Today, over 80 percent of institutional investors believe that crypto will overtake traditional investment vehicles within 10 years.
Institutions have been investigating crypto since the early 2010s, and over the last few years, liquidity of cryptocurrencies significantly increased as many new players entered the markets. New exchanges, instruments, and service providers to support digital asset investing have continued to mature.
Although these remain small markets relative to the most liquid markets in the world (bitcoin reached a $1 trillion market cap in 2021 whereas the global equities market cap stands at $125 trillion), crypto markets are growing large enough to allow for positions in sizes relevant to institutional investors.
When Is The Right Time?
Cryptocurrencies are operationally difficult for large institutional investors to access. Holding cryptocurrencies outright requires the development of new operational pathways and approvals for institutional investors.
Institutions need to know there is sufficient liquidity in the markets they participate in to execute trades. The scale of their typical investment allocations has simply been too big relative to the overall market capitalization of the crypto sector.
Spot bitcoin (and related derivatives) traded via crypto exchanges or over-the-counter (OTC) with specialist brokers are the most liquid instruments. However, these come with risks around custody and newer counterparties and require setup of new operational and execution capabilities.
In contrast, futures-based ETFs and Bitcoin CME futures are available through existing institutional pathways but represent a small share of the total liquidity. The CME futures also often trade at a premium to spot and have an associated basis risk (that has often ranged well above 10% annualized).
There are also other similar fund products that passively track Bitcoin, Ether, or a broader basket of crypto, but these all involve meaningful fees and/or have limited liquidity. As such, unless the SEC approves a spot bitcoin ETF, accessibility for large institutional investors will remain constrained by the development of custody and counterparty services.
Relative to trading strategies and risk, there have been concerns regarding market manipulation and other questionable practices in crypto, such as wash trading, which would have implications for institutional involvement.
Institutions have been reluctant to get involved in crypto due to a lack of regulatory clarity. To satisfy know your customer (KYC) and anti-money laundering (AML) regulations and remain compliant with rules built for TradFi, institutions need to know who is on the other side of the trade. The pseudonymous nature of most blockchains makes this problematic.
Despite these difficulties, the institutional investment landscape relative to digital assets is changing rapidly. All the factors holding back institutional involvement are getting resolved as the space grows and matures. Regulation is also catching up, and the ecosystem required to support institutional-grade investment is forming.
What Investments Are Institutions Getting Into?
Institutional interest in the cryptocurrency market excites current investors because institutions bring in fresh money, and certainly more money than retail can pour in.
When BlackRock adds crypto to its balance sheet, financial advisors and high net worth individuals naturally prick up their ears. BlackRock, the world’s largest asset manager with $9.5 trillion assets under management, is one of 16 mutual fund managers (including Morgan Stanley Investment Management) to gain exposure to the crypto market via its Global Allocation and Strategic Income Opportunities funds, which have a collective worth of over $40 billion.
Chainanalysis roughly estimates that institutional investors (anyone with more than $10mn to play with) accounted for 44 per cent of total crypto trading at the end of the second quarter of 2021, up from 8 per cent less than a year before.
At the tip of the spear, a growing and meaningful share of less-constrained institutional investors, such as family offices, have already begun to allocate a small portion of their assets to outright crypto exposure. As shown below, well over half of high-net-worth investors in Europe and Asia have access to digital assets, directly or through financial advisors. The number is lower in the US but still sizable. Additionally, about half of US family offices and about 30% of family offices in Europe and Asia already hold digital assets.
So what asset classes are available and the most popular for institutions to enter?
The most straightforward way of investing in crypto for institutions is to hold cryptocurrency on their balance sheets. Bitcoin, the largest cryptocurrency by market cap, is the gateway – and indeed the only stop – for many institutions that ventured into the cryptocurrency market.
As of June 2022, 6.47% of all bitcoin that will ever exist is held by institutions, a broad category that includes ETFs like VanEck in Canada and sovereign governments like El Salvador.
The institutional presence in crypto began in earnest when MicroStrategy, helmed by Bitcoin maximalist Michael Saylor, bought $250 million worth of bitcoin in August 2020, followed by an additional $175 million in bitcoin one month later. MicroStrategy’s big step was followed by payments processor Square’s $50 million BTC purchase in October 2021 and EV manufacturer Tesla’s $1.5 billion BTC in February 2021.
In April 2022, Fidelity Investments, the largest 401(k) provider in the United States, began offering exposure to Bitcoin through its 401(k) plans. If employers approve, Americans could invest in the cryptocurrency through their retirement savings.
A cryptocurrency exchange traded fund (ETF) is a fund consisting of cryptocurrencies. While most ETFs track an index or a basket of assets, a cryptocurrency ETF tracks the price of one or more digital tokens. Based on investor sales or purchases, the share price of cryptocurrency ETFs fluctuates on a daily basis. Just like common stocks, they are also traded on a daily basis.
