Reza Jafery

@RezaJafery

4 Hurdles Stopping Institutional Investors From Investing in Cryptocurrency

And the similarities between Blockchain and eSports.

Photo by Alyssa Ledesma on Unsplash

Disclaimer: I’m a partner at BlockchainWarehouse where we help companies launch token sales and token generation events, all opinions opinions expressed below, unless explicitly stated otherwise are my own and do not reflect the opinion of my company.

About two years ago I took the dive into blockchain. I have a history of getting involved in emerging industries, my previous startup, LVLUP Dojo focuses on eSports and streaming. We created eLearning content to help aspiring professional gamers and full-time streamers realize their aspirations. Blockchain, like eSports/Streaming, is a new and exciting industry. I’ve heard, “[Insert Industry here] is the wild, wild, west”, used to describe both.

What makes them exciting is the fact that they’re still developing, they have yet to reach their final form. There is room for innovation, and a chance to make a name for yourself as an entrepreneur, as a pioneer of a new field.

Unfortunately, while exciting: being a new, and sometimes polarizing, industry comes with its own set of problems. For example, in eSports, I had a difficult time getting people outside of the industry to take it seriously.

“You mean, people like to watch other people play video games? That sounds idiotic”, I’d hear from a diehard NFL fan. Fast forward two years and thanks to streamers like one of our LVLUP Dojo teachers, Ninja, streaming is practically main stream. Blockchain has seen a similar progression, mocked and ridiculed for years — soon after CNBC broadcasts a segment on how to buy cryptocurrency.

People mock what they don’t understand, until the people who don’t understand become those who are mocked.

With blockchain, the set of problems you face are a little more grandiose. While streaming challenged peoples perception of entertainment, blockchain challenges the perception of finance and banking. eSports and streaming are new industries that have been built from the ground up in the past decade or so, they are innovative but aren’t challenging any existing infrastructure besides current entertainment — which doesn’t have to change the way it operates to adopt this new form of media.

Blockchain on the other hand, challenges financial infrastructure almost as old as the United States itself. In order for blockchain to reach mass adoption, organizations that have spent their entire existence building infrastructure to support their business models have to rebuild those infrastructures to adopt it.

Another downside to the blockchain industry, is the regulatory uncertainty. A venture capitalist can very easily invest into an eSports team, or one of the supporting companies that also benefits from its rise in popularity.

The process of a venture capitalist getting into blockchain on the other hand, is a little more difficult.

They key difference between eSports and blockchain is, in my humble opinion, the fact that institutional investors have several roadblocks to face if they want to put capital into blockchain, while those roadblocks don’t exist in the gaming world. Institutional money is necessary for rapid growth of an industry, and although it goes against some of the core principles behind blockchain itself, we need big banks and hedge funds to get more involved if we want blockchain to become what it has the potential to be.

The Bitcoin ETF proposed by the Winklevoss bro’s is a quick fix to some systematic issues that stop hedge funds, family offices, and sovereign wealth funds from exploring this new asset class. Unfortunately the decision to accept or reject the ETF was pushed back another 30 days, meaning at the end of this time period, the SEC will be forced to come to a decision.

Working with BlockchainWarehouse (BCW), I’ve spent a considerable time researching the roadblocks sophisticated investors face. As a company, BlockchainWarehouse believes that institutional money, and increased regulation, are both necessary for mass adoption — so we conduct active research into the market landscape and what needs to change for the overall growth of the market. The information I’ve shared below is a snapshot of some of the research I’ve put together.

Think of it as, the cryptocurrency market from the view of an institutional investor.

Note: you can find all the sources for the data included in this article at the bottom in the “Sources” section.

The Crypto Market in a Nutshell

Since Bitcoin’s genesis block moment on January 3rd, 2009, the cryptocurrency market has exploded to include over 1600 different cryptoassets. The majority of the market’s growth occurred in 2017. Between Jan 1, 2017, and Jan 1, 2018, the aggregate market capitalization grew from USD$18.3 billion to USD$598 billion — with daily trading volume going from USD$140 million to USD$24.8 billion between the same date range. The market capitalization hit an all-time high on January 8, 2018 at USD$820.9 billion, with the daily trading volume peaking at USD$68 billion. Despite the rapid expansion of the market, cryptoassets are still in their infancy. When compared to other asset classes it represents only a fraction of the world’s money, but when taking into consideration the time these other assets have had to develop, and the speed in which cryptoassets are gaining capitalization, the future looks bright for crypto markets.

