The birth of a new asset class: crypto assets; Part II: Institutional investors are coming
This post reflects my personal views on the current crypto market.
Since last spring, I have been following the growth of the crypto market. After sharing my thoughts on the crypto capital markets landscape and crypto funds (setup and landscape), I wanted to share my view on crypto as an asset class. As always, I am very happy to have a chat or share notes with other investors / companies. You can email me at ebrunet40@gmail.com or use https://earn.com/etiennebrunet/ if you want a quicker response.
After sharing a ‘simple’ crypto assets adoption framework and highlighting why retail investors love crypto, please find below the second part focusing on institutional investors.
Enjoy.
Institutional investors are coming
Crytpo is now the new hot financial product. If you are wondering why the buy-side did not already invest en masse into crypto, observe the market size. A hedge fund manager told me recently that it is much easier to invest in Bitcoin with a $300bn+ market cap than with a $14bn one. Now a mid-size fund can deploy $10–20m ticket without moving the crypto market (Though some may argue you can still do it on some exchanges, but that’s another point).
Financial institutions are not yet in the game. It is true that 100+ crypto-funds have been launched since the beginning of the year but most are poorly managed with little to no understanding of basic portfolio management, risk management and post-trade management. It is true that investment banks have started to get smarter through panels, conferences as well as publishing research. They are learning about crypto and associated opportunities / challenges. However, no sell-side institutions currently offer OTC / Trading desks (I know GS is talking about setting on in June. I know), crypto products or allow their clients to invest / store in crypto. On the buy-side, there are some interests, but due to investment mandates and other challenges (more on that below) crypto investment is not something mainstream.
Wait a minute, Bitcoin futures was announced by CME, Nasdaq, CBOE and Cantor. Is the big short or big long coming? From my view, it is still early days to see any effect from the future launch. Not many FIs clear the futures, the product is very controversial to offer and therefore it is mostly used by arbitragers, HNWI and family offices. But let’s see in few months. I may be completely wrong.
Why do institutional investors want to invest?
Before diving into why most institutional investors sit on the sidelines, let’s look at why they want to buy some crypto.
- Massive returns 🤑
- If the S&P 500 is ending 2017 on a 12-month winning streak it would be a first in the history. This is not good news for alternative investors who historically have already had difficulty in returning 15% after fees. LPs ask questions about 2/20 rule and funds feel pressure. Hence, when a new asset class shows gargantuan returns (e.g. Ethereum has grown by +231748% since ICO in July ’14) investors start to pay attention.
2. Uncorrelated assets 🔑
- Today, crypto assets have little to no correlation with other asset classes as highlighted by Chris Burniske at Consensus invest. As an investor you should look at an asset as part of your portfolio and not as a single asset. Hence, adding a small percentage of your assets to crypto (e.g. Bitcoin) makes total sense to me. For example, a few months ago I met a portfolio manager of a very large long / short equities fund. He was interested in investing 0.5% of their total AuM in Bitcoin with the main motivation being able to generate alpha that his peers would not have. Genius.
3. Limited supply 🛒
- Most of the crypto assets have a limited number of tokens. Take Bitcoin, there will only be 21m. That’s it. Or until the next fork. The Bitcoin supply schedule cannot be inflationary due to central bank quantitative easing. Moreover, with about 20% of the Bitcoin lost forever, if you think that Bitcoin will become mainstream and stay relevant in the next 5–20 years the price may increase. $$$.
4. New asset class = inefficient market = 💲 💲 💲
- You don’t have to be a genius to see that crypto markets are not efficient. Prices for the same asset differ vastly from one exchange to another. News takes a few days before to be absorbed by the market. Sharing information with others is ok as tokens are NOT (yet?) securities creating information asymmetry. Yes. I know. Any hedge funds’ dreams
- There are so many ways to make money. Pardon. There are so many ways to help the market become efficient. How about you become a market maker on a different crypto exchanges and now with Futures? How about you spend time talking with companies to learn about future partnerships? How about you spend time tracking news on tokens?
But let’s not get too excited. There are massive challenges for institutional investors.
Note; there are other challenges such as regulations, tax treatments etc.. that are not covered in this section but are also important.
- Custody is a pain. Who wants to hold my magic beans? 💸
- The number one challenge preventing institutional investors from investing is the lack of a digital asset custodian that they can trust to store client funds securely. In legacy assets, custodians are independent third party providers to investors performing three key functions: validation, security and trust. Blockchain obviates the need for third party custodians and makes first-party custodianships the only responsible form of safeguarding client assets. In other words, whoever holds the private key is effectively treated as the owner of the currency.
- If one loses their private key they also lose their ownership rights. Sorry. Today, you have few actors providing the crypto custodian technology such as Ledger Vault but crypto custodians still need to become regulated and figure out insurance policies and other marvels. Coinbase custody aims to become a one-stop shop. Let’s see.
2. Exchanges for retail. OTC for professionals. 😎
- Most of the crypto exchanges were designed for retail investors. Most of them were on the brink of bankruptcy a few months ago and are now making nine figures EBITDA this year. The trading infrastructures were never made to handle billion of dollar of transactions volumes, to manage massive amount of DDoS Attacks, to offer complete “advanced” orders (stoploss etc.), professional UI (I am not a fan of 502 Bad Gateway)or blue-chip customer service. I also don’t mention lack of security, privacy and regulatory challenges that most of these exchanges face.
- All these drivers have had positive impact on the rise of OTC trading desks as B2C2 or Circle (handling $2bn per month!). The OTC desks provide security, privacy, price security as well as an ease of access. Vinny Lingham wrote a great post on OTC desks about a year ago. Banks / classic prime brokers should jump on the opportunity to help trade this new asset but are missing out. Big time.
3. AML/KYC. Who is your sugar daddy? 🍦
- Currently, AML monitoring mechanisms attributes every transaction to a pre-identified legal entity. Data tracked in a fiat money paper-trail includes: (a) the financial system entry point, i.e. opening bank account (b) any transaction within the system (e.g. receiving money from another bank account). FIs monitor transactions and can identify use of the financial proceeds of a crime to a particular individual.
- Regulators & financial institutions (FIs) see crypto as a black box due to its pseudonymity and privacy feature making it very hard to comply with existing anti-money laundering (AML) and anti-terror financing regulations. However, all of these essential regulatory and enforcement elements can all exist in the crypto-currency system. It’s all a matter of adjusting perspective. In addition, challenges such as counterfeit hard-currency do not exist in crypto currencies.
- In most countries today, one needs to undergo the process of KYC in order to open a new digital wallet on an exchange (e.g. Bitstamp, Coinbase). Nevertheless some wallets can still be opened without a proper identification process, which potentially may allow “dirty money” into the system. However, some companies like Chainalysis provide monitoring reports and due diligence tools for FIs. In the near term, new global regulations could designate standards for KYC wallets.
Thank you for reading my post.
Don’t forget to share with friends and your bitcoin early adopters colleagues!
Thank you Leon Marshall, Jason Manolopoulos, Rasheed Sabar and Jon for your feedbacks.
Best,
Etienne
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