What will it take for institutional investors to enter the cryptoasset market?
It’s practically a truism now: “it’s only a matter of time until institutional investors allocate some of their portfolios to cryptoassets.” The truth is, the shift has already begun. This year, family offices (who can invest in a variety of assets without restriction) began to to look at cryptoassets. According to Token Economy, 38 hedge funds accounting for $2b operate in the space, with many more entering. Tech VCs have been attracted by the token boom. Many conventional Wall Street analysts moonlight as traders, attracted by market inefficiencies that have long disappeared in equities.
However, for funds with portfolios in the billions, there are still significant barriers to entry. A few necessary conditions have yet to be satisfied:
Liquidity
Right now, trading is fragmented between various public exchanges and OTC desks. Volume is small (for those used to bond or equity markets), and market impact is large. Decentralized trading startups like OmegaOne will assist with liquidity provision. As useful as this may become for retail traders, the market is nevertheless tiny— at present, the total “market capitalization” of the cryptoasset universe is under $100 billion, or less than the market value of Kraft Heinz Co or L’Oreal. (Let’s ignore for a second the clear issues with adding up the value of all outstanding tokens and labeling this ‘market cap’.)
For cryptoassets to be considered a legitimate asset class by institutional investors, the network value will have to grow substantially. Otherwise trades will continue to have a prohibitively large market impact.
Regulatory legitimacy
This is some ways off. The SEC tends to react to problems rather than pre-empt them. However, the heat is building, and hundred-million dollar tokensales which turn around and buy portfolios of equities and bonds are making some onlookers nervous about securities law. Other thorny questions need to be settled. Some of the trickier ones include those relating to currencies like Zcash and Monero which are designed to be private. Some questions include:
- How will the IRS cope with individuals who have untransparent assets?
- How much disclosure will the US government demand of exchanges?
- How will the NSA and FBI treat a currency which enables opaque global transactions?
- Will node operators be absolved from responsibility for node traffic under a safe harbor framework?
- Will foundations or leadership organizations be asked to remove unpleasant or illegal distributed apps, if they have a history of editing the chain and removing transactions they disagreed with?
- What even is bitcoin? A currency, a commodity, an asset, property, a security, or something else?
These are questions that will need to be answered by lawmakers before many investors feel comfortable entering the space. At present, pension funds and endowments cannot easily purchase bitcoin, since it isn’t traded on regulated US markets. The primary mechanism US investors enjoy is the Grayscale Bitcoin Investment Trust (GBTC), which trades at a significant premium to NAV, and is only available over the counter.
Market efficiency
This one is a bit of a self-fulfilling prophecy. The market is inefficient at present because participants are poorly informed, because market research doesn’t exist in decent volumes, because no one is paying for it, because there are few institutional investors. Once they jump in, then a demand for serious research will appear, and this industry will appear to cater to the new demand, and trades will be more informed. More and better investors will also improve efficiency and raise overall faith in the markets.
You might argue that investors prefer markets to be inefficient, so they can trade against these inefficiencies. This is generally true. However indiscriminate frenzied buying tends to scare away seasoned investors, who are wary of being trapped at a market top. Inefficient markets are only profitable if a) you can short them reliably without taking on exchange risk and b) if they eventually return to fair valuations. The first concern is the principal objection that institutional investors present to me when I bring up cryptoassets. Bitcoin cannot be easily shorted, and not without placing margin on an unreliable exchange.
It’s not all bad, however. A few conditions have changed recently, making cryptoassets more palatable for professional investors.
Volatility
Contrary to popular belief, volatility is not prohibitively high. Bitcoin’s volatility has been on a downtrend for almost its entire existence. A cursory look at the excellent volatility index confirms this.
That said, 60-day bitcoin volatility is currently higher than it has been in the last two years, due to the uncertainty over scaling. This is unsurprising, given the colossal damage a chain split would do, and its ever-changing likelihood of occurring.
Contrary to the perceived orthodoxy, volatility is not a pure measure of risk. If you ask 10 fund managers how they measure risk, you will get 10 different answers. Ultimately, an investor’s greatest fear is permanent loss. Volatility can be ridden out and hedged against. But loss is loss. You made a bad call, and your investment lost 95% of its value. That hurts. Practically, volatility often adds constraints to institutional investors that reduce their ability to react to market conditions, but it’s not a prohibition against entering the market. After all, isn’t the worry that volatility is too low the chief complaint among equity investors today?
Fundamentally, bitcoin’s volatility only looks really elevated compared to major fiat currencies. However, it’s not competing with the dollar or the euro (for now): it only has to prove its worth as a store of value by outcompeting the worst fiat currencies, of which there are many. For traders, in any case, volatility is welcome.
Here’s one visualization of bitcoin’s competitors (discussion here):
Moreover, the certainty that bitcoin cannot be debased by a central bank makes the volatility tolerable for most users. For merchant purposes, services like BitPay mitigate exchange rate risk.
Acceptability
Fund managers have a tendency to exhibit herding. One or two years ago, mentioning digital currency would get you laughed out of any analyst meeting. These days, every Fortune 100 company boasts some blockchain initiative, and developers with solidity experience are the hottest commodity around.
Widespread acceptance is on the cusp of being realized. Fewer bitcoin obituaries are being published. The Ethereum and altcoin boom in May-June 2017 may ultimately prove to be a humbling experience for retail investors, but it did land cryptoassets on the front pages of the financial press and in the popular consciousness. It’s worth remembering that only a few million people have ever used bitcoin. Even though many in the digital currency space consider it old-fashioned or limited, to those outside the bubble, it is still an exotic and mysterious asset. Evidence is growing for its usefulness as an uncorrelated asset class and as a store of value. Acceptance grows with every front-page mention on the Wall Street Journal.
Thus, institutional participation in the cryptoasset market is still somewhat distant, and will not be seriously triggered until the emergence of deep liquidity, credible exchange products, and regularity clarity. When it does, expect a total network value in the trillions.