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Dipping a toe into crypto?

By: Jack Dominy


As institutional investors make tentative crypto allocations, questions are being asked as to whether the sector is robust enough in its current state

What was once an abstract, fringe concept dominated by tech enthusiasts and financial speculators is now creeping into the mainstream of asset classes and is reshaping how institutional investors may allocate their capital.

Bitcoin, the first decentralised cryptocurrency, was created back in 2009 and although it wasn’t the first attempt at a cryptocurrency, it was the first to utilise blockchain technology, be mined by users and be exchanged amongst an ever-growing base of crypto-converts.

The first trade, 10,000 Bitcoins for two pizzas, set into action a series of events that would see cryptocurrencies seep into the fabric of modern investing, with amateur speculators trading with cryptoenthusiasts, driving prices, demand and intrigue, resulting in today’s environment where institutional investors are increasingly considering the merits of the market.

Today, cryptocurrencies are on the cusp of being accepted as an asset class, but there will inevitably be those firmly parked on either side of the fence. For institutional investors, the interest in cryptocurrencies goes beyond assessing price points, rather, the interest is rooted in how well cryptocurrencies can be integrated alongside the broader asset classes and utilised as a strategic device to help achieve investment objectives.

All the while, cryptocurrency infrastructure is adapting to the needs of legacy financial services, and vice-versa. $17 billion (£12.37 billion) of venture capital poured into the crypto space in 2021, whilst the job market is rife with the flow of talented and enterprising individuals joining blockchain-enabled startups. Legacy institutions are racing to gather the best crypto analysts and technologists to bolster their own efforts within the space.

These efforts are resulting in galvanised interest. Seven in 10 institutional investors anticipate investing in digital assets in the future, a study by Fidelity’s cryptocurrency arm found.

Reallocation to crypto

The latest UK Institutional Market Study from Research in Finance found that an increased focus on ESG and sustainable investing was the most important asset allocation change over the past 12 months, and while the ESG and cryptocurrency worlds are often seen as being at odds with each other, divestment from other areas may facilitate greater flows into the emergent digital asset class.

More than a third of respondents said that they had decreased their allocation to both property and equities over the past 12 months, freeing capital that can be used elsewhere.

Likewise, the sentiment of various asset classes has been affected by the events of the past year, with diversified growth funds and property dropping into negative territory in the latest findings. Similarly, sector appetite for cash is slipping.

But cryptocurrencies, whether categorised as an established asset class or not, operate in a unique manner with limited parallels to the operation and functionality of other classes. For that reason, it may be sensible for institutional investors to align their cryptocurrency allocations with the diversifying role that alternative investments play, with capital previously assigned to a range of alternative investments instead flowing into Bitcoin, Ethereum and other cryptoassets.

Asset allocation trends can describe the thinking of the world’s leading financial institutions. You can find out much more in the Research in Finance UK Institutional Market Study, published annually, available here.

Regulatory reluctance

It is no secret that the institutional world has been sceptical and cautious about taking the plunge into cryptoassets. A recent survey by JPMorgan found that 58% of institutional investors believe that cryptocurrencies are “here to stay”, yet only 11% of investors said their firm either invests or trades in crypto. Personal interest in cryptoassets among institutional investors, however, is high, with 40% of investors being active on an individual basis.

A key barrier to a broader uptake of cryptocurrencies among institutional investors is the lack of clear regulation that can provide security, consistency and accountability to the emergent market.

Large institutions have intricate compliance requirements that necessitate a robust legislative framework to become as integrated into institutional portfolios as other assets.

The FCA is already exerting pressure on the industry to improve anti-money laundering standards, and further regulation may further cement the longevity of the asset, yet improper or overbearing legislation may deter others.

Meanwhile, a post-Brexit regulatory overhaul, as endorsed by the Kalifa Review of the UK’s Fintech sector, offers legislators an opportunity to stimulate institutional support for cryptocurrencies.

According to Fidelity Digital Assets, 71% of institutional investors say they will buy or invest in digital assets in the future, but a lack of fundamentals is a key barrier to further adoption.

If the recommendations of the Kalifa Review are implemented, and the UK brings in bespoke rules to support the industry, then issues surrounding regulation, infrastructure and crypto fundamentals will have to be addressed.

Regulatory flexibility was a key theme of the review and will be necessary to support the institutional use of cryptoassets and ensure that opportunities can be capitalised upon, but until that level of support has been achieved, institutional investors may be likely to continue their cautious approach.