPS

* The gas cost for transferring ERC-20 tokens is not clear-cut, unlike ETH transfers. Here, we use an estimated average ** Transaction throughput = transaction ceiling, per block/block time, assuming a block time of 13 seconds Source: Redburn, vitalik.ca

The output of Fig 65 is an upper bound for throughput on the current version of Ethereum. If, hypothetically speaking, the network only supported transfers of ether between addresses and a new block was added to the network every 13 seconds, its throughput would be c54 TPS. Expanding network functionality to include ERC-20- based token transactions decreases that number to c23 TPS. For context, the midpoint of c25-55 TPS is some 2.5x higher than the actual average throughput of the network.

In Fig 66, we compute the scalability gained from upgrading to Ethereum 2.0 in two steps. On the one hand, if each block contains the largest possible rollup, and we assume that new blocks are added to the network every 12 seconds, then rollup integration could increase transactions per second on Ethereum by a factor of 100. Instead, consider the increase in network space for new transaction data due to sharding, 60kB/s versus 1,398kB/s. Then, sharding the ledger could increase network throughput 20x. Together, the upgrades in Ethereum 2.0 look to yield a maximum throughput in excess of 100,000 transactions per section.

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Fig 66: Ethereum 2.0, theoretical transaction throughput Basic ETH transfer ERC-20 token transfer Gas limit, per block 15,000,000 15,000,000 Gas cost per ZK rollup *500,000 *500,000 Remaining gas, per block 14,500,000 14,500,000 Gas cost per byte of transaction data 16 16 Transaction data ceiling, per block 906,250 906,250

No. of bytes per transaction included in rollup 12 16 Transaction ceiling, per block 75,520 56,640 Theoretical throughput before sharding **6,293 TPS **4,720TPS

Network space, before sharding (kB/s) 60 60 Network space, after sharding (kB/s) 1,398 1,398 Theoretical throughput after sharding ***146,626TPS ***109,976 TPS

* Here, we use a specific type of rollup for modelling, a ZK rollup, but note that there is another category of rollups called optimistic rollups ** Transaction throughput = transaction ceiling, per block/block time, using an estimated Ethereum 2.0 block time of 12 seconds *** After sharding throughput = before sharding throughput * (network space, after/network space, before) Source: Redburn, vitalik.ca

What is a realistic estimate for potential Ethereum 2.0 throughput? We think the answer is close to 45,000. To get to this number, we combine the spread between actual and estimated throughput from Fig 65 and the bottom line of Fig 66.

Other cryptoassets While Bitcoin and Ethereum dominate the total market capitalisation, there has been a proliferation of other cryptoassets (both altcoins6 and stablecoins). Coinmarketcap currently lists 5,878, (as at 30 July 2021). The top 15 cryptoassets (including Bitcoin and Ethereum) account for c86% of total cryptoasset market cap.

Fig 67 presents an overview of the largest cryptoassets by market cap, and in the section that follows we present short biographies for the sixth largest altcoins (with biographies for another 11 of the largest altcoins set out in Appendix 4.

6 An altcoin is an alternative coin, or any cryptocurrency launched after Bitcoin.

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Fig 67: Overview of the largest cryptoassets, 30 July 2021 Release Consensus Fixed Circulating Mkt cap Platform date Native token Native blockchain mechanism quantity? supply (m) (US$bn) Use case Standalone Bitcoin Jan-2009 Bitcoin Bitcoin PoW Yes (21m) 19 744.5 Ethereum Jul-2015 Ether Ethereum PoW No 117 280.0 Binance Coin Jul-2017 Binance Coin Binance Chain Tendermint (BFT) Yes (c171m) 168 53.4 Dogecoin Dec-2013 Dogecoin Dogecoin PoW No 130,639 26.9 Online gratuity Aug-2017 Bitcoin Cash Bitcoin Cash PoW Yes (21m) 19 10.0 Payments Oct-2011 Litecoin Litecoin PoW Yes (84m) 67 9.4

Asset-backed (Stablecoin) Tether Feb-2015 Tether Bitcoin, Ethereum PoW, ERC-20 No 61,797 61.8 and other and other USD Coin Sep-2018 USD Coin Ethereum ERC-20 No 27,237 27.2 Payments Binance USD Sep-2018 Binance USD Ethereum ERC-20 No 12,253 12.2 Payments Dai Dec-2017 Dai Ethereum ERC-20 No 5,597 5.6 Diem (Libra) n/a Diem Diem (formerly DiemBFT (BFT) No n/a Libra)

Utility token Cardano Oct-2017 Ada Cardano PoS Yes (45,000m) 32,065 41.4 Ripple Jun-2012 XRP RippleNet XRP Ledger Yes 46,312 34.4 Payments (BFT) (100,000m) Polkadot May-2020 Dot Polkadot Relay PoS No 979 14.9 Digital privacy Chain Uniswap Nov-2018 Uni Ethereum ERC-20 Yes (1,000m) 587 11.9 Token trading liquidity Chainlink May-2019 Link Ethereum ERC-677 Yes (1,000m) 442 8.8 Solana Mar-2020 Sol Own blockchain PoH & PoS Yes (489m) 273 8.7 Polygon May-2020 Matic Ethereum Plasma Yes (10,000m) 6,411 6.6 Blockchain Framework & PoS infrastructure Stellar Jul-2014 Lumens Stellar Stellar Consensus Yes 23,374 6.5 Payments Lumens Protocol (c50,002m) Theta Mar-2019 Theta and Ethereum ERC-20 Yes (THETA 1,000 5.9 Video Network TFuel = 1,000m) streaming Internet May-2021 ICP ICP Protocol PoS No 137 5.6 Computer VeChain Jun-2018 VET and VeChainThor PoA & PoS Yes (VET = 64,316 5.4 VTHO c87,000m)

Source: Redburn, various

Binance Coin (standalone coin, market capitalisation US$53.4bn) Binance Coin (BNB) is the native asset on Binance Chain, Binance’s original blockchain, and the newly launched smart contract blockchain, Binance Smart Chain (BSC). Its primary use is analogous to that of arcade machine prize tickets; traders use fiat monies to purchase BNB, which, in turn, is spent on other cryptocurrencies and

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03/ The crypto landscape

transaction fees inside the Binance ecosystem. Incentives to use the coin include significantly lower network fees for smart contracts and sizeable discounts on exchange-related transaction fees.

Cardano (utility coin, market capitalisation US$41.4bn) Cardano, and associated coin Ada, is a purpose-built blockchain aiming to eliminate sustainability, interoperability and scalability issues that burden legacy platforms. Use cases range from education to healthcare, with the common denominator being high degrees of centralisation. The platform is still in development phase and currently Ada’s only use is as a medium of exchange. Notable early project work includes Ourobous Hydra, an off-chain solution that the University of claims can scale the network to over one million transactions per second.

XRP (utility token, market capitalisation US$34.4bn) XRP is the digital token used to facilitate payment settlement, asset exchange and remittance via the Ripple-designed infrastructure RippleNet. The token itself is a placeholder for anything that carries the definition of a unit of value; natural examples include fiat currencies and commodities, less obvious are mobile minutes and air miles. Its clear benefits to financial institutions have helped Ripple gather hundreds of customers including Santander and American Express. Whilst the network is decentralised and uses a distributed consensus mechanism to validate transactions, it does not use blockchain technology. In December 2020 the SEC filed an action against Ripple Labs, alleging the company raised US$1.3bn through an unregistered digital asset security offering. The lawsuit is ongoing.

Dogecoin (standalone coin, market capitalisation US$26.9bn) The joke coin that was created to mock wild cryptocurrency speculation in 2013 has continued to bear fruit, becoming one of the largest cryptocurrencies by market capitalisation in early 2021. By design, it has no differentiating qualities. It has, however, found a use case in online gratuity where coin donations provide a reward for the owners of content on social media platforms such as Twitter and Reddit and Amazon-owned streaming platform Twitch.

Polkadot (utility token, market capitalisation US$14.9bn) Polkadot is an ecosystem of connected blockchains, designed to allow specialised blockchains to communicate, exchange value and share functionality within one network. For example, a permissioned blockchain designed to store an individual’s background information and a blockchain optimised for smart contracts pertaining to job vacancies could communicate directly on Polkadot to automatically trigger an interview request should a job-seeking candidate meet all the requirements. The native currency Dot is used for network governance, the consensus mechanism and fees.

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Uniswap (utility token, market capitalisation US$11.9bn) Uniswap is a decentralised exchange designed as tool for the crypto community to transfer Ethereum-based tokens without fees in addition to those charged by the network or the use of an intermediary. Differentiating the platform is its use of liquidity pools (automated market making via deposits wrapped up in smart contracts) to remove the dependence of volume and consumer interest on token pricing. In return for providing liquidity to the network, users are rewarded with UNI tokens that are used to vote on network development decisions.

Stablecoins Stablecoins are an important subset of the wider cryptocurrency universe, designed with the goal of improving the traditional fiat currency model by using a highly scalable and price-stable system of intangible digital assets as a medium of exchange. Leveraging the benefits of blockchain technology, stablecoins theoretically promise improved transparency, security, immutability and low cross-border fees. Here, price- stability is derived from collateralisation or on-chain mechanisms and stablecoins can typically be categorised in one of four buckets: (1) fiat-collateralised stablecoins; (2) commodity-collateralised stablecoins; (3) crypto-collateralised stablecoins; and (4) non-collateralised stablecoins. We provide basic details for the ten largest stablecoins by market capitalisation in Fig 68.

Fig 68: Major stablecoins listed in order of decreasing market cap Mkt cap Coin Blockchain (US$bn) Collateral Detail Tether Ethereum, 61.8 Fiat 1:1 peg to USD, with deposits held in centralised Tether treasury Bitcoin & others USD Coin Ethereum 27.2 Fiat 1:1 peg to USD, with deposits in decentralised (private) accounts Binance USD Ethereum 12.2 Fiat 1:1 peg to USD, with deposits held by FDIC-insured banks Dai (single) Ethereum 5.6 Crypto Ether is held in a CDO with value of >150% DAI borrowed Dai (multi) Ethereum Crypto Protocol-approved coins are held in a CDO with value of >130-150% DAI borrowed TerraUSD Ethereum 2.0 None On-chain stabilising mechanism involving arbitrage and two coins, UST and LUNA True USD Ethereum 1.3 Fiat 1:1 peg to USD, with deposits held in escrow accounts Paxos Standard Ethereum 0.9 Fiat 1:1 peg to USD, with deposits held by FDIC-insured banks HUSD Ethereum 0.6 Fiat 1:1 peg to USD, with deposits held by FDIC-insured banks

Source: Redburn, CoinMarketCap (30 July 2021), companies

Stablecoins are predominantly backed by fiat currencies with a fixed peg between the coin and the collateralising asset (or basket of assets). In theory, there is a reserve controlled by the parent of the stablecoin that allows the holder to redeem their fiat deposit via a transfer from the reserve and the destruction of the equivalent coin. The structure is simple, allowing for more widespread adoption, and has two main advantages: (1) capital efficiency, since users can buy at scale with the exchange rate pegged at 1:1; and (2) theoretically low default risk, since the underlying fiat currency should be readily available for redemption. Providing the economy (economies) of the country (countries) a stablecoin is backed by remains stable, it is almost certain that

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03/ The crypto landscape

the cryptocurrency will remain stable too. Notable examples include Tether, USD Coin and Binance USD, all of which are backed by the US dollar.

A similar idea governs commodity-collateralised stablecoins, but here the currency basket is replaced by other tangible assets such as oil, real estate and gold. The key point of differentiation is that unlike a basket of fiat currencies, the underlying asset here has real value that may appreciate (although the converse potentially applies as well). The knock-on effect is that it provides an incentive to users to hold these coins as a store of value. Popular examples include Digix Gold (DGX) and Tiberius Coin, where each DGX coin corresponds to 1g of real gold stored in an audited vault in Singapore.

More complicated are crypto-collateralised stablecoins, backed by other cryptocurrencies, primarily ether. Unlike the previous two types of stablecoins, which require a centralised issuer, this category reaps further benefits from being on the blockchain by integrating trustless issuance. To that end, the price volatility risk of cryptocurrencies requires the holder to over-collateralise the asset, limiting growth and exposing a key drawback versus other stablecoin categories. The lynchpin example is Dai, which has a soft peg to the US dollar, is collateralised by 18 approved Ethereum-based assets and has a debt ceiling of 668 million coins. Here, purchasing $100 of Dai requires a deposit of at least $150 of ether, allowing the holder to withstand drawdowns of as much as 50% in the underlying before their holding is automatically liquidated via a smart contract.

A decentralised alternative to crypto-collateralised coins are those that fall under the category of non-collateralised coins. In addition to integrating trustless issuance, these coins remove the need for the holder to post collateral by utilising on-chain mechanisms such as supply adjustment and rebasing to maintain the peg. However, without collateral or liquidity backing the asset, volatility is amplified and a crash in the price of the coin would result in all holders losing their entire investment.

An early appeal of stablecoins was their use as an escape vehicle from high-volatility cryptoassets in the event of a market decline. They provided users with a low-cost method of rapidly converting their holding to a price-stable asset within a single platform. The only alternative to users in this scenario is converting their holding directly to fiat currency, a task that is burdened with fees. Additionally, not all crypto exchanges support the use of fiat currencies to purchase digital assets. These dynamics are evidenced by high levels of volume between the major stablecoins and bitcoin (Fig 69). Fig 70 highlights the exponential growth in the aggregate market capitalisation of the top ten stablecoins.

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Fig 69: Monthly Bitcoin volume traded into fiat or Fig 70: Aggregate market capitalisation of and daily stablecoins, 2018-21 volume traded in ten largest stablecoins, 2015 to date

100% 350 125

80% 280 100

60% 210 75 40% 140 50 20% Volume traded (BTC m) (BTC traded Volume 70 25

0% (U$b) volume daily Aggregate Aggregate market capitalisation (U$b) capitalisation market Aggregate 0 0 Jan-18 Jan-19 Jan-20 Jan-21 Sep-18 Sep-19 Sep-20 May-18 May-19 May-20 May-21

USDT USD EUR JPY KRW Feb-15 Feb-16 Feb-17 Feb-18 Feb-19 Feb-20 Feb-21 Aug-15 Aug-16 Aug-17 Aug-18 Aug-19 Aug-20

USDC GBP AUD TRY PLN Daily volume (lhs) Market capitalisation (rhs)

Source: CryptoCompare, Redburn Source: CoinGecko, Redburn

Stablecoins, however, are not without their faults. Of most concern is the validity of stablecoin reserves, particularly for fiat collateralised stablecoins since reputable auditors are reluctant be involved and there is no standard reporting framework. Even basic tasks such as verifying the existence of digital assets is challenging since by design cryptocurrencies are maintained on a distributed leger without a central authority to consult.

Tether Particular scrutiny has been bought to bear on Tether, the original and most popular stablecoin, which has been the centre of an investigation by the New York Attorney General (NYAG) and is involved in an on-going case led by the US Department of Justice regarding market manipulation. The NYAG concluded that (1) sister exchange Bitfinex and Tether had misled their clients by issuing false statements of assurance that their capital was being safeguarded by a third-party when in fact $850m of it was missing and is likely unrecoverable, and (2) Tether was not fully backed at all times as claimed.

“… starting no later than mid-2017 [note that the stablecoin started trading in February 2015], Tether had no access to banking, anywhere in the world, and so for periods of time held no reserves to back tethers in circulation at the rate of one dollar for every tether, contrary to its representations…”

… On November 1, 2018, Tether publicized another self-proclaimed ‘verification’ of its cash reserve … linked to a letter [from Deltec Bank & Trust Ltd. of the Bahamas] … which stated that tethers were fully backed by cash, at one dollar for every one tether. However, the very next day, on November 2, 2018, Tether began

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to transfer funds … from Tether’s bank accounts to Bitfinex’s accounts. And so, as of November 2, 2018 — one day after their latest ‘verification’ — tethers were again no longer backed one-to-one by U.S. dollars in a Tether bank account.” Extract from New York Attorney General press release, 23 February 2021

In consequence, Bitfinex and Tether were required to pay an $18.5m penalty, to increase reserve transparency and to cease trading activity in New York. Consistent with other major fiat stablecoins, Tether has recently had its claims of being fully backed assured by an international accountancy firm. It has also released further unaudited details on the composition of its reserves shown in Figs 71 and 72.

