Beyond Crypto – realising the potential for digital assets with institutional investors

Crypto currencies have been making headlines again over the last couple of weeks thanks to Chinese regulators banning financial institutions and payment companies from providing cryptocurrency transaction services, while also warning investors against speculative crypto trading. Sentiment was further undermined by Tesla’s CEO, Elon Musk, reversing a previous decision that his company would accept Bitcoin as payment.

The announcement by Chinese regulators and the Tweet from Musk sparked a major sell-off, with volatility perhaps highlighting the current fragile liquidity structure of crypto currencies But what many people fail to appreciate is that Bitcoin was devised as a way of transferring value rather than as a store of value – a misunderstanding not helped by the images that we see in every Bitcoin article of a stylized gold coin. But while concerns persist regarding price volatility, market manipulation, and the ability to gauge appropriate value, this is perhaps more a reflection on current crypto currency offerings and their retail origins rather than the broader opportunity for asset digitisation.

The potential for digital assets as institutional grade investments will depend, in part, on how quickly Governments create digital versions of their own currencies. China’s shackling of Bitcoin may be as much to do with its own aspirations for a digital Renminbi as it is with investor protection, while in the US the Federal Reserve Chairman, Jerome Powell, now sees a digital dollar as “a very high priority”. This would help accelerate the trend in tokenisation of real assets (where there is a clearly quantifiable value attached to an underlying asset) creating new markets in investible tokens targeted at institutional asset managers.

Latent demand is backed up by market research from Fidelity that shows that a growing number of institutional investors believe that digital assets should be a part of their investment portfolios. Stock market peaks and the huge sums still being channelled through VCs into tech start-ups suggest that there is a dearth of attractive investment opportunities with interest rates at historic lows and cash piles bloated by government stimulus packages. Tokenisation of  currently illiquid, administratively burdensome, or high capital commitment / long-term tie-in assets has significant potential to deliver more efficient funding choices for originators. This will naturally lead to attractive alternative investment opportunities for institutional asset managers. Whether these are real-estate, non-listed SMEs, litigation financing, or other more esoteric tokens,  we are seeing institutional investors show “greater interest in and acceptance of digital assets as a new investable asset class,” according to Tom Jessop Tom Jessop, president of Fidelity Digital Assets.

However, to make digital assets truly mainstream there are other challenges to be dealt with. Capital markets structures and business models are deeply embedded and highly regulated, having evolved through decades of trading trillions of dollars of traditional assets. To succeed, it is more likely that new trading venues launching new asset classes and business models will need to adapt to institutional asset management processes, not the other way around.

There are several key areas that must be addressed if digital assets are to become mainstream investment vehicles for asset managers and pension funds, and genuinely shift from retail to institutional grade instruments:

1. Transparency and trust – addressing concerns regarding market manipulation and gauging relative value, price formation and real-time data are central to efficient markets. Liquidity fragmentation across a long tail of exchanges creates challenges in deriving high resolution, uniform market data. MiFID has highlighted the focus of regulators on market transparency, so while the innovation derived from the broad universe of new venues is great, data quality and accessibility will need to be improved.

2. Make it easy – to accelerate the shift from retail to mainstream institutional clients, digital venues will need to align with existing capital markets infrastructure, particularly for secondary market trading. That means adopting standards such as FIX for receiving order messages and disseminating market data, ensuring the institutional grade speed and guaranteed message delivery they expect. Venues must also consider the robustness of their infrastructure and operations – traditional market infrastructure providers are already on high alert with regulators considering potential rule-tightening following a spate of exchange outages last year, including Deutsche Borse’s Eurex venue, the Tokyo Stock Exchange, and the ASX.

3. Enable liquidity – evolution of a prime broker and settlement model that reflects how funds operate in traditional asset classes is needed to drive engagement and grow liquidity. Digital assets predominantly operate on a model that requires immediate exchange of value, requiring investors to hold capital with venues they want to trade on. This is inefficient compared to the way institutional funds trade on traditional markets by leveraging the balance sheet of prime brokers to execute their trading strategies, with active funds making multiple intra-day trades under an end-of-day net settlement arrangement. The emergence of a digital prime model that can provide leverage, enable short-selling, and offer secure third-party settlement and custodian capabilities will improve capital efficiency and drive liquidity.

Ultimately, established and emerging digital venues need to make the participation of institutional investors as easy as possible by blending new technology and business models with established processes and infrastructure investment. The picture is changing fast as organisations look to address these issues and facilitate the growing involvement of institutional funds, encouraged by the desire of asset managers to access alternative investment opportunities. If they are successful it will enable a massive opportunity for the creation of many new tradeable asset classes that will underpin the next evolutionary cycle of capital markets.

Rapid Addition works with leading global liquidity venues and emerging digital exchanges to provide highly scalable, low latency, secondary market trading platform solutions. With robustness and throughput proven at tier-1 customers in extreme market conditions, Rapid Addition’s asset-class and message protocol agnostic technology underpins a broad range of trading models and business processes. To find out more about how our modular technology can solve your needs for client onboarding and connectivity, risk management, matching and auctions, or any other key component of your electronic trading workflow, then please get in touch through enquiries@rapidaddition.com.

Learn more about our leading edge Trading Technologies for today’s Financial Markets.