Institutional structures drive crypto adoption and store of value
Damian Bunce 10:47 - 02 August 2023
The cryptocurrency industry has overturned convention. A younger generation of retail (non-professional) traders and technologists have defined a product, market structure and a need for this new asset – and it has caught the world’s attention. The institutional community is also paying close attention, as are the regulators.
Much like the evolution of equity market structures over the past two decades, the crypto market requires a significant restructuring to establish itself as a mainstream investment product. There are numerous challenges on its path to universal adoption, but two prominent criticisms it faces today are its perceived lack of a reliable “store of value” and its association with illicit activities aimed at circumventing regulations.
The “store of value” argument is very subjective – although Bitcoin lacks physical collateral like gold or fiat currency, its value is inherently tied to the strength of its holders. If the majority of holders are younger, tech-savvy individuals with limited financial resources, they are more likely to sell the asset swiftly during a downturn, causing its price to plummet further.
Conversely, institutional asset managers and pension funds, responsible for managing trillions of dollars, allocate a small percentage of their portfolios to Bitcoin for diversification purposes, much like they do with other assets such as gold, private equity, and real estate. These institutional investors do not hastily sell their holdings at the first sign of trouble, as they can afford to hold onto the asset at its buying price, thus establishing a store of value, creating a natural floor for the product that can withstand market downturns. As more long-term institutional investment flows into the asset, its foundations strengthen, further solidifying its store of value. Bitcoin’s limited supply also contributes significantly to its valuation.
The concern that crypto is used to conduct illegal activities is, of course, indubitable, and will persist as long as regulation remains weak, disjointed and confused. However, it is common for new industries to face challenges from bad actors, ultimately leading to improvements in their offerings and assisting regulators and law enforcement agencies in devising corrective measures.
Crypto is at this stage of its evolution. While fiat currencies still face their fair share of illegal activities, they benefit from robust regulations and extensive collaboration within the global banking sector, ensuring stronger safeguards.
In contrast, crypto was initially developed with the interests of retail traders and investors in mind and has only recently gained approval from institutional markets. On the other hand, equity markets were originally designed by and for institutions, with accessibility for retail investors being introduced in later years.
During the early days of equity markets, trading was predominantly limited to a select group of operators, primarily conducted through “open outcry” market makers. Over time, exchanges emerged, facilitating trading among institutions. Subsequently, institutions established phone-based stock broking firms, granting retail investors the opportunity to trade equities via authorized brokers. The late 90s witnessed a rapid evolution with the emergence of electronic equity trading companies like Instinet (now owned by Nomura).
The advent of Microsoft Windows-based platforms enabled individuals to conveniently trade stocks from the comfort of their home computers. By the turn of the century, the trading process became even more streamlined and inclusive, with the ability to trade equities and various asset classes from anywhere in the world, often at no cost, even via mobile devices such as phones or Apple watches.
Foreign exchange (Forex or FX) trading has followed a trajectory similar to equities. Initially conducted over the phone between banks, it gradually transitioned to electronic trading exclusively among banks. Eventually, a version with wider spreads emerged, targeting retail traders.
Today the global FX market boasts a daily trading volume of around $7.5 trillion, with approximately $1 trillion contributed by retail trades. Spreads in this market are exceptionally tight.
The success and widespread adoption of Foreign Exchange trading can be attributed to its institutional origins. As it evolved from within institutions to cater to retail traders, regulations were ingrained into the system from the outset. Consequently, most issues were resolved between institutions long before the market was made accessible to retail traders.
In contrast, cryptocurrencies originated in the retail sector, which explains the persistent concerns surrounding weak regulation. Without institutional scaffolding, cryptocurrencies simply drew inspiration from the front-ends and trading screens of other asset classes, without a comprehensive understanding of the infrastructure’s fundamental requirements.
The labyrinthine structure of the now-bankrupt cryptocurrency exchange FTX, where a single entity controlled all aspects of the client journey including the platform, custody, coin currency, lending services, and liquidity, would not have been allowed to flourish in today’s equities markets.
Although it appeared to offer an appealing end-to-end business proposition for the exchange, it posed significant risks for clients due to the inability to monitor and ensure the absence of conflicts of interest. The collapse of FTX last year had far-reaching consequences and is likely connected to the ongoing legal actions taken by the U.S. Securities and Exchange Commission against Coinbase and Binance.
For the crypto trading market to thrive, its market structure needs to emulate institutional frameworks. This will incentivise institutional participants to enter the market and allocate tangible capital to its assets. The introduction of EDX markets, a new non-custodial digital exchange supported by prominent institutional market makers such as Citadel and Virtu, represents a significant step in the right direction.
Blackrock’s application for a Bitcoin Spot ETF is exactly the sort of news that can propel the cryptocurrency market forward. Considering that approximately 20% of Americans currently hold crypto, the introduction of such an ETF could play a crucial role in triggering mass adoption.
Laser Digital, the crypto investment arm of Nomura, recently conducted a poll involving 300 institutions with a combined asset value of $4.9 trillion. The results were overwhelmingly positive, with 96% of participants recognising crypto as a valuable diversification measure and 82% expressing optimism about its performance in the upcoming 12 months.
Today, regulatory bodies, especially in the United States, find themselves in a reactive position when dealing with the structural implications of cryptocurrencies. It would be more advantageous for them to proactively listen to and promptly address the concerns of the institutional community. This approach would yield immediate results, as institutional support, akin to that enjoyed by equities and foreign exchange, would significantly boost trust and interest in the crypto market.
We are already starting to see a few key crypto companies taking the institutional route. Typically led by executives with backgrounds in traditional finance, these firms possess a deep understanding of institutional market structures. By offering specialized services like trading and matching, separate from custody of assets, crypto trading venues and infrastructure providers like Finery Markets and Crossover Markets are actively facilitating institutional adoption.
Meanwhile, companies such as London-based Copper.co and Komainu specialise in crypto storage and custody, deliberately avoiding involvement in trading services. These enterprises recognise that domain-specific expertise is crucial for fortifying the crypto industry and fostering institutional adoption.
Damian Bunce, Chief Customer Officer, Exness