Whilst Tether has moved away from claiming the stablecoin is entirely backed by cash, purportedly representing c3% of total reserves, its new reserve structure reveals significant counterparty risk and liquidity concerns given that only 24% is locked up in high-quality liquid assets.

Fig 71: Tether reserve breakdown, 31 March Fig 72: Tether cash and cash equivalents 2021 and other breakdown, 31 March 2021

1.64% 2.73% 2.23% 9.96% 2.94%

12.55%

18.36%

49.60%

75.85%

Cash & Cash Equivalents and Other Commercial paper Secured Loans Fiduciary deposits Cash Corporate Bonds, Funds & Precious Metals Reverse repo notes Other Investments (including digital tokens) Treasury bills

Source: Tether, Redburn Source: Tether, Redburn

USD Coin Partly influenced by the factors discussed above, other new fiat-collateralised stablecoins have taken significant market share from Tether over the past few years (Fig 73). The largest gainer is USD Coin (USDC), which currently represents c20% of the market. USDC’s technology and IP is owned by , a blockchain-focused payment company, and governance is managed by CENTRE Consortium. Like other stablecoins, USDC tokenises its collateralising asset (the US dollar) to provide a low-cost on/off ramp for blockchain transactions and to facilitate fiat currency cross-border.

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Fig 73: Stablecoin market share split by market cap, January 2018 to July 2021

100%

80%

60%

40%

20%

0% Jul-21 Jul-20 Jul-19 Jul-18 Jan-21 Jan-20 Jan-19 Jan-18 Sep-20 Sep-19 Sep-18 Nov-20 Nov-19 Nov-18 Mar-21 Mar-20 Mar-19 Mar-18 May-21 May-20 May-19 May-18

USDT USDC BUSD DAI UST TUSD PAX LUSD HUSD FEI

Source: CoinGecko, Redburn

To date, c830 billion USD Coins have been transferred on-chain, of which transactions YTD represent c80% or c660 billion USD Coins, and total value in circulation is now c$27bn. Given the reserve question that dogs stablecoins, Circle publishes a monthly reserve account report that is independently reviewed. An overview of the reserves backing USDC’s US$22.2bn of issued coins at May 2021 is shown in Fig 74. On 8 July 2021, Circle announced an intention to IPO via a SPAC with Concord Acquisition Corp in a transaction that values Circle at US$4.5bn; the company is looking to rapidly grow account numbers and revenue (Fig 75). Coinbase holds a relationship with Circle, having a 50% interest in the Circle Consortium LLC (having been a founding member of the Circle consortium) and it also acts as the principal reseller of USDC.

Fig 75: Circle – account number and revenue forecasts, Fig 74: USDC reserve breakdown, May 2021 2021E-23E US$bn Allocation 2021E 2022E 2023E Cash & Cash Equivalents 13.4 61% Circle accounts 2,786 10,028 30,084 Yankee CDs 2.9 13% US treasuries 2.7 12% Circle revenue (US$m) 115 407 886 Commercial Paper 2.0 9% Of which: USDC income share and 19 56 108 Corporate Bonds 1.1 5% transaction costs (US$m) Muni Bonds & US Agencies 0.1 0.2% Total 22.2 100% Adjusted EBITDA (US$m) (76) (97) 76

Source: Circle Source: Circle Internet Financial Investor Presentation, June 2021

Given growth dynamics, over time we expect greater regulation to be wrapped around stablecoins, particularly if their popularity continues to expand. A recent Bank of England discussion paper provides a view of different possible future regulatory models for stablecoins (Fig 76). Greater regulatory certainty around stablecoin

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03/ The crypto landscape

structures could be an important factor in helping this segment of the crypto market become more mainstream, although we expect regulatory attitudes to stablecoins to vary from country to country.

Fig 76: Possible regulatory models for stablecoins Level of prudential regulation increases Restrictions on backing assets increase Stablecoins

Regulatory model

Bank model HQLA model CBL model DB model

Backing assets

Broad range of backing assets Narrower range of backing Funds placed in reserve at Funds placed in trust at including loans, HQLA and assets, including HQLA and central banks commercial bank(s) reserves reserves

Relationship with central bank No reserves (from stablecoins) Partially reserve-backed Fully reserve-backed custody bank is partially reserve-backed Access to contingent liquidity Indirect access to contingent Access to contingent liquidity not required liquidity via custody bank

Bank of England

Source: Bank of England

The emerging crypto infrastructure Fig 77 provides a conceptual mapping of the cryptoasset ecosystem and its intersect with mainstream financial markets. Each cryptoasset (such as those discussed in the preceding section) operates its own local ecosystem, a very simplified representation of Bitcoin and Ethereum also shown in Fig 77. These single-asset ecosystems will typically intersect with other ecosystems via gateways – crypto exchanges are the most widely used mechanism to facilitate this. The on-off ramps into the broader cryptoasset ecosystem are dominated by crypto-exchanges (e.g. Coinbase, Binance, Kraken), with certain payment service providers (e.g. PayPal, Square) also starting to facilitate this.

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03/ The crypto landscape

Fig 77: Conceptual mapping of monetary flows into and around crypto ecosystem

Cryptoasset ecosystem

Bitcoin Exchanges Ecosystem Crypto-only Ethereum Exchanges Ecosystem

Investors dApps/ ICOs

Miners Miners

Users Storage Providers

Multi- segment

Consumers Payment Service Providers Merchants Businesses

Fiat gateways Cryptoasset gateways Cryptoasset users

On/off-ramps

Source: CCAF (Cambridge Centre for Alternative Finance)

To support the operations, both individual as well as the broader crypto ecosystem, a broad crypto market infrastructure has developed in recent years (Fig 78). In terms of construct, it exhibits a strong resemblance to the wider global capital market infrastructure (Fig 79).

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03/ The crypto landscape

Fig 78: Crypto capital markets infrastructure

Pre-trade Trading Post-trade

Data & Analytics Exchange (centralised) - Spot -Coinbase -CoinMarketCap Clearing & Settlement -Binance - Cryptocompare -ErisX -Skew Exchange (centralised) - Derivative -Arwen -CME Indices -Binance - Solactive/CoinMarketCap Investor - Bloomberg/Galaxy Exchanges (decentralised) Investor Custody -Uniswap -Paxos Research Lending -Coinbase - Investment banks -Genesis - Boutique providers

Technology services (Fireblocks)

Regulatory and compliance services (Chainalysis)

Prime brokerage (Coinbase Prime; Galaxy Digital)

Interface with payment rails (Silvergate, Clearbank)

Source: Redburn

Fig 79: Capital markets infrastructure

Pre-trade Trading Post-trade

Data & Analyics Exchange Clearing & Settlement -Bloomberg -CME -LCH - Refinitiv -ICE -OCC -Factset -HKEX -DTCC

Indices Custody OTC -S&P - Clearstream - Investment banks

Investor -MSCI -Euroclear Investor - Interdealer brokers -FTSERussell -DTCC

Research Platforms Data -Investment banks -Tradeweb - Trading venues - Boutique providers -MarketAxess

Technology services (e.g. OMS / EMS)

Regulatory and compliance services

Prime brokerage

Interface with payment rails

Source: Redburn

Use cases and institutional engagement Despite the extremely rapid growth in value of cryptoassets in recent years, it remains to a large extent a self-contained universe with still limited connectivity to the traditional finance industry and a limited number of real-world use cases. The largest potential opportunity for the crypto industry is whether it can disrupt or exert a material influence on the global financial services industry.

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03/ The crypto landscape

We estimate financial services accounts for c6.6% of global GDP, or cUS$5.6trn based on 2020 global GDP estimates (Fig 80), underscoring the potential for this industry if it can achieve greater real-world adoption.

Fig 80: Financial services as a % of GDP, 2011-19

9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 2011 2012 2013 2014 2015 2016 2017 2018 2019

Global US China

Source: Redburn, OECD, IMF

Interest in the cryptoasset arena has to date been largely retail-led, with uncertainty around regulation and volatility of this new asset class (Fig 81) acting as barriers to institutional and corporate adoption. Over the past year this has started to change materially. Hedge funds, high net worth individuals (HNWI) and family offices, most of whom have more investment flexibility than mainstream institutions (e.g. pension funds), have started to deploy funds in the cryptoasset arena and have indicated a willingness to grow this (Figs 82 and 83), even though the concerns that pervade this arena remain (Fig 84).

More mainstream institutional adoption of cryptoassets will take longer, with key influences being regulation and strengthening of infrastructure around this asset class. In this regard, the banking, particularly the investment banking, sector will play a role. Analysis here suggests product offerings are starting to be developed, particularly by the largest US investment banks (Fig 85).

Beyond considerations around crypto as an asset class, a more interesting (and much broader) debate is whether it represents a potentially new way of constructing a financial system. We discuss this in the next section on DeFi.

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Fig 82: Hedge funds – % of cash holdings expected to be Fig 81: Bitcoin and Ether volatility vs other assets*** stored in cryptocurrency

90 2% 2% 3% 80 11% 14% 70

60

50

40 33% 35% 30

20

10 Over 20% 11%-20% 6%-10% 3%-5% 0 Ether Bitcoin Oil** Silver S&P500 Gold DXY*** 1%-2% Up to 1% None

* Average of 30-day volatility from January 2015 (March 2018 for Ether) Source: Intertrust Group ** WTI *** US Dollar Index Source: Bloomberg, Redburn

Fig 83: US financial advisors – plans to allocate crypto Fig 84: US financial advisors – issues with increasing or to client accounts in 2021 making first allocation to cryptoassets* 2021 survey 2020 survey 2% Regulatory concerns 54% 56%

15% Too volatile 39% 43% 15% No idea how to value 36% 41% cryptocurrencies Lack of easily accessible investment 37% 39% vehicles (e.g. ETFs) 28% Custody concerns/fear of hacks 30% 34%

40%

Definitely yes Probably yes Unsure Probably not Definitely not

Source: Bitwise Investments * Response to question: What is preventing you from either increasing your investment in cryptoassets or making your first allocation? (top five issues raised shown) Source: Bitwise Investments

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Fig 85: Investment banks – offerings of crypto services Crypto products for Crypto custody wealth clients Crypto futures trading Crypto spot trading accounts JP Morgan Goldman Sachs Morgan Stanley Citigroup Bank of America Credit Suisse Deutsche Bank BNP Paribas HSBC UBS Note: yellow = yes; black = no; grey = considering Source: Bloomberg (18 June 2021)

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04/ DeFi

DeFi

Potentially the greatest opportunity for the crypto movement lies in the area of Decentralised Finance (DeFi), which envisages a world of finance shorn of centralised intermediaries. With financial services accounting for c7% of global GDP and built on a centralised model, the prize for any shift in finance towards a decentralised model is enormous. DeFi has seen exponential growth over the past year, albeit largely within the confines of the crypto industry. Use cases are being made and the pace of innovation is extremely high, but execution is likely to be fraught with real-world complexity.

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04/ DeFi

An overview One of the areas in the crypto arena that has experienced the most rapid growth and highest level of interest over the past two years is Decentralised Finance (DeFi).

“DeFi is a general term for decentralized applications (Dapps) providing financial services on a blockchain settlement layer, including payments, lending, trading, investments, insurance, and asset management. DeFi services typically operate without centralized intermediaries or institutions and use open protocols that allow services to be programmatically combined in flexible ways.” Extract from DeFi Beyond the Hype, Wharton

Given the value (c7% of global GDP) that accrues annually to the global financial services industry, which itself is built on a centralised model, the appeal of DeFi as an alternative opportunity from a business, financial and, to many, a philosophical perspective is clear. DeFi and definitions around it are still at an early stage of development. Given often conflicting explanations and definitions, Fig 86 provides a framework for considering what constitutes a DeFi service.

Fig 86: Distinguishing characteristics of DeFi

Directly mediates the transfer of value? Auxiliary (e.g. price oracles) or no Non financial (e.g. distributed storage) yes service

Settlement on a public blockchain? no Traditional finance (e.g. banking) yes

Assets cannot be unilaterally expropriated/moved Custodial service (e.g. fiat-backed by third parties? no stablecoins) yes

Open source code and application programming interface (API)? no Private service or standalone digital asset yes

DeFi service Source: Wharton Blockchain & Digital Asset Project (University of Pennsylvania), World Economic Forum

DeFi aligns with the concept of the Web 3.0 (originally termed the Semantic Web by Tim Berners-Lee, inventor of the Web). The Web 2.0 saw the rise of the ‘Web as a Platform’ fuelled by mobile, social and cloud dynamics; a key feature of this iteration of the Web is a heavy level of centralisation. Web 3.0 is expected to be built on new technology innovations: edge computing, decentralised data networks and artificial intelligence. Critically, it envisages the individual as a sovereign on the Web operating in a decentralised manner with a much-reduced need for third parties (Fig 87).

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04/ DeFi

Fig 87: The second inning of tech decentralisation

App explosion Trigger, iPhone, Apps

High Android, SaaS

App & data decentralisation Trigger, AI, Distributed Ledger Apps Technology (DLT), Blockchain, Smart Contracts, Bitcoin, GS

Initial internet Data Apps Data

decentralisation Data concentration Scale and impact of App Data Trigger, Cloud computing, Trust IaaS, Visualization, AI/ML AI AI AI AI AI Apps/data 1 2 3 ... 1Google 5Tencent 2 Facebook 6 Alibaba Data 3 Amazon 7 Microsoft 4 Apple 8 ... Today Low

Web 1.0 Web 2.0 Web 3.0 Birth: 2004 Birth: 2004-2020 2008-

Source: Philipp Stauffer, FYRFLY Venture Partners

However, the realty within financial systems is that there are host of trade-offs between running a decentralised network versus a centralised network (Fig 88). While the benefits of decentralised networks include lowering economic rents and avoiding single points of failure (the cost of which was amply demonstrated in the global financial crisis), they face issues in critical areas such as security and scalability. A more detailed contrast of Centralised Finance (CeFi) versus DeFi is set out in Fig 89.

Fig 88: Framework for comparing costs and trade-offs of centralised and decentralised networks

Decentralised Centralised

Source: MIT, Coase

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04/ DeFi

Fig 89: Comparing Traditional Finance to DeFi Traditional Finance DeFi Custody of assets Held by a regulated service provider or custodian on Held directly by users in non-custodial wallets or via asset owners’ behalf smart contract-based escrow Units of account Typically denominated in fiat currency Denominated in digital assets or stablecoins (which may themselves be denominated in fiat money) Execution Intermediaries typically process transactions between Via smart contracts operating on the user’s assets parties Clearing and settlement Processed by service providers or clearinghouses, Writing transactions to the underlying blockchain typically after a period of time completes the settlement process Governance Specified by the rules of the service provider, Managed by protocol developers or determined by marketplace, regulator and/or self-regulatory users holding tokens granting voting rights organisation Auditability Authorised third-party audits of proprietary code or Open-source code and public ledger allow auditors to potential for opensource code that is publicly verified verify protocols and activity Collateral Requirements Transactions may involve no collateral, or collateral less Over-collateralisation generally required, due to digital than or equal to the funds provided asset volatility and absence of credit scoring Cross-service Interaction Limited. Movement toward Open Finance via Any service may integrate with any other service on the application programming interfaces or dedicated same blockchain, and potentially across chains intermediaries Access and Privacy Identity checks conducted by service providers. Identity verification requirements under discussion by Personal data subject to national privacy laws anti-money-laundering regulators. User balances and transaction activity are generally public Security Vulnerable to hacks and data breaches in software Vulnerable to hacks and other technical and operational systems controlling assets risks of smart contracts Investor Protection Government-mandated disclosure and consumer Users assume all risks as a default, although private protections, anti-fraud enforcement, exposure limits, redress arrangements such as DeFi insurance offer and insurance schemes some protection against losses

Source: Wharton Blockchain & Digital Asset Project (University of Pennsylvania), World Economic Forum

The current status An overview of the Defi stack is set out in Fig 90, while Fig 91 presents a view of major participants in different segments. The majority of Defi services are currently built on the Ethereum network, although other networks are being used, some in the crypto industry pointing to Solana as particularly promising network.

