In the last 18 months, the press has buzzed intensely over the institutional money about to flow into crypto-assets. Headlines make it sound as if a wall of institutional money sits on the sidelines, ready to wade in, as soon as certain conditions are satisfied – most notably, regulatory clarity from the SEC, along with secure custody from one of the legacy providers in the traditional space.
At Omniex, we believe that the flow of institutional money will take the form of a steady flow rather than a Tsunami. It will flow into crypto more gradually, in cycles, as the evolution of crypto as an asset class progresses in the next few years.
If large amounts of institutional money hit crypto all at once, there would be nowhere for all the money to go. At the end of 2017, there were $79.2 trillion in global assets under management, according to BCG. Even if just 1% of that amount flowed into crypto in a relatively short time frame, that would be $800 billion, a number which dwarfs the current market cap of ~$125 billion. This in turn would create a massive bubble as the number of crypto-assets and their perceived value wouldn’t have changed overnight.
Second, although institutional solutions are rapidly developing, the current market structure as a whole is not mature enough yet to deal with such scale and volume. Some of the infrastructure – like crypto exchanges – was developed for a retail investor base, and is now slowly upgrading to cater to the needs of institutions. Other components are being built with an institutional clientele in mind; however, development began in just the last two years and will take time to mature.
Finally, institutional investors are far from a homogenous group. There are many different flavors of institutional investors, with different risk appetites, return objectives, and investment strategies. These investor groups are subject to different regulatory requirements and investment mandates from their own investors. Assuming that institutional investors will eventually see crypto as a new asset class and understand that crypto investment will bring diversification, each group will still need different conditions to be satisfied before they can feel comfortable investing in crypto-assets.
At Omniex, we therefore believe that investment will come in cycles. In each, a major investor group will enter the space, its money “unlocked” by the fulfillment of a variety of conditions. The diagram below illustrates this progression. This post will briefly highlight different groups and their crypto needs; future posts will feature deeper dives.
Evolution of Crypto Investment
Unlike the rise of other asset classes, crypto first came to prominence through retail adoption, by a mix of anarchists, libertarians, and technology savvy retail investors. Traders and high net worth individuals followed.
Early in crypto adoption, little to no market infrastructure existed, depending on when an investor entered the space. Also, investment was not for the faint hearted. Retail crypto exchanges started developing, central limit order books performing multiple functions (exchange, custody, clearing, broker-dealer). This phase also saw the emergence of other technology solutions such as cold storage wallets.
“Liquid” Crypto Funds
Sparked by the ICO craze in 2016 and the 2017 bull market, numerous crypto funds were set up – both by early crypto investors with no background in traditional finance, and by people from the financial services industry with prior institutional investment experience.
Until recently, the crypto trade enjoyed few of the tools and services that are generally available to institutions in the traditional space. Investors were running their portfolios in an Excel spreadsheet, had to integrate exchange APIs themselves to get one view of liquidity, hold their money on-exchange, do self-custody, and perform other workarounds. That has started to change with the emergence of a variety of service providers and tools:
- Banks like Silvergate and Signature provide banking services to institutional crypto investors
- Kingdom Trust, DACC, BitGo, and Fidelity (starting in 2019), are amongst those offering institutional grade custody solutions
- Firms including MG Stover’s CoinVantage, Atlas, and Libra Tech provide fund administration and accounting services to crypto funds
- Cboe and CME have been offering cash-settled futures since late 2017
- Technology firms like Omniex provide investment and trading software and connectivity solutions
Proprietary trading firms and market makers
OTC market makers like Jump Trading, Genesis Trading, Cumberland, and Circle have been active in the crypto space for a number of years. However, the increase in institutional investment has sparked further growth in their businesses and invited new participants. High frequency traders have also become more active in crypto in 2018 although they are still at early stages, given that latency and market data solutions are not at their required standards yet.
This is where we are at right now. (Retail) crypto exchanges are shifting their focus to attract institutional clients and have started to upgrade their infrastructure. At the same time, institutional players like Bakkt and NASDAQ are preparing to enter the space.
Meanwhile, we see early indications of traditional long-only asset managers and multi-strategy hedge funds putting money into crypto. Various long only managers are working with regulators to set up funds while some of the major hedge funds have quietly spun up crypto trading desks, or are working out of a side-pocket.
Traditional asset management firms including hedge funds and long-only/mutual funds
Although a heterogenous group, it makes up the next category of investors adopting crypto investment. The main distinction we make here in terms of market structure needs is long-only investors vs. hedge funds. A brief characterization follows.
Hedge funds are privately owned, relatively unregulated investment vehicles, open to qualified investors only. Hedge funds invest in the same securities but seek absolute returns, instead of benchmarking their returns against an index. Unlike long-only managers, hedge funds may take short positions in assets that they think are overvalued, use derivatives, and apply leverage. They also use highly sophisticated trading strategies.
What do hedge funds need?
