Adam Y.

@adam_y

How will crypto markets change with the involvement of institutional investors?

The cryptocurrency market is gaining headlines all over the world and causing headaches for the regulators, yet the market is still small and niche in comparison to other financial markets. There is undeniable potential for this market to grow further when institutional investors are able to place funds in cryptocurrencies but there are currently barriers hindering them from doing so.

Cryptocurrencies are a revolutionary new store of value, medium of exchange and/or unit of account and have rose to prominence being accepted as a virtual currency due to solving the double spend problem. This has led some argue that cryptocurrencies represent a disruptive innovation on a scale unseen of since the birth of microchips and the computer revolution.

Since the creation of the first cryptocurrency, Bitcoin, by the elusive Satoshi Nakamoto, over a thousand new cryptocurrencies have emerged, the most notable of which being Ethereum. Ethereum allowed for the creation of smart contracts and on its distributed computing platform. This platform pioneered the way for the simple creation of new cryptocurrencies.

How cryptocurrency transactions work:

Source: Thompson Reuters

The cryptocurrencies are based on blockchain technology: a distributed ledger which relies on a computers that are located in a multitude of places (nodes) accepting information which is secured by cryptography and inputted it onto the ledger. This information is immutable by consensus, meaning a majority of computers inputting the data need to agree on what they place into a block on the chain. This information cannot be altered once it is inputted without a majority consensus and any retroactive changes mean an alteration or deletion of the data that precedes the altered block: this is how the double spend problem was solved and why cryptocurrencies have rose to prominence.

Institutional investors

Many have been able to make unbelievable returns on investments in cryptocurrencies, with Bitcoin having risen in value by 480% this year alone, whilst Ethereum has shot up by well over 3000%. However, not everyone has been able to take advantage of crypto’s rise and these are the biggest investment players of all: institutional investors.

Rise of Ethereum over the past year:

Source: WorldCoinIndex

There are barriers that hinder institutional investors from capitalising on this market, namely:

  • cryptocurrency does not have titled and therefore auditable ownership;
  • clearing and settling risks are abnormal;
  • there is no process of judicial recovery in cases where something goes wrong;
  • risk of cybertheft through security breaches.

Untitled and un-auditable ownership

Cryptocurrencies are pseudo-anonymous, meaning assets transferred are linked to a concrete address to another specific address. However, just like routing network packets on the internet, cryptocurrencies find a path from the sender to the receiver in a seemingly random fashion, but in fact here the path depends on input-output balance.

Furthermore, it is very simple to create a new cryptocurrency address without providing any identification documents to do so. This makes crypto differ from bank accounts since no personal information is needed, giving the impression of anonymity.

However, all transactions completed on the network are completely transparent, allowing several addresses to be “clustered” together and be linked to a single user. This is what makes them pseudo-anonymous.

Being identifiable does not help where investors controlling institutional funds come into play; such investors need to be clearly identified and be able to clearly identify where the assets come from. This is a fundamental legal prerequisite for institutional investors that must undergo audits, which involve anti-money laundering (AML) and know your client (KYC) verification, in addition to complying with other legal and tax regulations.

Abnormal clearing and settlement risks

At the present moment in time, cryptocurrency trading is conducted OTC or via crypto exchanges such as Bitfinex. These two channels carry significant settlement and clearing risks, not to mention cybertheft.

Traditional clearing and settlement process:

Source: VINEX

The main problem is that the exchanges are not willing to become the direct counterparty to each transaction, instead acting as a third party that arranges sales between buyers. This means that the system is opaque, with the exchanges not standardising or taking much responsibility for what happens on their platforms. As such, these exchanges only act as a counterparty where they are able to recoup funds from trades on the wrong sides of contracts when they make margin calls correctly and in timely fashion.

This is fatal for institutional investors who seek guarantees, transparency and reduced counterparts risk in their transactions.

No process of judicial recovery

Since it is difficult to identify wallet owners at the best of times, where fraudulent behaviour or mistakes take place, transactions cannot be reversed. This irreversibility of transactions is down to the blockchain’s immutability by design. Therefore, any asset transfers are final, regardless of what is stated in any legal contract.

This situation is compounded by the fact that cryptocurrencies aren’t governed by any sovereign. For many crypto enthusiasts, this is exactly the point: the decentralised nature of blockchain should remain without a single, centralised authority.

However, for large investors that represent financial institutions, this aspect is completely unworkable: they seek guarantees that, in the event of a mishap, they will be able to recover funds via traditional judicial recourse.

Cybertheft risks

Substantial risks exist for holders of crypto assets since any device connected to the internet is at risk of being hacked by cybertheives. Individuals holding cryptocurrency in their wallets are not the exception here, with instances of large exchanges having their clients’ funds stolen also taking place.

An alternative would be to keep keys to wallets in secure offline environments where they are unsusceptible to hacking. Such variants would have to implement security measures to prevent unauthorised access to keys, just as they would have to make provisions for the protection of keys from the elements, loss and destruction.

So what options do institutional investors have?

Overcoming the above would lead to a massive influx of capital into crypto markets, leading to an inevitable boom in the market’s capitalisation. The only current solution is the Bitcoin Investment Trust which is a cryptocurrency fund whose shares are traded OTC. However, other solutions which offer more complex financial products are in the pipeline. One example would be the securitisation of cryptocurrencies proposed by CyberTrust, which aims to have crypto asset derivatives trading on major exchanges.

Due to the gap in the market for such cryptocurrency based financial products, where they are offered, a large premium is present on the price of the base asset. This premium will reduce where more products from different players are on offer and fulfil demand, but, whilst states are still hesitant to declare cryptocurrencies a legitimate and tradable asset, the process of doing so by creating related financial products will command a premium.

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