While the traditional stock market is in an eight year bull-run largely due to institutional investment, the cryptoassets market experienced a market correction at the beginning of 2018. Notably, institutional investors were allowed their first crypto investment vehicle in late 2017: bitcoin futures. In an effort to ease into the market, the CME and CBOE Groups launched the first Bitcoin Futures contract. This marked the first institutional foray into cryptoassets. The crypto market is largely dominated by retail investors, or individual investors who can be lacking in financial training and general trading experience. This, in part, is why the cryptoasset market is extremely volatile, and sentiment driven. Bitcoin price fluctuations and surges have been known to correlate with the volume of google searches for the word, “bitcoin”. Despite blockchain technology being touted for its transparency, the market is surprisingly opaque, with a lack of credible information and data for traditional or professional investors to utilize in guiding their trading decision-making.

Google search volume for “Bitcoin” vs. Bitcoin price

Even with the limitations of the market holding back institutional investment, eager retail investors continue to flood into the market. The two largest exchanges, Binance and BitHumb, saw a record breaking amount of new users in 2017–2018. Binance reported that they were on-boarding approximately 250,000 users a day before they, and Bithumb, were both forced to close their doors to new customers, in order to scale their infrastructure to meet the demand securely.

The demand for cryptoassets is undeniable. And in the past, institutional interest has followed individual interest. While the market capitalization for these assets is sizable, it hasn’t realized its full potential. And it won’t reach its full potential until it is embraced by institutional investors. Much like the historic eight year bull-run that the stock market has seen recently, it’s institutional money, and not individual capital, that fuels hyper growth.

Institutional investment follows individual interest.

Despite its exponential growth in 2017, some institutional investors remain hesitant to enter the cryptocurrency market.

There is no lack of speculation about Bitcoin and the surrounding altcoins that have sprouted around it. Reminiscent to weeds in a garden — some altcoins serve no purpose, and their founders have no long-term goals to create value; yet they are nearly indistinguishable from the serious projects in the space. Cryptoassets do not present the traditional investment evaluation data or indicators that traditional stocks present. It’s more complex to qualify the real value proposition without significant and recognized data analysis points. Sophisticated investors shy away from the market because there is little clarity on their potential investments when determining viability— which has for the most part, made it impractical for family offices and hedge funds to venture into this investment space. Risk management is an absolute necessity when managing these large investment portfolios.

Despite the general lack of information, the market has seen a substantial uptick in the amount of equity financing being facilitated by venture capital firms during pre-sales. A pre-sale is typically a private round of fundraising that precedes an Initial Coin Offering (ICO). While institutional investors remain reticent, some serious investors have already entered.

For example, the initial volume that Bitcoin Futures founded was lackluster, until in April 2018 when they hit record highs; 19,000+ futures contract opened with varying expiration dates. This is triple the average daily volume that CBOE had seen previously. Increased demand in the space is causing other big players to consider entry. Goldman Sachs issued a statement to The Wall Street Journal in which they announced looking into investment products to offer their clients in this “controversial market.”

The 4 Crypto Roadblocks for Institutional Investors

At this moment in time, there are 34,000 sophisticated investors who can potentially enter the market, inclusive of: 23,000+ hedge funds and 11,000+ family offices worldwide. It’s important to note that these numbers don’t reflect individual customers, but funds with hundreds or thousands of clients, often controlling billions of dollars. If you combine the wealth controlled by these groups to the wealth held by Sovereign Wealth Funds (which globally manage $7 Trillion USD worth of assets) and High Net Worth Individuals (HNWI’s) — these groups account for a significant portion of the worlds wealth.

1. Lack of Institutional grade trading platforms

Sophisticated investors are accustomed to, and require “Bloomberg Style” solutions to trading. But within the crypto market, there is nothing that satisfies the decision-making data analysis that the traditional investor is accustom to. There are no all-in-one enterprise-level institutional tools available, and no mechanisms for sophisticated investors to trade in the same way as they do in traditional securities and currencies.

