Crypto: Where Are The Institutions?

Opinions expressed in this post are solely my own and do not express the views or opinions of my employer.

TL; DR: In 2017 and into 2018 there was a lot of talk about traditional institutional investors moving into crypto. Fast-forward 12 months and there is limited evidence of active participation by traditional institutions in the liquid crypto markets. So why have most of these investors stayed on the sidelines?

In my mind, there are three main reasons for this:

1. Crypto market structure has made a lot of progress but is not there yet
2. The overall crypto market size remains tiny compared to other asset classes
3. The asset management industry is facing structural pressures

A quick definition of what I mean by institutional investors for the purpose of this post: endowment funds, commercial banks, mutual funds, hedge funds, pension funds and insurance companies. For clarity, “traditional institutional investors” refers to non-crypto native institutional investors.

The institutions are watching

Let’s be clear, the institutions are watching. Crypto has caught the attention of traditional institutional investors.

First, there are many informal reports of asset managers closely monitoring the crypto space, running crypto working groups, and employees trading crypto on their personal accounts.

Second, some of the large US endowments and a few pension funds already have money invested in crypto-focused VC funds.

Finally, recent surveys by Global Custodian and Fidelity Digital Assets found that institutional interest is growing. The former focused on endowments and the latter on a broader spectrum of institutional investors including financial advisors and family offices.

All of these developments are very encouraging, but yet have to materialize into actual allocation of funds – by investment mandate – to liquid crypto.

What is holding traditional institutional investors back from investing in crypto?

Crypto market structure has made a lot of progress but is not there yet

Securities market structure can loosely be translated as the organizational design of a market. Let’s define an efficient market structure then as one that facilitates frictionless and fair trading across a broad range of investors.

The diagram below shows some of the main elements of market structure that come to mind for the liquid crypto market – seen through the lens of the trade process.

Crypto market structure has come a long way, in particular over the last 12 months. Having said that, most elements still have some way to go before satisfying the needs of traditional institutional investors. As providers continue to work on outstanding issues, the expectation – and hope – is that a lot of these will be solved over the next 12 months.

Regulatory Clarity

While all of the elements above matter, one of the key stumbling blocks for traditional institutions – a lot of whom are regulated entities – is the lack of regulatory guidance and clarity. In particular around what constitutes a security and a qualified custodian. Institutions need to have clarity around what they are trading and who can hold it (in custody). In other words, you need to know what to comply with before you can comply.

Counterparty risk in clearing & settlement

One promise of blockchain technology in the financial services industry is the one of near instantaneous settlement.

In traditional finance, a clearing house – for example, DTCC in the US – steps in between the buyer and seller after a trade has been affected and guarantees that the terms of the trade will be fulfilled. This takes away counterparty risk (credit risk) in the clearing and settlement of a transaction which for most liquid securities still takes 2-3 days.

In crypto trading, either the exchange fulfills the role of a clearing house, or the buyer and seller – in the case of an OTC transaction – are exposed to each other as counterparties directly. In both cases investors face credit risk from unrated and unregulated counterparties. In the case of the crypto exchange — which crosses trades on its books — settlement is instantaneous and the counterparty risk is associated with holding funds and crypto in custody at the exchange.

This lack of credit intermediation by a large regulated institution is a risk factor for traditional institutional investors.

Other missing pieces

There are other pieces missing today — most on their way to being resolved: a scalable custody solution (translation: a State Street or BONY entering the market), regulated exchanges, bulletproof real time market data feeds, regulated derivatives markets offering a variety of liquid options and futures contracts (including physically settled futures), cheaper borrow, capital efficiency, and so on.

Taken individually, these may not be deal breakers. However, taken as a whole, it means that crypto investing remains tricky from an operational perspective, and is not for the faint of heart. Taken together with the other issues discussed below, in my mind, this means that the risk/reward profile of investing in liquid crypto markets is not attractive enough, yet, for most traditional institutions.

