With the Securities and Exchange Commission’s rejection Wednesday of yet another swath of cryptocurrency ETFs, the digital asset market must now turn to its remaining hope — institutional investors.
But it could be a long wait. Throughout the summer, crypto investors eagerly awaited the arrival of the SEC’s approval of exchange-traded funds and anxiously speculated about institutional investors entrance into the market.
So far neither has happened.
{mosads}Now that the SEC has dashed investors’ ETF hopes; there’s still little sign institutional players are about to jump in. But these big-money players’ entrance on the crypto scene is far more important than the launch of a handful of ETFs ever will be.
Institutions such as banks, pensions, insurance companies and endowments are the top influencers of supply and demand in liquid markets and will be key to mainstream acceptance of the crypto asset class. For most institutional investors, this is likely years away, not months.
So, what is preventing mainstream institutional investors from investing in digital assets?
Two major obstacles stand in the way of would-be institutional allocators from investing in the space: lack of custodians and other financial intermediaries and uncertainty regarding how global regulators will govern exchanges, custodians and the underlying tokens.
Institutional allocators face rigid investment policies and steep due diligence obligations to large and sensitive investors.
Custody
The custody issue has been long cited as a key impediment to institutional investment in digital assets. Unlike traditional liquid markets, there is no prime broker, a role generally played by an investment bank, to facilitate the trading and safeguarding of crypto assets.
For now, there are two main solutions for custody, each that will likely be problematic for most mainstream institutional investors: qualified custodians and custody through exchanges.
There are platforms available for long-term storage by companies like Xapo, Kingdom Trust, BitGo and numerous other small companies. Some of these companies can (or will soon) meet the standard as a qualified custodian, and some even provide insurance.
However, for the time being, these solutions are long-term storage options held in cold wallets (in systems not connected to the internet), where the data is the safest.
Unlike a prime broker, which holds the security across multiple exchanges while the assets are being traded, these custodians cannot hold the assets in custody while positions are actively traded on the exchanges.
The technological side of this is probably not overly difficult. What is lacking is large enough providers to handle the security exposure of holding assets on exchanges (where the tokens usually carry the greatest cybersecurity risk).
The major online crypto exchanges also offer a form of custody, which allows assets to be held while being actively traded and provides insurance. But this does not allow an investor to hold custody for trades on multiple exchanges (as a typical prime broker would do).
The exchanges simultaneously act as brokers, custodians, marketplaces and sometimes holders of proprietary assets. This presents potential conflicts of interests, increased concentration of cybersecurity risk and insurance and counter-party risk.
Concentrated trading on a single platform also presents potential concerns with principles of “best execution,” a doctrine requiring brokers to execute trades in the best interest of the investor at the best price.
There are encouraging signs that, as the asset class matures, larger participants will start to enter the space. We expect that in the not too distant future — perhaps a couple of years — technological innovation and larger institutional players will take care of the custody problem.
Regulatory uncertainty
In contrast to the custody problem, which will likely be resolved with technology and money, the regulatory uncertainties are far more complex and will require ongoing coordinated efforts.
Among the open regulatory questions are: What governing bodies will provide the regulatory answers and how will the Commodity Futures Trading Commission and the SEC work together?
How will worldwide agreements, organizations and accords harmonize global laws? What will be the role of self-regulatory organizations (SROs)? And what does “resolved” look like?
For U.S. governance, regulatory standards will likely be set not by one authority, but by a combination of state, national, international and industry bodies, judicial precedent, international agreements and industry associations.
Regulators are trying to be careful not jump in too soon with comprehensive regulation and are balancing the need to protect early investors while allowing the industry to continue to evolve and take shape.
The comprehensive regulation needed to facilitate institutional investment will require the coordination of global standards, particularly for the exchanges.
Global standards will likely be headed by the Group of 20, with the help of the International Monetary Fund and other international organizations that are currently working on establishing international standards.
A measured approach to regulation will take time. But there is a silver lining in the slowness of the process. The very delay in comprehensive regulation that has kept out institutional investors and inhibited digital asset price growth will eventually contribute to more stable, safe, globally consistent and technologically appropriate laws.
When the regulatory landscape finally comes together, we can start talking about the potential arrival of institutional investors; hopefully by 2020.
John Lore is the managing partner of Capital Fund Law. Lore represents a large volume of cryptocurrency hedge funds throughout world. He co-founded the International Council of Cryptocurrency Self Regulation working group with the Stanford Journal of Blockchain Law and Policy.