Author: Christian Hsieh, CEO of Tokenomy
While cryptocurrencies have been relatively popular among fringe and retail investors, they have not gained significant foothold amongst institutional investors.1 The institutional segment has long been seen as the highway to widespread adoption.
The original crypto asset, Bitcoin, has led to the evolution of utility and security tokens, stablecoins, ICOs, and Decentralized Finance (DeFi) applications which are technologies that disintermediate the many layers of middlemen activities in the current financial system. These developments are meant to appeal to the needs of institutional investors and provide a bridge to conventional finance.2 Despite these innovations, adoption among institutional investors was still slow. A study estimated that institutional firms controlled only 7% of the global digital asset market with the remainder dominated by retail investors.3
A fear of the unknown and untested
Slow adoption is likely attributed to factors like the volatile and uncertain nature of cryptocurrencies, unclear regulatory stance in different countries, and a lack of education on the crypto market. In addition to that, institutional investors are also deterred by the lack of infrastructure within the current financial system to service activities within the crypto market.
Liquidity risks become more pronounced as current providers are not fully equipped to manage fiat currencies and cryptocurrencies. A lack of understanding of the technologies behind cryptocurrencies adds to operational risks as well. For instance, providers need to develop new training and security protocols around fund transfers and the protection of private keys.4
Growing to become an institutional-grade asset class
A survey by Fidelity Investments across over 440 institutional investors found that 47% of institutional investors were interested in crypto investments.5 However, only 22% have actually invested in digital assets. On the other hand, 74% of financial advisors and 80% of family offices that responded found digital assets appealing.6 This is likely because individuals are increasingly showing interest in this asset class and are bullish on the performance of these assets in the long run.7 This interest continues to spur ecosystem players to develop new solutions to improve the accessibility of cryptocurrencies to more clients that face stringent regulatory oversight.
The rise of institutional-grade infrastructure
In their pursuit to gain widespread adoption, many crypto trading platforms failed to implement a stringent process to verify their users. Fraudulent transactions were relatively prevalent among crypto-assets compared to conventional investments.
A KPMG study estimated a total of USD 9.8 billion worth of assets have been stolen since 2017 through a series of illicit activities.8 A Fenergo poll found that less than 5% of institutional investors considered existing cryptocurrency KYC (know your customer) and AML (anti-money laundering) processes to be effective. Close to half (40%) of the respondents thought they were highly ineffective.9
Issues around fraud and security have spurred a growth in custodian services – which hold, move, and protect securities on behalf of clients. Custodian services may help interested investors explore a new category of assets by reducing execution risks. Crypto players like Coinbase, Boerse Stuttgart, and Vontobel have already launched this service in a push to introduce more institutional investors to bitcoin and other digital assets.10
Grayscale, a cryptocurrency investment fund, saw a 15% increase in institutional investments in digital assets over the year after introducing its custodian services in Q1 2019.11 12 The positive impact was even more apparent as 48% of Grayscale investors are situated in the US. The SEC (Securities and Exchange Commission) requires institutional investors with customer assets worth more than USD 150,000 to store the holdings with a qualified custodian.13
In an (uncorrelated) class of its own
According to a study conducted by CoinGecko, a digital assets ranking website, cryptocurrency tends to outperform other asset classes. In 2019, the top-5 digital coins yielded an average 20.6% return.14 Bloomberg predicted that the performance of crypto products like Bitcoin in 2020 will continue strongly on the back of their 2019 growth.15 With a longer and stronger performance track record, crypto assets are becoming a more attractive option for investors looking to diversify their holdings.
While crypto assets have generally been regarded as being volatile, it has proven to be resilient during economic downturns. Its performance has been uncorrelated to the traditional assets as shown during the recent pandemic event. Despite the downturn of the traditional market, crypto-assets generated higher returns compared to more conventional securities at the same risk levels during the COVID-19 pandemic as seen in the following table.16
Table 1. Risk adjusted returns rate in Sharpe ratio (the higher the better)
|Asset||Ratio in Jan 1st||Ratio in April 1st||Change over the period|
|US real estate||1.13||0.11||-1.02|
Increasing regulation and education are welcome scrutinies that bolster the crypto market
Recent trends suggest that despite institutional investors’ wariness of holding onto digital assets, they would be willing to invest if risks are mitigated more effectively. For example, CME’s Bitcoin futures contract – which serves as a once-a-day reference rate of the U.S. dollar price of Bitcoin17 – allows institutional investors to speculate on cryptocurrency pricing by trading futures without having to hold the underlying crypto asset.18 As of 16 April 2020, the number of futures contracts outstanding was USD 181 million, up 70 percent from USD 106 million on March 22.
Regulation around transactions and the definition of crypto will likely attract more institutional investors. Europe has pushed the fifth AML directive (AMLD5), making it mandatory for crypto companies based in European Union (EU) member states to register with local regulators to collect customer data as well as sources of funds to prevent money laundering.19 A similar bill passed in Singapore required crypto businesses to get registered and licensed.20 Crypto derivatives will also eventually be allowed to be listed on approved exchanges in Singapore. These will likely raise institutional investors’ trust.
Cryptocurrencies are a relatively new asset class and crypto funds are continuously generating data to help fund managers better understand the asset. With the availability of new educational information and data to scrutinize, institutional investors are more likely to make a case for taking the plunge. The increase in the number of crypto asset think tanks and reputable analysts in the space only help to bolster investor confidence, and pressure traditional players to keep up with the crypto market – introducing services that improve accessibility and reduce risks.
A strategic imperative
As the crypto market matures, the evident performance of crypto assets starts to outweigh teething issues that underlie operational and liquidity risks – especially when the industry is increasingly regulated and scrutinized.
Exposure into the crypto market becomes more imperative for institutional investors that are looking to diversify for the longer term. Crypto assets independence from traditional assets makes it strategic for a comprehensive long term portfolio. Macro hedge fund investor Paul Tudor Jones recently said in the May 2020 market outlook note that he is allocating positions on Bitcoin, after a careful analysis on nine different asset classes/inflation hedges21. We may see other institutional investors follow suit after the macro investors make the first move.
Institutional investors may be the key segment to the widespread adoption of cryptocurrencies. Apart from the asset class’s relatively higher rate of return, recent developments will only continue to drive its adoption – the introduction of enterprise-grade compliance systems, more stringent regulatory requirements, and diversification of crypto products such as future derivatives. The recent pandemic has further accelerated innovation and interest in this space.
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