Just How Unfriendly Is the Crypto Ecosystem for Institutional Investors Today?
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Institutional-level traders and investors face serious barriers when attempting to trade crypto at scale. These numerous barriers include a lack of trustworthy custodians, an absence of a clear and standardized regulatory environment and an immature market structure. I’ll briefly run through how these barriers frustrate institutional attempts to trade high volumes of digital assets and what some players are doing to tackle market immaturity head on.
Lack of trustworthy custodians
From an institutional perspective, there’s massive interest to invest in crypto. However, according to a GreySpark Partners report, only a fraction (~2%) of the 5,500 hedge funds in existence globally trade crypto. It’s clear to me that the room for growth is there. However, their adoption is tempered by the SEC’s custody rule that prohibits institutional players from holding – or custodying – their own assets. For any other asset class, a trusted third party custodian,such as a major bank, would hold the assets for the fund in custody. But it’s a different story with crypto. Due to the hesitation of major custodians to hold crypto, whether on legal, technical or strategic bases, many institutional players are limited to trading crypto at a much lower volume. This lack of trustworthy custodial institutions therefore stymies the ability of institutional investors to trade crypto at a scale that they’re used to with other asset classes.
Lack of a clear, standardized regulatory environment
Major jurisdictions like the US and Europe have a patchworked regulatory environment, inciting restraint in firms worried about potential legal pitfalls and fines. In the US, for example, several federal agencies are responsible for financial regulation, and this overlap is further complicated by the fact that such regulation also varies state-to-state. A rare joint statement by three major regulatory agencies – the Securities and Exchange Commission, the U.S. Commodities Future Trading Commission and the U.S. Financial Crimes Enforcement Network – chillingly reminded crypto industry players, whether they be exchanges, broker-dealers or mutual funds, that it is their responsibility to abide by banking laws like the Bank Secrecy Act.
What stood out to me is that it is up to the individual to decide the “nature of the digital asset-related activities” he or she is involved in and then decide “which agencies that person should register with, as well as which other laws they need to comply with”. Of course, at the top of regulators’ minds is anti-money laundering, and a recent guidance from the Financial Action Task Force could see exchanges and wallet providers forced to reveal certain pieces of customer data to provide authorities the ability to monitor transfers. This points to a desire by regulators to harmonize the way cryptocurrencies are regulated with established practices for fiat – but without any technical roadmap on how to get there for crypto players.
Beyond that, disagreements abound between regulators regarding how cryptocurrencies even ought to be classified. One such disagreement was tracked in a recent article. For example, while the Securities and Exchange Commission (SEC) considers digital assets to be securities, the Commodity Futures Trading Commission (CFTC) classifies them as commodities, thereby allowing users to publicly trade cryptocurrency derivatives.
What all of this points to is a fragmented, unclear regulatory regime that requires serious legal expertise and resources to properly navigate. This barrier alone would be enough to dissuade any major institution from trading large volumes of digital assets and instead stick to more familiar and predictably regulated asset classes.
Immature market structure
A major contributor to institutional hesitation about trading crypto rests within the structure of digital asset markets as they exist today. Exchanges are built as vertically integrated behemoths, host trading, clearing and settlement in an all-in-one environment. Contrast this to the traditional financial world, where trading takes place through networks of agents that each provide custodial, credit, clearing and settlement services. In the absence of a networked financial system, crypto exchanges are siloed and separated from other players, who are viewed as direct competition as opposed to symbiotic members of an ecosystem. An outcome of this means that digital currency trading and settlement is slower: hedge funds used to high-frequency trading (HFT) are often faced with clearing and settlement times that extend into days, as opposed to the seconds or milliseconds that they are used to for other asset classes.
The significant length of settlement times mean that institutional traders’ funds are stuck in limbo for days at a time, leading to missed trading opportunities. It makes trading crypto in large volumes inefficient and unappealing, especially when considering the operational risk associated with coordinating massive collateral deposits across several exchanges to enjoy a fraction of buying power.
While the barriers described are certainly daunting, I don’t think that all hope is lost. As institutional interest in crypto continues to grow due to a never-ending pursuit for “a new source of alpha”, new players will emerge to help ameliorate at least two of the aforementioned barriers: custodianship of digital assets and the immaturity of the market structure.
As for the uncertain regulatory environment, that may be out of the crypto industry’s hands for now. The SEC continues to waffle, evidenced by its recent rejection of Bitwise’s Bitcoin ETF days after its global head of research claimed that the company was “closer than we’ve ever been before to getting a Bitcoin ETF approved”. The can can’t be kicked down the road forever, and the US government will need to streamline and clarify its regulatory regime if it wants to stay competitive against other looming crypto competitors like China.