Investing In Cryptocurrencies: Now is the Time For Institutional Investors To Pay Attention
The Bitcoin asset has grown from a few cents to thousands of dollars in less than 10 years. It has out-performed all other investment assets. It’s tipped as the future of money and one of the decentralised technologies that could transform industries ranging from transport and healthcare, to retail and politics.
In April of this year, I stated that the entrance of major banks and financial institutions like Goldman Sachs will lead to an increase in the liquidity of bitcoin, and ultimately, the bitcoin price:
“I think it’s fabulous that they’re getting into it because it brings in new liquidity. They’re going to develop futures markets, options markets, I even think you’re going to start to see interest rate markets around bitcoin. We’re used to hearing things about Libor, the index for bitcoin interest rates is Bibor.”
But so far, most institutional investors, including banks, insurance companies, pensions, and hedge funds, have steered clear of cryptocurrencies. However, that attitude is beginning to change and institutional investors will soon be entering the market in a major way. According to Nick Cowan, CEO of Gibraltar Blockchain Exchange, there is pent-up demand and “institutional money waiting on the sidelines” but he believes “there are concerns about not just the asset, it’s the custody of these things that has to be addressed for institutions to be able to say, ‘Okay, now we are happy and can come in’”.
Admittedly, 2018 has been challenging for crypto investors. Global market capitalisation fell about one third between January and the second week of May amidst worries over fraud risk, escalating token issuance, and ever-shifting cyber-security threats. Accusations of market manipulation and concerns around potential naked short selling by State-sponsored actors at “margined” exchanges (such as CME and CBOE cash-settled futures exchanges) are also doing little to lessen institutional investors’ concerns about cryptocurrencies.
Any large trader can exploit market illiquidity and shifting margin rules and contract limits at inexperienced exchanges. This has a large ripple effect in the market that scares away institutional investors. As the complexities and shy institutional uptake for the new cash-settled bitcoin futures products demonstrate, the industry must eventually move towards a futures contract that is physically-settled with proper warehousing standards.
Counterparty risk and custody provisions are even bigger worries for institutional investors. Although cryptocurrency exchanges are significant new platforms, they have been largely designed by the younger “gaming” generation of developers. Financial institutions care more about return of capital rather than return on capital, and they are understandably wary of the professional indemnity behind these platforms.
Despite this, I believe that now’s the right time for institutional investors to look seriously at making investments into cryptocurrencies. Doing so will reap multiple rewards, including “alpha” returns, more diverse portfolios, and legitimising an entirely new and uncorrelated asset class.
Some institutional investors have shown that they’re keen to seize these opportunities. In May 2018, Bloomberg and Michael Novogratz, a well-respected former hedge-fund manager, launched an index that tracks the performance of the ten most traded cryptocurrencies, including Bitcoin, Ethereum, Monero, Ripple, and Zcash. Additionally, Goldman Sachs will soon begin trading Bitcoin futures, according to recent news reports.
Novogratz predicted that major financial firms would soon start offering bitcoin or similar products as an investment option. “The institutionalization of this space is coming. It’s coming pretty quick,” he told Reuters, last year.
Europe is currently leading the United States in the institutional trading of cryptocurrency and overall the UK and EU countries attempt to make themselves attractive jurisdictions for cryptocurrency fintech startups.
European regulators in different jurisdictions have initially welcomed funds, whereas the U.S. regulator has pushed back on legitimising this approach. Last year, an investment management firm in Jersey (one of the Channel Islands near the United Kingdom), began what’s thought to be the world’s first regulated investment fund (“CoinShares”) to be denominated in cryptocurrencies.
Alpha returns and diversification
Cryptocurrencies are a once-in-a-generation, perhaps once-in-a-lifetime, investment opportunity. There’s currently no asset class that directly correlates to cryptocurrencies. If you’re a hedge fund manager running equity and foreign currency portfolios, that’s an attractive diversification tool.
Dan Morehead, CEO of cryptocurrency hedge fund Pantera Capital Management, recently predicted that the cryptocurrency market could eventually be worth $40 trillion.
You can liken the buzz around the cryptocurrency market to when gold was first traded. Or to when tech companies such as Amazon and Google took off. But many cryptocurrencies are developing much faster and technology innovations are crossing the chasm more quickly.
Unlike traditional asset classes, such as gold, cryptocurrencies can represent many different businesses. Owning bitcoin can be a proxy for owning an ETF on the entire Bitcoin-Blockchain sector. If you’re dealing with a utility token (a third method of raising project financing, after equity issuance or debt issuance), each particular asset has a market value linked to the protocol of that business and industry model, such as property, fintech, insurance, shipping, medical data, etc. I believe that the majority of innovation and creativity in the future will come from the utility/protocol token model.
