Forefront Communications

TabbFORUM: After the Gold Rush: The Institutionalization of Digital Assets


The value of cryptocurrencies has skyrocketed over the last half year, particularly for Bitcoin, which gets most of the headlines and hit $34,000 in recent days. This phenomenal rise in value has drawn increased institutional interest, but there is one hindrance to a wider spread adoption of this new “asset class” for mainstream money managers: Regulation. In this analysis, Sam Belden of Forefront Communications hears from Anton Katz of Talos Trading, Kapil Rathi of CrossTower Exchange and Itay Malinger of Curv as they offer a snapshot of the current digital asset landscape, including recent developments in technology, regulation and investor interest.

It’s official: we’re in the midst of another crypto boom. On January 3, bitcoin surged past $34,000 for the first time, far surpassing the mark it set in 2017, when digital assets went mainstream. In that year, bitcoin went from less than $1,000 on January 1 to a peak of over $19,000 by December 31.

This meteoric rise was fueled by widespread interest among individual investors, and while cryptocurrencies went on to lose most of their values in the ensuing months, its impact in terms of generating sustained retail activity cannot be overstated.

Some observers expected larger investors to follow suit, but to date, institutional adoption has not occurred at the same rate. A Fidelity Digital Assets survey of institutional investors from earlier this year found that while 80% of respondents found something appealing about digital assets, only 36% were currently invested. This discrepancy indicates that while the excitement and optimism that have fueled retail rallies are present on the buy side, there is significant progress that needs to be made before crypto adoption can rival that of other asset classes.

These obstacles may sound daunting, but recent years have seen a number of firms taking important steps to provide the kind of robust frameworks and tools that will speed adoption. At the same time, governments and regulators are turning their attention to this nascent space, signaling a willingness to help build the market structure necessary to woo institutional investors.

Sure enough, a number of prominent names have created headlines with their bullishness on crypto this year. In May, Paul Tudor Jones revealed that nearly 2% of his assets are in bitcoin, calling it a “great speculation.” In October, Stone Ridge Holdings Group stashed 10,000 bitcoin in its crypto subsidiary NYDIG, while last month, Guggenheim Partners wrote a filing suggesting it could invest “up to 10% of its net asset value in Grayscale Bitcoin Trust.”

One thing is clear: with so much innovation occurring today, 2017 wasn’t the end of the story – it was just the beginning.

Regulatory Reaction

It is often said that U.S. markets are among the world’s most robust due in part to the industry’s strong working relationship with regulatory agencies and the politicians that oversee them. By that logic, it is no surprise that institutional investors have historically been reticent to add digital assets to their portfolios. Despite recent momentum, there has been little clarity as to how this market will be regulated in the years to come.

“In quite a few EU and Asia regions, the regulators are running ahead of the U.S.,” said Anton Katz, CEO of Talos, a technology provider for the institutional trading of digital assets, and former Head of Trading Technology at AQR Capital Management. “This is not bad, as US regulators tend to take a more conservative approach, but we should also be careful not to be left behind.”

It’s true that other countries have taken significant actions to signal that they are committed to providing regulation to this nascent space. A September report from Reuters indicated that the EU wants to implement a comprehensive cryptocurrency regime in the next four years. In Asia, South Korea passed a law to install a permit system for crypto exchanges, while Singapore’s Payment Services Act granted formal regulatory powers to the Monetary Authority of Singapore, which requires all crypto businesses to be registered.

But that’s not to say there hasn’t been a growing amount of activity from U.S. entities. The Office of the Comptroller of the Currency, a unit of the Treasury Department, has in recent months issued interpretive letters to provide more regulatory clarity, with the goal to “demystify crypto” for traditional banks.

In July, it released a guidance letter stating that these entities are authorized to provide cryptocurrency custody services for clients, while in September it wrote that these entities may hold deposits that serve as stablecoin reserves.

Meanwhile, the state of Wyoming has made repeated overtures to the digital assets space – Gov. Mark Gordon even mentioned blockchain technology in his 2019 inauguration speech, calling his state’s approach “the envy of the nation.”

In the past few years, Wyoming has passed laws or introduced bills that have defined three categories for digital assets, granted digital assets the same legal status as money, authorized companies to issue certificate tokens instead of shares and created a fintech sandbox, among other actions.

Together, these moves have sent a powerful signal to the digital assets industry, with a number of firms launching or moving their operations to Wyoming. Recently, the Wyoming Division of Banking issued a no-action letter to Two Ocean Trust, a wealth management firm, authorizing it to custody both traditional and digital assets.

