Is the crypto market still too Wild West for the traditional buy-side?

As more major institutions continue to enter the digital asset space, Annabel Smith explores whether appetite from the traditional buy-side to engage with the crypto market is increasing.

Interest from institutional investors in cryptocurrencies has been undoubtedly rising with each passing year, sparking a flurry of crypto and digital asset initiatives launched with non-retail participants in mind.

What we’ve known for a while, is that hedge funds and family offices have partaken in the whirlwind digital asset market, but the level tends to drop off at the more traditional asset management end of the spectrum.

Traditional asset managers have held back from dipping their toes into this explosive market due to its volatile nature, a lack of appropriate infrastructure and by accountability to their end investors. In their eyes, the cryptocurrency market still has some growing up to do.

But once the many remaining questions around regulation and infrastructure are solved, and new products – whether that’s derivatives or ETFs – crop up, the rise in asset management participation is inevitable.

“We only deal with institutions and corporates – we do not serve retail investors. We can certainly attest to the fact that interest in our products and services has exploded over the last 12 months,” says Chris Tyrer, head of Fidelity Digital Assets Europe.

Research has shown that hedge funds are leading the charge in the crypto space, with the more traditional hedge funds (non-crypto specific) beginning to dabble. A report by the Alternative Investment Management Association (AIMA), PWC and Elwood Asset managers in May found that 21% of traditional hedge fund managers are investing in digital assets, with another 26% planning to invest.

The barriers to investments cited by the hedge funds surveyed included regulatory uncertainty, lack of infrastructure, and client risk or reputational risk.

The Wild West

For traditional asset managers, the reasons for not entering the space do not differ significantly from those listed by traditional hedge funds. Digital assets do not translate well into the rigorous risk management processes that investors require when planning to entrust their capital to a fund manager.

“There is a huge infrastructure of law, regulation, due diligence and more that asset managers must adhere to, that gives asset owners confidence that their assets are safe. The crypto world has been specifically designed to obviate the need for intermediaries,” says Carl James, global head of fixed income trading at Pictet Asset Management.

“Institutional asset managers broadly see [cryptocurrencies] too much as Wild West. It is very difficult to put a fundamentally driven price on crypto. Fund managers are asking themselves, is this an asset class I want to be managing for my clients, and if I do how? For a classic long-only asset management client, how do you construct fundamental analysis around any cryptocurrency?

“There are several large banks who are offering crypto services and their offering appears to be gaining traction from some asset managers – but these are early tentative steps.”

The client base of a firm has a significant impact on its engagement with digital assets. Those putting their money into hedge funds have a different appetite for risk compared to investors entrusting their money to traditional asset managers. Hedge funds are not subject to such stringent regulation, meaning they have more flexibility on how they choose to invest their money and a greater appetite for risk.

“Broadly speaking, when looking at the risk parameters that institutional asset managers adhere to for their institutional clients, they have strict agreed metrics which are generally lower than hedge funds and private family offices, whose clients have a higher risk tolerance,” adds James.

Up or down?

When looking to invest in cryptocurrencies, it goes without saying that tolerance to risk is important. The reason is simple: cryptocurrencies are notoriously volatile.

On Monday 24 May, Bitcoin’s value had fallen by half in 40 days, sparking a statement from investment bank HSBC that it would not promote the asset class to clients due to the volatility and lack of transparency.

“Volatility is something that we hear a lot from potential investors as being something that they are concerned about, however, in the fullness of time as with all immature asset classes this will subside,” says Tyrer.

The volatility means that long exposure is risky and this deters long-only investors. The price can shift 20-30% following just one news story or social media post from infamous pot stirrer and billionaire Tesla chief executive Elon Musk.

“That is a sign of the fact that it’s still quite an immature space,” says Stanislav Kostyukhin, commercial owner for the trader segment at Saxo Bank. “I think that as time goes by and the infrastructure develops as we see more institutional flow, then the volatility should subside as well. The market has obviously grown in capitalisation and historically as market cap grows, it’s more difficult to shift the market and influence the price.”

Saxo Bank confirmed plans to launch a new cryptocurrency offering on 19 May enabling institutional and retail clients to trade Bitcoin, Ethereum and Litecoin against EUR, USD, and JPY from a single margin account without a crypto wallet.

On the same day, Ethereum and several other digital assets saw their prices plummet, leading to a loss of more than $460 billion within 24 hours for crypto’s total market capitalisation.

What needs to change?