The existing market infrastructure works well with fiat assets, but crypto is different. The market is open 24/7/365, making it difficult to monitor in the traditional sense. In addition, there are crypto-specific signals that could inform trading strategies, but these signals are often overlooked due to a lack of credible information. These signals are largely unknown and completely unfamiliar to those coming from fiat based markets. For example, a family office might have no idea what a hard fork is, or what an increase in the hash power of a mining protocol does for the price of the asset tied to it.

Partially due to the large amount of dealer-to-customer (D2C) exchanges available to retail investors; there is no go-to verified source of market information, or information to help understand the spread for crypto trading pairs across exchanges. Lack of regulation has allowed them to remain opaque. The challenges for institutional investors in this space are numerous with lack of traditional data points.

Regulation

The current regulatory environment surrounding cryptoassets is littered with gray areas, left to the interpretation of legal teams. This is normal for any innovation, particularly related to money. But no matter how normal, governments are scrambling to understand and regulate the segment as quickly as possible. These teams are often deciphering legislation from across the globe, attempting to determine the best locales to establish their business entities.

This lack of regulatory clarity for retail investors is troublesome, but for sophisticated investors, it makes it nearly impossible to effectively manage investments in cryptoassets.

Know Your Customer (KYC)

KYC is a regulatory requirement that forces exchanges to identify whom they do business with, whether they be retail or institutional investor. The KYC process for popular exchanges can often take weeks to complete, and the data required to facilitate this process differs from exchange to exchange. These requirements are cumbersome to satisfy, and plainly, inefficient. There is no single solution to KYC an entity across all exchanges, and because no exchange caters to all cryptoassets, investors are forced to go through KYC processes across several different platforms. This is time consuming to sophisticated investors, who need a streamlined solution in order to manage the volume of capital they are controlling, effectively, efficiently, and securely.

Anti-Money Laundering (AML)

The Financial Industry Regulatory Authority (FINRA) defines AML rules as, rules to help detect and report suspicious activity including the predicate offenses to money laundering and terrorist financing, such as securities fraud and market manipulation. Essentially, AML aims to stop people who have earned funds illegally, from using those funds to generate additional revenue.

If you’re accustomed to trading in cryptocurrency markets, you’ve probably gone through several of these processes. Yet, having to go through these processes for each exchange is tedious and inefficient for sophisticated investors. Unfortunately, it is also necessary, with each exchange only offering a select % of the total coins in the market, and the fact that most exchanges don’t have enough liquidity for these investors).

This issue can only truly be addressed by governments and regulators. At the moment, governments are trying to fit blockchain and cryptocurrencies within the parameters created for traditional investment vehicles, which simply, will not work. Some are attempting to address it — but are proving to falter in the face of innovation. Change is scary, especially when it threatens decades worth of financial infrastructure. Only a few regulatory bodies and governments have really embraced blockchain, some with more suspicious intentions than others (cough Petra cough).

Lack of Liquidity

Binance has enough volume for mere retail investors like myself, but institutional investors place trades larger than current exchanges can handle. Their best option, if lack of volume is their only roadblock, is going through an OTC trading desk- but this isn’t conducive to a long term trading strategy, it’s not quick enough.

Even if an exchange has enough volume, the size of buy/sell orders hedge funds and family offices typically place would drastically sway the market. Imagine watching a 100 million dollar buy or sell wall appear, on top of the already volatile and manipulated market.

At this point in time, there aren’t any exchanges, companies, or platforms that solve the issue of liquidity for institutional investors. A few ICO’s have raised money to create theoretical solutions (such as Omega.one), but none of them have managed to pull it off.

Creating liquidity in this market has long been a barrier to sophisticated investors. Even the largest volume cryptocurrencies available are far less liquid than assets in traditional markets. Some of the most promising cryptocurrencies have limited market depth, which makes it difficult for larger buyers not to affect asset prices and disclose their trading strategies to the wider market.