Fig 92 shows the recent evolution of the level of value locked in the DeFi universe. It has grown exponentially over the past year, reflecting an intense level of interest in DeFi and its potential applications as well as inflation in the value of the underlying currency (ether), with the vast majority of this value locked in the Ethereum network (Figs 93 and 94).

However, DeFi is still in its infancy in terms of its development and primarily is focused on serving the crypto markets. Linkage and applicability to the mainstream financial systems are in a nascent state and it is in this area where DeFi has to prove itself, a dynamic many in the crypto industry acknowledge.

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04/ DeFi

Fig 90: The DeFi stack

User-centric platforms that connect to several applications and protocols. They usually provide tools to compare and rate services, allowing users to easily perform otherwise complex tasks by connecting to several Aggregation protocols simultaneously Develop tools and other non-end user Layer facing protocols designed to facilitate interoperability. Allows the native Yield Aggregators Multi-Protocol Interfaces Non-Custodial Wallets blockchain’s DeFi ecosystem to trustlessly interact with external assets and information Applications and interfaces for specific use-cases, usually implemented as a set of smart contracts Borrowing and Derivatives and Price oracles Insurance Application Lending Synthetics Layer … Decentralised Relayer networks Interoperability Prediction Markets Payments exchanges Facilitators Asset Tokenisation Services Tokens issued on top of the settlement layer, including the native asset and those based on token standards supported by the blockchain Asset Wrapper Services Asset Fungible token: Non-fungible ETH Layer ERC-20 token: ERC-271 Cross-Chain Bridges … Tokenised Real- Wrapped Assets Stablecoins World Assets KYC & Identity

… Allows the network to securely store ownership information and ensures that any state changes adhere to the Settlement network’s rule set. The foundation for trustless execution and a settlement and dispute resolution layer Layer Ethereum Network Bitcoin Network …

Source: BCG, Fabian Schar, crypto.com

Fig 91: DeFi Stack – product and application view

Source: StakingRewards

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Fig 92: Total value locked in smart contracts on Fig 93: Total value locked in DeFi by product area, Ethereum network, 2017 to date January 2020 to date

100 100

80 80 60

60 40 20

40 in (U$b) locked value Total 0 Total value locked in (U$b) in locked value Total Jul-20 Jul-21 Jan-20 Jan-21 Sep-20 Nov-20 Mar-20 20 Mar-21 May-20 May-21

Lending Decentralised Exchanges 0 Derivatives Payments Assets Dec-20 Dec-19 Dec-18 Dec-17 Apr-21 Apr-20 Apr-19 Apr-18 Aug-20 Aug-19 Aug-18 Aug-17

Source: DeFi Pulse, Redburn Source: DeFi Pulse, Redburn

Fig 94: Number of new DApps added per month, by platform, 2015 to date

175 4,000

140 3,200

105 2,400

70 1,600

35 800 No. new DApps added per month per added DApps new No. 0 0 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19 Dec-20 Apr-15 Apr-16 Apr-17 Apr-18 Apr-19 Apr-20 Apr-21 Aug-15 Aug-16 Aug-17 Aug-18 Aug-19 Aug-20

Ethereum platform (lhs) Other platforms (lhs) Total DApps (rhs)

Source: State of the DApps, Redburn

While DeFi purists may have a vision of a completely decentralised world of finance, there is a high degree of dependence on other market participants, with centralised characteristics as highlighted in Fig 95. Additionally, while potentially solving for problems in CeFi and lowering value transfer costs, Defi itself creates new financial risks, for example, operational risks stemming from underlying blockchains and smart contract-based vulnerabilities.

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Fig 95: DeFi protocols – map of interconnected risks Administration, governance, development, bug fixes Banks holding stablecoin reserves from tokenholder DAOs, foundations, or corporates

Depend on Depend on

Stablecoins/stablecoin issuers DeFi Applications

Run on Rely on

Miners/validators Arrange transactions into blocks

Public blockchains

Depend partially on

Human oversight, governance, periodic Grey: decentralised, blockchain based intervention Yellow: centralised

Source: DeFi Protocol Risks: The Paradox of DeFi (Carter/Jeng)

The opportunity Fig 96 shows the potential addressable market size for DeFi in 2030 if value starts to leak from the traditional finance sector towards DeFi. While any shift will be messy and is unlikely to be linear, it underscores that the prize for any shift in finance towards a decentralised model is enormous.

Fig 96: DeFi addressable market assuming share shift from mainstream finance markets, 2030E* U$ bn 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 5% 10% 15% 20% Quantum of shift from CeFi to DeFi

* Based on 2030E global GDP and assumes financial services account for 6.6% of global GDP (i.e. consistent with current levels) Source: Redburn, OECD, IMF

In the sections that follow, we examine the potential opportunity DeFi presents in several major financial sectors: payments, credit and exchanges.

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04/ DeFi

Payments Payment is frequently cited as one of the segments of financial markets carrying the richest opportunity for disruption. Globally it is estimated that fees earned by payment intermediaries equate to somewhere between 0.5% and 1.0% of global GDP.

The highly complex payments system, which extracts sizeable fees and which historically was bank-dominated, is already going through a period of profound change as technology-led payment-focused businesses (such as PayPal, Adyen, Alipay and Klarna) disrupt the industry (Fig 97). Please refer to Redburn’s report, ‘Payments: Trust the Processors’ (12 March 2021, Fahed Kunwar and Chris Hartley) for an in-depth analysis of this market.

Fig 97: An overview of the payment process, participants and economics

Customer Merchant Acquirer Network Issuer

Digital Wallet Payment Method Gateway Processing Acquiring Data Transfer Card Issuing Issuer Processing

PROCESS

Authorisation 1) Customer presents card (physically 2) Merchant transfers data to acquirer 3) Acquirer performs risk mgmt. and 4) Network transfers data to relevant process begins via NFC / QR code, or online) via gateway transfers data to network issuer

Authorisation 8) Merchant provides customer with 7) Acquirer forwards authorisation to 6) Network forwards authorisation to 5) Issuer checks customer account and process ends payment confirmation the merchant the acquirer provides authorisation to network

Flow of funds Settlement initiated daily Merchant 97.5- Customer initiated in Flow of funds during settlement process 100% by merchant Account 99% Account turn by issuer

PARTICIPANTS

Nexi / Worldline / Adyen / Barclays / JP Morgan / WorldPay / First Data / Apple Pay Global Payments Visa / Mastercard Nexi / Worldline

Klarna / Paypal / Square Domestic Networks Banks Alipay

ECONOMICS Merchant 97.5-99% Processing Fee 25-100bps Network Fee 50bps Interchange Fee 25-100bps

The merchant retains 97.5- Charged by the acquirer for enabling the merchant to accept payments via a Charged by the network for Charged by the issuer for taking 99% of total spend. variety of payment methods, providing the merchant with access to a transferring data between on the of the customer. physical or online gateway, providing the merchant with the technological the acquirer and the issuer. capability to process the payment, performing risk management and taking on the credit risk of the merchant, and in the case of card payments for transferring transaction data to the relevant card network.

Source: Redburn

DeFi holds the promise of imposing additional disruption and cost pressure on the payment industry. Fig 98 shows a simplified version of the current payment value chain versus what is could look like in a DeFi world with much lower costs.

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Fig 98: CeFi vs DeFi payments value chain

Pays $100 gets Pays $100 in $0.2 rewards (e.g.) LTC $0.2 Retains interchange Consumer rewards Consumer

Buys goods or $0.1 Buys goods or services scheme services Issuing fee Retains services $1.2 Charges fees $1.5 to issuer and Goods and Goods and acquirer services services interchange Network Validator fee services nodes Retains Retains $0.02-003 Retains $0.2 in network fees $0.4 $0.1 scheme Provides goods or Acquiring fee Provides goods or services services Earns services markup $2 merchant service fee Merchant Merchant Receives $99.98 in Receives $98.00 LTC

Source: BCG, Crypto.com

This view is highly theoretical and there are a large number of technical, commercial and regulatory obstacles to achieving it. Existing payments systems are already highly efficient, there is already considerable innovation within the payment environment and regulators are mindful of the systemic important of payment rails.

The area we argue is most likely to see efforts to apply DeFi principles is cross-border payments, particularly remittances, a segment of the payment universe characterised by elevated fees, a social imperative to improve and an area where regulators openly acknowledge broader system inefficiencies.

Credit Credit is another area cited as ripe for potential disruption; the opportunity here is principally the spread generated by the banking system. Fig 99 shows hypothetically what a Defi credit arrangement could look like, one of the critical benefits of the Defi credit arrangement being the minimal ongoing costs once the borrowing/lending contract is established as it is completely automated.

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Fig 99: CeFi vs DeFi lending value chain

Requests a Requests a loan Borrower loan Borrower

Interest 4.02% Loan Interest 2.9% Loan and network fees Collateral $6-14

Risk Service Provides a scoring fees Interest rate pass-through: 20-30% loan 0.2% Bank Credit Validator Protocol assessment Service Gover- governance fees nodes nance Provides risk Deposit/ Provides services governance equity/ Interest 0.5% Deposit Interest 3.82% bonds

Makes a Makes a Liquidity deposit deposit provider Investor /lender

Source: BCG, Crypto.com

Basic DeFi credit protocols have formed. For example, Compound is a protocol that allows users to lend or borrow from a pool of assets in a smart contract; interest rates are determined algorithmically and based on supply and demand. A limited amount of outstanding borrow is held by the protocol to incentivise governance.

However, applicability and use are anchored in the crypto universe with little real- world connectivity at present. As with payments, there are a large number of technical, commercial and regulatory obstacles to moving mechanisms that operate in the crypto universe into the real world at scale. For example, at present DeFi lending is usually backed by digital asset collateral, with over-collateralisation a feature (in part reflecting cryptoasset price volatility). The ability of a system built on this basis to, for example, extend uncollateralised consumer loans is unclear.

Exchanges/brokerage Brokerage and exchanges could also see disruption in multiple areas, ranging from trading to clearing. Fig 100 shows differences in the construct of a centralised versus a decentralised exchange value chain. Recognition of the potential technology changes pending has been evidenced by various exchanges looking to apply DLT to parts of their operations (e.g. the Australian Stock Exchange is planning to use this technology as part of the overhaul of its equities clearing and settlement system).

Crypto exchange Binance started offering tokens for trading certain listed companies (including Apple and Microsoft), perhaps offering a glimpse of what a tokenised exchange future could look like. This particular initiative is in the process of being closed after it attracted considerable regulatory ire about encroachment into regulated securities markets, underscoring a degree of real-world complexity that crypto purists

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04/ DeFi

arguably overlook. However, the idea encapsulated around a concept like security tokenisation is unlikely to disappear.

Fig 100: CeFi vs DeFi exchanges value chain

Pays $100 Gets $97 Pays $100, gets $99.50 0.5% taxation Retains fees interchange Investor Investor $1 fee Buys $100 in Estimated Clearing Buys 1 ETH Decentralised $0.5 house network Apple shares with 100 DAI exchange fees (fixed) Retains Broker $2

Ownership DAI ETH Exchange Validator nodes Retains Retains $ $2 $1 fee Estimated Sells $100 in Sells 1 ETH Apple shares Broker for 100 DAI Earns Blockchain markup Registry $3 service fee Liquidity Investor Sells $100, gets $97 provider Pays $99.50, gets $99.50

Source: BCG, Crypto.com

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05/ Crypto exchanges

Crypto exchanges

Crypto exchanges have been among the prime beneficiaries of the growth in interest in crypto markets in recent years, profiting from rising volumes and cryptoasset prices. Historically dominated by spot markets, the past two years have brought explosive growth in derivative markets, which industry data suggest now exceed spot markets in volume. Lacking the strict regulation of the mainstream exchange operators, questions exist about the veracity of data from some venues; this view is underscored by industry surveys showing there is considerable variation in the quality of exchanges.

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Spot and derivative markets Fig 101 presents an overview of crypto exchange volume evolution over the past three years. We highlight that the term ‘exchange’ in crypto markets is somewhat misleading, as typically these businesses play a much broader role than that associated with exchanges in mainstream capital markets. In crypto markets, many of the largest businesses act not only as exchanges but also broker dealers, market-makers, custodial business and data providers.

Growth has been exceptionally strong, reflecting growth in underlying volumes fuelled by rising investor interest as well as strong appreciation in the price of cryptoassets. One notable trend has been the much more rapid growth of derivatives volumes relative to spot volumes. This rapid growth reflects the roll-out of new derivative products, new venues listing derivative products and growing institutional interest.

Fig 101: Crypto exchange volumes (spot and derivative), November 2018-June 2021

12,500 90%

10,000 78%

7,500 66%

5,000 54%

2,500 42% Monthly volume traded (U$b) traded volume Monthly

0 30% Jul-19 Jul-20 Jan-19 Jan-20 Jan-21 Sep-19 Sep-20 Nov-18 Nov-19 Nov-20 Mar-19 Mar-20 Mar-21 May-19 May-20 May-21

Derivatives Spot % spot

Source: CryptoCompare

In contrast to heavily regulated trading venues such as traditional stock exchanges, crypto exchanges are largely unregulated and largely privately owned, complicating the assessment of the relative volume performance. Wash trading (where an investor simultaneously buys and sells the same financial instrument, thereby artificially inflating volume) is a particular issue, with both academic research and submissions to regulators by market participants highlighting this. We would expect issues such as this to be resolved as regulation around the crypto industry becomes more formalised. Fig 102 shows on-chain volume for Bitcoin and Ethereum, which we overlay against aggregate exchange volumes, as the trends are directionally very similar.

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05/ Crypto exchanges

Fig 102: Top tier exchange volume compares to Bitcoin + Ethereum on-chain volumes, November 2018-June 2021

4,200 1,200

3,500 1,000

2,800 800

2,100 600

1,400 400

700 200

0 0 Jul-19 Jul-20 Jan-19 Jan-20 Jan-21 Sep-19 Sep-20 Nov-18 Nov-19 Nov-20 Mar-19 Mar-20 Mar-21 May-19 May-20 May-21

Top-tier exchange vol. (U$b, lhs) BTC +ETH on-chain vol. (U$b, rhs)

Source: CryptoCompare, Coin Metrics, Redburn

Fig 103 shows the evolution of spot volume handle by the largest crypto exchanges, the rapid growth in cryptoasset values fuelling the rise in activity with April and May 2021 the highest on record.

Fig 103: Top tier exchanges – monthly spot volume, November 2018-June 2021

3,000

2,400

1,800

1,200

600 Monthly volume traded (U$b) traded volume Monthly 0 Jul-19 Jul-20 Jan-19 Jan-20 Jan-21 Sep-19 Sep-20 Nov-18 Nov-19 Nov-20 Mar-19 Mar-20 Mar-21 May-19 May-20 May-21

Binance Coinbase Bitfinex OKEx Huobi Global Bitstamp BeQuant Kraken LMAX Digital

Source: CryptoCompare

Fig 104 shows volume of the major exchanges in the crypto . Reflecting the growth in volumes, has also expanded, hitting a record high in April 2021 before falling back in May and June.

The dominant derivative product in crypto markets is perpetual futures contracts. These futures are cash settled and differ from regular futures in that they lack a

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05/ Crypto exchanges

pre-specified delivery date and can therefore be held indefinitely without the need to roll over contracts as they approach . While terms differ across exchanges, this market is often characterised by very high levels of leverage. Data from Bitcoin Futures Info, based on the breakdown of open interest at 16 July 2021, show that approximately 62% of Bitcoin open interest was in perpetual futures contracts.

