If you build it, they will come!!!! If you build it, will they come??? Seriously, where the hell are they because we are building it?!?!?

The drums started beating in the second half of 2017. Every day as prices climbed higher,market punditsand blockchain enthusiasts, myself included, cited impending institutional interest and eventual allocation as an ongoing bullish narrative for crypto currencies.

In the spring of 2017, bitcoin and crypto markets madeinfrequent appearances on CBNC and Bloomberg TV.  By the fall, both networks had real time price tickers for bitcoin, side by side the S&P 500, and hourly content covering the crypto markets.

Crypto exploded from the shadowy corners of internet forums and burst into the mainstream mediaas outspoken economists and revered investors lined up on either side of the aisle.  They often only agreed onone thing - love it or hate it, it was sexy to talk about bitcoin and blockchain.

But talk is cheap, we needed action

No reasonable bull actually expected institutions to simply plow trillions of dollars into a nascent technology just because it was sexy, did they?

The infrastructure to support an institutional level of investment needed to be built.  The regulators needed to weigh in and the institutions needed to do their homework andmaybe, just maybe, the euphoria needed to leave the market to get them to act.

In this post, I will examine the progress that hasbeen made towards the institutionalization of the asset class and attempt to shed some light on the allusive question, “Where are the institutions?”

The Infrastructure: Big names with big plans are paving the way

Institutional investment in in any asset class requires a robust, redundant and secure set of infrastructures to facilitate participation.This year, while seeing large declines in the price of crypto assets, has seen considerable gains made in the establishment of this infrastructure.

Product Offerings:The spot market (trading of the underlying asset), except for leveraged trading on Bitmex, (which couldn’t be further from institutional), has dominated crypto volumes to date. While spot trading is important in all markets, institutional investors require a more complete product set. They needthe ability to use capital efficiently, short, and hedge or speculate with derivatives.These product offerings are here and improving rapidly.

In December of 2017, the CME and the CBOE launched their respective bitcoin futures contracts, which marked the first crypto offerings by establishment exchanges.As you can see in the chart below, these futures have been well received and are growing rapidly on a monthly basis.

 

CME Bitcoin Futures Avergae Daily Volume by Month.png

Recently, the CME created the reference rate used in the settlement process for ethereum as well. This signals an intention to launch ethereum futures in the near future.

In order to facilitate demand to short the market, Genesis Global Capitalwas launched to allow investors to borrow the needed crypto to establish short positions.

Ledger X has led the charge in creating an options market for bitcoin. The exchange is fully collateralized and CFTC regulated to give investors confidence in the solvency of the options traded.

The presence of these products and the diversification and risk management they provide create an environment more conducive to further institutional investment.

Trading: The infrastructure offered by even the largest crypto exchanges pales in comparison to what is offered by traditional equity and derivatives markets that institutional investors are accustomed to.

Coinbase, the NYSE and NASDAQ are among exchanges looking to change this. The presence of traditional names on this list is notable and demonstrates the changing tides of the crypto landscape. This increased investment in exchange infrastructure will have a meaningful impact on the sophistication of crypto trading.

An additional obstacle to large scale trading is that of illiquidity. OTC, over the counter, solutions exist and are used to help deal with this issue.

This market has been dominated by privately held trading firms such as Cumberland Mining, a subsidiary of DRW Trading. However, the perceived safety of dealing with the balance sheets of large public banks is something that has never been an option to date in the crypto markets as it is in other asset classes. This is all beginning to change as Goldman Sachs  announced they will soon be entering the market, albeit in a limited capacity at the onset.

Storage/Custody:Seemingly, the issue holding Goldman back from more meaningful involvement is that of custody. Until recently, crypto custody has been a significant issue for many investors. There is a well established set of best practices for individuals storing their own crypto holdings, but these practices are not without risk and therefore don’t scale to an institutional level. This has left funds like the CAOF to create redundant, multi-signature cold storage solutions that are proprietary to the individual funds. While quite secure and well-conceived, these solutions are a long way from the custody of a more traditional asset and leave much to be desired for the storage of hundreds of millions of dollars.

Coinbase Custody, Xapo for Institutions and others continue to enhance the services and products they offer for large scale storage.Additionally, more traditional qualified custodians are becoming involved. BitGo is awaiting approval for an acquisition of Kingdom Trust, which would combine for the first time crypto custody with a traditional custodial name and balance sheet.  A custody solution on this magnitude would likely open the gates for other traditional custodians and prime brokers to enter the space, which in turn should translate to further institutional involvement.

The Regulatory Environment: Forced to read between the lines

Many have cited the lack of regulation as one of the factors limiting institutional investment in the space.

A leading institutional investor who I have been fortunate enough to form a strong relationship with agreed to offer some insight for this post. He says “ I do think the current regulatory environment is the key hang-up for investors. This creates uncertainty…. which causes people to hold off on investing.”

I believe that the SEC and the CFTC are aware of this uncertainty and have been increasingly working towards clarity in recent weeks and months. This is not to say an investment doesn’t have regulatory risk.  It certainly does.  But, the information and disclosures are there to provide a level of transparency.

Howey Coins is a mock ICO project created by the SEC. The model ICO is meant as a demonstration of an ICO that would be considered an illegal securities offering. While on first glance many members of the crypto community found this model quite humorous as it seemingly mocks illegitimate projects, it is actually quite serious in nature. It demonstrates concrete examples of actions that can’t be legally taken in an ICO.  While hardly a regulation, itdemonstrates the SEC’s focus on investor projections.

Also, the CFTCrecently released a formal staff advisory about the regulation of crypto derivatives and how it relates to spot markets. The memo shows the CFTC’s dedication to keeping up with innovation and advancement of the markets.

Staying abreast of these communications and interpreting their meanings does not alleviate the risk of a regulatory surprise, but it does allow for a better understanding of how the agencies may be viewing the markets.

The crypto markets are still very much evolving, and I believe the regulators realize this. It is hard to create formal regulatory clarity at this nascent stage.  We may have to be patient and continue to read between the lines of the pronouncements by the regulatory agencies. However, the question is - “isthis something institutional investors are willing to do?”

 

Institutional Diligence: No trivial task

I have been continually impressed by the amount of resources institutions have dedicated to educating themselves on the crypto markets. In mymeetings with many of them, the one thing which is clear isthey want to learn about the space. They come both with open minds, but also with a pre-determined list of topics they want to discuss and understand better.

Some have begun to make small allocations.  Some seem almost ready.  Others are seemingly not close.

The institutional investor adds “I do hear more and more family offices talking about the space and wanting to make investments.  That is a fact. I think a family office will target 5% of their liquid portfolio to these types of investments.”

It is our role as an industry to help to educate regardless of what stage they are at and I take my part in this role seriously.

A matter of when not if?

The investor goes ontoconclude, “I do think the tide is turning in a big way.”

While statements like this, and the discussed developments to the infrastructure of the market, have me excited about the future, timing the entrance of large in flows of capital into the market is a fool’s errand.

The declines of the first half of 2018 have humbled the high-flying mentality we had built in 2017, but in my opinion this has been a healthy development. I believe we will look back at this time period and the progress that has been made as a critical moment in the institutionalization of our asset class.