How financial services firms win as the market consolidates

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Capitalizing on the crypto and blockchain deal rush

Cryptocurrencies and blockchain are disrupting financial services, unleashing vast improvements in speed, transparency, efficiency, and security. To capitalize on this new opportunity, financial institutions are turning to mergers and acquisitions (M&A). Executing deals is a challenge and the stakes are high. Failed transactions will cost buyers not only their initial investment but also their chance to claim a leadership position in the new world of money. Meanwhile, firms that successfully integrate these transformative assets should gain a significant competitive advantage.

To develop this paper, KPMG researchers conducted detailed analyses of 117 cryptocurrency and blockchain transactions in the financial services industry between mid-2017 and mid-2019, studying deal volume, flow, size, type, and outcome. The findings are summarized on the following pages.

Our findings underscore the growing recognition that the winning financial services firms of the future will be those that successfully integrate these powerful technologies into their business. However, capitalizing on the deal rush remains a difficult challenge for established financial services firms.

In the following pages, we provide detailed insights into:

— The forces driving the M&A surge in crypto and blockchain

— Challenges facing dealmakers

— How incumbent firms can execute a successful M&A strategy in crypto and blockchain

1© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Crypto and blockchain consolidation is comingThe future of money is digital. Cryptocurrency is making inroads in financial services, particularly in the payments business. Distributed ledger technology (blockchain) promises breakthrough improvements in the speed, cost, and security of all kinds of financial transactions, while also enabling a range of new services.

To benefit from these transformative technologies, financial services companies are rushing to build up knowledge and capabilities in crypto and blockchain.1 Meanwhile, a frenzy of start-up activity has produced an oversupply of young companies in crypto and blockchain, many of which struggle to get a firm foothold.

The conditions are ripe for consolidation. Financial institutions that need to quickly position themselves for future competition are hooking up with innovative start-ups looking to scale up. In fact, there is already an M&A boom in crypto and blockchain businesses. From 2017 to 2018,

crypto M&A shot up 150 percent, from 22 transactions to 53.2 In the first half of 2019 there was an average of four M&A transactions every month.3 Researchers predict that blockchain-focused M&A will triple in 2019.4

While there is no shortage of deals, finding and executing the right deal at the right time is extremely complex and challenging. Buyers need to find ways to value start-up businesses that are developing technologies that have not yet been commercialized on a large scale. People with the expertise to value such companies are typically employed by potential targets, rather than by potential buyers.

For many financial institutions, this is unfamiliar and difficult terrain, and the costs of making the wrong deal are high. In addition to wasting money on a failed transaction, acquirers risk falling far behind in the next phase of technology innovation. But, players that execute crypto and blockchain deals well will be that much farther ahead.

1 Source: KPMG LLP, “Institutionalization of cryptoassets” (November 2018)2 Source: KPMG analysis of cryptocurrency and blockchain deals involving financial services and fintech companies between 2017 and 2019 (June 2019)3 Source: KPMG analysis (based on M&A deal data from Capital IQ and CB Insights, June 2019)4 Source: Circle Research, “2018 Crypto Retrospective” (January 24, 2019)

2© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Incumbents are using acquisitions and partnerships for a wide variety of strategic reasons. Some of the more popular types of deals are “platform plays” which assume an ability to scale a nascent business given an initial cohort of paying customers, scalable technology and an investment thesis that is predicated on bolt-on acquisitions. We find that buyers are especially interested in technology and platforms used in trading and exchange, and for payments and remittances. Together, transactions in these categories account for 80 percent of deals by established players.5

Often, deals are motivated by the realization that banks and other incumbents lack the wherewithal—both technical and organizational—to ramp up crypto- and blockchain-based processes and businesses on their own. By partnering with or purchasing start-ups, incumbents can create the equivalent of an in-house new business incubator.