The largest open interest in more regular Bitcoin futures is on CME Group, which, in contrast to most crypto exchanges, is heavily regulated as the world’s largest futures and options exchange. Figs 106 and 107 show the progression of volume and open interest respectively of the major crypto futures contracts listed on CME since their introduction on the exchange. The trends broadly mirror those of wider market. CME, however, applies by crypto standards strict margin requirements, disclosing on the Q1 2021 call that an initial margin of 38% is required for Bitcoin and micro-Bitcoin futures.

Fig 104: Exchanges – monthly crypto derivative volume, Fig 105: Exchanges – crypto open interest, October November 2018-June 2021 2020-June 2021

6,000 40

4,800 32

3,600 24

2,400 16

1,200 (U$b) Open interest 8

Monthly volume traded (U$b) traded volume Monthly 0 0 Jan-21 Jun-21 Oct-20 Feb-19 Feb-20 Feb-21 Feb-21 Dec-20 Apr-21 Nov-18 Aug-19 Nov-19 Aug-20 Nov-20 Nov-20 Mar-21 May-19 May-20 May-21 May-21

Binance Huobi Global Deribit Binance Huobi Global Bybit BitMEX OKEx FTX OKEx CME BitMEX CME bitFlyer Bybit Deribit Kraken

Source: CryptoCompare Source: CryptoCompare

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05/ Crypto exchanges

Fig 106: CME Group – Bitcoin and Ethereum futures Fig 107: CME Group – Bitcoin and Ethereum open trading volumes, May 2018-June 2021 interest, May 2018-June 2021

40,000 60,000

32,000 48,000

24,000 36,000

16,000 24,000 (contracts) 8,000 12,000 Open interest (contracts)

0 0 Monthly average daily traded volume Jul-18 Jul-18 Jul-19 Jul-19 Jul-20 Jul-20 Jan-19 Jan-19 Jan-20 Jan-20 Jan-21 Jan-21 Sep-18 Sep-18 Sep-19 Sep-19 Sep-20 Sep-20 Nov-18 Nov-18 Nov-19 Nov-19 Nov-20 Nov-20 Mar-19 Mar-19 Mar-20 Mar-20 Mar-21 Mar-21 May-18 May-18 May-19 May-19 May-20 May-20 May-21 May-21

Bitcoin Futures Ethereum Futures Bitcoin Futures Ethereum Futures Micro Bitcoin Futures Micro Bitcoin Futures

Source: CME Group Source: CME Group

Exchange rankings At discussed earlier in this report, there is limited regulation around the cryptoasset industry. Industry data provider CryptoCompare undertakes a periodic review of over 160 crypto exchanges on a variety of metrics, ranging from know your customer (KYC) through market quality. Fig 108 shows a summary of results for the ten exchanges that screened best in the most recent survey, published in February 2021.

Fig 108: Exchange rankings (top ten) – February 2021 KYC/ Quality/ transaction diversity Legal/ Data Team/ Negative Market Exchange risk of assets regulation provision Security exchange reports quality Total Coinbase 13.3 4.8 12.9 8.8 15.0 13.7 0.0 17.0 85.3 Gemini 15.0 4.5 12.5 10.6 13.8 12.1 0.0 14.4 82.9 Bitstamp 15.0 4.3 11.4 10.3 11.8 12.3 0.0 15.4 80.5 Kraken 9.9 4.8 11.4 10.6 10.9 13.7 0.0 14.6 75.9 itBit 13.3 4.0 10.7 10.6 10.7 14.7 0.0 11.6 75.6 Luno 9.9 4.0 11.8 11.1 12.0 12.6 0.0 14.0 75.4 Liquid 13.3 3.5 13.6 11.1 4.3 13.9 0.0 14.0 73.8 Cex.io 11.1 4.8 10.4 10.6 12.5 11.0 0.0 13.2 73.5 LMAX Digital 13.3 4.0 11.4 10.3 10.7 11.0 0.0 12.4 73.1 Bitfinex 13.6 3.5 9.6 11.4 7.1 10.7 0.0 15.6 71.6

Source: CryptoCompare

Pricing from the top five exchanges based on this ranking are used as inputs to CME’s regulated Bitcoin and Ether contracts.

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“CME CF Crypto Currencies Indices have been generating BRR and BRTI rates since November 2016 with several bitcoin exchanges and trading platforms providing pricing data, including Bitstamp, Coinbase, Gemini, itBit, and Kraken. Both the BRR and BRTI are registered benchmarks under the European Benchmarks Regulation (EU BMR).” CME Group

“CME CF Ether-Dollar Reference Rate & CME CF Ether-Dollar Real-Time Index. Ether is based on formidable blockchain technology and the CME CF Ether- Dollar rates will provide a standardized reference rate and spot price index to bring confidence to any trading strategy. Major cryptocurrency exchanges Bitstamp, Coinbase, Gemini, itBit, and Kraken provide the pricing data to bring our dependable and regulated rates to the market.” CME Group

In Chapter 6, we examine the investment case around Coinbase, which obtained the highest score in the above ranking.

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06/ Coinbase

Coinbase

Coinbase is a leading global crypto exchange, a top five player in volume terms on spot markets, and it holds over 10% of global cryptoassets on its platform. In addition to gearing to crypto industry expansion, the company has a multitude of growth opportunities – geographic, asset and service/product based. Coinbase is well positioned to deal with a more demanding regulatory environment. Concerns exist around the sustainability of retail transaction margins; however, our analysis underscores a variety of factors that support this. We start coverage with a Buy rating.

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Overview Coinbase was founded in 2012 with the idea of making investment in and holding of Bitcoin simple and easy. Brian Armstrong, Chairman and CEO, had initially teamed up with Ben Reeves (who founded blockchain.com); however, that partnership dissolved. Armstrong subsequently partnered with Fred Ehrsam to build up Coinbase (Ehrsam left in 2017 but is still a board member). Following a series of funding rounds, the company went public in April 2021.

The company’s stated mission is to increase economic freedom in the world by building “a more fair, accessible, efficient and transparent financial system enabled by crypto”. It is easy to be cynical about such a lofty goal; however, considering c1.7 billion adults globally are unbanked and the annual c7% toll on GDP the global financial system extracts to facilitate financial value transfer and safekeeping, Coinbase’s mission has a point. There is something of a contradiction at the heart of Coinbase – a company that offers a number of centralised services promoting and supporting the idea of decentralised financial services. This seeming incongruity is not unique to Coinbase, but, as discussed in prior sections, it is a common feature of crypo markets. Coinbase, in its relatively short history, has proven adept at handling this. c85% of Coinbase’s revenue is generated by trading activity it facilitates. After a difficult 2018, from a low in Q1 2019, trading activity handled by Coinbase has grown exponentially, fuelled by renewed interest from both retail and institutional investors in cryptoassets (Fig 109).

Fig 109: Coinbase – quarterly trading volume, Q1 2018- Fig 110: Coinbase quarterly trading volume and Bitcoin Q2 2021E price*, Q1 2018-Q1 2021

U$m U$m U$ 450,000 400,000 50,000 400,000 350,000 45,000 350,000 40,000 300,000 300,000 35,000 250,000 250,000 30,000 200,000 25,000 200,000 20,000 150,000 150,000 15,000 100,000 100,000 10,000 50,000 50,000 5,000 0 0 0 Q1 18 Q1 18 Q2 18 Q3 18 Q4 19 Q1 19 Q2 19 Q3 19 Q4 20 Q1 20 Q2 20 Q3 20 Q4 21 Q1 Q1 18 Q1 18 Q2 18 Q3 18 Q4 19 Q1 19 Q2 19 Q3 19 Q4 20 Q1 20 Q2 20 Q3 20 Q4 21 Q1 Q2 21E Retail Institutional Trading volume (LHS) Bitcoin price (RHS)

Source: company, nomics.com * Average Bitcoin price in the quarter Source: company, Bloomberg, Redburn

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06/ Coinbase

In assessing the investment case around Coinbase, two considerations heavily inform the current debate:

 The strong correlation between crypto prices (especially that of Bitcoin) and trading activity of Coinbase (Fig 110). This is not unique to Coinbase and can be applied across the industry.

 The sustainability of transactional margins (Fig 111), particularly that generated from retail trading, which in 1Q21 was over 30x that of institutional trading. In 2020, retail trading accounted for c80% over total revenue.

Fig 111: Coinbase – transactional revenue as % of trading volume, Q1 2019-Q1 2021

0.90%

0.80%

0.70%

0.60%

0.50%

0.40%

0.30%

0.20%

0.10%

0.00% Q1 19 Q2 19 Q3 19 Q4 19 Q1 20 Q2 20 Q3 20 Q4 20 Q1 21

Source: company

As such, we argue three considerations are of particular importance in thinking about the Coinbase investment case:

1 Development of a broader crypto offering.

2 Exposure to growth of the overall crypto market.

3 Fade rate of retail transaction margins.

Developing a broader crypto offering In framing thinking about how Coinbase is likely to develop a broader crypto offering, we examine this through three lenses, which are interrelated: geographic, asset and product/service expansion.

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Geographic expansion Coinbase has steadily grown its number of verified users in recent years (Fig 112). The number of monthly transacting users has also grown, albeit this correlates more directly to cryptoasset pricing. Despite the growth in user numbers and operating a global platform (it offers services in over 100 countries), its dominant geographies are the US (c81% of Q1 2021 revenue) and UK & Europe (which generates the majority of the rest).

We anticipate an effort to significant expand presence and grow user numbers in other markets (Fig 113), with recent commentary from CEO underscoring this:

“We put a huge amount of effort into working with regulators in the US, UK, EU, etc. which has generated an enormous amount of value for customers in these regions, but it can also lead to products that are hyper focused on the western world. We’re going to flip this approach on its head by shipping more products in international markets on day one, while still partnering with regulators in more established markets to ensure our products are compliant with their local rules.” Extract from Coinbase CEO blog post, 29 June 2021

These efforts will be supported by a ramp-up in marketing spend well beyond historical levels.

“So, historically, we spent less than 5% of revenue on sales and marketing, if you look at our financial results for 2019 and 2020. As we shared in our outlook, we’re planning to make significant investment to increase our spend here, up to 12% to 15% of our net revenue.” Alesia Haas, Coinbase CFO, 13 May 2021

Fig 112: Coinbase – verified users and monthly Fig 113: Coinbase – adopting an international first transacting users, Q1 2018-Q1 2021 mindset (m) (m) 60 7

50 6 5 40 4 30 3 20 2

10 1

0 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 18 18 18 18 19 19 19 19 20 20 20 20 21 Verified users (LHS) Monthly transacting users (MTU, RHS)

Source: company Source: company (June 2021)

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06/ Coinbase

Asset expansion Alongside geographic expansion, further expansion of unique assets offered on Coinbase’s platform will be an additional contributor to growth. Relative to peers, Coinbase was slow to roll out new assets in the period 2017-18, despite a proliferation in the number of cryptoassets and evidence that other crypto exchanges were capitalising on this. The appointment of Balaji Srinivasan (who joined via the acquisition of Earn.com) as CTO in 2018 saw a pick-up in the pace of adding new cryptoassets. Srinivasan subsequently left Coinbase in May 2019; however, the pace of new asset additions has continued and remains a priority.

“And asset addition is something that’s near and dear to my heart. There are more and more assets being created in the crypto economy. I think it’s going to be something, kind of, like apps in the App Store or on the iPhone where there are eventually millions of these assets created over time and so we’re putting a lot of work and thought into how do we accelerate our pace of asset addition, and one of those is Doge, as you mentioned, which has been getting a lot of attention recently. So, to answer your question directly, we plan to list Doge in the next six to eight weeks. And then more broadly, we’re going to be focused on how we can accelerate asset addition in the future.” Brian Armstrong, Coinbase CEO, 13 May 2021

Fig 114: Coinbase – unique assets on the platform, 2019-Q1 2021

120 100 80 60 40 20 0 2019 2020 Q1 2021

Source: company

Product/service expansion – becoming a broad infrastructure provider Of all the expansion areas, the most important in our view is product/service expansion. As discussed in Chapter 5, although Coinbase is deemed an exchange, it effectively operates as a broker dealer, exchange, market-maker and custodian. The opportunity on the product side is to build out an infrastructure that straddles the entire crypto infrastructure arena (Fig 115).

In this regard, it has certain strategic advantages including:

 That of incumbency. The business holds on its platform c11% of cryptoasset market cap with a strong presence in both the retail and institutional markets.

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 A high-value currency to facilitate acquisitions to boost its infrastructure and ecosystem.

Fig 115: Crypto capital markets

Pre-trade Trading Post-trade

Data & Analytics Exchange (centralised) - Spot -Coinbase -CoinMarketCap Clearing & Settlement -Binance -Cryptocompare -ErisX -Skew Exchange (centralised) - Derivative -Arwen -CME Indices -Binance -Solactive/CoinMarketCap Investor - Bloomberg/Galaxy Exchanges (decentralised) Investor Custody -Uniswap -Paxos Research Lending -Coinbase -Investment banks - Genesis -Boutique providers

Technology services (Fireblocks)

Regulatory and compliance services (Chainanalysis)

Prime brokerage (Coinbase Prime; Galaxy Digital)

Interface with payment rails (Silvergate, Clearbank)

Source: Redburn

Fig 116: Coinbase – assets held on platform and as % of Fig 117: Coinbase – assets held on platform (retail and crypto market cap, Q1 2018-Q1 2021 institutional), Q1 2018-Q1 2021 U$m U$m 250,000 250,000 14%

12% 200,000 200,000 10% 150,000 150,000 8%

100,000 6% 100,000 4% 50,000 50,000 2%

0 0% 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q1 20 Q2 20 Q3 20 Q4 20 Q1 21 18 18 18 18 19 19 19 19 20 20 20 20 21 Assets on platform (LHS) As % of crypto mkt cap (RHS) Retail Institutional

Source: company Source: company

A summary of Coinbase’s acquisition history is set out in Fig 118. The pace of acquisitions has increased in the past two years and has been focused on the institutional arena. Little data are available to assess the track record of acquisitions to date, although they have undoubtedly contributed to growth in number of institutions on the platform from 1,000 at end-2017 to 7,000 at end-2020. As Coinbase further

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06/ Coinbase

scales up, we expect M&A to become a more important tool and potentially an important area for value creation.

Fig 118: Coinbase major acquisitions Business acquired Date Cost Business Earn.com April 2018 cUS$100m* Paid email business model. This was subsequently closed in favour of in-house- developed counterpart Coinbase Earn Neutrino February 2019 US$13.5m* Blockchain intelligence platform August 2019 US$55m Institutional custody business with over US$7bn of assets under custody Tagomi July 2020*** US$41.8m** Institutional brokerage for cryptoassets Bison Ventures February 2021*** US$457.3m** Platform-as-a-service company that provides a suite of easy-to-use crypto infrastructure products and services on multiple blockchains to custodians, exchanges and funds Skew April 2021**** Not disclosed Institutional data visualisation and analytics platform for cryptoassets

* Based on media reports ** Preliminary consideration *** Completed **** Announced Source: Redburn, company, Coindesk

The expansion areas outlined above all effectively fall under the first pillar of Coinbase’s strategy: ‘crypto as an investment’ (Fig 119). Despite the opportunities and initiatives outlined above, the company offers a broad and thoughtfully curated set of services for the retail (e.g. Coinbase Exchange, Coinbase Wallet) and institutional market (e.g. Coinbase Prime, Bison Trails) as well as ecosystem partners (e.g. Coinbase Commerce).

However, the company’s ambitions are much broader than just ‘investment’ and they encompass two further pillars:

 Crypto as a new financial system. This involves developing a much broader financial services offering built on crypto rails, including DeFi, payment, earning and borrowing/lending.

 These are at varying stages of development, with a nascent revenue contribution. For example, in Q1 2021 Coinbase generated US$10m in staking revenue (which falls under the earning category above).

 The opportunity here will key off, in particular, development of DeFi. As a hypothetical example, if by 2030, per the analysis in Fig 5, 10% of financial services shifted into DeFi and Coinbase captured 5% of that (noting a c11% share of cryptoassets on its platform), this implies a US$45bn revenue opportunity.