We should, therefore, view cryptocurrencies as much more than just an alternative asset class. Within a couple of years, cryptocurrencies will become a standard part of a diversified portfolio. I predict that they will typically account for a couple of percent or five percent, or more, of an institutional investor’s portfolio, alongside other relatively new assets or markets, such as emerging markets and renewable energy.
Of course, past performance does not guarantee future returns. That said, we have had eight years of rapid growth in cryptocurrencies.
Crypto exchanges
If this growth continues, and if traditional stock exchanges continue to keep away from cryptocurrencies, they’ll miss out on a growing and profitable market. They’ll also be playing catch-up on trading in cryptocurrencies and the related byproduct technology known as the Blockchain.
New crypto exchanges, such as Coinbase and Bitstamp, are trying to fill a gap in the market but don’t provide all the financial infrastructure, information, and services that institutional investors need to make large-scale investment.
Technology can smooth over some gaps. CRYPTALGO’s Galaxy infrastructure software — a comprehensive backbone for the trading process — connects different crypto exchanges, giving institutional traders a “total view of the market”. It also includes features such as “best price” and “best executions”, which financial institutions require before entering the market.
Alliances between companies in financial markets can also accelerate growth and maturity in cryptocurrency trading. In April, CRYPTALGO and Elysium Technology Group, the U.S.-based supplier of trade-processing technology for Foreign Exchange and Futures, announced a partnership to develop cryptocurrency trading technology for financial institutions.
Cryptocurrency exchange markets will also consolidate over the next couple of years. Why? That’s what happens in maturing businesses in any industry. Traditional stock exchanges will also buy crypto exchanges to gain a foothold in the market. Small crypto exchanges will struggle, due to lack of liquidity and global trading volumes.
The consolidation has already begun. In February, Circle, a Goldman Sachs-backed cryptocurrency start-up, acquired Poloniex, a large crypto exchange.
Risk and reward
But for the cryptocurrency market to fulfill its great potential and change investment, it still needs to get the institutional investors on board. How?
Standards, both financial and technological, will help.
A proposal for an ISO 4217 international currency code (XBT) for bitcoin has been submitted. It would be the equivalent of GBP or EUR, and would propagate into all enterprise-level software and the world’s financial markets. It’s a major advancement for cryptocurrencies.
I believe the industry will also naturally install its own standards as crypto trading becomes more visible. Currently, much of the investment in cryptocurrencies by institutional investors is done unofficially in OTC venues. In investment banks, there are little-known clubs of traders (usually younger employees) who have side funds in crypto and are trading proprietary accounts, rather than in the name of their commercial bank or trading house.
As more investors are attracted into this part of the market and it becomes more formalised, better practice and standards will come to light, aided by the SROs, self-regulatory organisations.
In the meantime, investment risks in cryptocurrencies can be reduced in a number of ways, just like for traditional investment assets.
First off, as mentioned above, there are several futures and derivatives markets where you can hedge cryptocurrency risk in a similar way to how a multinational corporation can hedge its balance sheet risk against fluctuations in multiple currencies.
As a second example, CRYPTALGO’s Galaxy backbone provides a risk solution by offering trading at very high volumes across multiple exchanges. This activity, aided by the deep pools of liquidity that CRYPTALGO facilitates with its multi-exchange connection, helps reduce volatility and mitigate the chances of market manipulation. It also helps to address counterparty risk as crypto and fiat currencies do not remain with a particular exchange for long.
Individual crypto exchanges are looking to do something similar to this, but do not yet have the comprehensive infrastructure or liquidity needed to appeal to institutions.
Conclusion
As you can gather, I’m a (realistic) bull on cryptocurrencies and institutional investment.
I am not underestimating the challenges facing the cryptocurrency market, but while we need robust multi-jurisdictional infrastructure, I disagree that we need aggressive “crypto-specific” regulation. Existing regulations for money service businesses and account custody can already be applied to cryptocurrency exchanges.
Regulators and major banks should start to treat bitcoin (XBT) as just another currency with an ISO 4217 currency code. It would create a level playing field between state-sanctioned currencies and cryptocurrencies.
To reach this stage, though, we’ll need robust and liquid global exchanges, similar to national currencies, that can offer risk management via futures and options.
This pivotal moment in financial markets, business and economics will occur at different times, in different countries, but it will happen soon. Institutional investors have the chance to act now and benefit from this exciting and emerging market.
At CRYPTALGO, I’m proud to be part of an effort to bring highly liquid and efficient cryptocurrency trading to the institutional market.
Disclosure: Author is Founding Director of the Bitcoin Foundation and Advisory Board Member at CRYPTALGO HOLDINGS AG. CRYPTALGO’s Galaxy system is a live beta platform.
