The cryptocurrency sector and crypto investing have largely been driven by retail investors so far, with major financial institutions starting to make their move but full adoption is still pending. Once the industry reaches a tipping point, we can expect an influx of institutional participation.
In 2017, niche crypto funds led professional investors into the sector, but the entry of major players like pension funds, mutual funds, hedge funds, investment banks, sovereign wealth funds, and insurance companies was still awaited.
Further, Bitcoin Spot ETFs brought many institutional investors into the sector thus fostering the institutional adoption of the evolving digital asset landscape.
Institutional Investment vs Retail Investment: Main Differences
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There are several key differences between retail and institutional investment.
Investment Size: Hedge Funds, Institutional Investors, and Retail Investors
The primary differentiator is investment size. Institutional asset managers handle substantial sums that significantly impact digital assets' spot prices and liquidity.
Institutions operate on a different scale entirely, managing institutional portfolios of billions of dollars of assets under management AUM.
Trading and Investing Strategies
While retail investors in the crypto space typically use simple trading strategies, institutional investors employ advanced, analytics-driven approaches. They have access to higher-quality financial data, utilize automated trading tools, and leverage top-tier trading research for better-informed decisions.
Risk
Institutions are far more cautious and focused on risk management in their investment strategies compared to retail investors. This heightened attention to risk is primarily because asset managers are managing other people's money rather than their own.
Both retail and institutional investors assume varying degrees of risk, yet generally, institutional investors exhibit significantly lower risk appetites on average.
Factors That Hold Institutional Investors Back
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Asset custody, governance, and compliance pose distinct challenges for an institutional investor compared to retail investors. Institutional investors are bound by strict corporate regulations that retail investors need not navigate. Institutions face heightened scrutiny in adhering to governance and compliance standards, overseen by multiple state agencies.
Ownership and custody of digital assets tend to be more straightforward for individual investors, who directly possess both digital assets and real-world assets. In contrast, institutional investors and asset managers may not hold the assets themselves; instead, their clients are the ultimate owners.
The various factors outlined above elucidate why institutional crypto investing has been minimal until now. Institutions operate under specific fundamental prerequisites that must be met before contemplating entry into the fledgling financial markets of cryptocurrency.
Institutions require assurance of ample liquidity in the markets they engage with to swiftly execute trades. However, the scale of institutional investment allocations has historically surpassed the overall market capitalization of the crypto sector.
For instance, while Bitcoin attained a $1 trillion market cap in 2021, this pales in comparison to the $125 trillion global equities market cap, alongside a similarly substantial bond and private equity market.
Concerns regarding crypto market manipulation and dubious practices, such as wash trading, have also deterred institutional involvement, particularly concerning trading strategies and risk management.
Additionally, institutional investor hesitance stems from regulatory uncertainty. To comply with Know Your Customer (KYC) and anti-money laundering (AML) regulations, institutional players require clarity on counterparties—a challenge compounded by the pseudonymous nature of most blockchains in the crypto space.
Despite these obstacles, the landscape of institutional investment in digital assets is evolving rapidly. The impediments to institutional adoption are gradually being addressed as the cryptocurrency space expands and matures. Regulatory frameworks are advancing, and the necessary ecosystem to facilitate institutional-grade investment is taking shape.
Indexing in Digital Assets
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In traditional markets, index funds offer individuals a straightforward avenue for passive investment with reduced fees. While institutions typically engage in active fund management, there's a scenario in the crypto sphere where exposure to an index-like vehicle could prove advantageous for them.
Despite institutions' generally conservative risk appetite, there's a growing interest in accessing the potentially high-yielding crypto market. Given the elevated risk associated with individual crypto projects in their early stages of development, a product that mirrors the entire crypto market would hold appeal for them.
To address this demand, Cryptex Finance has introduced the Total Crypto Market Cap (TCAP) token. TCAP operates as an Ethereum smart contract, leveraging trusted crypto data oracles to provide real-time price data.