 Crypto as an app platform. This is an even more formative area of investment that involves driving crypto innovations and products beyond financial use cases.

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Fig 119: Three pillars of Coinbase’s strategy

Source: company

The pace and depth of development of these three pillars (especially the latter two) will depend heavily on development of the overall crypto market.

Development and growth of the overall crypto market In the near term, Coinbase’s performance will likely remain geared to fluctuations in cryptoasset prices (Fig 120) and development of the DeFi industry (Fig 121). As framed in the first five chapters of this report, we are optimistic on the broader development of the crypto industry, particularly the opportunity for it to broaden beyond just being seen as a proxy for Bitcoin (Fig 122).

Fig 121: Total value locked in smart contracts on Fig 120: Crypto market cap, 2013 to date Ethereum network, 2017 to date

3,000 100

2,500 80 2,000

1,500 60

1,000 40

Market capitalisation(U$b) 500

Total value locked in (U$b) locked value Total 20 0

0 Oct-13 Oct-14 Oct-15 Oct-16 Oct-17 Oct-18 Oct-19 Oct-20 Apr-13 Apr-14 Apr-15 Apr-16 Apr-17 Apr-18 Apr-19 Apr-20 Apr-21

Total Excluding BTC Dec-17 Dec-18 Dec-19 Dec-20 Apr-18 Apr-19 Apr-20 Apr-21 Aug-17 Aug-18 Aug-19 Aug-20

Source: CoinMarketCap, Redburn Source: DeFi Pulse, Redburn

Important note: see regulatory disclosures on page 123 of this report. 91 Cryptoassets / 5 August 2021

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Fig 122: Google search volume

100

80

60

40

20

0 over the periodbeginning Jan 2017) Jul-17 Jul-18 Jul-19 Jul-20 Jul-21 Relative search interest (100 being peak interest interest peak being (100 interest search Relative Jan-17 Jan-18 Jan-19 Jan-20 Jan-21 Sep-17 Sep-18 Sep-19 Sep-20 Nov-17 Nov-18 Nov-19 Nov-20 Mar-17 Mar-18 Mar-19 Mar-20 Mar-21 May-17 May-18 May-19 May-20 May-21

Uniswap NFT Coinbase Ethereum Bitcoin

Source: Google Trends, Redburn

While we expect no let-up in the pace of innovation of the crypto industry, the speed of adoption will be influenced by real-world developments especially around regulation (as discussed in Chapter 2). Here, Coinbase screens favourably relative to most other exchanges (Fig 123).

Fig 123: Ranking of crypto exchanges on legal/regulatory and KYC/transaction risk criteria (top ten shown)*

30

25

20

15

10

5

0 AAX Liquid Bittrex Gemini bitFlyer Bitstamp Coinbase CoinCorner LMAX Digital Independent ReserveIndependent

* Maximum possible score = 30 Note: the number of exchanges ranked was 163 Source: CryptoCompare (February 2021)

This reflects a philosophical orientation that has been applied at Coinbase since its inception, to operate as compliantly as possible within the regulatory frameworks of the countries in which it operates. However, as discussed in Chapter 2, this is often not

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straightforward as, in most instances, legal and regulatory frameworks do not exist for cryptoassets and crypto-native businesses. As regulatory scrutiny on the crypto industry tightens, a significant competitive advantage is likely to emerge for those exchanges with the strongest legal and regulatory governance and processes.

The relative lack of regulatory clarity that exists around the crypto industry may, in the near term, offer crypto incumbents a degree of competitive advantage as larger financial service incumbents restrain broader entry into this market until greater regulatory clarity emerges. However, any economic benefit derived from lower competitive intensity is likely to be transitory, although it exerts an influence in thinking about transaction margins, especially retail margins.

Fade rate of retail transaction margins The engine room of Coinbase’s performance since inception has been the generation of transaction fees from its retail business. While we expect the relative contribution from this business to fall over time as other sources of revenue grow faster, a pivotal consideration will be how retail transaction margins evolve. The market’s expectation is that they will steadily fall (Fig 125).

Fig 124: Coinbase – retail and institutional transactional revenue as % of trading volume, Q1 2019- Fig 125: Coinbase – retail transactional revenue as % of Q1 2021 trading volume, 2020-24E

1.60% 1.60%

1.40% 1.40% 1.20% 1.20% 1.00% 1.00% 0.80% 0.80% 0.60%

0.40% 0.60%

0.20% 0.40%

0.00% 0.20% Q1 20 Q2 20 Q3 20 Q4 20 Q1 21 0.00% Retail Institutional 2020 2021E 2022E 2023E 2024E

Source: company Source: Visible Alpha (27 July 2021)

It is tempting when evaluating exchange costs to look at fees and little else. However, there are a variety of other important considerations. In the long term, we expect retail transaction fees to fall, fuelled by more intense competition from both crypto exchanges and mainstream financial participants moving in the crypto trading arena. However, a variety of factors argue for a degree of persistence of retail transaction margins at higher levels than the market perceives. These include:

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 Difficulty in comparing complex pricing structures across exchanges given complexity of the crypto landscape as well as use of the ‘rails’ into and off it.

 The importance of market quality, particularly dynamics around bid ask spreads and execution , which assume greater importance in an unregulated setting.

 Security is a core consideration given the nature of cryptoassets and the fact that exchanges are often performing the function of custodian.

 Branding.

We consider each of these in more detail below.

The points below summarise the fee structure for a variety of leading exchanges. For the sake of brevity, we only provide detail for non-stablecoin US dollar-denominated transactions. We would highlight that evaluating the fees paid by a customer of a crypto exchange are not straightforward – there are an array of charges, tiering structures and other factors that directly impact the price paid.

 Coinbase Exchange – bid-ask spread plus the ‘Coinbase fee’ (the greater of a fixed transaction fee of $0.99-2.99 for purchases below $200 and a variable fee of 1.49- 3.99% depending on payment method).

 Gemini Web – ‘convenience fee’ of 50bp (a bundled platform and bid-ask spread) and a fixed transaction fee of $0.99-2.99 for purchases below $200 and a variable fee of 1.49% thereafter.

 Kraken – bid-ask spread plus the ‘Kraken fee’ (1.50-4.49% variable fee depending on payment method).

 Coinbase Pro – taker fee (4-50bp) or maker fee (0-50bp) instead of bid-ask spread, determined by the trailing 30-day dollar trading volume. Fee tiers are updated after each trade.

 Bitstamp – taker fee (0-50bp) or maker fee (0-50bp) instead of bid-ask spread, determined by the trailing 30-day dollar trading volume. Fee tiers are updated after each trade.

 itBit – taker fee (6-35bp) or maker fee (-3-25bp) instead of bid-ask spread, determined by the trailing 30-day dollar trading volume. Fee tiers are updated after each trade.

 Kraken Pro – taker fee (10-26bp) or maker fee (0-16bp) instead of bid-ask spread, determined by the trailing 30-day dollar trading volume. Fee tiers are updated at midnight 7pm EST/midnight GMT.

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 Gemini Active Trader – taker fee (3-35bp) or maker fee (0-25bp) instead of bid-ask spread, determined by the trailing 30-day dollar trading volume. Fee tiers are updated after each trade.

Fees are only one consideration in assessing a trading venue. Market quality also matters hugely. In this regard, Coinbase screens well. Quality encompasses characteristics such as spread, liquidity and trading behaviour. As highlighted in Figs 126, 128 and 129, Coinbase screens strongly on these metrics relative to peers. These dynamics assume greater importance in unregulated crypto markets. Given the nature of cryptoassets and that the exchange is often also acting as a custodian, security is a further pivotal consideration with Coinbase’s security viewed as among the best in the industry (Fig 127).

Fig 126: Ranking of crypto exchanges on market quality Fig 127: Ranking of crypto exchanges on security criteria (top five shown)* criteria (top five shown)*

20 15

15 10 10

5 5

0

0 OKEx Coinone Coinbase Luno Cex.io Huobi Global Gemini Coinone Coinbase Korea

* Maximum possible score = 20 * Maximum possible score = 15 Note: the number of exchanges ranked was 163 Note: the number of exchanges ranked was 163 Source: CryptoCompare (February 2021) Source: CryptoCompare (February 2021)

Fig 128: Bitcoin/US$ bid-ask spread across various crypto exchanges, June/July 2021

30 24 18 12 6 0 Bid-ask spread (bps) spread Bid-ask 26/06/2021 28/06/2021 30/06/2021 02/07/2021 04/07/2021 06/07/2021 08/07/2021 10/07/2021 12/07/2021 14/07/2021 16/07/2021 18/07/2021 20/07/2021 22/07/2021 24/07/2021 26/07/2021

Coinbase Bitfinex Kraken Bitstamp Gemini LMAX Digital

Source: Kaiko, Redburn

Important note: see regulatory disclosures on page 123 of this report. 95 Cryptoassets / 5 August 2021

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Fig 129: Slippage on $100,000 BTC/USD sell order across various crypto exchanges, June/July 2021

7.50 6.00 4.50 3.00 1.50 Slippage (bps) 0.00 26/06/2021 28/06/2021 30/06/2021 02/07/2021 04/07/2021 06/07/2021 08/07/2021 10/07/2021 12/07/2021 14/07/2021 16/07/2021 18/07/2021 20/07/2021 22/07/2021 24/07/2021 26/07/2021

Coinbase Bitfinex Kraken Bitstamp Gemini LMAX Digital

Source: Kaiko, Redburn

There is also a branding dynamic to consider around crypto exchanges. In Figs 130 and 131 we have shown the Google Trends results for different exchanges. Based on the output, Coinbase has the strongest brand awareness among the major crypto exchanges in the US and the second highest globally behind Binance.

Fig 130: Worldwide search interest for crypto Fig 131: US search interest for crypto exchanges, exchanges, January 2020 to date January 2020 to date

100 100

80 80

60 60 Jan 2020)

40 40

beginning 20 20 0 0 over the period beginning Jan 2020) Jan beginning period the over over the period period the over Jul-20 Jul-21 Jan-20 Jan-21 Sep-20 Nov-20 Mar-20 Mar-21 May-20 May-21 Jul-21 Jul-20 Jan-21 Jan-20 Sep-20 Nov-20 Mar-21 Mar-20 May-21 May-20 Relativesearchinterest (100 being peak interest Relative search interest (100 being peak interest peak interest being (100 interest search Relative Binance Bitfinex Bitstamp Binance Bitfinex Bitstamp Coinbase Gemini Huobi Coinbase Gemini Huobi itBit Kraken OKEx itBit Kraken OKEx

Source: Google Trends, Redburn Source: Google Trends, Redburn

A further factor to consider is that building infrastructure for new cryptoassets is extremely technical. Each new asset added carries its own idiosyncrasies, particularly if the code base differs substantially from that of Bitcoin or Ethereum. One of the undoubted competitive threats to Coinbase will emerge from sources such as digital wallets and brokerages where crypto trading is free or near-free (for example, from Robinhood, PayPal and Square in the US and Revolut in the UK).

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However, in the context of the aforementioned comment on complexity, it is important to note that, in many instances, mainstream providers of crypto trading are not building or running the crypto infrastructure themselves but white-labelling a third-party service. As an example, PayPal’s crypto offering is underpinned by technology provided by Paxos.

“Technology: Paxos Crypto Brokerage provides crypto custody and trading for PayPal. Our APIs allow PayPal to offer crypto services seamlessly within the PayPal app with its simple and intuitive user experience…

Regulatory Licensing: Paxos has pioneered a regulation-first approach in the crypto industry starting with securing the first Trust charter to custody and offer crypto- and blockchain-based digital assets. We’re achieving another regulatory first again today: through Paxos, PayPal has been granted the first virtual currency conditional license from the New York State Department of Financial Services. Our dedication to regulatory licensing and consumer asset protection directly enables our clients’ ability to provide crypto to their customers.” Extract from Paxos website blog, 21 October 2020

Finally, it is worth noting that within financial markets, there has historically been a good correlation between a lower cost of trading and volumes increasing (Fig 132). If transaction costs in the crypto environment were to decline faster than expected, there may well be a volume offset.

Fig 132: Financial market – relationship between cost of trading and number of trades across asset classes

1,000

Commodity Derivatives 100 IRD OTC Equity Derivatives CDS

10 Rates FX Derivatives FX 1 Listed derivatives 2007 average cost per trade ($) trade per cost average 2007 Cash Equities 0 1 10 100 1,000 10,000 100,000 Average number of daily trades (k)

Source: BCG/ICAP

Important note: see regulatory disclosures on page 123 of this report. 97 Cryptoassets / 5 August 2021

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Benchmarking and valuation Fig 133 shows the performance of an index of listed crypto stocks (the Redburn Crypto Index7) since 2018 relative to the performance of Bitcoin and Ether over the same period. This index has strongly outperformed the two largest cryptoassets, reflecting the gearing these businesses carry to both cryptoasset prices and broader development of this industry. This gearing cuts both ways; the index endured a sharp correction since mid-April (Fig 134).

Fig 133: Redburn crypto index* vs Bitcoin and Ether, Fig 134: Coinbase price performance vs Redburn crypto January 2018 to date* index and bitcoin, April 2021 to date

1,200 160 140 1,000 120 800 100 80 600 60 400 40 20 200 0 0 Jul 18 Jul 19 Jul 20 Jul 21 Jan 18 Jan 19 Jan 20 Jan 21 Oct 18 Oct Oct 19 Oct Oct 20 Oct Apr 18 Apr Apr 19 Apr Apr 20 Apr Apr 21 Apr 02 July 2021 12 July 2021 22 July 2021 03 May 2021 13 May 2021 23 May 2021 02 June 2021 12 June 2021 22 June 2021 13 April 2021 23 April 2021

Redburn crypto index Bitcoin Ether 01 August 2021 Coinbase Crypto Index Bitcoin

* Rebased to 100 at 1 January 2018 * Rebased to 100 at 1 January 2018 Source: Redburn, Bloomberg Source: Redburn, Bloomberg

A very short history, newness of the cryptoasset class and limited comps create a challenging backdrop to valuing Coinbase. To help in framing valuation, we have assembled a comparator group of highly rated, well-established (for the most part) and growth-oriented financial technology stocks. Relative to this group, Coinbase has the highest forecast growth over the period 2020-23E. However, almost all this growth is expected to occur in 2021, with Coinbase having the lowest forecast growth rate in the period 2021E-23E, underscoring the uncertainties around forecasting a business geared to a young and volatile industry.

Coinbase’s consensus pre-tax margins are forecast in 2023 to be at a comparable level to 2020 (Figs 137 and 138), reflecting the market’s view that the upsurge in margins expected in 2021 is unlikely to be sustained in 2022-23.

7 The Redburn Crypto Index includes the following stocks whose businesses models are primarily focused on the crypto industry: Coinbase Global Inc; Coinshares International; Silvergate Capital; Voyager Digital; Argo Blockchain; Galaxy Digital; Marathon Digital; Riot Blockchain. It also includes two financial technology companies that have started building a presence in crypto markets: PayPal Holdings and Square Inc.

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Fig 139 shows the valuation of Coinbase on the basis of enterprise value (EV) over 2023E revenue. Relative to this fintech peer group, it carries the lowest rating. This rating is even lower on a growth-adjusted rating, reflecting the market’s current assumption of negligible top-line growth in 2022-23 for Coinbase (Fig 140).