Finally, some acquisitions are about gaining access to talent with skills and knowledge that are in short supply. Blockchain and crypto developers are highly specialized engineers with hard-to-find skill sets. Staffing a team can be difficult without acquiring external talent. In fact, many cash-rich companies, such as Coinbase, are looking at making “acqhires” —deals predicated on bringing in specific individuals who are leaders in their areas of expertise.

5 Source: KPMG analysis based on M&A deals data from Capital IQ and CB Insights (March 2019)

blockchainCapabilities of Use in financial

services

— Cross-border payments

— Remittances

— Trade financing

— Insurance claim settlement

— OTC trading contracts

— Clearing and settlement of trades

— Anti-money laundering/know your customer compliance

— Fraud detection

Distributed ledger

Smart contracts

Immutability and transaction provenance

Payments — Cross-border payments,

remittances

— A new speculative asset class

Investment

Exchanges and wallets

— Purchase, sale, and trade of cryptocurrency

— Storage of cryptocurrency

Capabilities of Use in financial servicescrypto

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Industry consolidation at a glance

Capability building: Traditional institutions are turning to partnerships, joint ventures, and acquisitions to speed up development of crypto and blockchain and reduce the risk of trying to build these in-house. The top 20 global banks have all entered into a partnership or joint venture with a crypto or blockchain company since 2017.6

Too many start-ups: There are way too many cryptocurrencies clogging up the investable space, many of which aren’t very liquid. Of 2,250 investable cryptocurrencies, only 360 have a market cap north of $10 million, and a mere 91 tallied in excess of $10 million worth of trading volume over the trailing 24-hour period.7

High failure rate: Crypto and blockchain start-ups have a high failure rate. Since 2013, an estimated 114 blockchain companies received first-round or angel funding. Only one made it to Series D.8

Market pressure: Leading banks and technology giants are making significant commitments to crypto and blockchain for their businesses. Both JP Morgan9 and Facebook10 have launched their own cryptocurrency, while Apple is launching a tool to help developers build security for apps using cryptographic techniques.11 These moves raise the pressure on financial services players to get moving.

6 Source: KPMG analysis based on Capital IQ and news articles (March 2019)7 Source: CoinMarketCap.com, “Top 100 Cryptocurrencies by Market Capitalization,” (June 25, 2019)8 Source: Pitchbook, “Venture Capital Deals and Manager Data” (June 25, 2019)9 Source: CNBC.com, “JP Morgan is rolling out the first US bank-backed cryptocurrency to transform payments business” (February 14, 2019) 10 Source: Techcrunch, “Facebook announces Libra cryptocurrency” (June 18, 2019)11Source: Coindesk, “Apple’s CryptoKit Launch Paves the Way for Secure Mobile Wallets” (June 5, 2019)

The crypto and blockchain M&A wave is being propelled by a number of market factors, motivations, and rationales.

2,250

36091

4© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Dealing with crypto and blockchain transaction risks

Evaluating deals

While financial services companies have no trouble making deals to bring crypto and blockchain into their businesses, the way consolidation is playing out raises concerns that deals may not work out in the long run. Cryptocurrency and blockchain dealmakers face unique and significant challenges throughout the deal lifecycle, including properly evaluating and valuing targets, then integrating acquisitions and realizing value from their transactions. Valuation is

a particular challenge: some market analysts warn that the irrational exuberance of the cryptocurrency market—massive price swings and high-fliers with questionable business propositions—is a sign of another tech bubble. For firms to have the confidence to move forward with a partnership or acquisition, careful, vigilant dealmaking—from evaluation to execution—is critical.

It is a significant challenge for financial services firms to identify promising start-ups, evaluate their products and technology, and assess how and where these new platforms can unlock growth and revenue potential. The skills required to evaluate these novel technology platforms are not widely available outside the start-ups themselves.

Due to their early stage in commercialization, due diligence for cryptocurrency and blockchain assets must go much deeper to validate technology viability.

