Institutional adoption of digital assets is coming as barriers begin to fall
I wrote the first iteration of this article in late February this year. Only eleven weeks have passed since then, but it feels like a lifetime away. I was in the midst of an industry deep dive, and was enthusiastic about the strong momentum I saw in the digital assets space. Founders of startups like Copper, Keyrock or Kaiko were feeling super optimistic as their products began building initial traction on the market. The Digital Asset Summit in London in early February concluded on a note that institutional adoption was imminent.
And then along came COVID-19.
I had to figure out if my hypotheses were still valid or if the whole narrative had collapsed. So I stepped back and followed the market closely, looking for signals on how all of this would impact the digital assets space.
Ten weeks into this mess and one sharp sell-off later, I see positive signals popping up again. Bitcoin, for example, has quickly recovered from the drop in early March and is now trading again at around $160bn market cap.
Another positive signal is the ongoing recovery of aggregated open interest (i.e. total outstanding contracts) in bitcoin futures. As bitcoin futures are predominantly traded by professional actors, open interest is widely regarded as a proxy for institutional activity in this space.
A third positive signal is the new interest of legendary hedge fund managers to build exposure to bitcoin that have never before invested in digital assets. Paul Tudor Jones recently announced that he holds 1–2% of his assets in bitcoin, saying that “Every day that goes by that bitcoin survives, the trust in it will go up”. Also, the legendary Medallion Fund managed by Renaissance Technologies (“the world’s greatest hedge fund”) has sought approval to trade bitcoin futures over the Chicago Mercantile Exchange. Their interest in bitcoin is a seal of approval to a nascent alternative asset.
Apart from these signals, the tone of my conversations with industry operators has again become very optimistic, so I feel confident that our key hypothesis still holds true today:
Key roadblocks are gradually being removed, paving the way for true institutional adoption of digital assets in the near future.
Institutional adoption of digital assets has been something of a holy grail for many years now. Take Goldman Sachs, that in Aug-17 said “institutional investors can no longer ignore bitcoin”, or Bitcoin.com that in Nov-17 found “62% of institutional investors are buying or considering buying bitcoin”.
But almost two years later, precious little has been achieved. Sure, some digital asset investment funds were launched, but the LPs of these were not pension funds or insurances, but primarily friends and family. Grayscale is the industry juggernaut, with currently $2.2bn assets under management. These aside, there are very few funds today that manage >$50m of assets. Institutional trading volume in digital assets remains very low to date. Trading volumes in bitcoin options oscillate around $50m per day. Compare that to the c. $20bn notional traded volume in traditional options daily on the CBOE, the largest options exchange in the US alone.
Speaking to professional asset managers reveals that a number of key roadblocks prevent them from engaging more with this emerging asset class, among them:
But these obstacles are being eliminated, and below I discuss each one in more detail to show that significant progress is being made at every level.
The lack of a robust infrastructure
The hype surrounding digital assets in 2017/18 was enabled by platforms like eToro_Official, Coinbase, MyEtherWallet, Poloniex, Ledger. These were aimed primarily at retail investors and proved not to be enterprise-ready. Some retail platforms suffered very significant and very public hacks. Even if institutional investors were looking to invest in this asset class, they simply did not have the right tools to do so, particularly those asset managers without sophisticated technical understanding of the emerging tech-stack behind cryptocurrencies.
This is changing rapidly, however. Startups and progressive incumbents are diving into the institutional digital assets world by re-building the infrastructure of traditional capital markets for crypto-land.
To provide an overview of just how much activity there is in this field, I have created the following landscape. This overview is simplified and by no means exhaustive, but if you want your logo to appear on the image below, please let me know and I will consider adding it.
The above landscape highlights a few important points:
- the entire value chain of incumbent capital markets is replicated with dedicated service providers for digital assets;
- a significant number of startups are active both in total and per sub-vertical;
- a number of incumbent players (below the dotted line if applicable) have entered the market, many of them driven by a combination of inspired leadership and client demand for access to digital assets; this is significant as it provides credibility to an emerging market.
