Why institutional investors are warming to crypto and the 3 key developments that will accelerate the process

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This is the first in our three part series on capital structures in the crypto industry:

  1. Why institutional investors are warming to crypto and the 3 key developments that will accelerate the process
  2. How crypto fits within capital markets and why it will emerge as the most exciting opportunity since the emerging markets boom
  3. What is the current investment and tech outlook, who are the key players, and our projections for the next 3 to 5 years

Read on for an objective view, and keep an eye out for parts 2 and 3, coming soon.

Why is institutional capital keen on crypto and what’s stopping them?

“When it’s that easy [for institutional investors to enter the market], the price of Bitcoin or Ethereum is going to go much higher. And that is a lot closer than people think. The institutionalization of this space is coming. It’s coming pretty quick.” Mike Novogratz

On a wave of euphoria, crypto markets topped out at around $800 billion combined market cap, with Bitcoin at around $20,000. As reality has set in and the market has abruptly retraced many have reacted with a fair amount of despair. Those left with hope were clinging to a number of factors that they hoped would boost the market (some more far fetched than others, and to date none of them have come to pass).

One constant hypothesis among investors is the belief that institutional money will enter the market in large volumes bringing the next wave of adoption (and potential price increases).

But why is institutional money so keen on crypto? It is for the same reasons investors want to be involved in any emerging tech market or asset class. We are still in the very early stages of blockchain tech adoption, but crypto has emerged as an emerging asset class with high growth potential. The next phase is the influx of institutional capital, coupled with genuine, real world adoption of blockchain solutions. If crypto does take off, institutional investors don’t want to be caught short and under-allocated. They want the big returns made possible by getting in early.

Indeed, many parallels can be drawn between the crypto markets and the recent emerging markets boom. This report by Bain & Company makes interesting reading. The key points around the attraction of emerging markets — the growth challenge, chasing yield vs. catching bubbles, identifying paths to prosperity, and a power shift from owners of capital to owners of ideas — rings very true for crypto markets. Crypto is a new emerging asset class where institutional investors see a great opportunity for diversification and high yields (we will cover this in more detail in part 2 of our series on institutional investors).

Here’s a timeline of what has happened so far in 2018, and we follow this with a look at three major roadblocks (in simple terms; regulation, liquidity and fiat on ramps) and the current developments that are underway to overcome them and give institutional investors the confidence and means to invest.

1. Regulations

The problem: Where else to start, but with regulations. As per our article in March 2018 on the current regulatory landscape of G20 nations, it is clear that, well… the crypto markets are hardly regulated at all. Traditional financial markets and institutional investors are heavily regulated. They are under constant scrutiny and have a fiduciary duty to their shareholders and investors.

They are simply not going to take big financial risks in a market that is not clearly defined from a legal and regulatory perspective. If they do so, and regulations do not pan out as expected, this could have serious financial and legal ramifications.

The solution: Quite simply the market needs regulation, to cut out uncertainty, unnecessary risks and scams. However, it is not as simple as drawing up a set of regulations today and implementing them tomorrow. Just as considered regulation can help the market grow, over zealous and incorrect regulation has the potential to kill the market.

The positive news is that slowly but surely we are seeing regulation come into play, generally in a fair and considered way. This is allowing the market to breathe and evolve at its own pace. The SEC recently suggested that neither Bitcoin nor Ethereum should be classed as securities, South Korea has is officially recognising crypto exchanges as regulated banks, and we have witnessed countries such as Switzerland and Thailand laying out specific regulatory frameworks for crypto. In time, this will breed confidence and encourage investors to put money into the markets.

This is a new and disruptive market, and regulators need time to understand it, to work with the entire value chain and to learn where to apply restrictions and where to let the market breathe. So far, it seems regulators have taken a positive and considered approach and slowly but surely we are seeing regulations come in a staged manner. Regulation is coming, it’s happening and we’ve covered some of the key events in our infographic above!

2. Liquidity, Volatility and Valuation

“Now, a growing number of institutional investors are watching cryptocurrencies as the frontier of risk-taking to evaluate the sustainability of asset prices. The result is that institutional investors, who are supposed to value assets using their sophisticated financial literacy, analysis, and information-gathering strengths, are actually seeking feedback about the market from cryptocurrency prices (which are mainly formed by retail investors).” Deutsche Bank

The problem: Liquidity, volatility and valuation are three unique but interlinked issues. Starting with liquidity, consider that the global stock market sees hundreds of billions of dollars traded daily, and in global forex markets it’s trillions. Current daily volumes in the crypto markets sit at just over ten billion.

This is still a small market still in the early stages of growth, acceptance and adoption. At best, entering or exiting any position at volume causes major fluctuations in price, at worst, it is impossible due to extremely thin order books. Have a look at the impact of the Mt. Gox sell off on the price of Bitcoin, or the implications of an EOS sell off for the price of Ethereum.

This links in to the point about volatility. A lack of liquidity and thin order books, coupled with suspicions around market manipulation and wash trading (both illegal in regulated markets) mean that crypto asset prices can move quickly and severely, both up and down. A lot of money can be made, and lost, in a very short space of time, and often for reasons that are unknown or defy the logic and reason derived from traditional financial markets.

However, institutional investors are looking for asset classes that they can model, and apply algorithms and strategies that will yield consistent profits over time. Currently the market driven largely by speculation meaning that it is driven by speculation, and is quite unpredictable due to the aforementioned issues. As per the quote from Deutsche Bank, institutional investors are looking at prices driven by retail investors (speculators), and despite a desire to invest, this makes them nervous.

The point about speculation leads into the next issue around valuation. Institutional investors are looking to apply valuation models to understand the underlying value of any asset in which they invest. As the cryptocurrency space is still in its infancy, adoption is still fairly minimal and therefore it is hard to evaluate assets based on their underlying utility and potential future value.

