Why Have Institutional Investors Traditionally Stayed Away from Digital Assets?

Institutional investors are vital sources of capital and a mark of legitimacy for asset markets. They represent the majority of available capital: about 80% of the entire equity market cap is institution-owned.

Gunnar Jaerv By Gunnar Jaerv on 16 October 2019

Institutions take a longer-term view of investment, seeking stable growth rather than sudden riches; while they’re not attracted to volatility for the most part, they are attractive to businesses and sectors that desire long-term growth themselves.

However, institutional investors have tended to hang back from a digital assets marketplace dominated by small-scale retail and hobby investors. Why is this?

Essentially, institutional investors have been dissuaded from entering the digital assets market because of four main types of risk: the risk of hacks and thefts, risks associated with not understanding the assets and how they work, the risk of being defrauded, and the risk of market volatility.

While that’s changing as improved professionalism and regulation encroach on the once highly-individualistic digital assets space, there are real risks associated with exposure to digital assets. Only by addressing these can the space become a major target for institutional investment.

The risk of hacks and thefts

The digital asset space has grown rapidly, bringing into being a secondary economy of parasites dedicated to hacking exchanges and stealing digital assets from investors.

The risk posed by this should not be understated: even retail investors have been woefully under-protected until very recently, and institutional investors have faced significant barriers to entry in the form of poor protection against this type of attack.

Hacks against exchanges have risen sharply in frequency and value as the potential rewards have grown; one of the earliest digital assets exchange attacks was against Mt. Gox in 2011, and was for digital assets worth only about $30,000; South Korea’s Bitthumb attack in 2019 saw thieves pocket $31.5 million.

The exchange-level solution, decentralized exchanges, often suffer from serious liquidity issues and merely shunt the problem of security one step backwards, onto the investor or their representative.

That’s hardly reassuring when so many attacks are against investors through social engineering and phishing. When the cryptography is unbreakable, thieves don’t bother trying to break it, relying instead on the now-venerable hacker’s toolkit of spoofed emails, password trawling and even simple guesses.

Risk of not understanding digital assets

What are digital assets? How do they work? How are they worth anything? If you’re familiar with the space, you likely settled these questions to your own satisfaction so long ago that you don’t remember what it’s like to not know the answer. But imagine explaining them to the most intelligent person you know who doesn’t already know the answer, and you’ll see how difficult it can be to assuage the sense of unease that larger investors may feel when approaching an asset class whose entire basis is obscure to them.

Where retail investors typically make investment decisions themselves, for themselves, the picture is obviously different for institutional investors. Rather than a process of educating individuals, it’s a more complex dynamic involving businesses hiring and adapting for digital asset comprehension and expertise. With more governance and oversight, considerably higher stakes and many more stakeholders, institutional investors have moved more slowly than their retail counterparts to enter the digital assets space.

Risk of being defrauded

The risk of fraud grew sharply in 2017 with an explosion in a new fundraising method for businesses, the Initial Coin Offering. Associated tools like Initial Token Offerings allowed small companies to raise money quickly to support their ventures, seeming to usher in a new world of rapid access to finance and business ideas with massive potential, without intermediaries, delays or barriers to entry.

Unfortunately, the ICO space really did lack barriers to entry; coupled with the sometimes-abstruse nature of the technology involved, this led to a proliferation of openly fraudulent ICOs in a space filled with projects that weren’t always well-thought-out. Vaporware, exit frauds and wishful thinking abounded, and the mostly-retail investors who entered the space were defrauded of millions.

Look a little closer, and the picture changes, though. In 2017, just three major fraudulent ICOs accounted for the majority of dollars lost to digital assets fraud — not just in the ICO space. While three quarters of 2017’s ICOs were scams, most were ineffective, generating little profit for their perpetrators. The biggest effect scam ICOs had was to discredit ICOs, and digital assets more generally, and to foreground the fear of being defrauded amongst institutional investors.