To gain the insights needed to make key deal decisions, a more holistic evaluation framework is required—one

that includes extra technology review tasks designed to understand strengths and weaknesses in areas that are specific to crypto and blockchain assets, including blockchain network mechanics, cryptography policies, and consensus mechanisms.

At the close of due diligence, savvy investors must understand the technology at a fundamental level. Ideally, they should take an early equity position in promising new ventures, then help influence the design and architecture of new offerings. Assessing the potential of a partnership also requires deep market knowledge coupled with visionary creativity.

Due diligence for crypto and blockchain requires additional considerations

5© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Valuing deals

12 Source: CoinMarketCap.com, “Top 100 Cryptocurrencies by Market Capitalization,” (June 25, 2019)13 Source: Coindesk, “The 17 Millionth Bitcoin Is About to Be Mined: What It Means and Why It Matters” (April 26, 2018)14 Source: Coindesk, “What is Ether?” (March 30, 2017)15 Source: Altcoin Buzz, “Ripple Now Has Over 200 Partners, 5 New Financial Institutions Are Using XRP” (January 8, 2019)

How do you value an asset that lacks a clear definition and means different things to different people? How do you estimate potential value from products and services that can be used in a wide range of applications—but are largely unproven? Where do you place your bets in an industry that is still in flux and where rapid innovation is unleashing creative destruction?

Blockchain solution valuation is a dual challenge. Foremost, the assessment of the solution’s potential is ambiguous at present, dependent on a commercially unproven technology. Secondly, traditional valuation methods such as discounted cash flow (DCF) analysis and comparable company analysis are difficult to arrive at, given lack of precedent transactions, limited predictability for success, and the inherent highly technical nature of the industry.

To value potential crypto and blockchain targets, buyers need to vet all the financial data, and then apply nonfinancial metrics. The choice of nonfinancial metrics will vary according to the specific deal and the acquirer’s situation. However, in every case, buyers should be sure to consider these three factors:

Strength of technical architecture: Buyers need to know that the target’s technology is

sufficiently robust, reliable, and secure for the intended use. For example, high-volume credit card transaction processing has a different set of scalability requirements than a system for managing highly complex reinsurance transactions.

Developer talent: Talent is a critical factor for valuing crypto and blockchain acquisitions. Expertise

is the scarcest commodity.

Integration potential: Acquirers must understand onetime integration costs. This requires technical

know-how to understand and identify integration options with existing systems, and financial analysis to estimate their cost.

Purchasing cryptoassets presents additional challenges. Traditional value indicators such as price of the asset, rank, market capitalization, and trading volume do not give a full or accurate view. High volatility of cryptoassets compounds the challenge, even with the latest data visualization tools.

However, by examining traits of the largest cryptocurrency companies by market capitalization,12 we have identified three factors that appear to drive values and which buyers should consider:

Scarcity: Certain coins are designed with a finite number that can be generated or mined. For

example, the maximum supply of Bitcoin—the largest cryptocurrency—is 21 million, which are expected to be mined by 2140. As of 2018, approximately 80 percent had already been mined.13

Utility: The potential use of the cryptocurrency has a huge impact on its value. The more applications,

the higher the potential value. So, leading cryptocurrency issuers continue to create new applications for their coins and tokens. For example, Ethereum’s cryptocurrency, Ether, is used as a form of payment for running distributed applications (dApps) built on the platform.14

Market perception: How the cryptocurrency is viewed by the broad financial services ecosystem

also impacts its value. Adoption by leading banks is seen as a sign of strength. For example, Ripple’s XRP is often viewed as a better option than Bitcoin because Ripple has more than 200 collaborations around the world.15

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16 Source: U.S. Securities and Exchange Commission, “Statement on ‘Framework for Investment Contract Analysis of Digital Assets’” (April 3, 2019) 17 Source: Cointelegraph, “What Crypto Exchanges Do to Comply With KYC, AML and CFT Regulations” (May 17, 2019)18 Source: CNBC.com, “SEC rejects bitcoin ETFs” (August 22, 2018)