Prime broking services: In traditional asset classes like equities, hedge funds typically use the services of a prime broker – usually a large investment bank – that provides credit (leverage), securities lending (to be able to set up short positions), and custody. Various technology solutions have emerged over the course of 2018 – including Lendingblock, BlockFi, Celsius Network – and also some OTC market makers are active in this area or are planning to. Genesis Global Capital reported $226 million in borrow volume over the first 3 quarters of 2018.
Execution Infrastructure: Similar to proprietary trading firms, hedge funds also need trader-friendly infrastructure – services including guaranteed latency and access to reliable real-time market data. This is particularly important given the volatile nature of crypto markets. Tested execution algorithms that focus on best execution also fall into this category.
Physically-settled derivatives: In order to more efficiently facilitate arbitrage trading – a strategy favored by hedge funds – the market needs physically settled derivatives. The crypto derivatives contracts currently available are mostly cash settled. There have been two obstacles to offering physical settlement at scale: the need for CFTC approval, and a secure custody option to store the underlying crypto-assets. Pending regulatory approval from the CFTC, Bakkt is planning to introduce a physically settled futures contract along with physical warehousing in January 2019.
Long-only Asset Managers
These managers take long positions in an asset and measure their portfolio performance against a benchmark. Investors access these portfolios through mutual funds or separately managed accounts. Both are highly regulated.
What infrastructure does this category need to invest in crypto?
- Custody: As regulated vehicles, these asset managers must use the services of a Qualified Custodian. Also, given the size of institutional assets under management, without a large custodian, investment from this group is hard to scale.
- Regulation: As regulated vehicles, having regulatory clarity will make it a lot easier for these fund managers to navigate the crypto investment process effectively
- Valuation & Research: Long-only asset managers invest on the basis of fundamentals and need tested valuation frameworks which don’t exist yet for crypto-assets, although many smart people are working on frameworks and approaches. This will take time to develop and test as real-world crypto use cases evolve and are validated over time. Broker and independent research also play a role here.
- Benchmarks: Basket indices provided by a trusted major index provider to act as a benchmark to measure funds’ performance against
There have been quite a few headlines about investment banks getting into crypto. Goldman Sachs, Morgan Stanley, Citi are amongst those looking at crypto trading. However, none of them has moved ahead yet. Why is that?
Regulation: One obstacle is the lack of regulatory clarity. As highly regulated institutions, banks are unlikely to move ahead before that is in place.
Institutional Investment: A second roadblock is that banks are unlikely to open these trading desks until there is proven demand from their clients, namely large “traditional” institutional investors. Under the Volcker Rule, investment banks can no longer engage in proprietary trading; therefore, client facilitation is the raison d’être of their trading desks. These desks can’t be profitable without sufficient client demand.
With global assets under management of close to $44 trillion, pension funds are the largest type of asset-owning institutions, and are likely to adopt direct crypto investment last of all. Pension funds are conservative by nature. Among their main investment objectives are capital preservation and diversification. In an era of prolonged low interest rates, pension funds have been seeking superior risk adjusted returns and have allocated an increasing percentage of assets towards alternative investments.
There have been various analyses pointing out that adding some crypto to a portfolio can increase risk-adjusted returns and decrease the overall volatility of a portfolio. That is how investment in crypto-assets could be useful to pension funds in the future.
One consequence of the GFC was much higher regulatory scrutiny on the part of pension funds. Particularly in terms of proper governance around strategies, processes and investment decisions, that must adhere to much stricter rules. Pension funds are usually managed by a board that consists of representatives from various stakeholder groups. The final investment decision is typically the result of agreement between the investment committee and the board of directors, which is ultimately accountable.
Time: It will likely take at least two to three years for pension funds to get comfortable and ready to directly invest in crypto. Pension funds will be followers, not leaders, in this space. By that time, market structure will likely have made substantial progress: regulatory clarity will hopefully arrive, as well as multiple large trusted custodians, investment banks offering broker services, funds with a track record in which to invest, valuation frameworks. All of these are key ingredients for pension funds interested to invest in this space.
On a final note
What all of these institutional investors need is a bigger and more liquid market for the larger investors to be able to make meaningful allocations. It takes time, for any asset class, to grow to a certain size. In the case of crypto, this will happen as clarity arises around which use cases work and which don’t. The industry is in the process of developing the infrastructure and ecosystem in which decentralized use cases and their financiers can flourish.
(Cheaper) liquidity is also important for active trading strategies to work, and to enable large investors to trade in and out of positions with relative ease. This liquidity will evolve as the asset class grows in size, and as truly institutional exchanges develop where large institutions are comfortable playing.
A benefit of the 2017 bull market and early signs of institutionalization is that the crypto market has captured the interest of some of the brightest people from the technology and financial services industry. These leaders are working on crypto projects and infrastructure. They are leaving high paid jobs to do it, because they fundamentally believe in the potential of blockchain technology and crypto as an asset class. This is a good sign and will help in building the real value that is needed for the crypto asset class to grow.
In future posts we will take a deeper dive into some of the needs we addressed in this article.
Unlocking institutional crypto,