The Barriers to Institutional Entry Into Cryptocurrency
Some hopeful investors believe that big financial institutions are waiting on the sidelines with trillions of dollars, ready to jump into the cryptocurrency markets as soon as certain conditions are met. While the floodgates of money might not open that simply, some big players are preparing to invest, not just in futures contracts and derivatives, but actual coins and tokens. However, many legal and cultural barriers remain to widespread direct institutional investment into the cryptocurrency sector.
Major regulatory hurdles prevent institutional capital from directly investing in cryptocurrency. First, the legality of various tokens is still uncertain. Although the Securities and Exchange Commission has ruled that Bitcoin (BTC) and Ethereum (ETH) are not securities but commodities, numerous tokens could be classified as unregistered securities. Such unregistered securities risk federal prosecution and blacklisting by legitimate exchanges.
Second, fiat/cryptocurrency custody is a work in progress. Institutions do not like the idea of giving custody of large amounts of cryptocurrency to exchanges. They want to know how their funds are stored, secured and insured. They prefer regulated cold storage to reduce the risk of theft and loss.
Third, counterparty risk is still worrisome. Though exchange security has improved since the days of Mt. Gox and BTC-e, this year’s hacks of Coinrail, Bithumb and Bancor demonstrate that malicious actors have grown emboldened and exchange security can be further optimized.
Fourth, cryptocurrency liquidity remains relatively low. Compared to the New York Stock Exchange’s average daily volume of $50 billion and the USD/EUR market’s average daily volume of $575 billion, cryptocurrency’s average daily volume is a drop in the bucket. Institutional investors do not want to move markets unexpectedly or be stuck in large illiquid positions, so actual trading volume is attractive.
Finally, cryptocurrency exchanges need to comply with know-your-customer and anti-money laundering regulations as strictly as equity exchanges. They also need to protect investors from opaque price formation and market manipulation, which has been common lately. Demonstrated compliance with modern financial regulations is the last but perhaps most difficult task necessary to draw institutional interest.
Cultural barriers to entry also drive institutional capital away from investing. Cryptocurrency is a young asset class barely a decade old, and all but the most adventurous investors are wary of jumping right in. As long as retail investors and the clients of institutional investors believe in the stigma of cryptocurrency as a sector plagued by fraud, pump-and-dumps and unethical trading, the conservative fund managers will divert capital elsewhere. The ability of the average person to understand investments also plays a role. Whereas millennials might be eager to invest in a new asset class, older boomers nearing retirement are more worried about volatility. Finally, the often radical language used by some cryptocurrency founders and enthusiasts may be foreign or offputting to big banks and funds. Fortunately, cryptocurrency is shifting from a subversive tool to supplant the financial elite to a complementary instrument to raise efficiency, solve problems and cut costs.
Perhaps one day, institutions, including big banks, hedge funds, mutual funds, pension funds, university endowments, family offices and sovereign wealth funds will universally invest in cryptocurrency as a way to check a box for diversification. But it will probably not happen for a few years, due to numerous legal and cultural barriers to entry.