Realizing deal value

Crypto and blockchain deals also have different sources of postmerger value capture. With the scale of start-up operations, there is usually little to be gained through cost synergies, so the value must come from opening new markets, or streamlining existing operations by introducing blockchain-based processes into the acquirer’s operations. Acquirers should focus first on value-generating initiatives, but should also foster a culture that allows new opportunities to arise as they integrate the acquired technologies, processes, and skill sets into their existing operations. Successful acquirers typically build a model that is light on product integration, allowing the new company to align its product roadmap with the intended application for the new technology.

Regulatory action is also a potential obstacle to value capture in crypto and blockchain deals. For the moment, regulators are taking a cautious approach to allowing widespread adoption of cryptoassets. But scrutiny is increasing in some areas, including greater oversight of initial coin offerings by the Securities and Exchange Commission,16 as well as additional anti-money laundering and know-your-customer requirements.17 Regulators also recently rejected two proposals for bitcoin ETFs.18 To realize value from their investments in crypto and blockchain, financial services firms will need to actively engage with regulators. And, they should have realistic expectations about how long it will take for the market for cryptoassets to mature under a stable regulatory regime.

Integrating deals

Large financial services firms face significant challenges in integrating innovative, fast- moving technology startups. Buyers can sometimes smother the creativity and disruptive thought processes that make crypto and blockchain organizations succeed. This problem is not unique to crypto and blockchain acquisitions, but is particularly relevant in this space, when it isn’t uncommon for a 100 year old incumbent institution to acquire a bleeding edge startup. Crypto and blockchain talent who had initially been drawn to a startup environment may not work well under a corporate umbrella, and vast cultural differences may even cause them to seek opportunities elsewhere.

Acquirers, therefore, must strike a delicate balance between allowing a new acquisition the freedom to continue to innovate and evolve, and extracting value from the acquisition. Integration strategies must be tailored to the specific path to value realization expected for the deal, and payback timelines and return on investment expectations must be realistic. As is the case for any nascent disruptive technology, the expectation of supernova-like returns drives the irrational exuberance that will ultimately be replaced by a bumpy road to cooler markets, as long-term winners and losers emerge.

7© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

How financial services players proceed—and how they’ll succeed—with crypto and blockchain M&A may have lasting impact on their ability to adopt new technologies and compete in the future. Here are some ways incumbent firms can take action, strategically and operationally, to gain the greatest strategic and monetary value from crypto and blockchain M&A.

How to win with crypto and blockchain deals

As consumer and corporate clients push for greater speed, security, and transparency in transactions, financial services incumbents have an immediate incentive to use crypto and blockchain solutions to improve current services and build new ones.

Start by understanding where to apply the new technologies first to get the greatest benefit. Where are there gaps in their current offerings that could be filled with blockchain-based solutions? What services most need improvement? Connecting directly with sales and marketing teams—and evAen customers—is a great way to uncover areas that would most benefit from technology transformation. Also review the potential for crypto and blockchain in trading, exchange, payments, remittances and other services.

To aid the tricky valuation process, buyers can use a range of new data and visualization tools to make sense of available data on blockchain activity and players. These tools help value cryptoassets more precisely than manual analysis. Tools like OnchainFX and Bitcoinity allow tracking of crypto market data. Others, like Coin Metrics and Bitcoin Visuals, do the same for blockchain market data. There are also tools to track ICOs and tokens, such as ICO Tracker, TokenData, and Messari. Lastly, there are data visualization tools like Satoshi’s Place.

Identify high-potential opportunities Timeline: immediate

Invest in valuation analytics Timeline: immediate

Once incumbent firms identify specific applications for crypto and blockchain technology, they can evaluate what they can build, what they should buy, and with whom they might partner. At this stage, tough questions are sure to arise that will ultimately impact what deals incumbents pursue. For example, a firm may envision integrating a distributed ledger product to expedite remittances, but realize that the required consensus mechanism actually reduces speed-related benefits.