It functions as a crypto-derivative asset closely mirroring the pricing of thousands of crypto assets, enabling both individual and institutional investors to gain exposure to the entire crypto market's price movements in real time.
While the US currently lacks a crypto exchange-traded fund (ETF), investment trusts like Grayscale and index funds offered by Bitwise are accessible through conventional markets. However, these options are typically limited to the major cryptocurrencies.
Institutional-Grade DeFi Products
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Pioneers in the crypto realm have pinpointed the challenges faced by institutions when making digital asset investments and are actively devising solutions to address them, particularly concerning compliance with regulatory developments. The following segment highlights examples of such products already available in the market.
Aave, one of the most influential DeFi protocols, has introduced Aave Arc, tailored specifically for institutional crypto investments.
Aave Arc functions as a permissioned iteration of the Aave Liquidity Protocol. Regulatory constraints prevent regulated institutions from accessing the open-source Aave protocol. However, with Aave Arc, all participants undergo AML compliance checks and KYC verification.
segregating permissioned liquidity pools from the standard Aave pools, institutions can now tap into DeFi space while remaining compliant with the latest developments in the regulatory landscape.
In the case of the Compound Liquidity Protocol, Compound Treasury has been unveiled. Distinct from the original protocol, The Treasury enables institutions to deposit dollars via traditional banking channels. These funds are then channeled to the Compound Protocol through the Treasury. This intermediary layer offers institutions a trusted conduit, ensuring adherence to KYC, AML, and other regulatory mandates.
Additionally, other market players have shifted gears to accommodate the anticipated influx of institutional capital. Cryptex Finance is poised to launch Cryptex Tower, a product featuring new vaults with reduced collateral ratios, designed to attract institutional investors alongside their existing DeFi product's standard mode vaults. Gemini is extending support to this initiative by providing institutional-grade asset custody services.
This is just the beginning of the mainstream acceptance of digital assets that will allow for portfolio diversification for major institutions that would like to delve into blockchain technology to generate new income flows.
Digital Assets for Real-world Applications
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Tokenization and digital assets offer numerous features and benefits for institutional interest, one of which presents a significant opportunity for institutional portfolio allocations: unlocking the value of illiquid assets by introducing them to a new segment of investors.
Similar to how fractional shares revolutionized retail investing and expanded opportunities for both individual investors and financial institutions in traditional finance, fractional ownership of illiquid tokenized assets enables investors to purchase fractions of this asset class to diversify their portfolios.
Moreover, tokenization facilitates the elimination of intermediaries from the settlement process by employing the trustless nature of blockchain technology, simplifying the transfer of securities. Utilizing smart contracts, these inefficiencies can be eliminated by providing real-time visibility into the movement of securities, automating processes, and consequently reducing costs. These are the most compelling factors that allow to retain the current investors and attract potential ones.
Bitcoin Spot ETFs
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Spot Bitcoin ETFs are investment vehicles that mirror the performance of an underlying asset or a group of assets, spot ETFs offer the convenience of trading on stock exchanges with real-time pricing. Unlike futures ETFs, which derive their value from contracts speculating on the future price of a cryptocurrency, spot ETFs directly invest in the underlying asset, providing direct exposure to its market movements.
Spot bitcoin ETFs offer a significant advantage by broadening investment access, enabling investors to capitalize on bitcoin's price movements without directly owning the cryptocurrency. This is particularly advantageous for institutional investors, such as wealth managers and private banking entities, who may prefer a passive approach to investment strategies while benefiting from emerging trends and the current market dynamics.
This newfound accessibility paves the way for segments previously hesitant due to investment mandate constraints. With the vast financial landscape of the US market, boasting over $6 trillion in 401(k) total assets under management, there's potential for a substantial shift in wealth management strategies and institutional engagement.
Portfolio Diversification and Risk Mitigation
Given bitcoin's low correlation with traditional asset classes like equities and bonds, spot bitcoin ETFs present an attractive option for institutional investors seeking to diversify their portfolios and hedge against conventional market volatility. By spreading risks, these ETFs have the potential to enhance portfolio performance while safeguarding against market fluctuations.