The lack of investable assets
The lack of investable assets is a significant issue. After all, where there are no assets there is no capital market. Currently, two trends are emerging that will solve this problem.
Firstly, bitcoin is establishing itself as an investable asset. One pointer supporting this thesis is the growing interest of established hedge fund managers (Paul Tudor Jones, Renaissance Technologies) in bitocoin. Another is the report by the Vision Hill Group, a digital asset hedge fund, that summarizes this narrative in their report “An Institutional Take on the 2019/2020 Digital Asset Market”, saying that bitcoin:
- is the safest asset in the digital asset space,
- has been holding significant value throughout various cycles,
- is liquid enough and able to absorb larger trades, and
- due to its scarcity, can be characterized as digital gold.
As a digital store of value, bitcoin could gain significant value over the coming weeks when rewards for miners drop by 50% on May 12th (“halving”). Ceteris paribus, halving the supply of freshly minted bitcoin should lead to an increase in the ask price. Long-term bulls view bitcoin as a macro-hedge against the ongoing unprecedented printing of fiat money and in major economies in reaction to COVID-19.
A second ongoing trend is the creation of new digital assets through tokenization. Various assets/ securities are and will be digitized, e.g. stakes in closed-ended funds, rights to cash-flows, property ownership, etc. Asset tokenization promises, among others, 24/7 real-time clearing and settlement of trades, a separation of the issuers and the general ledger of buyers and sellers, the potential for increased liquidity, overall efficiency gains and lower costs of trading.
Asset tokenization is still in its infancy, and very few projects have been successfully completed. It currently feels like there are more tokenization platforms than there are actual projects. But activity is picking up across various asset classes:
- Brickblock.io is tokenizing real estate funds
- Various teams have tokenized fiat currencies like the EUR or the USD
- The owner of the St. Regis in Aspen has tokenized part of his property
- eToro_Official has tokenized metals like gold and even silver
- Others have tokenized more exotic assets like art, oldtimers or Whiskey
The graph below shows that the total number of completed security token offerings (STOs) has grown over the past three years to reach a total of 95 by the end of 2019. Total capital raised throughout these projects is close to $1bn. The tidal wave of new assets, however, is yet to hit the market.
The lack of liquidity
Capital markets that are not liquid or deep enough to digest larger trades are not attractive to institutional investors. Professional asset managers need to be certain that they can liquidate holdings should they want to. If this is not a given, they would rather not get exposed in the first place.
Fortunately, more and more startups are bringing liquidity to the market. Companies like Keyrock, flov and DeltaBlock offer their services as designated market makers for specific trading pairs, thereby increasing flow liquidity by deepening the respective order books. At the larger end, (prime-) brokers like AiX and Genesis are connected to various liquidity pools and use these to process larger block trades for their clients.
While these are positive developments, the market remains rather illiquid for most assets. The only way to create a truly deep capital market around digital assets is to have institutional investors deploy much more capital into the space.
Excessive volatility and a lack of agreed valuation models
Cryptocurrencies have arguably been a rather volatile asset class in the past. This fact alone has kept some institutional investors away, especially those with long-only strategies. Volatility has, however, markedly decreased in more recent years. The graph below shows the 30-day volatility of BTC/USD over the past ten years. The trend (apart from the recent spike due to COVID-19) is one of decreasing volatility.
Even if bitcoin remains relatively volatile in the future, not all digital assets are cryptocurrencies. Many assets will be tokenized that are inherently less volatile, like stakes in closed-ended private equity funds. It can be expected that such tokens trade around fair value most of the time without having the excessive swings frequently observed in bitcoin.
Another obstacle to widespread adoption of digital assets is the lack of commonly-agreed valuation models for deriving fair value of the asset in question. Imagine a fund manager trying to argue in front of her investment committee that BTC is currently undervalued. Which valuation methods would she utilize to make that point convincingly? Which of them would the members of the investment committee understand?
