The Institutionalization of Crypto Markets
Crypto markets are relatively volatile and although the current infrastructure around crypto is improving, the current status is not yet where it needs to be compared to the infrastructure around stocks. This makes it challenging for the “big” money, to invest in crypto markets. Current and past routes for “big money” to invest in digital assets are, for example, the Bitcoin Futures of CBOE and CME and the purchase of crypto from mining farms through an IPO (initial public offering). According to many, 2019 would pave the way for large investors to invest securely in digital currencies such as Bitcoin. The new Bakkt trading platform would take care of this. Bakkt, a subsidiary of Intercontinental Exchange (ICE), is known as the owner of large stock exchanges such as the New York Stock Exchange. In addition, ICE works together with large multinationals such as Microsoft. The experience, collaborations and the goal to professionalize the crypto infrastructure would inspire confidence among institutional investors. Still the enthusiasm for Bakkt was disappointing and the Bitcoin price dropped after the launch. How accessible is crypto really for institutional investors and “big money” and do we really see that the interest of these parties in investing in crypto is increasing? Let’s first look at which past and current challenges are obstructing the “big money” from investing in digital assets.
Challenge 1: Regulation and definition of digital assets
For a long time it was difficult to invest in cryptocurrencies because of huge regulatory risks. There was a shortage of laws to prevent and punish price manipulation and fraud. In addition, there was little protection for the investor. This makes it possible for funds to harm investors for their own gain in an unethical way. Also, to prevent financing of terrorism and anti-money laundering, it must be clear what happens to the invested funds. Where will they be stored? How will they be protected from unlawful activities? Institutional investors demand high standards in this regard. Crypto exchanges today, however, still lag behind in this. Luckily, these exchanges are becoming more professional with KYC / AML processes to counter this. In addition, it is not clear what crypto exactly is in a regulatory context. Is it money or a commodity? This is important for institutional investors to know because it affects how tax is declared and whether it is legal or illegal in a country to invest or trade cryptocurrencies.
Challenge 2: Counterparty risks
The oldest crypto investors probably do remember Mount Gox. Almost 800,000 Bitcoin were stolen from the exchange. There were still hacks occurring last year, but luckily on somewhat smaller exchanges. In addition, maintenance is sometimes performed at curious moments, causing exchanges to close for a few hours. It is sometimes thought that insider trading is going on during these times. The counterparty risk to manage and trade your crypto is certainly present. Besides that, it must be possible to convert large amounts of fiat to crypto instantly without any problems to manage it, if exchanges want to satisfy “big money”. The custody is a lot more difficult than with conventional stocks for institutional investors because it is sometimes not clear how their funds are managed exactly and what their guarantees are when things go wrong. If you register at a stock exchange, a thorough vetting process follows. However, we hardly see this with cryptocurrency exchanges.
Challenge 3: Organizational complexity and lack of knowledge
Digital assets are a complex asset class. Research of Asset Management Fund Vision Hill Group shows that the steep learning curve causes investors to need time to fully understand what they are investing in. This is no surprise as the information about cryptocurrencies is rather fragmented due to the open source nature. In addition, institutional investors sometimes do not know what kind of structure to invest in according to research of Vision Hill Group. Do they do that through a hedge fund or through a venture fund? Or a mix thereof? Organizational investors do not make investments as quickly as a retail investor. Several people make decisions within an organization and many people need to be convinced of an appropriate investment strategy in a new asset class.
In recent years, a huge number of hedge funds have emerged with a focus on fundamental analysis and portfolio management. A distinction was often made between public and private cryptocurrencies and a barbell strategy approach (a fixed-income portfolio consisting of short-term and longer-term investments) was used to invest in them. The managers of such funds must therefore be competent in managing the asset-liability. Besides that, many of these hedge funds have lock-up periods and low liquidity. This is not always handy for the institutional investor that quickly wants to redeem funds.
How to overcome these challenges?
Today, It seems that institutional investing is easier according to research of Vision Hill Group. This is mainly because of the launch of Bitcoin-focused products such as Bakkt, Galaxy Digital’s new funds and Fidelity. In addition, legal decisions are starting to give more room to such platforms and funds. For example, the SEC gave green light to a fund of 15 billion for cash-settled Bitcoin futures in order to prevent potential market manipulation and fraud. In addition, the fund ensures that there are no extreme fluctuations in liquidity because daily redemptions are not possible. The investor is protected with risk disclosures and only registered investment advisors are hired. This is a sign of progression, as SEC Commissioner Hester Pierce says.
