The institutions are coming. But what are they bringing?
Last month has been testing the nerves of investors, both in crypto and in fiat. Nasdaq 100 and BTC, in a near-perfect correlation, went down by 17 and 25%, respectively, while S&P 500 dropped by 12%.
Fiat markets have been spooked by the seeming inability of the most reputable central banks (the Fed, Bank of England, and the ECB, to name a few) to tame inflation. Many market players are calling for more aggressive interest rate rises, even though these will further hurt valuations, as a possible recession and a stagflation loom on the horizon.
With this in mind, can any solace be found currently by investors in crypto markets?
Unlikely.
Crypto markets have been living through their own psychodrama. To recap in a sentence, the 3rd largest stable coin TerraUSD (often referred to as UST) lost its peg to the USD, wiping out its accompanying cryptocurrency, Luna. In a matter of a few days, Terra’s blockchain was frozen, it was delisted from most exchanges, and Luna’s value went to zero. Investors into what was a promising project that could provide new rails for payment systems lost $60bn, with the overall crypto market shedding $400bn over just a few days.
Stablecoins are designed to retain their 1:1 peg to a major fiat currency, in most cases USD. This peg is supported either algorithmically or by over-collateralization of liquid (at least in theory) assets. They are used as safe havens and base currencies for going into and out of various DeFi assets.
The collapse of UST has also triggered significant volatility in other (centralized and decentralized) stablecoins.
The timing of this market shock is not ideal, as this is the year when the crypto world is seeing a stampede of institutions dipping their toes into crypto waters. According to a recent report from Messari, 70-80% of surveyed institutions plan to make an allocation in crypto in the near term. This is critical to the further growth of the crypto market, driving demand for key digital assets, and pulling the sector out of its current ‘crypto winter’, with the BTC price at the moment lingering around $30,000.
And now back to our main question: who is coming and what are they bringing?
The first group is larger asset management companies that are looking for (any) decent source of return for their retail and corporate clients (and in some cases on a part of their proprietary book), hopefully at a lower correlation with the rest of the market. They need to start with a simple and secure offering of crypto as a store of value, and some source of alpha return (at a manageable level of risk). So hot buttons here are custody, best execution (in crypto it’s an art as for a large trade you’d have to navigate a path of multiple centralized and centralized exchanges), and compatibility with other trading platforms/reporting/risk management systems. Many opt for offering ‘entry-level’ single asset solutions (mainly BTC), Fidelity Digital Assets being just one example.
This group’s speed of adoption will be faster if the market shows steady growth, with a few large-scale Terra-esque surprises as possible.
The second group is users of the new DeFi infrastructure, in particular, as new faster, cheaper and more reliable rails for payments. Here models of TradFi, or ‘legacy’ banks are under threat, and many of them are testing the waters. For them, stablecoins, in particular, are an important element of the new rails. As they are highly regulated, they would have a natural bias toward asset-backed, more centralized stable coins.
This group is interested in the stability of the underlying protocols, stable coins, and interoperability of tech with other platforms they use.
At this stage, both groups are in their learning mode and are often sourcing services and tech from native crypto platforms, and their initial allocations start from the tens or hundreds of millions. However, over time they will build their full crypto trading teams, and become more aggressive in their trading strategies, if and when more money gets allocated to crypto.
The third group of incoming institutions are the ones that have already become or have the potential to become crypto whales. These would include hedge funds, large TradFi market makers and fintech platforms that have sophisticated traders and large volumes of liquidity. They would have more appetite and firing power to test the strength of various parts of the crypto markets and drive out weaker players, making money on the way down. Some estimates suggest that $800m could have been made by some players from the crash of UST. While conspiracy theories exist in abundance with regards to who might have been behind the UST crash, it is clear that whoever has access / can borrow large volumes of any digital asset, could instigate such crashes in future.
These institutions will join a number of crypto whales - crypto native institutions that have amassed such exposure to digital assets, that their actions could have a disproportionate effect on the market. One example of such power is market makers Alameda Research (spearheaded by Sam Bankman-Fried, a crypto billionaire and founder of FTX, one of the largest crypto exchanges) and Cumberland Global (a subsidiary of trading giant DRW), which have received at least $60.3bn USDT (Tether, or c.55% of its outbound volume.
Minding that Chinese walls are much lower (or often non-existent) in crypto, and leading players combine exchanges/market making/VC investments, this creates unprecedented opportunities for large-scale speculative actions that could lead to further shocks. As trading talent is flocking into space, the crypto universe will be tested to its limits.
In our view, this could result in the following
Regulation will be shaped up to suit larger, more established players, who are better versed (and have extensive experience in interacting with and influencing the regulators. Circle (USDC), which is in the process of a merger with Bob Diamond’s Spac, for example, is on a path to becoming a U.S. federally-chartered national commercial bank. We believe that this could create drift away from bleeding edge, truly decentralized, DeFi solutions towards the more familiar territory.
This could create pricing dynamics in the digital asset markets that would be more similar to current equity markets, where often prices of assets do not reflect the strength of underlying businesses (or in crypto terms, projects) but are often driven by speculation, inclusion into indices, and various macro factors.
On a more positive side, the overall quality of projects and their related digital assets could improve over time as the result of market pressure testing and stronger regulation.
Ultimately, this could change the ethos of the crypto world. Initially created by geeks and having dreams of fair rewards for all creators, it might drift towards rewards being concentrated among a limited number of large players, retail investors losing their money, and blockchain users insufficiently benefitting from their creation, therefore migrating elsewhere.
What do you think? Let us know in the comments or get in touch directly with us.