Institutional Money in Crypto: A Status Update
When scouring the airwaves for analysis and commentary about the future for Crypto prices, one commonly reads predictions that a wall of institutional money is going to hit the market — and it always apparently “just around the corner”. However, it is uncommon to find such statements backed up by facts or figures, or even to see the argument set out in an organised fashion.
To answer the question “Are the institutions coming to crypto?” I will break the question into three parts. Firstly, why would mainstream asset managers want to allocate capital to digital assets at all? Secondly, what are the issues which are preventing this? And thirdly, what evidence — if any — do we currently have of institutional investment in digital assets?
Reasons for Asset Managers to Invest in Digital Assets
I believe there are two main driving forces here: one financial and relatively immediate, and the other structural and longer-term.
Asset Allocation
Currently we live in a world with high asset valuations and low expected returns. Asset managers are struggling to either generate healthy risk-adjusted returns (absolute basis) or stand out from the crowd (relative basis). Bitcoin is a highly volatile asset, which has recently shown very little correlation to other risk assets. As such, it offers the opportunity — through a small percentage allocation — for asset managers to move their efficient frontier upwards, thereby increasing expected risk-adjusted returns of optimal portfolios. This financial incentive is rooted in modern portfolio theory, upon which much of institutional investing relies, and thus the incentive is a strong one.
Structural Changes
Another important point about the world in which we currently live is that we are undergoing a relentless shift towards digitalisation, due to the inherent economic efficiencies of doing so. The financial world is certainly not immune to this, and it is becoming generally understood that blockchain technology, as both a ledger and a platform for smart contracts, will soon allow the issuance and distribution of securities and their cashflows with far fewer middle men. As a result, markets will become cheaper and more efficient for both issuer and investor. Further, it is likely that an increasing percentage of financial securities will be issued in digital format, as a result of which asset managers who are unable to trade digital assets will simply be left behind.
In summary, I believe that most asset managers out there who have the theoretical ability to trade digital assets, will be looking at it as a potential opportunity, or even a requirement.
Issues Preventing Asset Managers from Investing in Digital Assets
I see three main problem areas which have so far provided valid reasons why asset managers are unwilling or unable to invest in digital assets. These are custody, regulation, and liquidity.
Custody
Custody is a critical component of the traditional financial markets. For an individual investor custody is important, as a total loss of an asset due to theft would of course be disastrous. But for an asset manager, who is investing somebody else’s money, the onus of their fiduciary duty to their customers (fund investors) means that the importance of custody is at an altogether different level. The fiduciary duty essentially means that asset managers are unable to risk the loss of an asset. In practice, they will always ensure they have the ability either to point the finger at somebody else (a custodian) or to recoup the loss (insurance), in the event that an asset does go missing.
In traditional financial markets, there is one other crucial element of custody: the separation, between two different entities, of the functions of liquidity provision and custody. Bernie Madoff is infamous for operating a long running Ponzi scheme which ended up defrauding thousands of customers of tens of billions of dollars over many years. He is on record as saying, since his conviction, that he would never have got away with it, had he not been able to self-custody. Cryptocurrency exchanges often act as custodians to retail traders who leave crypto and fiat within the exchange, and there have been a number of exchange hacks where it is generally assumed that it was an inside job. The parallel is by no means exact, but the point is that the separation of the two functions does make it much harder for bad actors to get away with fraud. Institutional asset managers will demand this separation.
Custody is a complex business with regard to digital assets, because of the very nature of the assets: effectively non-physical bearer securities accounted for within a decentralised ledger. What makes custody challenging is not the physical separation of cold wallets from the internet, nor is it the mechanism for encrypting private keys: what makes it so hard is the operational challenge of ensuring that one internal bad actor cannot steal custody assets. Solving this challenge is what has recently enabled some custodians to offer a solid Lloyd’s of London insurance policy as part of their custody offering.
The digital asset custodian business is currently made up of early digital asset custodians (eg. BitGo, Xapo, Coinbase), later entrants who offer improvements either on security (eg. Copper) or on settlement layer (eg. SeedCX), and then a few large names from traditional finance who have yet to publicise much detail about their offerings (eg. Fidelity, Bakkt). Many of these solutions already offer a standard of custody which would be deemed acceptable to asset managers in the non-digital world. As a result one has to conclude that in the world of digital assets, custody is a problem which is very nearly, if not already, solved.