Risk of market volatility

Digital assets markets move fast. They appear to be volatile from the point of view of investors in traditional assets, and while that’s partly because they’re much more fast-moving, it’s also because they are volatile.

Just a few days ago, on September 24, 2019, the value of nearly every widely-traded digital asset that’s widely traded fell by around 10% in a single day. For experienced digital asset investors, that’s not necessarily anything to worry about; for investors accustomed to the smaller, slower changes that are normal in the world of traditional assets investment, it’s a major shock.

Institutional investors are accustomed to moving large sums, protected by law, regulation and professional standards and ethics. The extent to which the digital assets space can provide these is the measure of likely institutional involvement in this asset class.

To what extent have these risks been ameliorated?

Fiscal professionalism and better regulation

Increasingly, finance professionals and institutions are entering the digital assets space, offering solutions that the earlier, retail-focused infrastructure of the space could not: from investment advice and management to pensions, trust and custody services, as well as additional technological solutions to the persistent security problems that plagued the digital asset space.

New company types grew up, featuring mixed specialities — neither banks seeking access to lucrative new markets, nor tech companies seeking access to financial markets, but hybrid firms with a foot in each camp and able to instruct their individual and institutional clients on how to get the best from an exciting new asset class.

At the same time, regulation became stronger and more nuanced. Again, this took place simultaneously from two directions. Existing agencies have assessed their remits and absorbed those aspects of the digital assets space that they or the courts have concluded are in their wheelhouse. In the USA, for instance, a series of court decisions established that the SEC has the right to oversee some types of ICO as securities sales, creating clearer guidelines for both investors and sellers and establishing the likely future boundaries of legislation. The SEC issued new guidance on the subject in July this year, and has spent the time since in consultation with other agencies including those in Switzerland and elsewhere, seeking to ensure an appropriate level of understanding of digital assets to regulate effectively. (SEC staff will be speaking to Congress to help legislators do the same.)

Other countries’ regulators are moving in similar directions — Hong Kong’s SFC announced new rules on digital assets in November of 2018 — and at the same time, international regulators are looking to establish regional and global frameworks of regulation. While their focus tends to be on money-laundering (AML) and use of the proceeds of financial crimes to fund terrorism (CFT), the effect is to create safer, better-regulated spaces for digital assets transactions globally.

Institutional exposure now

Institutional investment has already grown significantly, though there is considerable room for improvement. The typical Bitcoin investor owns about $3,500 worth — far less than one BTC. And the typical institutional investor is not exposed to the digital asset space at all. Thus, the picture of a year or two years ago, of a space substantially populated by retail and hobby investors, appears superficially unchanged.

Yet, 22% of institutional investors have some exposure to the digital assets space, according to a survey from Fidelity Investments, most of which was acquired in the last three years. These investors showed a preference for investment products that held digital assets rather than to purchase the assets themselves, indicating a growing market for these types of assets.

In the majority of cases, capital inflows focus on the best-known digital assets, BTC, with Ethereum a distant second and other assets trailing in terms of inflows and matching these leaders in terms of market performance. Capital inflows to Grayscale’s BTC investment trust grew from under $2m in January 2019 to just under $160m just six months later, indicating significant institutional interest.

The view ahead

Regulations across the space are likely to be less intrusive than some fear, and there will probably remain a dynamic space within the wider digital asset sector where new assets, underlying technologies and asset forms and functions can be tested by neophiles in a less-regulated, lower-risk way.

The majority of the financial inflow into the digital asset space will probably come from institutional investors within the next eighteen months, however; this transition has already begun. Institutional investors see low correlation between digital and other asset types as a positive benefit, and as the risks deterring entry fall before rising professionalism and increasing regulation, inflows will accelerate rapidly.

Disclaimer:

Disclaimer: This publication is general in nature and is not intended to constitute any professional advice or an offer or solicitation to buy or sell any financial or investment products. You should seek separate professional advice before taking any action in relation to the matters dealt with in this publication. Please note our full disclaimer here.

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