Whilst new models will certainly be required for the crypto markets, institutional investors are looking for deeper data and underlying fundamentals to base their decisions on rather than simply charting the whims of a market largely still driven by retail investors and speculation.

The solution: We covered regulation first, because this underpins everything. Whilst we are focusing on institutional investors, regulation is also a key factor across the entire value chain. This includes the fiat on-ramps and investment vehicles covered in the next section, as well as the businesses building blockchain solutions and their potential end users.

In short, companies will be prepared to make small moves in the space to make sure they are set to capitalise on future opportunities. But, they will only push large scale adoption once they are comfortable with the regulatory landscape. Once this is in place and we start to see large scale adoption of blockchain solutions and clear regulated access to the market, we will then see a positive influx of money.

Fiat on ramps and investment vehicles (covered in the next section) will give that access and bring liquidity, which will create a tighter, more efficient market comprised of assets valued on their underlying technology and adoption. This will create stability (around price movements) which will attract further institutional and retail investors, driving further growth. Parallels can be drawn with the forex liquidity hierarchy illustrated below. This is the kind of infrastructure we need in place to bring serious institutional capital into the markets.

It sounds simple, but clearly comprises a large number of moving parts across regulators, financial institutions and business. So again, we are not likely to see an overnight solution. However, as per the highlights in our infographic, we will see that slowly but surely, as with regulations, the necessary infrastructure is being put in place to drive the industry forward. Institutional money is big money, and big money needs big markets. But the infrastructure is coming to facilitate this (more on this below).

3. Fiat On Ramps and Investment Vehicles

“In response to client interest in digital currencies, we are exploring how best to serve them in this space.” Goldman Sachs

The problem: To create big markets for big investors they need a way to; get their fiat currency securely into and out of crypto markets. They also need regulatory approved investment vehicles that they can package up and sell to their clients. Currently neither of those things exist at a large enough scale to facilitate a genuine influx of institutional capital.

There are a lack of fiat on ramps; Coinbase is currently the only organisation licensed by accept fiat and sell crypto in all 50 states, with both Gemini and Bittrex making inroads, but still lagging behind. Many large Bitcoin transactions are still conducted over the counter (OTC) via unregulated intermediaries. Many exchanges are both unregulated, and unsecure, with a large number of hacks occurring each month.

Assuming that in due course institutional investors are able to get large volumes of fiat into the regulated and liquid crypto markets of the future; what do they do with it and how do they invest it? Bitcoin has emerged as a store of value and can be seen as an investment vehicle (and the launch of Bitcoin futures in December 2017 goes some way to supporting this view). However, this is still fairly limited as it predominantly allows participants to bet on the price of Bitcoin, rather than injecting large volumes of real capital into the market.

Institutional investors need a wider range of investment vehicles in order to justify involvement and spread risk, They need solutions that offer them the capability to “sell” such investment vehicles to clients.

The solution: Fiat on ramps and investment vehicles go hand in hand. The create a set of linked platforms through which institutional investors can participate in a market in as seamless and secure a manner as possible.

Yet again, regulation makes this possible. Fiat currency is already the subject of strict regulation (e.g. around KYC and AML), and companies, such as Coinbase, need to adhere to these and secure the appropriate licenses in each territory in which they operate in order to accept fiat. The good news is that companies such as Coinbase, Binance, Bittrex, Gemini and Ethos are making good headway on this front and just recently Coinbase opened up their custody solution to accept fiat from a wide range of eligible financial institutions.

These are some of the first positive steps required to on board institutional investors (and in turn bring the liquidity and stability we discussed previously). It is our opinion that, Coinbase is leading the way and soon others will follow. Indeed, we have recently seen progress as Bittrex has announced fiat pairs, as has Binance, and Ethos has launched it’s anticipated wallet with plans for a fiat gateway and a potential hybrid platform combining crypto and traditional assets. These are the building blocks that will make it possible for institutional money to enter the market in far larger volumes.

We have also seen other positive developments, as recently the CBOE has filed with the SEC, in a bid to launch a Bitcoin ETF. This will provide a regulated investment vehicle to allow interested investors to invest large sums in Bitcoin in a controlled manner, via financial institutions. JP Morgan called Bitcoin ETFs “the holy grail for owners and investors”.

So, we are seeing the emergence of both the fiat on ramps and the emergence of the necessary financial instruments to bring in the money of financial institutions and their clients. This is an important step that should not be underestimated. And this completes the flow (as per this article) that will allow the market to flourish. We will leave you with this chard showing the impact of gold futures and gold backed ETFs; parts of this chart look strangely familiar! So it’s not a huge stretch to envision the Bitcoin and crypto markets following a similar pattern.

Source: @ZeusZissou

Our conclusions: 2018 is paving the way for institutional capital

We have attempted to give a balanced and realistic view across; why institutional capital is interested in crypto, the current roadblocks that are preventing them from entering the markets, and the solutions that are being put in place to break down these barriers.

Clearly there is still some way to go, but as per our timeline of events, whilst the price of Bitcoin and other assets has plummeted, there is a lot of work going on behind the scenes. Regulators and institutions are using the downtime to play catch up, and it is clear to see that there is a great deal of infrastructure being put in place to facilitate this.

We can’t give a guaranteed timeframe, but it is our opinion that all the necessary infrastructure is being put in place to create a regulated, liquid, and open market. There will most likely be bumps along the road, but we are looking forward to seeing how the below timeline extends out into the second half of 2018 and beyond.

We hope you enjoyed this article and it has give you food for thought. We’ll be back soon with part 2 in our series: How crypto fits within capital markets and why it will emerge as the most exciting opportunity since the emerging markets boom.

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