Fig 135: Coinbase vs selected comparators, 2020-23E Fig 136: Coinbase vs selected comparators, 2021E-23E revenue growth CAGR revenue growth CAGR

80% 200%

160% 60%

120% 40% 80%

20% 40%

0% 0% Visa Visa Adyen Adyen Paypal Paypal Bakkt* Square Square Circle* Shopify Shopify Bill.com Bill.com Coinbase Coinbase Silvergate Silvergate Mastercard Mastercard

Source: Visible Alpha (2 August 2021) * Data for Circle and Bakkt per Circle investor presentation June 2021. Circle and Bakkt announced plans in January 2021 and June 2021 respectively to list via SPACs Source: Visible Alpha (2 August 2021)

Fig 137: Coinbase vs selected comparators, 2020 vs Fig 138: Coinbase – adjusted pre-tax profit margin, 2023E adjusted pre-tax margins 2020-23E

75% 50%

60% 40% 45%

30% 30%

15% 20%

0% 10% Visa Adyen Paypal Square Shopify Bill.com Coinbase Silvergate Mastercard 0% 2020 2023E 2020 2021E 2022E 2023E

Source: Visible Alpha (2 August 2021) Source: Visible Alpha (2 August 2021)

Important note: see regulatory disclosures on page 123 of this report. 99 Cryptoassets / 5 August 2021

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Fig 139: Coinbase vs selected comparators, enterprise Fig 140: Coinbase vs selected comparators, growth value/2023E revenue adjusted enterprise value/2023E revenue

50x 1.5x

40x 1.2x

30x 0.9x

20x 0.6x

10x 0.3x

0x 0.0x Visa Visa Adyen Adyen Paypal Paypal Square Square Shopify Shopify Bill.com Bill.com Coinbase Coinbase Silvergate Silvergate Mastercard Mastercard

Source: Visible Alpha (2 August 2021), Redburn, Bloomberg Source: Visible Alpha (2 August 2021), Redburn, Bloomberg

In addition to considering Coinbase’s relative valuation, we also use a DCF valuation methodology (Fig 141). We use an explicit four-year forecast period and a normalised period of six years, after which we forecast a terminal-year cash flow. Our assumptions include:

 A normalised growth rate of 20.0% and a terminal growth rate of 7.0%.

 A CoE of 10.5%. The inputs used are a risk-free rate of 3%, an equity risk premium of 5% and beta of 1.5. Given Coinbase’s business model and debt-free balance sheet, we do not incorporate a WACC component in valuation.

 We assume a tax rate of 23%.

Based on these assumptions, we derive a fair value of US$335 per share.

Fig 141: Coinbase DCF valuation summary US$m Forecast cash flows 5,406 Normalised cash flows 11,666 Terminal cash flows 67,590 Total cash flows 84,662 Other adjustments 3,503 Implied market cap 88,165 Share count (diluted) 263 Implied fair value per share (US$) 335

Source: Redburn

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Fig 142 shows a sensitivity analysis of our DCF model. The wide range of fair value estimates across different terminal growth and cost of equity assumptions reflects the significant contribution made by the terminal year figure to Coinbase’s fair value.

Fig 142: Coinbase DCF sensitivity analysis (US$) CoE/g 5.50% 6.00% 6.50% 7.00% 7.50% 8.00% 8.50% 9.0% 375.7 424.4 492.6 594.9 765.4 1,106.5 2,129.6 9.5% 326.6 361.6 408.2 473.6 571.6 734.9 1,061.6 10.0% 288.5 314.6 348.1 392.8 455.4 549.3 705.8 10.5% 258.2 278.2 303.1 335.3 378.1 438.1 528.0 11.0% 233.4 249.1 268.2 292.2 323.0 364.0 421.5 11.5% 212.9 225.4 240.4 258.8 281.7 311.3 350.6 12.0% 195.6 205.7 217.7 232.1 249.7 271.7 300.0

Source: Redburn

Important note: see regulatory disclosures on page 123 of this report. Cryptoassets / 5 August 2021

Coinbase financials financials

Fig 143: Coinbase summary financials 2019 2020 2021 2022 2023 2024 Shares Share price (US$) 230.18 Mkt cap*, Y/E n/a n/a 60,284

Earnings and dividends Net profit (30) 322 1,922 1,733 1,962 2,573 NOSH (’000s) 206 263 266 269 272 Reported EPS (diluted) 1.57 7.31 6.51 7.29 9.46 Consensus EPS 8.08 5.00 6.21 7.60 Price/EPS 31.5 35.3 31.6 24.3 EV/EBITBA 19.5 20.5 17.2 12.6 DPS - - - - Dividend yield n/a n/a n/a n/a BVPS 14.1 21.9 30.5 41.5 Price/BVPS 16.3 10.5 7.5 5.5

Income statement Revenue 534 1,277 5,942 5,990 6,839 8,341 EBITDA (adjusted) 24 527 2,922 2,676 3,045 3,902 Pre-tax profit (45) 409 2,466 2,251 2,548 3,341 Net profit (30) 322 1,922 1,733 1,962 2,573

Balance sheet and cash flow Cash and equivalents 549 1,062 4,662 6,792 9,228 12,349 ST and LT debt 130 108 118 118 118 118 Net cash/(debt) 0 954 3,293 5,424 7,860 10,981 Total assets 2,392 5,855 14,168 17,134 22,094 28,532 Total liabilities 1,330 4,329 9,896 10,759 13,328 16,693 Shareholders’ common equity 497 1,526 3,720 5,823 8,214 11,287 Tangible equity 372 1,388 3,162 5,291 7,705 10,786 Cash flows from operations (81) 3,004 6,162 3,021 5,001 6,452 Cash flow from investing (105) 51 (59) (30) (50) (60) Cash flow from financing (17) 19 60 0 0 0

Return and margin metrics EBITDA margin, adjusted (%) 5% 41% 49% 45% 45% 47% RoE (%) 32% 73% 36% 28% 26% Revenue growth (%) 139% 365% 1% 14% 22% Cost growth, adjusted (%) 50% 304% 8% 14% 17%

* Fully diluted basis Source: Redburn, company, Bloomberg (3 August 2021)

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Coinbase financials

Fig 144: Coinbase income statement Y/E December (US$m) 2019 2020 2021E 2022E 2023E 2024E Revenue Transaction revenue 463 1,096 5,280 5,091 5,621 6,679 Subscription & Services revenue 20 45 290 495 707 1,003 Net revenue 483 1,141 5,570 5,585 6,329 7,681 Other revenue 51 136 372 405 510 660 Total revenue 534 1,277 5,942 5,990 6,839 8,341

Operating expenses Transaction expense (82) (136) (795) (764) (843) (1,002) Technology & development (185) (272) (944) (1,100) (1,300) (1,500) Sales & marketing (24) (57) (649) (726) (823) (999) General & administrative (232) (280) (641) (700) (825) (950) Restructuring (10) 0 0 0 0 0 Other opex (46) (125) (456) (450) (500) (550) Operating expenses (580) (869) (3,485) (3,740) (4,291) (5,000) Operating income(loss) (46) 409 2,457 2,251 2,548 3,341 Other income, net 0 0 9 0 0 0 Income /(loss) before tax (45) 409 2,466 2,251 2,548 3,341 Taxation 15 (87) (544) (518) (586) (768) Net income/(loss) (30) 322 1,922 1,733 1,962 2,573

Proforma net income/(loss) per share attr to common st. Basic (US$) 1.76 9.56 8.54 9.57 12.43 Diluted (US$) 1.57 7.31 6.51 7.29 9.46

Weighted average NOSH – common stockholders (pro forma) Basic (m) 183 201 203 205 207 Diluted (m) 206 263 266 269 272

Source: Redburn, company

Important note: see regulatory disclosures on page 123 of this report. 103 Cryptoassets / 5 August 2021

Coinbase financials

Fig 145: Coinbase balance sheet Y/E December (US$m) 2019 2020 2021 2022E 2023E 2024E Assets Cash and equivalents 549 1,062 4,662 6,792 9,228 12,349 Restricted cash 34 31 31 31 31 31 Customer custodial funds 1,201 3,763 7,593 8,453 10,968 14,239 USDC 88 49 102 102 102 102 Accounts receivable 17 189 209 211 240 293 Other current assets 97 40 56 56 56 56 Current assets 1,987 5,134 12,652 15,644 20,625 27,070 Cryptoassets held 34 316 651 651 651 651 Lease right-of-use assets 123 101 111 111 111 111 Property and equipment, net 47 49 54 54 55 57 Goodwill 55 77 481 481 481 481 Intangible assets, net 70 61 77 50 28 20 Other non-current assets 76 117 142 142 142 142 Non-current assets 405 721 1,516 1,489 1,469 1,462 Total assets 2,392 5,855 14,168 17,134 22,094 28,532

Liabilities, preferred stock and stockholders’ equity Custodial funds due to customers 1,107 3,849 7,525 8,385 10,901 14,171 Accounts payable & accrued expenses 45 85 374 377 430 525 Cryptoasset borrowings 0 271 544 544 544 544 Lease liabilities, current 24 25 30 30 30 30 Other current liabilities 47 16 85 85 85 85 Liabilities, non-current 107 83 1,339 1,339 1,339 1,339 Total liabilities 1,330 4,329 9,896 10,759 13,328 16,693 Convertible preferred stock 565 0 552 552 552 552 Total stockholders’ equity 497 1,526 3,720 5,823 8,214 11,287 2,392 5,855 14,168 17,134 22,094 28,532

Source: Redburn,company

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Coinbase financials

Fig 146: Coinbase cash flow statement Y/E December (US$m) 2019 2020 2021 2022E 2023E 2024E Net income/(loss) for the period (30) 322 1,922 1,733 1,962 2,573 Depreciation and amortisation 17 31 45 56 70 67 Stock-based comp expense 31 71 370 370 430 500 Deferred taxes (21) 0 0 0 0 0 Other non-cash income 23 (37) (60) 0 0 0 Changes in working capital (100) 2,617 3,886 861 2,539 3,312 Cash flow from operating activities (81) 3,004 6,162 3,021 5,001 6,452

Business acquisition/disposal cash (69) 23 (26) 0 0 0 Capex (40) (19) (25) (30) (50) (60) Proceeds/(purchases) of AFS securities 0 0 0 0 0 0 Other investing activities 2 0 0 0 0 0 Net (purchase)/disposal of cryptoassets 1 46 (8) 0 0 0 Net cash used in investing activities (105) 51 (59) (30) (50) (60)

Issuance of common stock on of stock options 4 21 59 0 0 0 Cash paid to repurchase equity awards (21) (2) 0 0 0 0 Net cash used in financing activities (17) 19 60 0 0 0 Net increase in cash, cash equivalents and restricted cash (203) 3,074 6,163 2,991 4,951 6,392 Effect of exchange rates on cash (0) (2) 16 0 0 0 Cash, cash equivalents and restricted cash, beginning of year 1,987 1,784 4,856 12,285 15,276 20,227 Cash, cash equivalents and restricted cash, end of year 1,784 4,856 11,035 15,276 20,227 26,619

Cash, cash equivalents and restricted cash, end of year (breakdown) Cash and cash equivalents 549 1,062 4,662 6,792 9,228 12,349 Restricted cash 34 31 31 31 31 31 Customer custodial funds 1,201 3,763 7,593 8,453 10,968 14,239 1,784 4,856 12,285 15,276 20,227 26,619

Source: Redburn, company

Important note: see regulatory disclosures on page 123 of this report. 105 Cryptoassets / 5 August 2021

Appendix 1 – Key ideas in Bitcoin 1 – Key ideas in Bitcoin

Fig 147: Chronology of key ideas found in Bitcoin

Linked Byzantine Public timestamping, Digital Proof fault keys as Smart verifiable logs cash of work tolerance identities contracts

1980 Merkle Chaum Ecash [10] Tree [33] Byzantine anonymous Generals [27] communication[9]

Chaum 1985 Security w/o identification [11]

Paxos[28] Haber & Offline Ecash[32] Stornetta [22]

1990 Benaloh & DigiCash de Mare [6] Anti-spam [15] Bayer, Haber, Stornetta[5] Szabo essay[41]

1995 Micro- Haber & mint [44] Hashcash[2] B-money[13] Stornetta[23]

Client PBFT[8] puzzles[25] Goldberg 2000 Paxos made dissertation[20] simple[29] Sybil attack [14] Bit gold [42]

2005 Bitcoin[34] Computational impostors[1]

2010 Private blockchains

Ethereum

2015

Nakamoto concensus

Source: ‘Bitcoin’s Academic Pedigree’, Narayanan/Clark

106 Important note: see regulatory disclosures on page 123 of this report. Cryptoassets / 5 August 2021

Appendix 2 – Bitcoin mechanism 2 – Bitcoin mechanism

How to Bitcoin In this section, we attempt to distil what is extremely complicated cryptography and explain how a user transacts and stores funds on the Bitcoin network but remark that it is very similar for other major blockchains. Our focus here shifts away from the consensus mechanism and mining process and instead towards purchasing motions and cryptocurrency wallets.

Cryptocurrency wallets Bitcoin wallets, paradoxically, do not store bitcoins. It is the combination of private and public key(s), special numbers derived from public key cryptography (PKC), that create the concept of a Bitcoin wallet. Put another way, the wallet is more like a keychain than a leather folio. For completeness, the coins are ‘stored’ on the blockchain itself in bitcoin addresses. The role of the wallet, therefore, is to provide a gateway for the user to prove ownership of the coins stored at the addresses. Note that PKC is not unique to Bitcoin and is used by almost all blockchain networks to verify transactions.

The main idea behind PKC is that a user, say A, generates a private key and a public key (some numbers), say X and Y respectively, that are mathematically related8 and such that any message encrypted with X can be decoded using Y and any message encrypted with Y can be decoded using X. Further, Y is made freely available to all of A’s friends whilst X is kept secret.

Assume now that A wishes to send a message M and encrypts it using X, in turn, creating a new message N, which is broadcast publicly. Since Y can decode any message that has been encrypted using X, any other user, say B, who also knows Y can decode N to recover the original message M. Moreover, B knows that the only individual able to generate N from M is the user that knows X, i.e. A has digitally signed the message with their private key (Fig 148).

8 PKC uses one-way functions to relate the two numbers. These functions are best thought of as sequences of mathematical operations that, given the output, are near-impossible to reverse to retrieve the input without additional information. In the proceeding text, Y is the input and X is the output.

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Appendix 2 – Bitcoin mechanism

Fig 148: Public key cryptography – an illustration

Sender (User A) Network Receiver (User B) Private Key Public Key Public Key Public Key

Digital signature Encrypted Message (N): Verification algorithm algorithm qYfbmqH9Vwr3nfYR

Message (M): Message: RedburnToday.com RedburnToday.com

Source: PreVeil, Redburn

In the Bitcoin arena, bitcoin addresses (derived from public keys) are known by all nodes on the network, whilst private keys are kept secret. From a private key, a user can generate their public key and so too their bitcoin address. However, neither the bitcoin address nor the public key can be used to generate the private key. This is the fundamental property of public key encryption. For those that wish to continue reading beyond the scope of this report, we include some minutiae of Bitcoin’s public key cryptography in Fig 149. Bitcoin’s pending Taproot will modify both the hashing algorithm (the first arrow) and the encoder (the second arrow).

Fig 149: Inside the wallet – Bitcoin’s public key encryption and one-way functions First SHA-256 hash, next RIPEMD-160 Elliptic curve scalar hash, then Base58 multiplication. encode. Private Key Public Key Bitcoin address

Source: Antonopoulos, A., Chapter 4, Mastering Bitcoin: Programming the Open Blockchain, 2014, Redburn

As mentioned above, coins are ‘stored’ on Bitcoin addresses that live on the blockchain network. The wallet provides a user-interface, comparable to online banking in the fiat monetary system, that allows users to engage in Bitcoin transactions. In the background, custody over the funds involved in outgoing transactions is proven using the private key, whilst incoming coins are aggregated into a total user balance. We enumerate the key steps involved a bitcoin transaction between two users below.

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Appendix 2 – Bitcoin mechanism

1 Obtain the recipients bitcoin address and detail the location (sender’s bitcoin address) of the funds to be sent, the nominal value of the transaction and the network fee via the wallet or exchange platform. Out of sight, the transaction instructions are digitally signed using the sender’s private key.

2 The transaction is then broadcast to the entire Bitcoin network and the details included are verified by the nodes using the sender’s public key. If the sender’s public key is unable to decrypt the message supplied, then the user does not have custody of the funds stored at the corresponding bitcoin address. This is the digital signature.

3 After passing the verification stage, the transaction joins a queue to be included in the next block. Upon reaching the front of the queue and solving the PoW consensus algorithm, the miner propagates the new block into the network and the recipient sees the first confirmation of the transaction.

