Why aren't institutional investors coming in? What are they worrying about?

Source: Medium

Author: Cristián Bohn

Translator: Xin Nan

Produced by: Odaily Planet Daily

The entry of institutional investors is a topic of constant discussion in the crypto circle in 2019.

At present, some special asset management companies and some financial institutions have started to use cryptocurrencies, but we have not seen institutional investors using cryptocurrencies as an asset class for asset allocation.

Although the market size of cryptocurrencies is small, the demand of retail investors has grown rapidly in the past few years, which has led to an increase in the valuation and profitability of companies in the crypto ecosystem.

This article mainly discusses the challenges that hinder institutional investors from allocating crypto assets or investing directly in crypto assets. We hope to explore solutions to accelerate institutional entry and solve core problems.

This article will focus on institutional-level asset management companies, including traditional active asset management companies, passive asset management companies, and hedge funds.

(Odaily Planet Daily Note: The focus of active asset management is to outperform benchmarks, such as the S & P 500 index, etc .; while the goal of passive management is to imitate asset holdings of specific benchmark indexes. The goal of investors implementing an active asset management strategy is Beyond the benchmark index by buying and selling securities such as stocks, options, and futures. Implementing passive asset management involves buying assets in the benchmark index, with the goal of generating similar returns to the selected index.)

Think of cryptocurrency as an asset

In countries with major financial centers, the regulatory content of cryptocurrencies as assets remains vague. Regulators in most countries have issued guidance but have not passed any specific regulations.

This is a major obstacle for some asset managers with low risk tolerance, and in their view, uncertain policy factors may lead to blockade at any time. And some asset management companies with stronger risk tolerance will think that the guidance given by the regulator is close to future regulations, especially assets such as Bitcoin and Ethereum, they are not considered as a security, but distributed Tokens used in distributed networks to provide incentives.

We look forward to regulators around the world continuing to explore their understanding of crypto assets and their ecosystem. Once some important regional and national legislation considers cryptocurrency as an asset class, other regions will also be forced to take action. But for asset management companies that tend to have low or even zero risk, the regulation of cryptocurrencies remains the main challenge for them to enter the market.

Capital allocation

When asset management companies conduct cryptocurrency operations with multiple counterparties, they often face inefficient capital allocation. The lack of infrastructure and services between banks, exchanges, custodians and OTC providers to manage cryptocurrencies and fiat currencies has led to new operational burdens and may also be exposed to unnecessary risks.

In traditional financial market capital allocation, intermediaries can be used instead of management or operations. These intermediaries may be Prime Brokerage (PB) and Central Counterparties (CCP). (Odaily Planet Daily Note: The main function of PB is to provide a full industry chain service for hedge funds, such as a package of capital introduction, margin financing and margin trading services; the main function of CCP is to offset counterparty risks in commodity futures trading, and in derivatives trading The central counterparty clearing house replaces bilateral clearing and becomes the buyer of each seller. If the seller of each buyer defaults, it can also ensure the completion of the transaction.)

The crypto ecosystem has limited demand for these institutions. Because crypto finance is automated through smart contracts and software of different standards. DeFi based on smart contracts is still far from meeting the needs of asset management institutions.

We are also starting to see some vertically integrated platforms on which institutions can obtain services such as transactions, custody, and loans, but there are still huge gaps in software and services, and asset management companies cannot follow the same regulations as traditional asset classes Standards to manage digital assets.

Risk factors in crypto ecosystem

When asset management companies analyze their investment process, they generally consider the following risk factors: market, credit (counterparty), liquidity, operational risk and security risk. In the crypto ecosystem, the risk challenges facing asset management institutions are mainly credit (counterparty), operational and security risks.

Counterparty credit risk is the most concerned risk factor in traditional financial markets. However, in the crypto ecosystem, since most counterparties are not prepared to disclose their relevant information, the credit of exchanges, OTC providers and related bank partners is often ignored by asset management institutions. In a market downturn, insufficient credit risk may bring considerable systemic risk to the crypto ecosystem.

However, due diligence on counterparties in traditional financial markets takes into account all the above-mentioned risk factors. The reality of the crypto ecosystem is that few exchanges and OTC participants can meet the minimum risk policy requirements for serving asset management institutions.

At the same time, operational risk is often underestimated by existing asset managers, but this risk may cause irreversible losses when dealing with crypto assets.

In a decentralized environment, institutions must open multiple accounts for different counterparties (such as custodians, banks, and trading venues). Managing and controlling the portfolio virtually adds a lot of operational burdens. These operational burdens also bring many Operational risk.

Manage and control portfolio

This is mostly related to manual operations, reconciliation difficulties, and lack of proper software and integration.

For asset management agencies, private key management is a new concept and a new security risk. At the same time, private key management is also a key concern in the industry. Cryptocurrency custody solutions have evolved significantly over the past few years. We believe that at present they are strong enough to serve institutional asset management companies, especially when traditional financial institutions are also beginning to provide crypto custody services.

Going forward, we expect crypto exchanges and OTC providers to continue to improve their risk policy standards to allow institutional clients to enter the market. The recently emerging STO exchanges are also working to provide a regulatory framework that makes them ideal trading venues for institutional investors.

Investor Protection Regulations

Investor protection regulations for asset management companies are also a challenge.

In Europe, MiFID II regulations, introduced in early 2018, set new requirements for pre- and post-trade activities. Among them, there are two specifically for cryptocurrency transactions: 1. Over-the-counter transaction restrictions, which essentially promote transactions to regulated exchanges; 2. Increased cost transparency and improved transaction records, which also include "best execution" requirements, Asset management companies are required to take all sufficient steps when executing orders to obtain the best results. To meet this requirement in the crypto ecosystem, it means that asset management companies need to purchase crypto assets from 2 to 3 exchanges.

The market infrastructure required for cryptocurrency trading among several counterparties is not simple and requires high technology and professional market knowledge. As a result, for asset management companies, the cost and speed of conducting cryptocurrency transactions internally is very high.

At present, there are very few high-quality pre- and post-trade service providers that meet the minimum requirements. We are seeing more and more start-ups working to address the lack of infrastructure and services needed by asset managers. This wave of infrastructure construction is very important for asset management institutions that are still waiting to see it. These infrastructures and financial services that are being constructed are a necessary step in entering digital assets.

As more asset managers connect to institutional-level software and services, we expect this will help the STO industry.