Cryptocurrency exchange traded funds (ETFs) track a single cryptocurrency or a basket of different digital tokens and currencies Among the benefits of ETFs are low cost of ownership, diversification, and outsourcing of knowledge- and time-intensive functions related to picking crypto tokens.
The first cryptocurrency ETF started trading in October 2021: the ProShares Bitcoin Strategy ETF. We find that institutions primarily invest in blockchain ETFs. According to a paper published on November 17, out of the 1,462 observations for institutional crypto holdings, blockchain ETFs account for 74.7%.
Aave is one of the original DeFi money market protocols. Aave Arc has been developed specifically with institutions in mind, as it’s a permissioned version of the Aave Liquidity Protocol. Due to compliance and regulatory concerns, regulated institutions cannot access the open-source Aave protocol. With Aave Arc, all participants are AML compliant and KYC verified. With the permissioned liquidity pools isolated from the regular Aave pools, institutions can now access DeFi without violating compliance rules.
For the Compound Liquidity Protocol, Compound Treasury has been launched. Separated from the original protocol, institutions can supply dollars to it via traditional banking, and Compound Treasury, in turn, gives those funds to the Compound Protocol. This degree of separation provides a trusted intermediary for institutions, allowing them to remain compliant with KYC and AML standards and other regulatory requirements.
Venture Capital or Public Equities
For institutional investors, investing in blockchain companies provides exposure to the potential of distributed ledger technologies - or indirect exposure to the cryptocurrencies themselves in some cases. Exposure is small relative to their large balance sheets but easy to do, as they often already have buckets carved out for VC, and a few large IPOs in the last year or so created public equities that can provide exposure.
As shown below, venture funding for cryptocurrency and blockchain companies more than quadrupled to over $25 billion in 2021, and a number of high-profile IPOs in the space monetized large gains for early investors and created public equity exposure opportunities. Crypto exchanges are a particularly popular growth investment for institutions, and we’ve seen several large investors take stakes in FTX, Gemini, and of course the publicly listed Coinbase.
How is it paying off?
We see institutional investors beginning to access these markets in a few distinct ways for different purposes:
- Outright exposure to cryptocurrencies: This is the most relevant to watch, since it could grow significantly in size and impact the overall risk and asset allocation of large institutions. The most liquid and common cryptocurrency for outright direct exposure is Bitcoin, which is a potential “digital gold” asset. There is also growing interest and liquidity in Ethereum, a blockchain-based computing platform, whose native currency, Ether, is required as “fuel” to power the decentralized apps on its network—akin to a “digital oil.” Exposure by smaller institutions (e.g., family offices) has grown rapidly. For the largest institutional investors, exposure is much lower but rising, with adoption still held back in part by significant operational and regulatory concerns.
- Exposure to arbitrage and money-making opportunities: The size of potential opportunities in any pool of liquidity can be measured by how often it trades and how high its volatility is. The crypto ecosystem has quickly emerged as a sizable pool of liquidity from this perspective, so we are seeing players step in to trade it. In turn, it is slowly becoming a part of institutional investors’ alpha risk budget as they begin to gain access to these opportunities through their holdings of hedge funds expanding into this area as well as some new crypto-specific funds.
- Exposure to technological growth via venture capital or equities: A large number of new businesses utilizing blockchain tech are being formed, and institutional investors are increasingly investing in them through venture capital or the few listed public equities in the space. This is generally an easy way to gain exposure, as it fits neatly into existing investment mandates and competencies. That said, venture and a few specific public equity names can only be a relatively small part of large institutions’ asset allocations.
Crypto-specific hedge funds are also starting to emerge, specializing in strategies primarily intended to access crypto assets directly on native platforms and, in some cases, bridge inefficiencies between crypto-linked assets in traditional finance and their corresponding on-chain products. As shown below, estimates of total AUM remain relatively modest, at about ~$20 billion. Many of the largest crypto-native active managers have both hedge fund and VC arms, which can often entail both overlaps and some synergies but makes it difficult to cleanly attribute AUM. Some of the largest crypto funds are also now effectively “prop shops” that do not accept outside capital.
According to a paper published on November 17 by Luke DeVault, who teaches in the department of finance at Clemson University’s College of Business, and Kainan Wang of the University of Toledo’s College of Business and Innovation, the asset class may be paying off for a “small but growing” group of diversified investors.
Institutions investing in crypto assets outperform those institutions who do not (by about 2.8% per year), supporting the notion that sophisticated institutions invest in crypto assets. Moreover, institutions investing in crypto assets hold portfolios consisting of securities with lower average beta and return volatility, suggesting that crypto assets are pursued by managers that place a premium on diversification.
According to the paper, crypto assets can play multiple roles in a portfolio — investors can use them either to increase returns or improve diversification. While these assets tend to produce high expected returns and low correlation to other assets, the writers recognize that prior research has shown that there is a “great deal of risk” in the asset class. But according to this paper’s conclusions, the risk is worth it.