Institutional investors are slowly entering the cryptocurrency space, but so far adoption has been largely retail-driven. This has been happening because the risks associated with cryptocurrencies are still too big.
Cristián Bohn, co-founder and CFO of ParFin, a firm providing clearing services for cryptoasset, has detailed in a Medium blog post why institutional investors are mostly just dipping their feet in the cryptocurrency space, and the answer is to do with risk.
In his post, Bohn detailed that the regulatory framework of crypto as an asset class isn’t clear in countries that host major financial centers, and as such institutional asset managers with low risk tolerance stay away from the space. Those with more risk tolerance may assume regulators’ guyidance is close to their future legal approach.
Capital allocation inefficiency is also said to be a barrier stopping institutional investors from entering the space. Bohn details the lack of infrastructure and services needed to manage cryptocurrencies and fiat currencies between banks, exchanges, OTC providers, and custodians may lead to unnecessary risk.
In traditional markets capital allocation efficiency is based on intermediaries that aren’t necessary in the cryptocurrency space, where automated software and smart contracts may handle everything. While the decentralized finance movement has been growing, he says, it’s still “far away from catering the needs of institutional asset managers,” Bohn added:
There is still a big gap of software and services needed by asset managers in order to manage digital assets with the same regulatory standards as traditional asset classes.
He then outlined several risk factors asset managers take into account when analyzing an investment. These include the market, counterparty risk, liquidity, operational and security risks. In the cryptocurrency space there’s significant counterparty risk as counterparties aren’t prepared to disclose relevant information.
The data-driven investor noted that institutional investors would only be allowed to use cryptocurrency counterparties with equivalent risk policies to traditional financial market counterparties. He added:
The reality is that very few exchanges and OTC players meet the minimum risk policy requirements to serve institutional asset managers.
Operational risks are also something to take into account, as in the cryptocurrency space losing one’s private keys or sending a transaction to the wrong address may lead to irreversible losses. To tackle these and security risks, institutional asset managers may use crypto custody solutions.
Per Bohn, these have evolved substantially and are “currently robust enough to serve institutional asset managers, especially with traditional financial institutions starting to deliver crypto custody services.”
Security token exchanges like tZERO will provide the regulated framework for institutional investors to enter the space, he said, and are likely going to become their most desired trading venue. As time goes on, more start-ups are looking to tackle the lack of infrastructure needed by institutions to enter the space, among them ParFin.