Institutional investors and crypto trading: Will they or won't they?

Published by Investment Europe on 11 February 2019

Whispers that “Institutional Investors are coming to crypto” have been bandied about for the past year and a half or so. Names of some high-profile institutions are being dropped in relation to the development of cryptocurrency products, including Goldman Sachs’ creation of crypto custody and derivatives products, Fidelity’s cryptocurrency trading company, Nasdaq’s plan to launch Bitcoin Futures contracts, and NYSE’s owner’s cryptocurrency platform focussed on institutional investors. Yet will the 2018 downturn in value of cryptocurrencies have a decisively negative impact on large institutional players joining in? Or does the prospect of institutional investors mean a maturing of the markets and fresh influx of capital?

The good...

Overall, the crypto markets have taken positive steps in two main areas in order to attract institutional investors: the development of a nascent crypto derivatives market; and better trading tools.

Because institutional investors are not permitted to hold underlying cryptoassets, crypto derivatives provide traders with an ‘in’  to getting involved in crypto markets, and potentially minimise loss. In 2018, institutional investors were reported to be the biggest buyers in the cryptocurrency market through over-the-counter (OTC) transactions, buying more than $100,000 cryptocurrencies via private sales according to a report by Bloomberg. Demand for crypto derivative products was also thought to have increased due to recent price fluctuations of cryptocurrencies. Further, research by Digital Assets Research and TABB Group discovered that during April 2018, daily OTC transactions ranged from $250 million to $30 billion, compared to the $15 billion traded on a daily basis in crypto exchanges. Investors can now speculate on cryptocurrency pricing by trading futures on exchanges like BitMEX, LedgerX and OKCoin. In the United States, Bitcoin Futures contracts are available on the Chicago Mercantile Exchange (CME) and Chicago Board of Exchange (CBOE). In September 2018, cryptocurrency startup Bakkt, launched by Intercontinental Exchange (ICE), announced it would be offering physical Bitcoin Futures contracts against the United States Dollar, Euro or Pound Sterling.

In order to attract serious traders to the crypto scene, however, better mechanisms need to be developed to provide deeper pools of liquidity. The Blockchain Exchange Alliance (BXA) has made a start in this area by partnering with ONEROOT to create a network of exchanges that will share and contribute to a single, large liquidity pool within the BXA ecosystem. The benefit of exchanges pooling their resources is seamless interaction with large liquidity pools thereby reducing arbitrary pricing. By making the markets attractive to these professional players, a substantial capital influx should logically follow.

Room for improvement

In terms of further improvement to crypto markets, and making them more attractive to institutional investors, increased security, consistent regulation, and coordinated industry initiatives top the list:

• Security: According to the New York attorney general’s report, cryptocurrency exchanges do not have “common standards for security, disclosures or other investor and consumer protections” required by law for traditional exchanges, leaving many vulnerable to abuse by currency manipulators using automated trading. Other exchanges have conflicts of interest due to the fact that some exchange owners hold large portfolios of virtual currency traded on their exchanges, and some employees are even permitted to trade on their own exchanges despite having access to non-public information which could inform their decisions. Further, is it estimated that 68% of cryptocurrency exchanges operating in the U.S. and Europe are not fully KYC compliant. It is the lack of an investor-grade infrastructure that is preventing further market penetration for institutional investors. There is a pressing need for qualified custodians to meet regulators’ security standards and safeguard the growing amount of cryptoassets. Some moves have been made to rectify this, however, with Coinbase recently partnering with Electronic Transaction Clearing (ETC) to launch custody services, while ItBit and Xapo also offer similar services.

• Regulation: A real driver in terms of the acceleration of institutional investment is greater regulatory clarity. We believe that more jurisdictions will strive to create appropriate regulations to protect investors without hurting innovation, similar to moves in Malta, Hong Kong, Japan and Switzerland. Regulators are especially keen to bring rogue players involved in fraudulent ICOs to justice, as well as defining the differences between utility tokens and security tokens.  Furthermore, it is believed that crypto ETFs could soon be approved by the SEC in the US. The UK’s FCA is consulting on where different types of cryptoassets might fall in the regulatory perimeter. In Europe, the European Banking Authority (EBA) and European Securities and Markets Authority (ESMA) have called for consistency in approaching cryptocurrency regulations noting that, while some crypto platforms should be trading under MiFID II rules, a bespoke regulatory regime would be the most appropriate course of action. ESMA also believes that Anti Money Laundering (AML) requirements should apply to all cryptoassets and activities involving cryptoassets, as well as appropriate risk disclosures in order to help inform consumers. In a positive move, it appears that most institutional investors are now working closely with the regulating bodies to develop clear KYC/AML policies and guidelines that favour both parties.

• Industry Initiatives: In order for investors to have confidence investing in cryptoassets, concise information is required to have a better understanding of the markets. This in turn means that industry stakeholders need to come together to standardise data across the crypto landscape so that information can be properly defined and measured. A number of efforts by various working groups include a Code of Conduct and best practices for cryptoassets, as well as a Taxonomy report by CryptoCompare which provides an independent classification of cryptoassets. All of these efforts need to be furthered upon, however, in order to help educate market participants and regulators, while protecting consumers and supporting the growth of the crypto industry.

Grown up and legitimate

Given that cryptoassets have relatively low correlation to other asset classes, cryptoassets could well end up providing a form of safe haven in what is predicted to be a tricky upcoming year for traditional markets. Market players are poised in developing the cryptosphere as recent moves of big firms only serve to further validate the industry. Though trust by regulators regarding cryptoassets still needs to be garnered, it is expected that more international regulations will move forward with approving new financial tools, pushing through stronger regulations and verification procedures. Indeed, the maturation of the crypto markets invariably goes hand-in-hand with the advent of increasing regulation, yet these regulations will only serve to bring increased transparency and legitimacy across the market, which will not only attract institutional money, but make the market safer for the individual investor as well.