Exchange Hacks and maintenance of exchanges at sometimes crucial market periods still occur in the markets. Recently, however, hacks mainly occur on smaller, less developed exchanges. Due to increasing competition from exchanges at top tier level and regulation of the industry, it seems that maintenance at crucial market times is declining. An increasing number of exchanges also use professional custody for institutional investors around the world. For example, very recently, Coinbase announced the launch of a custody for European investors. In addition, regulatory measures such as the European Union’s 5th Anti-Laundering Directive ensure the minimization of fraud, money laundering and terrorism within the crypto markets. This automatically ensures a better vetting process of exchanges, making the market accessible to “big money”.
Organizational structures of funds also seem to become easier to understand for institutional investors. Especially venture funds seem to be attracting the attention of “big money” recently because of their longer existence and exuberant experience and because of their standard investment structures without bells and whistles. Cryptocurrency as an asset class already has so much complexity that it only seems to scare most institutional investors if there is a complex investment strategy such as the hybrid barbell strategy that many hedge funds use. More standard structures are cheaper as well. However, if investors look for alpha besides their Bitcoin investments, then it might be worthwhile for them to search for active hedge funds to diversify. A mixture of beta (in this case Bitcoin) and alpha potentially outperforms Bitcoin specific strategies. Active hedge funds however must have a deep understanding of mining strategies, thematic trends, fundamental and technical aspects of the altcoin market, risk management and market timing skills. This is quite a unique combination of factors and a lot of hedge funds to close down during the last two years because of underperformance compared to beta-focused funds.
Is the interest for institutional investing really increasing?
Yes. Interest is for institutional investing in crypto is clearly rising. Both traditional exchanges like Coinbase and platforms which are built to further improve the infrastructure or crypto trading like CMEGroup show rising weekly and quarterly amounts of crypto deposited and traded by institutional investors.
Another crucial statistic is the amount of addresses with a substantial amount of Bitcoins allocated to it. Famous Bitcoin price analyst Willy Woo shows a visualization from GlassNode of that in an obvious graph. From 2010-2014 the amounts of Bitcoin addresses with a lot of Bitcoin on it were rising steeply. Between 2014 and 2018 there does not seem to be a lot of trending activity. But after 2018 it shows the same steep growth as the first four Bitcoin years in amounts of addresses with a lot of Bitcoins allocated to it. This seems to be correlated with the inflow of capital that Coinbase and CMEGroup are showing. Therefore it looks like the graph is extra evidence that institutional investors are increasing their exposure to Bitcoin consistently from the end of 2018 till now. It clearly looks like this will continue as there is no clear change in trend visible in the graph.
It is important to realize that this graph is only about Bitcoin. You probably know that many people refer to a tablet, but then say Ipad. Asset Management Fund Vision Hill Group indicates that when people talk about cryptocurrencies, they often say Bitcoin while they mean the same thing. However, there is a huge landscape of digital currencies ranging from smart contract tokens, decentralized finance, privacy coins to web3 innovations. It makes sense that people think about Bitcoin first, since it is the first and the largest crypto currency in terms of liquidity. When people read the news, it is usually about Bitcoin. It is also the least volatile asset in the crypto market and volatility is a factor that institutional investors consider important in their balanced portfolio strategy. In addition, Bitcoin is compared to traditional assets such as gold due to the scarcity and is often seen as a hedge against a potential global crisis in the event of a currency crisis related to central banks. It is therefore logical that institutional investors, because of simplicity, risk aversion and the narratives, stick to Bitcoin instead of “the rest”.
The vague and often undeveloped regulator landscapes and definitions of digital assets were challenging for institutional investors to navigate. The infrastructure around the crypto markets is not as professional as the ones of stock markets in terms of guarantees and vetting. The organizational structures of hedge funds did not help either with their long lock-down periods and complex hybrid investment approaches. They were almost as steep as the learning curve of understanding cryptocurrencies themselves; a complex and fragmented landscape or thousands of different things to invest in.
However, this is changing at a rapid pace. Investing in digital assets is becoming increasingly accessible to institutional investors. Laws are becoming clearer through concessions and the adaptation of investment funds to the wishes of regulators. In addition, regulators now know better what is and what is not legal in the crypto markets. The structures of funds are simplified as more experienced venture funds increase in popularity. Their (bitcoin) products have standard structures to maintain a portfolio in digital assets.
Since 2018, the number of deposits and investments on both traditional exchanges and on new professionalised platforms has been consistently increasing every month. This is also reflected in the number of addresses with a large amount of Bitcoins. Bitcoin remains the most popular cryptocurrency to invest in due to its accessibility, familiarity, relatively lower volatility and attractive narratives in a global economy. It is likely that institutional investing will rise substantially during 2020.
Contributed by @LordCatoshi