Each subsequent block that is mined into the network generates an additional confirmation for the recipient. Best practice stipulates that the transaction should not be considered complete until the recipient has received three confirmations – the rationale being that after a single confirmation there is a non-zero probability that the transaction may be reversed due to double-spending. Three confirmations make that outcome sufficiently unlikely.

As an aside, the process of minting new Bitcoins occurs via a unique type of transaction called a ‘coinbase transaction’. This differs from the usual sender-recipient address process detailed above since the miner (recipient) does not specify an origin address for the funds in the transaction instructions. The new coins are a reward from the network itself and have no previous owner to detail on the ledger.

Not all wallets are created equal. With coin ownership resting entirely on the security of the corresponding private key, it is unsurprising that an ecosystem has formed offering users a variety of storage solutions. Wallets can be partitioned two ways: hot wallets versus cold wallets, or custodial wallets versus non-custodial wallets.

 Hot versus cold wallets: a hot wallet is connected to the internet, providing ease of use to the consumer and decreasing the time taken to execute transactions (step 1, above). The drawback is that funds are extremely vulnerable to cyberattacks. Alternatively, users can store their keypairs offline using a cold wallet. Whilst vastly increasing security, they are inconvenient to use and often expensive.

 Custodial versus non-custodial wallets: with non-custodial wallets, the users bear the responsibility of managing the keys, whilst custodial wallets offload that duty to a third party, often cryptocurrency exchanges. Losing the password/PIN to a non-custodial wallet renders the associated funds useless. Custodial wallets on the other hand likely offer the user the opportunity to reset their details in-browser.

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Appendix 2 – Bitcoin mechanism

In Fig 150 we categorise the five main types of wallets by storage type and private key security, and in Fig 151 we rank by user convenience. Hardware wallets authorise transactions offline using a physical electronic device that stores the private key. Any public and private key pair can function as a wallet, even if it is written on paper; paper wallets are often printed as QR codes, but all carry the risk of being easily lost or damaged. Desktop wallets are programmes that store the key pairs in files saved on the user’s computer. Web wallets function like a website, whilst mobile wallets function via an application installed on the user’s handset.

Fig 150: Cryptocurrency wallets, split by security and private key custody Fig 151: Cryptocurrency wallets ranked by convenience Wallet type Storage type Private key security Hardware wallet Cold (offline) Non-custodial Hardware wallet

Paper wallet Cold (offline) Non-custodial Paper wallet Desktop wallet Desktop wallet Hot (online) Non-custodial Mobile

Private key security Web wallet Web wallet Hot (online) Primarily custodial, but wallet some are non-custodial Mobile wallet Hot (online) Mixture of custodial and Convenience non-custodial

Source: Redburn Source: Redburn

Purchasing cryptocurrency In part, the rise in popularity of digital assets can be attributed to the growth in cryptocurrency exchanges and platforms for users to transact on. Placing aside the obvious differences between a and a conventional portfolio, the purchasing motion for trading the digital coins is near-identical to trading equities and other well-established investment products.

Bitcoins are primarily purchased and sold through cryptocurrency exchanges, like Coinbase, either in-browser or via a mobile application (Figs 152 and 153). Other methods include cryptocurrency ATMs, online forums, in-person events (particularly popular in 2009-10 when there was little infrastructure) or taking delivery of the underlying asset from a cryptocurrency future.

To open an account at an exchange, it is often required that the user provides bank account information and valid identification documents – identical to setting up a brokerage account.

The actual method of buying or selling crypto has simplified greatly over the years. Most platforms/exchanges follow procedures similar to those of standard trading platforms. The first step is to transfer or deposit money into your trading account. Then, the user can initiate a trade by entering the coin and quantity of assets they wish

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Appendix 2 – Bitcoin mechanism

to buy or sell (Figs 152 and 153). A user-owned wallet involves an additional set, requiring the individual to specify their keypair to complete the transaction.

Fig 152: Purchasing digital assets via an Fig 153: Purchasing digital assets via an exchange, Coinbase mobile application exchange, Coinbase mobile application

Source: Coinbase Source: Coinbase

Typically, the exchange account acts as custodial wallet whereby any cryptocurrency purchased is held on exchanged-owned keypairs. Reputable exchanges use cold storage for their keypairs, but this is not always the case.

Until the cryptocurrency is transferred into a non-custodial wallet, the user’s digital assets are nothing more than a virtual balance hidden behind a username and password. Should the exchange be the victim of cybercrime, which is an issue in the crypto sphere (Fig 154), the lack of key-ownership renders the user’s funds lost forever.

Fig 154: Cumulative value stolen from exchanges in publicly confirmed heists, 2011-19

2,000 $1,814.74m

1,600 $1,532.14m 1,200

800 $656.64m $495.14m

exchanges (U$m) exchanges 400 $487.04m $570.64m $0.04m $0.74m $3.94m Cumulative value stolen stolen value from Cumulative 0 2011 2012 2013 2014 2015 2016 2017 2018 2019

Source: Chainalysis, Redburn

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Appendix 3 – Ethereum 2.0 3 – Ethereum 2.0

In this section we set out key features of the pending overhaul of Ethereum, whose goal is to address network scalability and sustainability. Similar to Bitcoin, Ethereum has a challenge: decentralisation and security of the network was achieved at the cost of scalability. Demand for constrained network resources has led to an unwanted growth in fees, whilst the popularity of the network has rapidly increased the disk space required to participate in securing the network, in consequence centralising the network. Ethereum 2.0 or Eth2 or Serenity is Vitalik Buterin’s solution to these issues, a reboot of the network with improved architecture that sustainably solves the Blockchain trilemma.

The upgrade itself is the launch of several interconnected projects expected to finish in late 2021/early 2022. Scalability improvements will come from: (1) sharding the transaction database and (2) integrating layer-2 solutions, specifically rollups. Sustainability and security are addressed by the same project – a movement from energy-expensive PoW consensus mechanisms towards energy-efficient PoS consensus mechanism coordinated by the Beacon Chain. Security improvements will come from random staking algorithms provided by the Beacon Chain. We discuss these in more detail below.

The Beacon Chain The Beason Chain is the lynchpin of the Ethereum upgrade, responsible for coordinating communication in the sharded database and successfully implementing a PoS consensus mechanism. As an aside, in PoW, users buy hardware to become miners. In PoS, users deposit, or stake, cryptocurrency to control validator nodes.

Mining entire blocks is an energy-expensive task due to the vast computing power required to confirm transactions. PoS seeks to address this issue, revealing the ESG aspect of Eth2, by requiring network participants to mine fractions of blocks related to the quantity of ether staked in the network. To control an entire validator node on the Beacon Chain requires a user to control and stake 32 ether, or c$80,000/c£58,000. Under the new mechanism in Ethereum 2.0, a user who stakes 8 ether is only required to mine 25% of the block; that is, the user quarters their energy spend. The Beacon Chain coordinates these efforts to ensure the entire content of the block is verified, as it would be under PoW, and uses a random allocation algorithm to assign stakers to shards increasing security.

Worth noting is that the Beacon Chain went live in December 2020, albeit operating independently from the Ethereum main chain. It does not yet confirm transactions but instead uses PoS to keep a timely record of the ledger. Deposits into the Beacon Chain are locked up until the penultimate phase of the Eth2 project. To date, the validators on the Beacon Chain control c6 million ether, or 5% of the total circulating supply, from c200,000 participants.

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Appendix 3 – Ethereum 2.0

Sharding (a layer-1 solution to scaling) The first scalability upgrade for Ethereum will arrive in the form of a layer-1 solution or, equivalently, the underlying Ethereum protocol will receive an upgrade. Developers have two choices when it comes to scaling a network: either appeal to vertical scaling, increasing the size and power of each node to generate higher network throughput; or leverage horizontal scaling techniques to distribute the load on the network and run tasks in parallel.

Whilst vertical scaling is the easiest to implement, it implicitly increases the capital requirement to participate in securing the network and, in turn, threatens decentralisation. Horizontal scaling is more involved. It requires, for distributed ledgers, new software to be implemented to partition transaction data into smaller, easier to execute, pieces of logic, which are then distributed into the network. Specifically, the developers involved in Eth2 are set to implement database sharding, a technique that is commonly used in database management and is illustrated in Fig 155.

Fig 155: Database sharding – one large table split into many small tables Product Price Widget $118 Gizmo $85 Trinket $37

Shard 1Shard 2Shard 3 Product Price Product Price Product Price Widget $118 Gizmo $85 Trinket $37

Source: Redburn, IoT Academy

In sharding the blockchain, the network will transform from a single chain containing the entire transaction history of the network into, initially, 64 parallel chains, each working to validate and store different pieces of transaction data. Note that the current blockchain will be one of the 64 shards, meaning that the new infrastructure will still contain the entire transaction history of the network. Above, the existing blockchain is represented by the list of products and prices, the transaction data are represented by the individual entries and the process of sharding is represented by the larger table becoming three smaller tables. An important difference between the pre- and post sharded database is the order in which tasks are completed. Under current architecture, tasks are completed in series – each node on the network works the same task at the same time. Under Eth2, tasks are split and assigned to different nodes, each node working on a different piece of the task at the same time. The advantage is clear, having computationally easier jobs with constant computing power implies transaction data are verified quicker.

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Appendix 3 – Ethereum 2.0

Combined with the PoS consensus mechanism, from the Beacon Chain, 51% attacks are near-impossible as: (1) the probability that offending participants would be assigned to work on the same shard is near-zero and (2) the PoS mechanism means the capital required to control 51% of the shards would be immense.

Rollups (a layer-2 solution to scaling) The second scalability improvement will come from a layer-2 solution whereby additional mechanisms are overlayed atop the existing blockchain protocol to move computations off-chain and decrease the time to verification. The Eth2 solution involves integrating rollups, a tool whose input is transaction data relating to many users and output is a single cryptographic proof instead of many separate cryptographic proofs. Multiple transactions are ‘rolled up’ into one. Here, most of the work is completed off-chain or, independent from the Ethereum network, with greater speed and efficiency, submitting the verification that the data included in the rollup are legal to the network for storage. The above effort is also coordinated by the Beacon Chain.

Transaction throughput on par with payment processing majors As a reminder, the speed of the blockchain network is measured by the transaction throughput, defined as transactions per second (TPS).

In Figs 156 and 157, we show the impact on transaction throughput of upgrading the current Ethereum infrastructure to version 2.0. The first column (respectively second column) shows transaction metrics for the transfer of ether (transfer of ERC-20-based tokens) between two users. Throughout, we assume (1) each block contains a single type of transaction (either ether or ERC-20-based token transfers) and (2) that each block is maximally filled or, equivalently, the miner is aware of the true gas cost of each transaction in the network and exhausts the entire gas limit of the block. This is optimistic. Indeed, it is unlikely that a block would only contain a single type of transaction and be filled maximally. Nevertheless, the modelling below provides useful insights into capability of next-generation blockchain networks.

Fig 156: Ethereum 1.0 (current version), theoretical transaction throughput Basic ETH transfer ERC-20 token transfer Gas limit per block 15,000,000 15,000,000 Gas cost per transaction 21,000 *50,000 Transaction ceiling, per block 714 300 Theoretical throughput on Ethereum 1.0 **54 TPS **23 TPS

* The gas cost for transferring ERC-20 tokens is not clear cut, unlike ETH transfers. Here, we use an estimated average ** Transaction throughput = transaction ceiling, per block/block time, assuming a block time of 13 seconds Source: Redburn, vitalik.ca

The output of Fig 156 is an upper bound for throughput on the current version of Ethereum. If, hypothetically speaking, the network only supported transfers of ether between addresses and a new block was added to the network every 13 seconds, its

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Appendix 3 – Ethereum 2.0

throughput would be c55 TPS. Expanding network functionality to include ERC-20- based token transactions decreases that number to c25 TPS. For context, the midpoint of c25-c55 TPS is some 2.5x higher than the actual average throughput of the network.

Fig 157: Ethereum 2.0, theoretical transaction throughput Basic ETH transfer ERC-20 token transfer Gas limit, per block 15,000,000 15,000,000 Gas cost per ZK rollup *500,000 *500,000 Remaining gas, per block 14,500,000 14,500,000 Gas cost per byte of transaction data 16 16 Transaction data ceiling, per block 906,250 906,250

No. of bytes per transaction included in rollup 12 16 Transaction ceiling, per block 75,520 56,640 Theoretical throughput before sharding **6,293 TPS **4,720 TPS

Network space, before sharding (kB/s) 60 60 Network space, after sharding (kB/s) 1,398 1,398 Theoretical throughput after sharding ***146,626 TPS ***109,976 TPS

* Here, we use a specific type of rollup for modelling, a ZK rollup, but note that there is another category of rollups called optimistic rollups ** Transaction throughput = transaction ceiling, per block/block time, using an estimated Ethereum 2.0 block time of 12 seconds *** After sharding throughput = before sharding throughput * (network space, after / network space, before) Source: Redburn, vitalik.ca

In Fig 157, we compute the scalability gained from upgrading to Ethereum 2.0 in two steps. On the one hand, if each block contains the largest possible rollup, and we assume that new blocks are added to the network every 12 seconds, then rollup integration could increase transactions per second on Ethereum by a factor of 100. Instead, consider the increase in network space for new transaction data due to sharding, 60kB/s versus 1,398kB/s – then, sharding the ledger could increase network throughput 20x. Together, the upgrades in Ethereum 2.0 look to yield a maximum throughput in excess of 100,000 transactions per section.

What is a realistic estimate for potential Ethereum 2.0 throughput? We think the answer is close to 45,000 TPS. To get to this number, we combine the spread between actual and estimated throughput from Fig 156 and the bottom line of Fig 157.

London hard fork Releasing at block height 12,965,000 are five EIPs, colloquially known as improvements to the Ethereum blockchain and collectively known as the London hard fork. Their aim is to bridge the gap between the current version of the network and Ethereum 2.0. Most interesting are improvements ‘1559’ and ‘3554’, which in short make ether a deflationary cryptocurrency and delay the rapid increase in mining difficulty until December 2021. We provide more detail on these propositions below.

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Appendix 3 – Ethereum 2.0

 EIP-1559: the specifics of ‘1559’ are that the network fees will no longer follow a first-price auction model and will instead follow a fixed-price sale. In addition, miners will no longer have a claim to the entire fee. To get here, developers will implement three changes to the network fee model: (1) firstly, instead of network fees deriving from volatile gas prices, each transaction will have a fixed cost ‘BASEFEE’ and an optional (variable) tip to the miner; (2) secondly, the ‘BASEFEE’ is burnt, or sent to an unobtainable public key address, permanently removing ether from circulation and cutting miners’ income to the block reward plus income from tips; and (3) thirdly, the block gas limit of 15m gas is removed and replaced with a long-term target miners agree to adhere to, on average, and block gas limit ceiling of 30m gas. This is the most important update to the network.

 EIP-3554: in 2015, the ‘difficulty bomb’ or ‘Ethereum Ice Age’ was embedded in the Ethereum protocol. It is a mechanism designed to evaporate all economic profit in PoW mining by parabolically increasing the difficulty of the hash function after a certain number of blocks have been mined, in turn, rapidly increasing the block time until no miner can confirm new transactions – an internal ‘grow or die’ force. EIP-3554 buys the developers roughly five months to prepare the final aspects of Ethereum 2.0. The London upgrade represents the fourth difficulty bomb delay implemented since 2017 (EIP-649, EIP-1234, and EIP-2384), a combined delay of c10 million blocks, due to developmental issues and bugs. Fig 158 charts the historical block time of the network, including previous bomb delays and prior effects of the mechanism. The wave-like pattern illustrates the call-and-response relationship between the difficulty bomb mechanism and manual intervention.