Transparency in Pricing
Spot ETFs enable investors not only to integrate Bitcoin into investing strategies but track real-time Bitcoin prices. These instruments offer investors clear visibility into their investments throughout trading hours. This transparency aligns with the need for timely decision-making in the crypto industry, empowering investors to gauge market depth and liquidity levels, potentially reducing market volatility.
Regulatory Compliance
The SEC's approval of spot bitcoin ETFs, traded on reputable exchanges like the New York Stock Exchange (NYSE) and Nasdaq, appeals to institutional investors accustomed to operating within well-defined regulatory frameworks. By bridging traditional financial market regulations with the innovative digital asset sphere, these ETFs facilitate institutional engagement in cryptocurrency, fostering market growth and maturity.
Market Expansion Catalyst
Spot ETFs serve as a bridge between traditional and digital asset markets, promoting inclusivity, diversification, and maturity in the global financial ecosystem. As institutional participation increases, liquidity and market depth follow suit, leading to more stable pricing and reduced volatility. This enhanced market attractiveness appeals to a broader spectrum of investors, driving sustained growth in the long run.
DeFi Services for Institutions
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In response to the demand and requirements of institutional interest, various services have emerged, akin to KYC- and AML-compliant DeFi liquidity pools placement.
Asset Custody
Dedicated digital asset custodians, such as BitGo, Gemini, Coinbase Custody, Copper, and Anchorage Digital, have stepped into the scene. Tailored to institutional needs, their offerings include insured cold storage custody and rigorously reviewed multi-signature security measures.
Crypto Banking
The emergence of crypto banks like Seba and Signum provides institutions with solutions for navigating the digital assets class.
Over-the-counter Markets
Institutions already involved in crypto often opt for over-the-counter (OTC) markets over centralized exchanges utilized by individual investors. Numerous providers, including GSR, Galaxy Digital, Genesis Block, FTX OTC, and Jump Trading, have entered this space.
Transaction Bridging Services
Web3 wallet provider Metamask has heightened its focus on serving institutional clients with the launch of Metamask Institutional. This institution-compliant wallet offers the same functionalities as the original version but with tailored features to facilitate optimized trade flows and reduce potential risks.
Why Financial Institutions Should Embrace Digital Assets Promptly
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The competition from exchanges is intensifying. Cryptocurrency exchanges, like Coinbase, are aggressively vying for market dominance, equipped with substantial financial resources to swiftly develop and deploy successful business models.
With traditional assets undergoing digitization, these platforms are poised to attract both institutional and retail investors by offering a diverse array of services and assets, including digital stocks and tokenized real estate. Consequently, traditional financial service providers may need to pivot towards the burgeoning realm of digital assets to sustain competitiveness.
The significance of digital asset custody services is escalating. Analogous to the custodianship of conventional financial asset classes, digital asset custody entails securely storing assets. Concerns regarding asset safety have perennially plagued institutional investors.
Bottom Line
Institutional involvement in the digital assets market has been limited thus far, but the sector is poised for significant growth once institutional investor fully embraces these asset classes. With institutions accounting for over 85% of US stock trading volume, the participation of institutional interest could dramatically boost cryptocurrency market capitalization.
While there are key differences between retail and institutional investing, as well as between cryptocurrency market investments and traditional investment strategies such as investment size, trading strategies, and risk management, the evolving landscape is witnessing the emergence of tailored solutions to address institutional needs and regulatory concerns.
Institutional-grade DeFi products, such as Aave Arc and Compound Treasury, cater to compliance requirements while enabling institutional access to decentralized finance. Additionally, services like asset custody, crypto banking, over-the-counter markets, and transaction bridging are paving the way for institutional involvement in digital assets.
As the crypto market matures and regulatory frameworks evolve, the barriers hindering institutional investment are gradually being addressed, signaling a promising future for institutional participation in the digital asset space.