“We hope that regulators will continue to offer guidance and engage with market participants in policy-making, as both have accelerated the pace of institutional adoption,” said Kapil Rathi, Co-Founder and CEO of digital exchange operator CrossTower and former Senior Vice President, Options Business Development at Cboe Global Markets. “We believe the government’s role is to continue to provide this regulatory guidance and clarity for the benefit of market participants like ours, without stymieing innovation.”

Despite this progress, there is still a strong demand for further regulatory clarity.

“One issue that is coming to light lately is that much of the regulation in digital assets has originated almost solely at the state level. This could create a patchwork of regulatory frameworks that is sometimes challenging to navigate,” Katz said. “Federal regulation would provide consistency and a more uniform blueprint for all digital asset participants which, in turn, would accelerate both adoption and development of services across the industry.”

Tools for the Job

The suddenness of the crypto craze created a world in which interest in digital assets far outpaced the development of the robust platforms and trading tools necessary for institutional adoption. Over the past three years, industry veterans have been hard at work to close this gap.

The exchange space is a primary example. Between heavy consolidation and a number of firms exiting the business, the number of reputable crypto trading platforms is shrinking, yet the longstanding issues with these providers persist, according to Rathi.

“Widespread shortcomings such as inadequate or non-existent regulatory and compliance controls, subpar technology and poor client service have left an opportunity to take market share from incumbents,” Rathi said. “In addition, compared to other asset classes, the cost of trading digital assets is extremely high due to lack of liquidity and high commissions charged by exchanges.”

CrossTower is attempting to change these dynamics by providing a low-cost fee structure, even providing a rebate to retail traders to help speed adoption. Between the rebate and the depth of its order book, Rathi claims CrossTower can save customers approximately $50 for each bitcoin compared to other markets.

Security is another issue – according to Itay Malinger, Co-Founder and CEO of Curv, a provider of digital asset security infrastructure, there were an estimated 12 major crypto exchange hacks in 2019 with nearly $300 million in assets stolen. Curv offers multi-party computation (MPC) protocol technology that eliminates the need for private keys to transact, removing blockchain’s single point of failure.

“By eliminating the private key, the single point of failure in blockchain, Curv’s MPC technology has been able to support financial institutions of all kinds in reducing exposure to such threats, both external as well as internal,” said Malinger. “Given a key is never created in the first place, it cannot be compromised. As a result, single points of failure are eliminated and security is reaffirmed for institutional clients.”

There are also unique challenges surrounding the settlement of crypto transactions. Today, institutional investors must pre-fund their trades by sending capital to all the exchanges where they believe they might execute; the exchanges then hold the institution’s capital in a sort of escrow account, with funds being deducted when the trade occurs. For Katz, this is a key root cause of the lack of institutional adoption.

“The settlement process as it currently exists invites excess counterparty risk since the institution has just turned over capital that they no longer control,” said Katz. “It precludes best execution because the firm’s capital is now spread across multiple venues. It also invites needless information leakage, since the institution’s capital transfers are completely transparent on the blockchain. This particular piece of the trading lifecycle has to be fixed before digital assets will be fully embraced by institutional investors.”

As part of its tech infrastructure that powers the full digital asset trading lifecycle, Talos helps crypto custodians enable their clients to trade using their capital in custody as an alternative to pre-funding. Barriers to institutional adoption remain, but with offerings like these, the roadmap to trading digital assets is steadily being filled in as the buy side continues to educate itself.

Looking Ahead

While the future of digital assets has long been a hot topic, the events of 2020 may have offered some clarity. The record volatility in March and April served as a stress test for crypto markets, and there is widespread agreement that they passed with flying colors. Indeed, crypto adoption increased among both institutional and retail audiences this year.

“Despite strong market volatility, digital assets exhibited a remarkable degree of resilience and lack of correlation with more traditional assets,” Katz said. “This provides further support for the argument of using crypto as an uncorrelated asset in portfolio construction.”

In addition, central banks around the world have flooded the markets with money supply, presenting a new use case that has fueled further institutional interest. While noting that inflationary pressure is currently being offset by the pandemic, Rathi stated that “cryptocurrencies are seeing historic institutional interest and inflows as direct investments, a means of portfolio diversification and/or hedges against inflation.”

Ultimately, while the crypto conversation has shifted dramatically over the past three years, the fundamental question remains: what can be done to help historically slow-moving institutions wade into an asset class that has existed for just over a decade? There will be continued challenges ahead, but with governments, regulators, exchanges and technology providers all moving at full speed to provide an answer, the industry is closer to making this a reality than ever before.

“While the pace of adoption may be slower than what the most optimistic observers postulated in 2017, the industry has made massive strides over the last three years,” Katz said. “We are now on the cusp of true widespread institutional adoption of an asset class that didn’t even exist 10 years ago, and that’s a major accomplishment.”

This article includes firms that are clients of Forefront Communications.

To read the full article, click here.


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