Digital Asset Market 2021: The Year of the Institutional Investor?

This year has proven to be a turning point for institutional investment in the digital asset market as the price of Bitcoin continues to soar, while US state and federal regulators are making some significant announcements on how cryptocurrencies can fit into existing regulations designed for traditional assets. Institutional investors pumped $429 million into cryptofunds and other products for the week ended December 8 pushing the sector’s assets to an all-time high of US$15 billion, according to digital asset manager Coinspaces. Whether 2021 will be the year most institutional investors, such as endowments, pension plans, insurance companies, wealth management firms and family offices, are finally comfortable enough to wholeheartedly embrace cryptoassets as an alternative asset class remains to be seen. From what most the majority of digital asset market tell FinOps Report there is plenty of reason to think so. Of course, there are a few naysayers.

Wall Street powerhouses– such as Goldman Sachs and JP Morgan– appeared to change their tune when it came to whether cryptocurrencies were legit enough to be part of investment portfolio and Guggenheim Partners has just filed with the US Securities and Exchange Commission for its Macro Opportunities Fund to make an investment in Greyscale Bitcoin Trust, a common stepping stone for institutional investors in the cryptomarket. Investment firm SkyBridge, founded by former Goldman Sachs vice president Anthony Scarmucci has also asked the SEC for approval to buy cryptocurrency while insurance company MassMutual says it has purchased US$100 million in Bitcoin for its general investmnt account. Billionaire hedge fund manager Paul Tudor Jones is also singing Bitcoin’s praises as a buffer against inflation.

The growing tide of support comes as state and federal regulators try to resolve a critical stumbling block– just who can provide custody of digital assets. Following Wyoming’s passage in 2019 of multiple measures designed to define cryptocurrencies as property and create the ability for state-chartered banks to become special purpose depository institutions for digital asset custody, the state’s Division of Banking gave Kraken and Avanti Financial its blessing as SPDIs this year.  The Office of the Comptroller of the Currency’s decision in July to let national banks act as digital asset custodians, was hailed as the badly needed impetus for institutional investment. However, the SEC’s continued silence left institutional investors hesitant about doing more than dipping their toes in the cryptoasset pond.

It was not until the Wyoming Division of Banking decided that Two Ocean Trust met the SEC’s definition of qualified custodian for digital assets, that the SEC finally asked for industry input on how its custody rule applies to state-chartered digital asset custodians. Lawmakers from both political parties now want the SEC and Financial Industry Regulatory Authority, the broker-dealer watchdog, to clarify their custody regulations and how digital asset custodians can become registered-broker dealers so the backlog of applications can be resolved. The SEC’s “custody rule” allows banks, trust companies and registered broker-dealers to act as qualified custodians with trust companies needing to accept deposits or have fiduciary responsibilities similar to a bank. So far, most financial institutions that offer digital asset custody operate as state-chartered trust companies under either New York or South Dakota law. Wyoming’s Division of Banking decided that Two Ocean Trust, albeit a trust company, acts like a bank. Lawmakers from both political parties now want

Custody issues aside, regulators have a long way to go before institutional investors– including pension plans, endowments, and family offices– are entirely comfortable either investing directly in cryptoassets or through a pooled vehicle such as a fund. Valuation, asset protection, taxation, and cybersecurity measures remain unresolved. It is unclear whether digital assets can meet the SEC’s requirements for fair valuation of assets, how customer protection and segregation rules apply, and what happens to client assets if a trading platform or service provider goes bankruptcy. There have been instances of investors left out in the cold when C-level executives holding the private keys for access die or become unavailable. Security breaches have also been common and the Internal revenue Service wants its fair share of taxes even if it isn’t clear about how investors should calculate them.