Amid the extreme volatility many firms unsurprisingly want to access the market using their existing sell-side bank and prime broker partners. However, the lack of regulation in place means some major financial institutions are reluctant to involve themselves.

“Banks are some of the most heavily regulated institutions on the planet and so they naturally want to have that regulatory air cover before they enter the space,” adds Fidelity Digital Asset’s Tyrer.

Fidelity Digital Assets was launched in 2018 in response to growing demand from institutional investors for a trusted platform provider to engage with cryptocurrencies. It marked a significant milestone in the uptake of cryptocurrencies for institutional investors. The digital asset arm of $7.2 trillion asset manager Fidelity Investments offers trading and custody of cryptocurrencies to institutional investors such as hedge funds, family offices and market intermediaries.

As it stands, however, regulators have little jurisdiction to supervise activity in the market because the digital assets being traded are not legally classified as either a currency or a commodity, which has prevented many of the largest banks from entering the space.

On 3 June, the UK’s Financial Conduct Authority (FCA) extended the end date of its Temporary Registrations Regime for crypto businesses to March next year allowing firms who had applied for registration and those whose applications are still being assessed to continue trading while it continues its “robust assessment” of the space.

A cryptocurrency hedge fund report from AIMA also found that 82% of those surveyed cited regulatory uncertainty as the greatest barrier to investing. Infrastructure and service provider availability were other key barriers to entry, with custody being the area with most need for improvement.

New regulation on the horizon has the potential to encourage more investment from major institutions. In the US, the Office of the Comptroller of the Currency issued guidance letters in January this year which gave banks the green light to offer custody services for crypto assets and stablecoins.

Across the pond, a draft copy of the European Commission’s crypto assets legislation, MiCA, was also leaked in September setting out the EU’s stance on cryptocurrencies, security tokens and stablecoins in a largely similar manner to the MiFID II regulation covering securities markets, investment intermediaries and trading venues.

“It is our expectation that it will be at least 18 months before MiCA is implemented, but that would have crypto or virtual asset service providers, like exchanges and custody providers, regulated. I think that we will start to see meaningful moves from banks and other financial intermediaries in the lead up to the implementation of that regulatory piece,” says Tyrer.

“I think right now if we compare the state of the infrastructure within the Bitcoin and the digital asset ecosystem, it’s night and day between now and four years ago. Some of this is a little bit disjointed, that connective tissue is still being built out. I think that the infrastructure is all in place, it’s now connecting some of the dots.”

Infrastructure and regulation in the space is certainly bulking out. In the first six months of 2021, several sell-side participants have taken the plunge and filled custody and brokerage gaps in the market. Notably, Northern Trust and Standard Chartered partnered to launch an institutional crypto custody solution in what was considered a landmark move for institutions vying to enter the space. Custody giants BNY Mellon and State Street followed suit with announcements of their own digital asset servicing plans.

Standard Chartered also launched an institutional digital asset brokerage and exchange platform for UK and European markets, while Cowen moved to provide institutional clients with access to cryptocurrencies.

In terms of crypto exchanges, Gemini and Archax became the first to receive approval from the FCA in 2020. Digital asset exchange heavyweight, Coinbase, which recently floated on the Nasdaq stock exchange with a valuation of $86 billion, also confirmed in May that it will launch a prime brokerage custody solution.

Despite the infrastructure becoming more concrete, attention has been drawn recently to its robustness and reliability during flash crashes, like the one on 19 May that saw the price of Bitcoin plummet by $10,000 in under an hour. With 8,000 clients and $122 billion of assets traded, Coinbase was one of the first exchanges to buckle alongside fellow high-profile crypto exchange, Binance, which was thrown into the spotlight for similar systematic issues.

The future

Crypto is undoubtedly becoming a driving force in the market. The asset class has little correlation to the traditional investment market because of its alternative methods of price discovery. It can offer diversification opportunities and alternative sources of portfolio return to investors in a market where yields are low.

There remain a few pieces of the puzzle left to put together before a whole image of the market can be discovered and this uncertainty causes traditional institutions to pull back from the asset class. The violent peaks and drops in pricing seem unlikely to flatten without the weigh-in from major financial institutions and that is unlikely to happen without sturdy regulation and infrastructure.

Originally coveted by cyber-punks, institutional involvement in digital assets was the last thing on the minds of those that sought to usurp the traditional investment market with cryptocurrencies, but as the space becomes more regimented and interest in market rises, traditional institutions could be forced to jump on the band wagon, whether that be full blown involvement or watered-down crypto tracking funds.