An effective deal strategy will address all key deal questions, including: how the target will enable growth; how exposed it is to evolving crypto regulations; what is the underlying blockchain type (private or public); what will be the integration challenges and associated costs; and how resilient is the target to disruption.

A crypto innovation hub can help the management team assess, evaluate, and ultimately complete a transaction in this highly technical niche, as well as incubate and govern technology innovation on an ongoing basis. Staffed with blockchain and crypto specialists, an innovation hub can also provide leadership, best practices, and support as the company explores, integrates, and pilots blockchain solutions.

Develop a deal strategy Timeline: 1–3 years

Establish a crypto innovation hub Timeline: 1–3 years

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How KPMG can helpKPMG’s Technology M&A and Strategy practice has deep experience helping financial services firms develop and execute cryptocurrency and blockchain transactions that drive value to the business.

We have helped organizations across the financial services ecosystem develop viable and practical crypto and blockchain strategies, weigh the financial and operational pros and cons of in-house development versus partnerships or acquisitions, and identify potential deal targets in line with the overall strategy. We have also guided the thorough evaluation of potential deal targets, including the strength of the target’s crypto algorithms and platforms, potential applications for the target’s products and services, technical depth of the target’s engineering team, and rigor of the target’s technology governance processes.

Our approach brings the talent and depth of KPMG to significant M&A challenges facing the financial services industry. Our deal specialists skillfully apply the firm’s well-tested, cross-industry approaches to dealmaking to the crypto market, leveraging the technical know-how of our highly trained in-house crypto and blockchain engineers.

What we do How we work

9© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Authors

Sanjay is a managing director in KPMG’s Strategy practice, specializing in guiding clients in M&A strategy and execution of deals in banking and capital markets. Sanjay has advised on over 100 transactions, including corporate acquisitions, spin outs, and management buyouts. He has been actively engaged in fintech incubators and is well versed in emerging technologies such as blockchain and crypto and their impact on the valuation of a bid and integration of an asset.

Sanjay BasuManaging Director, Strategy

Azmat is a director in KPMG’s Strategy practice with a specialization in product/platform reviews in the context of assessing the embedded value and sustainability of a proprietary software in the diligence stage of an M&A transaction. Previously, he designed and piloted blockchain projects for a mid-sized regional bank. Azmat has worked on digitization and automation projects for a number of firms in the financial sector.

Azmat MohammedDirector, Strategy

Kyr is a director in KPMG’s Strategy practice specializing in technology’s role in M&A, with deep experience in technology integration for mergers and acquisitions, as well as software application development and global implementation. Kyr has been closely involved in the transformative potential of disruptive technologies such as blockchain, intelligent automation, and advanced data analytics to help clients realize the potential of their M&A transactions.

Kyr GaganidzeDirector, Strategy

David is a principal in KPMG’s Strategy practice, with over 20 years of experience providing strategic insight and implementation support to financial services companies. He has led many business operations and technology transformation initiatives, with a focus on enterprise growth and efficiency. He is active in KPMG’s distributed ledger efforts and led an engagement to assess the impact of a blockchain payments solution at a top-20 bank.

David Montes Principal, Strategy

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The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

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Learn more

Sanjay Basu Managing Director, Strategy KPMG LLP E: sanjaybasu@kpmg.com T: 212-954-8307

David Montes Principal, Strategy KPMG LLP E: dlmontes@kpmg.com T: 404-979-2115

Kyr Gaganidze Director, Strategy KPMG LLP E: kgaganidze@kpmg.com T: 303-382-7677

Azmat Mohammed Director, Strategy KPMG LLP E: azmatmohammed@kpmg.com T: 312-665-6712

Contacts

Thought leadership

Institutionalization of cryptoassets

Blockchain and the future of finance