The outcome of the presidential election may have some effect on the decisions of regulatory agencies but for now the rocky transition to a new government during a pandemic is taking center stage. As FinOps Report went to press, California Democrat Maxine Waters who chairs the powerful House of Representatives Financial Services Committee, called on President-elect Joe Biden to rescind the OCC’s crypto-related guidance as part of a broader approach to undo the legacy of the Trump administration. The acting head of the OCC Brian Brooks predicted a lineup of cryptocurrency guidance by year-end, but if the Republicans lose control of the Senate in January there is no telling whether those measures would main intact. Meanwhile, Treasury Secretary Steven Munchin reportedly wants to rush new regulations to ban cryptocurrency self-wallets wanting cryptocurrency exchanges to verify know-your-customer rules before allowing cryptocurrencies to be moved off exchanges into wallets.

FinOps Report asked eight well-known legal experts and service providers in the digital asset market to predict what they think will happen or hope will happen in 2021 that will either increase or decrease institutional interest in the cryptoasset market. Their responses are published below ranging from the most positive to the most skeptical.

Three factors will contribute to a meaningful increase in institutional investment in cryptoassets- especially Bitcoin and US dollar stablecoins –in 2021.  The first is the bull market in Bitcoin, which happens every four years after Bitcoin’s inflation rate is cut in half, according to Bitcoin pre-set algorithms. That “halving” happened earlier this year and like clockwork the four-year cycle is playing out again in Bitcoin’s price. If the past is prologue it appears that Bitcoin is in a bull market that will carry into 2021. Another factor is the continued significant investment in institutional custody infrastructure to digital assets of all types. The industry is ready to service institutional investors that are subject to the strictest fiduciary standards not just those (such as hedge funds and family offices) that can take higher legal and operational risks. The third factor has to do with stablecoins, such as the explosion of velocity of US dollar stablecoins as financial transactions went increasingly digital around the world. The verifiable on-chain velocity of US dollar stablecoins is averaging 109x meaning that each stablecoin trades on its blockchain on average 109 times annually. Reported velocity — including off-blockchain crosses of stablecoins at exchanges — is now at a US$16 trillion rate while B2B payments in the US are US$25 trillion. This trend will continue in 2021 when I believe bank-issued versions will come into the market. When that happens mainstream payment users can start to enjoy the benefits of a programmable US dollar in a better, faster, and cheaper way relative to traditional US dollar payment systems.

I am more bullish than ever when it comes to institutional investment in the cryptoasset market due to greater involvement from traditional institutions (non-crypto players) as well as increased regulatory clarity. The OCC’s July announcement that US national banks could now custody digital assets is a perfect example of some of the strategic regulatory strides made in 2020. At the same time, as major influencers and companies including Franklin Templeton Investments, BNP Paribas and PayPal– enter the market and express their enthusiasm, we will continue to see involvement and adoption in a way that advances the asset class to the next level. Trusted technology partnerships will continue to play a significant role in the adoption of digital assets across traditional institutions given the need for extremely high levels of safety and security with infrastructure that cannot be built in-house. In 2019 alone there were an estimated twelve major cybersecurity hacks with nearly US$300 million in assets stolen. The presence of a single point of failure caused by the use of private keys was the culprit in each case. For institutional adoption to reach its potential we will need to see the further adoption of multi-party computational (MPC) protocols that eliminate private keys and enable transactions to be signed in a secure, distributed way regardless of the underlying protocol an institution uses, builds a product with, or the geographic region in which it operates.

We will see a further increase in institutional investment in the digital asset market in 2021 due to three developments: regulatory clarifications, a growing maturity by service providers, and strong institutional demand. The OCC provided some guidance when it came to the critical element of custody services, which has been a bone of contention for institutional investors. The SEC could follow suit now that it has asked for industry feedback on qualified custodians. Service providers, such as digital asset custodians, fund administrators, prime brokers, and trading platforms, will also be moving their operating models closer to the familiar ways institutional investors are accustomed to in the traditional markets, giving them some comfort in their investment workflows. One example is how the settlement portion of the digital asset trade lifecycle is evolving and moving closer to the prime brokerage model used in most traditional asset classes. Finally, asset managers are looking to capitalize on pent-up and growing demand for allocations in digital assets. As a result, these service providers are working to better understand the associated operational and legal risks to establish a scaleable and safe investment workflow.