Fig 158: Average daily Ethereum block time*, 2015-21

30 Byzantium upgrade, +3m block delay, 24 16 Oct 2017 18

12 Constantinople upgrade, +2m block delay, Muir Glacier upgrade, +4m block 6 28 February 2019 delay, 2 January 2020 Time taken to confirm (s) confirm to taken Time 0 Jul-15 Jul-16 Jul-17 Jul-18 Jul-19 Jul-20 Jan-16 Jan-17 Jan-18 Jan-19 Jan-20 Jan-21 Oct-15 Oct-16 Oct-17 Oct-18 Oct-19 Oct-20 Apr-16 Apr-17 Apr-18 Apr-19 Apr-20 Apr-21

Source: Redburn, Etherscan.io

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Appendix 4 – Altcoins 4 – Altcoins

A brief biography of additional large Altcoins, in addition to those discussed in Chapter 3, is set out below.

Litecoin (standalone coin, market capitalisation US$9.4bn) Launched in 2011, Litecoin was intended to be the silver to Bitcoin’s gold. It was founded with the goal of prioritising transaction speed and did so with shorter block times and a different hashing algorithm. Its common usage is almost identical to that of Bitcoin: as a medium of exchange and store of value. With the Litecoin’s USP being quicker transaction speeds at lower fees, the development of the Bitcoin Lightning Network potentially undermines the value of Litecoin.

Bitcoin Cash (standalone coin, market capitalisation US$10bn) Bitcoin Cash (BCH) is a popular spin-off of the original Bitcoin (BTC) blockchain, differing only in total block size, with a BCH block size of 32 MB versus a BTC block size of 1 MB. Its primary function is as a low-cost peer-to-peer electronic cash system that is secured by the Bitcoin blockchain protocol and confirms transactions in minutes rather than hours. Disagreements surrounding the correct block size led to a second hard fork in 2018, creating a third currency closely associated with Bitcoin, Bitcoin SV, whose current block size is 2 GB (1 GB = 1,024 MB).

Chainlink (utility token, market capitalisation US$8.8bn) Chainlink is a decentralised network of nodes that collect real-world data from trusted off-chain sources for use in on-chain smart contracts. Its use in crowdfunding is an easy proof of concept: individuals donate monies to a fund and a smart contract is set up to track total donations. At the end of the pre-specified period, if the desired funding has been achieved, the smart contract executes and financing is provided to the cause, otherwise the donations are returned. The native currency, Link, is used on the network to compensate node operators for gathering data as well as staking.

Polygon (utility token, market capitalisation US$6.6bn) Polygon, previously Matic Network, is a framework running atop the Ethereum blockchain that connects compatible networks via layer-2 solutions and proprietary PoS side chains. Whilst similar in motive to Polkadot, Polygon focuses on improving the interoperability of the Ethereum ecosystem with the added benefit of existing scale and an established community of developers. The Matic token is used to reward users for computational effort and related services on the network.

Solana (utility token, market capitalisation US$8.7bn) Solana is an open-source blockchain that provides the framework and ecosystem for the deployment of DApps with high throughput and quick transaction speeds without using off-chain technologies. The network’s USP is its consensus mechanism, using a novel proof-of-history algorithm combined with PoS to achieve web-like transaction speeds of 50,000 per second. Its use cases are similar to Polkadot and Polygon: any

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Appendix 4 – Altcoins

DeFi application and marketplace seeking to grow quickly. Sol, the native token, is used to pay network fees and stake.

Theta Network (utility token, market capitalisation US$5.9bn) Theta Network is a decentralised content delivery platform using blockchain technology to improve video streaming. Differentiating the platform from traditional high-cost methods is a group of users, collectively nodes, that donate excess bandwidth and other computing resources to help stream higher quality (resolution) videos with reduced buffering. The network runs a duel coin model: Theta coin is used for network governance and staking, whilst Theta Fuel is used for on-chain transactions such as purchasing content and rewarding nodes for sharing their bandwidth.

Stellar Lumens (utility token, market capitalisation US$6.5bn) Stellar Lumens, and token XLM, is a digital ledger technology tackling the issue of moving fiat currencies across political and geographic boundaries with negligible costs. Its primary focus is on helping those outside the scope of traditional banking services in the areas of remittances and bank loans. A network of trusted partners, or Anchors, are used to exchange deposits of tangible fiat monies 1:1 for digital fiat tokens, which can be freely swapped and redeemed across the entire ledger. The current network fee is fixed at 0.00001 XLM.

Internet Computer (utility token, market capitalisation US$5.6bn) Internet Computer is a platform designed to allow developers to build software and share content, i.e. data sharing, via smart contracts using a decentralised cloud computing resource. Its primary goal is to democratise the internet, while enhancing security and granting the ability to host back-end software internally rather than requiring the services of giants like Google. The network’s utility token, ICP, allows users to participate in network governance and pay for computational effort.

VeChain (utility token, market capitalisation US$5.4bn) VeChain is an enterprise solution combining smart contracts and Internet of Things devices to improve business operations with efficient information transfers and product monitoring capabilities in complex supply chains. Its customers are industry- focused and it has proven use cases in almost all verticals including in food with Walmart China and in automotive sales with BMW. The network has two native tokens VET and VTHO, the former used to store and transfer value (data) whilst the latter is used to pay network fees.

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Appendix 5 – Glossary 5 – Glossary

Below is a glossary of selected cryptoasset terminology.

51% attack: a 51% attack is a hypothetical scenario in which more than 50% of a blockchain network’s nodes fall under the control of a single group. In such a circumstance, the consensus of a network is no longer sufficiently distributed enough to be viable, leaving the blockchain open to manipulation.

Bitcoin: Bitcoin is a blockchain network with a native cryptocurrency (bitcoin). It is the first blockchain and cryptocurrency, hence its dominant presence within the broader crypto ecosystem. Bitcoin was established in 2009 and pioneered Proof of Work, a technology for reaching consensus on a decentralised network. bitcoin (BTC): bitcoin (BTC) is a cryptocurrency that can be directly transmitted between users on the Bitcoin network. It is spelled with a lowercase B, as compared to the Bitcoin network, which is denoted with an uppercase B.

Blockchain: a blockchain is a public ledger of transactions that is maintained and verified by a decentralised, peer-to-peer network of computers that adhere to a consensus mechanism to confirm data. Each computer in a blockchain network maintains its own copy of the shared record, making it nearly impossible for a single computer to alter any past transactions or for malicious actors to overwhelm the network. Sufficiently decentralised blockchains do not rely on centralised authorities or intermediaries to transact globally, securely, verifiably and quickly, making technology like cryptocurrency possible.

Byzantine Fault Tolerance (BFT): Byzantine Fault Tolerance refers to a blockchain network’s ability to reach consensus and continue operating even if some of the nodes in the network fail to respond or respond with incorrect information. A network that is Byzantine Fault Tolerant solves the Byzantine Generals Problem, a situation in which all parties must agree but one or more parties are unreliable. Most actively used consensus mechanisms are Byzantine Fault Tolerant.

Cryptocurrency: cryptocurrency is a digital asset that circulates on the internet as a medium of exchange. It employs blockchain technology – a distributed ledger of transactions that is publicly available – and is secured by advanced cryptography. This revolutionary asset architecture allows for certainty that cryptocurrency coins and tokens cannot be double-spent, even in the absence of a centralised intermediary. The first cryptocurrency to achieve mainstream success was Bitcoin, which paved the way for the proliferation of many other cryptocurrencies.

Decentralised Autonomous Organisations (DAOs): a decentralised autonomous organization (DAO) is a blockchain-based organisation that is democratically managed by members through self-enforcing open-source code and typically formalised by smart contracts. DAOs lack centralised management structures. All

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Appendix 5 – Glossary

decisions are voted upon by network stakeholders. DAOs often utilise a native utility token to incentivise network participation and allocate proportional voting power to stakeholders based on the size of their stake. As DAOs are built on top of blockchains – often Ethereum – their transactions are executed transparently on the underlying blockchain.

Decentralised Applications (DApps): software applications built out of smart contracts, often integrated with user-facing interfaces using traditional web technology.

Decentralised Exchange (DEX): a decentralised exchange (DEX) is a financial services platform for buying, trading and selling digital assets. On a DEX, users transact directly and peer-to-peer on the blockchain without a centralised intermediary. DEXs do not serve as custodians of users’ funds and are often democratically managed with decentralised governance organisation.

Decentralised Finance (DeFi): Decentralised Finance (DeFi) is a major growth sector in blockchain that offers peer-to-peer financial services and technologies primarily built on Ethereum.

Digital assets: a catch-all term for assets that exist digitally. The term covers a wide spread, including cryptocurrencies, utility tokens, security tokens, digital stocks and digital collectables. All cryptocurrencies are digital assets, while not all digital assets are cryptocurrencies.

Distributed Ledger Technology (DLT): DLT is a decentralised peer-to-peer digital system for recording transactions between parties in multiple places at the same time. DLT deploys cryptography and consensus mechanisms to allow participants to share an immutable replica of the same ledger. It gets rid of the need for a centralised store of data and dispenses with the requirement for a central authority to carry out administrative functions, as is necessary with traditional databases.

Ether (ETH): ether is the native cryptocurrency of the Ethereum blockchain, and it plays an integral role in the Ethereum ecosystem. Transactions on the Ethereum blockchain are paid for in micropayments of ETH, referred to as gas, while ether also facilitates interactions with and between smart contracts throughout the Ethereum platform and ecosystem.

Fork: a fork occurs when one blockchain is divided into two blockchains. This type of split in a blockchain network happens when an update is made to the blockchain protocol, but not all of the network participant nodes agree to adopt it. Blockchains can experience two main types of forks: a soft fork or a hard fork. Soft forks result in an update that is ‘backwards compatible’. This means that nodes that accept the update are still capable of interacting with nodes that do not. In a hard fork, the update significantly alters the original blockchain protocol such that the two versions are no

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Appendix 5 – Glossary

longer compatible with one another. The result of a hard fork is two unique blockchains that diverge after the hard fork event.

Hashing: hashing is the process of taking an input of any size and using a mathematical function (called a hash) to create an output of fixed size. Hash functions are considered one-way. Unlike encryption, which is intended to conceal data as they move over a network or are stored on a device, hashing is primarily used to verify the authenticity of data. Hashing also serves an important security function in protecting network components such as passwords and sensitive information that can be stored as hashes – the outputs of hash functions.

Layer-1 blockchain: a layer-1 blockchain is typically a name used to describe a main blockchain network protocol such as Ethereum or Bitcoin. The name layer-1 comes from its relationship with layer-2 scaling solutions such as state channels, rollups, nested blockchains and plasma side chains. Layer-1 blockchains are simply the main network that a layer-2 scaling solution attaches to in order to improve the scalability and transaction throughput of the main chain, or layer-1. Layer-1 blockchains can also be known as the parent chain or root chain, among other classifications.

Layer-2 scaling solution: layer-2 scaling solutions are protocols that integrate into blockchains like Bitcoin and Ethereum as separate, secondary layers built to increase transaction throughput and reduce transaction costs. Examples of layer-2 solutions include Bitcoin’s Lightning Network and Ethereum’s Plasma.

Oracles: data feeds that allow information from sources off the blockchain, such as the current price of a stock or a fiat currency, to be integrated into DeFi services.

Stablecoins: digital assets whose values are pegged to a fiat currency, a basket of fiat currencies or other stable-value assets.

Satoshi Nakamoto: Satoshi Nakamoto is the pseudonymous individual or group responsible for creating the Bitcoin protocol. Satoshi Nakamoto famously published the Bitcoin white paper in October 2008 and mined the first ‘genesis’ block on the Bitcoin network in January 2009. The true identity of Nakamoto remains unknown.

Sharding: sharding is a mechanism that is used to partition a blockchain network or other type of computer network or database. Its purpose is to distribute the network’s computational and storage workload across a broader set of devices, or nodes, in order to increase the throughput and transaction speed of the entire system.

Smart contract: smart contracts are computer programmes that run within a blockchain protocol that automatically execute based on pre-set conditions. They execute a predefined set of terms automatically in a trackable and irreversible manner without the need for a third party.

Important note: see regulatory disclosures on page 123 of this report. 121 Cryptoassets / 5 August 2021

Appendix 5 – Glossary

Token: within the context of blockchain technology, a token generally refers to a unit of value for a programmable asset that is managed by a smart contract and an underlying distributed ledger. Tokens are the primary means of transferring and storing value on a blockchain network – most often Ethereum. Tokens can also be designed to be either fungible or non-fungible, depending on a network’s specific needs.

Wallets: software interfaces for users to manage assets stored on a blockchain. With a non-custodial wallet, the user has exclusive control of funds through their private keys. With custodial wallets, private keys are managed by a service provider.

Sources: Gemini.com; Risk.net; Wharton; Redburn

122 Important note: see regulatory disclosures on page 123 of this report. Cryptoassets / 5 August 2021 RECOMMENDATIONS

Redburn argues that the stock price will rise by at least 15% over one year. For high beta stocks the hurdle rate may be commensurately higher.

Redburn argues that the stock price will be lower in 12 months than it is today.

Redburn currently has no strong opinion on the likely movement of this stock price.

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Redburn (Europe) Limited’s Conflicts of Interest Policy is set out in Regulatory Information at www.redburn.com. REDBURN (EUROPE) LIMITED:  never owns positions in shares exceeding 0.5% of the issued share capital of a company on which we issue research (“Covered Company”)*;  has no shareholder which is a Covered Company;  is not itself, nor is it the holding company or a subsidiary of, a company which: - is a market maker or liquidity provider in the financial instruments of a Covered Company; - has been lead manager or co-lead manager over the previous 12 months of any publicly disclosed offer of financial instruments of a Covered Company; - is party to an agreement with a Covered Company relating to the provision of services as set out in Sections A and B of Annex I of Directive 2014/65/EU; - is party to an agreement with the Covered Company relating to the production of the research; and - has employees whose remuneration is linked to the provision of services as set out in Sections A and B of Annex I of Directive 2014/65/EU or who would receive or purchase the shares of a Covered Company to which the research relates prior to the public offering of such shares. *Positions in shares only arise as a result of our failure to match our client’s orders precisely LIST OF RECOMMENDATIONS

Clients can request a list of research recommendations made to them in the last 12 months by sending a request to [email protected] PUBLICATION DETAILS This research was completed at 15:00 on 4 August 2021. This research was published at 06:00 on 5 August 2021. REGULATORY DISCLOSURE This report has been issued by Redburn (Europe) Limited (‘Redburn’), authorised and regulated by the Financial Conduct Authority and is intended for use by professional and business investors only. It is solely for the information of the addressee only and is not an offer, or solicitation of an offer, to sell, or buy, any securities or any derivative instruments or any other rights pertaining thereto. The information in this report has been compiled from sources believed to be reliable but neither Redburn, nor any of its officers or employees makes any representations as to its accuracy or completeness. Any opinions, forecasts or estimates herein constitute a judgement, as at the date of this report, that is subject to change without notice. This report does not have regard to the specific instrument objectives, financial situation and the particular needs of any specific person who may receive this report. Redburn may have disseminated information contained in this report prior to its publication. Notice for US recipients This report is not intended for use or distribution to US corporations that do not meet the definition of a major US institutional investor in the United States or for use by any citizen or resident of the United States. Redburn (Europe) Limited, and its research analysts, are not members of the Financial Industry Regulatory Authority and are not subject to the FINRA Rules on Research Analysts and Research Reports and the attendant restrictions and required disclosures required by that rule. Redburn (Europe) Limited is a correspondent of Redburn (USA) LLC. All US persons receiving this report and wishing to buy or sell the securities discussed herein should do so through a representative of Redburn (USA) LLC. Redburn (USA) LLC and its affiliates: do not own any class of equity securities issued by any of the companies discussed in this report; have not received, and do not intend to receive, any investment banking compensation from any of the issuers discussed in this report; and, have not acted as manager, or co-manager, of any public offering of securities issued by any of the companies discussed in this report. Neither Redburn (USA) LLC, nor any of its officers, own options, rights or warrants to purchase any of the securities of the issuers whose securities are discussed in this report. Neither Redburn (Europe) Limited, nor Redburn (USA) LLC, make a market in any securities, and do not stand ready to buy from or sell to any customers, as principal, any of the securities discussed in this report. © Copyright 2021.

Important note: see regulatory disclosures on page 123 of this report. 123

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