Crypto market size remains tiny compared to other asset classes

Relative to other asset classes crypto is small and concentrated. This means it is hard for managers to allocate AUM in size and produce gains on a risk adjusted basis. Managers have to stack this up against opportunities to generate alpha in other asset classes.

Putting the current crypto market size (at time of writing $275 billion) into perspective shows that it is still tiny compared to other major asset classes – e.g. less than 0.5% of global equity:

Next, let’s look at the crypto market itself:

The top 5 coins account for 79% of the total crypto market cap. As an investor you don’t want to put all of your eggs into one basket and would like to see a broader variety of assets to invest in. However, what I understand from a number of discussions with current crypto investors is that there are not that many interesting investment opportunities outside of the top coins, and that these are crowded.

Based on the above, my sense is that, from a traditional institutional investor perspective, too small of an allocation to crypto may not be worth the heightened operational risk (and cost of setting up operations), whereas the market is not large and diversified enough yet for a substantial number of funds to make a larger allocation.

So, what will make the crypto market cap grow?

Clarity around use cases and adoption

Let me draw the cliché parallel with the internet space. Investors saw the potential of this new technology but there weren’t enough proven use cases to allow for fundamental valuation of this new category of companies. Investors were speculating. After the dot-com bubble burst in the early 2000s, surviving companies continued to build, and over time investors were able to see what use cases saw mass adoption. This allowed for investment on a fundamental basis. The market caps of internet companies grew exponentially in turn, to the extent where the likes of Amazon and Facebook are amongst the largest companies in the world today.

The expectation is for a similar thing to happen to crypto. At the moment, much of crypto’s market value is based on speculation and not fundamental valuation. Although speculation in itself can drive market value up substantially (and it has!), sustainable value has to be built and well understood. What we need to find out is which crypto use cases are going to see wide-spread adoption.

Therefore, it is very positive that talent has been flowing into crypto and teams are continuing to invent and develop.

Broader retail adoption of crypto concept in general

On a related note, what would accelerate adoption of crypto use-cases is retail investors adopting crypto in general. Compare it to getting a computer and an internet connection and getting comfortable with transacting on the internet. Once you know your way around, you are likely to branch out!

The fact that highly recognizable companies with massive user bases like Facebook are planning crypto projects is a very big deal and a huge step forward.

The asset management industry is facing structural pressures

Last but not least, the asset management industry as a whole is facing structural challenges with large-cap asset manager stock multiples trading at multiyear lows. In other words, asset management firms have bigger things to worry about.

Fee pressure

Fee pressure is one major challenge – caused by both an ongoing move of assets from active to passive funds and a growing unwillingness to pay for active management, or at all.

Complexity of doing business

The complexity and cost of doing business have increased massively over the last decade too – amongst other things driven by regulation and technology. So, fees have gone down, costs have gone up, meaning margins are under disproportionate negative pressure too.

Need to redefine value proposition

Making the case for alpha remains a challenge for many active managers. A study has shown that 86.7% of active US funds have underperformed their benchmark over the 10-year period ending in 2017. According to a recent report by Oliver Wyman and Morgan Stanley, investors with poorly performing products increasingly appear to switch out of active management altogether. In the opinion of the authors of the report, asset managers have to redefine their value proposition into something their investors are willing to pay for, or revenue growth prospects will be weak.

In my opinion, the above makes it less likely that managers are willing to:

1. Take on additional operational cost and risk until there is regulatory clarity and the market is big enough and underpinned by a number of proven use cases
2. Take reputational and career risk

Conclusion: what does all of this mean?

Institutional investors are watching and many recognize the massive potential of crypto and blockchain technology. The turn in the hockey stick will come, it just isn’t here yet. In the meanwhile, providers continue to build out the necessary crypto market structure, project teams are building out crypto-native applications, and more consumers learn about and adopt crypto. The forces are all there!