In a study conducted by BarclayHedge, 52% of Commodity Trading Advisors surveyed expressed that concerns about liquidity stopped them from trading Bitcoin futures, this concern extends beyond futures contracts, and into the general crypto market, where only 28% of funds surveyed in 2017 expressed interest in entering the market at all. While far from mass adoption, this 28% reflects a potential $991 billion that can flow into the market when looking at the total value of assets under management by hedge funds globally.

There is no standard solution for sophisticated investor to safely access crypto liquidity sources. As highlighted above, the current ecosystem is fragmented, and sophisticated investors would be forced to utilize several different platforms — often varying in professionalism and usability. None of these platforms provide the functionality or quality that institutional investors require to facilitate their trades without affecting the mass market.

Institutional investors require extensive data in order to execute their investment strategies. The systems they use are completely different from the cryptoasset solutions currently available that are tailored towards retail investors. Although there are billions of dollars traded daily on cryptoasset exchanges, with the potential of institutional money primed and ready to enter the market there will be an absolute requirement for real-time information sources.

According to a study by BarclayHedge, a total of USD$3537.6 billion worth of assets were under management by hedge funds across the world in Q4 2017. While, a study by Autonomous Next estimates there are currently USD$3.5–5 billion in cryptoassets currently being managed by hedge funds.

Wallet Inefficiency and Lack of Custodial Solutions

There are over 1,600 cryptoassets currently in circulation. While there are a few companies in the space providing multi-coin wallets, there is no truly universal wallet. Creating a wallet compatible with all available coins is a large undertaking. I’d even go as far to say its borderline impossible.

The term wallet refers to the cryptographic keys required to access and transact one’s cryptoassets on the blockchain. While exchanges provide wallets for the cryptocurrencies they secure, no single exchange has comprehensive coverage of all assets. Furthermore, it’s an industry standard to avoid storing ones assets on exchange wallets, as they create a “honeypot” for hackers.

The term “honeypot” refers to when one centralized organization is responsible for the storage of an entire community or customer’s assets. It creates a very appealing target for hackers, as the return from hacking an exchange is far greater than hacking any individual wallet.

The cryptoasset market is still in search of a solution for asset custody. Currently, major players in both the crypto, and traditional finance world are working towards custody options for institutional investors. Coinbase is seeking approval to serve clients a custodian service that meets the standards in place for guarding assets. Other blockchain focused companies such as Circle and BitGo are simultaneously speaking to regulators towards the same goal. In the traditional finance world, Nomura Holdings Inc, Bank of New York Mellon Corp., JPMorgan Chase, and Northern Trust Corp are all working towards digital custody services. Recently, the NYSE’s parent company (ICE) started to offer direct settlement for crypto in the form of a new exchange. ICE has engaged in conversations with financial institutions about setting up a new operation through which banks can buy a contract, known as a swap that will end with the customer owning Bitcoin the next day — with the backing and security of the exchange.

This probable development by ICO and NYSE to offer swap contracts likely means that they have found a custodian solution that fits within the SEC qualified criteria. Which could mean that this particular roadblock is being addressed.

There are solutions on the horizon.

With the custodial services Coinbase wants to offer, and the Bitcoin ETF’s being proposed now — its feasible to believe we’ll see institutional capital entering the market in the next 6–12 months. There are variables that could stop it from happening, such as the SEC stopping these ETFs from going through, or Coinbase failing their current objective.

Yet, despite the roadblocks, and decades of infrastructure and stakeholders in said infrastructure that might want to hold blockchain as a whole back from adoption: I think it might be too late.

The more people that adopt blockchain, and begin understanding how cryptocurrencies work — the more people will understand how money works. This may seem silly, “Of course people understand how many works”, you might think. I’d argue that they don’t. I for one, didn’t truly understand money and how it derived its value until I began to study Bitcoin. Sure I knew how I could hand someone paper and they’d give me something in exchange, but not why.

As more and more people understand why the fiat currency we use holds value, more and more people will start to see the merit in cryptocurrencies. So, when I say its’ too late, I mean too many people understand how currency works, and the possibilities that arise when an asset is decentralized. Too many understand that an improvement is available for us to remain comfortable with the current status quo.

— — — — — — —

If you like the article, and want learn more about blockchain, crypto, and other random ramblings of a crypto-geek — check out some of my other articles.

Sources

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