Cryptoassets & Institutional Money

Current challenges and possible solutions

Why and how will more institutional money enter the crypto world en masse, and what types of innovation do we need to facilitate that? To take the next step into widespread adoption of blockchain technology we need smarter investing — and especially more investing. Hedge Fund, VC money and ICOs are currently the financial foundations for all things crypto, however, it cannot and should not stay like this forever. The influx of institutional money will inevitably transform the crypto and blockchain space by increasing market cap significantly, providing more legitimacy and, most importantly, funding more projects.

The crypto investments space is still in its infancy — crypto hedge funds currently hold only about 0.001% of all hedge fund AuM (Crypto HF AuM $3.5billion as per Next report / Total HF AuM $3.5 trillion.)

Currently, institutional money is waiting patiently at the sidelines when it comes to crypto investments because of a lack of:

  • infrastructure
  • credibility was cited as one of the biggest deterrents for institutional investors by J.P. Morgan’s Jan Loeys
  • clarity around regulation
  • stability
  • and an investor-friendly ecosystem.

However, the appetite for crypto investments is tremendous. Hedge funds have been performing poorly over the past few years, partly because of lack of volatility. The current economic environment, fears of a recession and crypto mania are making investors bullish on blockchain.

Why institutional money will move into crypto

Hedge funds are attracted by seemingly low-correlated returns of cryptoassets to traditional assets, something that has become increasingly rare in a world of global synchronized growth. In addition, mainstream cryptoassets, like bitcoin and ethereum, have been center of attention because of their high returns and incredible volatility.

Crypto hedge funds have sprung up numerously in the past year and transaction volume seems to have increased (e.g. as told by Bobby Cho from Cumberland Mining.) This comes as no surprise and is an indicator of a growing field. However, most of them have low AuM and none of them are part of the large players. For example, one of the largest and best-known crypto hedge funds, Polychain Capital, manages “only” $250 million, which wouldn’t even qualify them as a top 100 hedge fund. Most average to big hedge funds are currently better off investing in crypto through smaller hedge funds, which might explain the high number of smaller crypto funds (e.g. Fortress Investment invested in Pantera in order to have exposure to crypto.) The over $3 trillion heavy hedge fund world could buy up all 1500 largest crypto assets 8 times over (as of 03/2018). All of this ample room for expansion will provide opportunities for smart entrepreneurs. In late 2017, Bitcoin futures introduced actual institutional money and more credibility into the space. Further development (ETFs anyone?) will introduce even more investors and is pointing in the right direction.

What is needed

How can entrepreneurs take advantage of this massive opportunity? First, we need to understand why institutional investors have been reluctant and unable to invest in crypto assets. Some of the issues include heavy price fluctuations, lack of crypto expertise and lack of track record. While the latter two concerns will diminish with time, we can speed up the flattening of volatility through the help of more and larger liquidity providers. 
Institutional investors don’t want to deal with large counterparty risks (with exchanges) and weak security of wallets or other unprofessional custody solutions. Cryptoassets come with liquidity issues, which is one of the major risk factors for portfolio diversification for hedgers/asset managers (as per J.P. Morgan 02/2018 crypto report.) Hedge funds can mitigate these risks for other institutional investors, like insurances or pension funds, but they need the right tools and products. Currently, fundamental operational functions have not yet been adequately addressed, including managing counterparty risk when trading OTC, custody, KYC/AML, accounting (esp. tax), wallet management. With smoother operations and lower risk, more and bigger hedge funds will be able to enter the space and give a boost to the crypto economy.

Solutions

Liquidity providers (market makers)

  • Solution: providing crypto-liquidity to large players, stabilizing markets
  • Incumbents: like Cumberland can “charge” up to 15% in spread and there are only few options. Traditional brokers and liquidity providers (e.g. AKJ, IS Prime, ED&F Man, Stater) are moving into the space and might have to make up their lack of crypto expertise through M&A
  • Challenge: Cumberland seems to have carved a niche through their early adoption and contracts with Chinese miners. How can entrants take a share of the pie?
  • Cherry on top: liquidity providers are less regulated than other financial institutions.

Custody services

  • Solution: an insured, extra-safe “wallet” for institutional-size investors.
  • Coinbase Custody has launched, which proves appetite for such services. The hefty price tag provides room for cheaper entrants. There are several tiers of investors who would be interested in it besides institutional investors, like UHNW clients and family offices.
  • Incumbents: banks cannot and do not want to provide custody (yet.) This is the moment for startups to take advantage of “regulatory arbitrage.”
  • Challenge: How do entrants prove their trustworthiness to institutional investors who are used to protective regulation and decades-long relationships?

Prime Brokerage

  • Solution: Custody, Counterparty reporting, Trade execution, Margin lending, Risk management — an all-in-one service for heavy players, like large hedge funds.
  • Incumbents: are not able to provide prime brokerage for institutional crypto investors (yet.) Currently, each solution is delivered by one of many different providers, which can be inefficient.
  • Challenge: Same as with custody services. Will incumbents move into crypto prime brokerage and wipe out startups?

Conclusion

These three areas will be a crucial part of the first wave of blockchain innovation alongside infrastructure projects. Currently, there aren’t many challengers in the space and it hasn’t become a FAANG oligopoly. The space is new and it is beaming with opportunities. Competent entrants will facilitate inflow of more institutional money into the crypto space and thus provide part of the building blocks of our future.