Regulation
Financial regulation is a huge topic, and the word is bandied around loosely in reference to many different meanings. However, when I hear the moaning about a lack of clarity from regulators, it is mostly from exchanges and other rent-seekers who made good money from the 2017 ICO boom, and are keen to generate a similar environment for STOs. The problem for these players is that they need to be careful not to contravene securities regulations, especially if they themselves are not regulated, or if they are soliciting for business from non-accredited investors.
For institutional players, I believe this is less of a problem. They are almost certainly regulated institutions themselves, and most of their customers are either accredited investors or regulated institutions. In terms of which digital assets are or are not securities, I don’t really see why this would be an issue. Bitcoin, Ether, and a few of the other larger currencies are most certainly not securities, and they currently make up two thirds of crypto total market cap, so there is no issue with them. On the other hand, should a traditional fund wish to invest in a security token, they are a regulated institution, they will treat it as a security, and they will take all necessary precautions to ensure they do not contravene any regulations with respect to either themselves or their customers.
Perhaps I am being over-simplistic here, and I am certainly no expert in regulation, but in terms of what is preventing institutional investors from investing in digital assets, I consider regulation a bit of a non-issue.
Liquidity
Liquidity is a slightly slippery concept, which is often misunderstood by those not directly involved with trade execution. Often people claim that a market is liquid if it trades heavy volume, or if the order board is thick with bids and offers. Neither is conclusively correct. Liquidity defines how much one must move the price of an asset to execute a purchase or sale of a defined notional.
Consider a typical unregulated crypto exchange today. Without regulators to watch what is going on, unscrupulous exchanges will naturally sell information to the highest bidder. And information comes in the form of understanding who, of all the players in the market at any specific point in time, has the most urgent need to trade. Once this information passes to other market players, the market is no longer a level playing field. For a small guy to trade on such an exchange, he might as well play a round of poker with his cards out on the table.
In this case, one might look at the order board and make an assessment about liquidity, but as soon as one starts entering orders, some of your private information is leaked to other players in the markets, and due to their knowledge of your needs, execution immediately becomes more difficult, meaning that liquidity (for you) is worse than expected.
Institutional investors will not accept such terms for doing business, and for this, and a number of other reasons, will tend to look to the over the counter (OTC) market for liquidity. The OTC market is a place where expert execution traders (market makers) price large blocks of risk for asset managers (market takers) who are expert at positioning, but not execution. Think of this as another important division of function. OTC markets also enable the pricing of liquidity for large blocks of bespoke financial instruments, which would never be liquid on an exchange, such as swaps and options with specific expiry dates and strikes.
One can understand therefore, that a well-functioning OTC market is a pre-requisite for institutions to be trading digital assets. Recently such a market has begun to take shape. Groups of digital asset traders have been coming together to try to figure out how to professionalise the market around a set of defined standards and rules. One such group, the CORA (Cryptocurrency OTC Roundtable Asia) network is defining standard rules and definitions for trading, collateralisation, and settlement of both spot and derivatives trades. This is a huge step forward on the path to creating an organised wholesale market, into which institutions can confidently step.
There is no reason in my mind why OTC markets for liquid digital assets would not evolve into something similar to current FX markets. In FX, liquidity is provided via multiple mechanisms such as direct trading, electronic trading, and through inter-dealer brokers (IDB’s). The IDB’s assist in the aggregation of liquidity where necessary (nowadays less so in spot FX, and more so in swaps and options), and also provide anonymity for those customers who wish to keep their name off market until a trade is agreed.
Anonymity is important in OTC markets, because professional traders have a good understanding of the nature of the businesses run by their customers and their competitors. As a result, given a certain market environment, and a price request with a name on it, professional traders can often make a good guess at whether the request is a buyer or a seller. And if they think he is a buyer, they will tend to skew their pricing higher, and vice versa. Over time, these small advantages and disadvantages dictate who wins and who loses in markets, so one can understand why, in certain instances, certain players will feel they can access cheaper liquidity by going to market anonymously through an IDB.
My own company AiX is working through various issues to enable us to provide the first anonymous IDB service to professional digital asset traders, and we shall launch our first version of this service very shortly. The solutions will involve both traditional solutions such as custodians, central counterparties, collateralisation and margining, and systems of standardised terms and trusted counterparties. More modern solutions, native to digital assets, are also evolving, such as atomic swaps for stable coins, and will also be employed by AiX to enable us to offer a full IDB service, akin to what we see in traditional markets.