The lack of commonly-agreed valuation models is a significant roadblock. Coming up with a fair value of bitcoin is still — after 11 years of existence — a difficult task. Different models have been suggested, like the “Three Ways to Value Bitcoin”, i.e. as a commodity, as a network, or through its utility based on market adoption. Other methodologies have been suggested (see this article for deeper discussion of a number of such ideas), but none of them have gained common acceptance in the market, yet.
While there is no guarantee that straight-forward valuation models will emerge for digital assets, it would be surprising if the market fails to develop them. Apart from that, the new wave of tokenized assets will be easier to value based on their well-understood underlying. So even if institutional investors shy away from bitcoin, they will be able to determine fair value for a host of other digital assets based on models that are well known and understood.
The lack of regulatory clarity
One of the most significant and largest roadblocks has been and still is regulatory uncertainty. Institutional investors cannot and will not engage in a space where substantial legal questions remain unanswered. Regulators need to create comprehensive frameworks for parties to be able to navigate this space, and there are positive signals coming from a number of them. Below are a few select examples:
- Liechtenstein recently passed a comprehensive legal framework (Liechtenstein Blockchain Act) allowing for straight-forward asset tokenization with regulatory certainty (read more here by Prof. Philipp Sandner of the Frankfurt School of Finance);
- The Bank of England together with the Central Banks of Canada, Japan, Sweden, Switzerland and the ECB formed a working group to explore the potential benefits of issuing central bank digital currencies (CBDC), while China is officially starting testing its own digital cash in four cities this month;
- The Financial Stability Board (FSB) recently issued a consultative paper on global stablecoins to examine regulatory issues and to advise on multilateral responses to them;
- The intergovernmental economic organization OECD recently issued a long-form analysis of the potential implications of tokenized assets on financial markets, along with a number recommendations for policy makers;
- With the implementation of the 5th EU AML Directive, the German financial regulator BaFin enables financial institutions to offer crypto custody as a licensed activity (even if that might have mixed effects); 40 banks seem to have applied for a license to date;
- Christine Lagarde, the head of the ECB, has been an outspoken supporter of cryptocurrencies for a while and wants the ECB to be open and “ahead of the curve”;
- Bitbond, a regulated German entity, proved that fully-compliant security tokens are possible by issuing the first-ever STO debt token.
Unfortunately, widespread regulatory uncertainty still surrounds this topic and it remains a key roadblock to deeper engagement of institutional investors. We can only hope that regulators will come to fully understand the potential of this innovation and embrace the movement. The positive signals are there, but these need to translate into comprehensive regulatory frameworks.
While a few years back digital assets were a retail phenomenon with only a few brave institutions daring to build exposure, this seems to be changing fast. Or, as one executive of a global digital asset custodian put it:
Everybody [in the asset management industry] is doing or has done their work, unlike three years ago when it was niche; now people take it seriously and the more sophisticated traders are fully up to date and have concrete plans to move forward.
2020 will be a defining year in the development of the digital asset capital market. Slowly but surely we are seeing the biggest roadblocks to institutional adoption being dismantled:
Startups are building the enterprise-grade infrastructure needed for investors to interact with the market. An increasing number of assets are fit for investment. The market is becoming more liquid and is able to process larger trades. And while the lack of agreed valuation models is a problem for digital assets, the problem will disappear when asset managers become more familiar with bitcoin, and traditional assets are tokenized into digital assets.
Much depends on how fast regulators will create legal certainty around digital assets. This comprises a clear definition of what constitutes digital assets, which capital market regulations they are subject to, which governmental bodies are tasked with oversight, unified protocols for KYC/AML, et cetera.
The market and its various players are ready to put their platforms to work. From the developments I have seen in various startups throughout 2019 I am very optimistic that this momentum will continue and gather pace in 2020 and that we will see the steady emergence of large and valuable companies in the digital assets space over time.
If you are building a product in the digital assets capital market and looking for a partner, we at CommerzVentures are happy to hear from you. CommerzVentures is an independent venture capital fund sponsored primarily by Commerzbank Group. Thanks to everyone who provided valuable feedback on this article, especially Yoni Assia and team at eToro_Official.