Institutional investment in the cryptoasset space will continue to grow partly due to more avenues for payment with cryptocurrency, such as Paypal and Square, and numerous projects in the banking systems designed to ease the acceptance of cryptocurrency as payment. Investment interest will also be driven by continued higher returns from cryptoasset managers. regulatory updates and operational controls. As regulators begin to embrace cryptoassets as acceptable investments and service providers, such as digital asset custodians, technologically innovate the sporadic spurts of interest from institutional investors will be replaced with consistent ones. Turnkey investment platforms are also adapting to offer institutional clients access to the cryptoasset market. As a result, pension plans and endowments will join high net worth individuals and family offices in dipping their toes in the cryptoasset pond. Even a 0.5 percent or one percent allocation of a huge pension fund can make a market impact.

The continued evolution of regulations and products has the potential to increase investment in digital assets. That evolution resembles a kaleidoscope. With each turn there is clarity and a better understanding of the depth of the institutional interest in the asset class. In 2018 Delia Blass, director of the SEC’s Division of Investment Management, identified the five major issues — valuation, custody, liquidity, arbitrage and potential manipulation– that need to be resolved before registered cryptocurrency funds can be offered to the retail market. That announcement can be viewed as a reasonable proxy for the concerns of many institutional investors about crypto investments. Two and a half years later, the OCC arguably “turned the kaleidoscope” on the issue of custody when it issued a letter authorizing national banks to offer digital asset custody services on their own or partnering with fintech firms. It is unclear which of the remaining issues will be addressed next, although liquidity concerns will abate as the market for cryptocurrency derivatives evolves. In short, the resolution of each issue will be a turn of the kaleidoscope in the direction of clarity and is likely to result in increased institutional interest.

I believe that 2021 will be an inflection point for institutional investment in the cryptoasset market as we look to see whether there will be an increased regulatory embracement of cryptoassets and decreased regulatory fragmentation. Right now, we have a situation where no regulator wants to be left out. Institutional investors want to see rules that promote the use of cryptoassets and regulatory collaboration instead of a one-size-fits all piecemeal approach. In addition, a change in administration in Washington DC and new leadership at the various regulatory agencies could bring about meaningful change in cryptoasset regulatory policy in 2021 which I suspect will play a large role in determining where institutional participation is on the investment curve. We have a number of agencies with an interest in cryptoassets, such as the SEC, CFTC, OCC, and CFPB, among others. It would be a welcome development for the institutional investment community to see for example the Financial Stability Oversight Council (FSOC), of which these agencies are members, take the lead in coordinating a cohesive unified strategy to reduce regulatory overlap. Just by way of example if an institutional market participant wants to offer a token or coin based on barrels of oil (a commodity) it is not sufficiently clear whether the SEC or CFTC or both should have jurisdiction. If it is both who will take the lead and does it need to be both? Addressing these types of questions would likely promote the use of cryptoassets by the institutional investment community.

As fiduciaries, institutional asset managers are concerned about complying with federal securities laws and there are still some regulatory risks with valuation, custody, and fraud. Until all these risks are addressed it will be a difficult environment for institutional fund managers to fulfill their legal obligations. Because of the SEC’s investor and risk disclosure mandate regulatory skepticism even under a Democrat-controlled SEC is likely to continue. However, I do expect that investor demand, a more hospitable environment for technology innovation, and clearer guidance on the custody issue will buoy institutional interest. The most significant risk that will remain largely unmitigated will be fraud and AML, which will challenge institutions’ ability to fulfill their fiduciary obligations.

There is much uncertainty regarding the policies Washington DC will set in the next two years. Former Vice President Biden will be the next commander-in-chief come January 2021, however, we won’t know until January 2021 whether the Republican Party will gain control over the US Senate. It seems to me that Biden is more regulatory-focused than his predecessor and more sympathetic to individual investors. The only question is how much control Biden will have if his actions were limited to executive orders should the Republicans gain control of the Senate. I think that Biden will pay closer attention to regulating the cryptoasset market and if so there would be less institutional interest in the market until the impact of more regulations is digested.

(Editor’s Note: This article was updated on December 10,2020 to reflect new developments in the cryptomarket)