In summary, I have posited three main issues discouraging institutions from investing in or trading in digital assets: custody, regulation, and liquidity. Custody, I have shown, is basically a solved problem. Regulation is a non-issue for institutions. And liquidity is a work in progress, but recent infrastructure advancements are certainly moving things in the right direction. I would conclude by saying that the window in which asset managers can validly claim to be unable to trade digital assets is closing fast.
Evidence of Institutional Investment in Digital Assets
Data points for direct investments by institutions into liquid cryptocurrencies are hard to come by, as fund managers simply do not telegraph what they are buying and selling in real time. However, anecdotal evidence does imply the existence of a growing base of institutional asset managers who are making investment either directly in digital assets, or in the equity of companies which generate returns primarily from digital asset markets. As might be expected, the earliest movers seen to have been funds which are expected to take long-term views at the expense of short-term gains, such as sovereign wealth funds and university endowments. This is almost certainly due to the high level of volatility in digital assets.
A survey of 150 endowment funds (mostly US based) conducted in Q4 2018 by The Trade Crypto and Global Custodian, in partnership with BitGo, found that 94% of them took part in crypto-related investments during 2018. These were split approximately evenly between direct investments and investments via a fund. Perhaps even more informative was the fact that, of those surveyed, 49% of respondents said they expected their allocation to crypto investments to increase over the next year, against only 7% who expected that number to decrease.
A more specific example was reported in February 2019, involving Morgan Creek Digital’s $40m raise for a new crypto venture fund, which was anchored by two individual public pensions, an endowment, a hospital system, and an insurance company.
Last year we also saw some large institutional investments into digital asset market infrastructure. Goldman Sachs partnered with Galaxy Digital to invest around $15m into BitGo’s series B round of equity fund raising. Vertex Ventures, a wholly owned subsidiary of Temasek (Singapore sovereign wealth fund) made a direct investment in Binance to fund development of a crypto-fiat exchange in Singapore. And Bakkt was created by ICE (owner of the NYSE), and is now also backed by Microsoft and Starbucks, to offer institutional investors a way to buy, sell and store digital assets. ICE is a huge operator of global financial marketplaces, to which Microsoft will lend their expertise in technology, and one supposes Starbucks sees a marketing opportunity through offering a crypto payment mechanism to their millions of retail customers.
Finally, Fidelity Investments, the world’s 5th largest asset manager, which has announced plans to offer a digital asset prime brokerage and custody service to its clients, recently released research which surveyed 441 institutional investors, including pensions, hedge funds, family offices, financial advisors, and endowments. The survey showed that 22% of respondents have already purchased cryptocurrency, and that 47% of respondents view digital assets as having a place in their portfolios. One has to imagine that both of these numbers would have been much closer to zero a few years ago, suggesting that interest in digital assets is showing strong growth.
Conclusion
I have argued that there are two very solid reasons why professional investors should be allocating capital to digital assets. In financial terms, in today’s low return environment, the risk-adjusted returns of an optimal portfolio can be increased by the addition of a high-vol, low-correlation asset such as Bitcoin. Structurally speaking, unless one believes that there is zero percent probability that blockchain technology will provide the ledger for tomorrow’s securities markets, then one would be prudent to make preparations for a world moving towards that scenario.
I have identified what I feel are the three most common reasons cited as holding back asset managers from investing in digital assets, being custody, regulation, and liquidity. I believe custody is very nearly a solved problem; regulation is really just an excuse; and liquidity, while still a work in progress, is improving in both quantitative and qualitative senses.
Finally I have presented some evidence of growing institutional interest in investing in both digital assets and digital asset market infrastructure.
There is no doubt that institutional money is still wary of investing in this new asset class. But at the same time, it must be noted that the dangers have been identified, so they are already known unknowns, and a lot of hard work is now being done — or has already been done — to prise open the bottlenecks. In my opinion we are probably less than a year away from the point in time at which stories of institutional investment in digital assets will no longer make the news at all.
***This article was amended on 03 June to correct an error about digital asset custodian Copper. The original article stated incorrectly that Copper outsources its operational security to a third party. In fact, Copper has its own proprietary security, allowing them to claim a rather unique and advanced custody offering.***
