Institutional Investment in Digital Assets

Gunnar Jaerv
Gunnar Jaerv 1 June 2020

The market for digital assets has undergone several profound transformations since the 2009 release of the Bitcoin white paper.

Some have been technical, such as the proliferation of non-currency blockchain use cases and the simultaneous explosion of non-PoW consensus algorithms. Others have been in the sphere of business, initially blockchain-focused businesses but spreading out to affect other spaces; the ICO/ITO boom would be a good example of this. But none has been as serious, or had consequences as far-reaching, as the entry of institutional investors into the digital assets space.

Institutional investors

Institutional investors can be thought of as investors whose investments themselves form a part of the financial infrastructure. They are organizations that pool funds on behalf of others and invest in a broad variety of financial instruments and asset classes. These include investment funds such as mutual funds and ETFs as well as insurance funds, pension plans, investment banks and hedge funds. Institutional investors include public and private pension funds, insurance companies, investment companies, savings institutions, endowments and foundations, and sovereign wealth funds.

Managed and guided by teams of highly-qualified professionals and disposing of millions or billions of dollars, they form a bellwether for future investment and industrial trends as well as a weathervane for the current state of a vertical.

For instance, the news that many developed countries were now seeing over half their energy produced from renewables came at around the time that over half of coal-fired power plants were declared unprofitable. But the clincher is the Norwegian sovereign wealth fund’s announcement that it intends to divest from fossil fuels. While the Scandic countries might be more interested than most in renewables, the Norwegian fund is itself based on the country’s oil wealth and, typically, does not make unprofitable investment decisions.

How institutions invest

Institutional investors approach investment differently from retail investors. They are strategic rather than tactical. Retail investors often seek to avoid losing money; institutional investors will accept losses now for likely later gains later, and view individual investments in context as a part of an overall investment strategy. Retail investors are often lured by the promise of either rapid wealth or reliable income, while institutional investors already wield considerable financial power and aren’t unduly dismayed by losses.

For similar reasons, they’re typically less interested in exposure to unproven technologies or enterprises, and more concerned with security and professionalism.

Institutions and digital assets

For the early years of the space, the typical digital assets investor was a tech-savvy individual investing his or her own money. Some were drawn by their fascination with the technology — especially in the earlier days of the space — or its social and technical implications. Others saw an opportunity to get rich quick, either by investing directly or by selling the same premise to others, with varying degrees of honesty. Gradually, businesses began to be interested in the digital assets space, seeing an opportunity to develop new products, services and revenue streams rather than investment opportunities per se, though their new offerings became opportunities for others.

Throughout this process, the lack of regulation and professionalism within the space has caused it to be dogged by suggestions that it is a bubble or a fraud. How seriously have institutional investors taken these accusations?

Why have institutional investors traditionally avoided digital assets?

While commentators have posited that security and technological concerns were major reasons why institutional investors avoided the space until recently, that seems unlikely to tell the whole story. Direct investment opportunities in digital assets per se have largely been fairly straightforward; exchanges allow you to purchase digital assets, wallets allow you to store them.

Beyond this, the explosion in ICOs and ITOs in 2017 let users buy into startups by purchasing tokens which would then be replaced with the startup’s own coin when their project came to fruition, or entitle the holder to a share of the business’ profits or services from its network.

These businesses received a bad press, with much reportage centering on the tendency to various types of fraud including vaporware, picaresque variations on exit fraud and open theft. And it is true that 80% of ICOs were scams — a damning figure on first reading. And investors lost almost $100m to fraudulent ICOs in 2017 alone.

However, the typical scam ICO was also typical of a low-risk/low-reward criminal enterprise: the ICO consisted of a website and a plagiarised white paper, costing little effort or expenditure, and generally won no reward for its perpetrators. Most vanished without trace and most of the money lost to scam ICOs was lost to just three.

Rather than the space’s reputation — partially earned but as we have seen partially a product of sensationalist coverage — for larceny and disorder, the real reason institutional investors stayed away from it was the same reason that oil tankers don’t dock at fishing jetties. There was nowhere for them to go.

Institutionalizing digital assets

Institutional investors have complex needs that center around security, volume and liquidity. Their standard investment pattern involves approximately 40% of assets to equity and 40% to fixed income, with a further 20% of total assets allocated to alternative investments including real estate, private equity, hedge funds, cash and other alternative investments.

These figures vary sharply between institutions and represent averages. In addition, changes in investment strategies can be seen across the institutional space — in 1980, just 18% of institutional investment was in equities.

Institutional investors often dispose of large sums of money belonging ultimately to clients and thus act under fiduciary duties not applicable to retail and hobby investors, limiting their activities. While technical concerns were noted, the principal obstacle to institutional investment in digital assets has been the lack of regulation and professionalism in the space. As this changes, we can see institutions increasingly turn to digital assets.

Digital assets are among the fastest-growing asset classes in the world today. In the years 2013-2017, the signature digital asset, Bitcoin, saw its market cap grow 1,700%. Other digital assets such as ETH typically track Bitcoin’s value and investment volume increases. In the same period the underlying US economy grew by just 5.9%, and the stock market grew 280% from 2000 to 2020, finishing out the last year of the 2000s at ‘the highest point of the index in the last two decades’ — and still underperformed digital assets.

These reasons alone might not have been enough to tempt institutional investors into the space. But with new, greater regulatory clarity coming from multiple countries and agencies since 2017, institutional money has quietly but decisively poured into the digital assets space.

Capital inflows to Grayscale, a BTC investment trust, were just under $2 million in January 2019; six months later, they stood at $160 million. That’s symptomatic of the direction investment is moving in, rather than a one-off. In 2019, Fidelity released a report indicating that 22% of institutional investors had some exposure to digital assets.

More recently, Bakkt Bitcoin Futures reached an all-time high of $45.56 million. Bakkt’s physically-settled Bitcoin futures contracts are a direct indicator of institutional interest in the space, so the signs are that institutional interest is growing even during uncertain times. This may partly be a safe-haven effect, as well as being a result of low returns across the traditional asset market, but it’s also an effect of the performance of digital assets in their own right. Prices may be volatile but the trend is unmistakable and institutional investors are looking at timeframes considerably higher than the five years investors are advised to hold assets for (to say nothing of the three-years-and-change that they actually retain them); monthly price fluctuations are of far less importance than long-term effects.

Regulation, professionalisation and technology As institutional investors move into the digital asset space, a new industry grows up to support them; when oil tankers start showing an interest in your fishing jetty, you start building, fast. The space has typically lacked three key components of a robust solution for institutional investors: clear unambiguous regulation, professionalism comparable to the traditional finance world, and technological solutions to the unique problems posed by holding and trading nonphysical assets in a 24/7, very rapid market.

All these areas have seen extremely rapid changes. Regulation is moving worldwide as existing regulators establish authority over some digital asset transactions and types, while new legislation establishes new areas of authority and new obligations.

Simultaneously, finance professionals from the traditional investment and banking world are moving into the digital assets space and transforming how possession, trading and managing are viewed.

The centuries-old trust-and-custody structure is used to manage custody and trading of Bitcoin, Ether and security tokens, using technology derived from the first generation of cold wallets for consumers, with additional security and collaborative and trading functionality baked in.

To learn more about how finance, technology and institutional investment are coming together in this unique and exciting space, get in touch with us.


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.