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3 themes driving institutional adoption of digital assets

What makes 2021’s roaring crypto market different from 2017’s are the banks and VCs piling in, writes Calvin Shen of Hex Trust. What’s behind their crypto adoption?

When I first discovered the digital assets space in mid-2017, the total market value of cryptocurrencies was around US$100 billion. At the time, the market was largely retail-driven and the mantra was that institutional investors were about to enter the market. That optimism soon faded as 2018 marked the beginning of a period referred to as crypto winter. Speculators and those with weak fundamentals couldn’t stand the cold and exited the market, leaving only the true believers to continue building the infrastructure and products that would reignite interest in the digital asset industry a year later.

Fast forward to 2021, and the digital asset market is now valued at over US$3 trillion with clear indications that institutional investors have now officially entered the market — albeit slowly and cautiously. We have transitioned from hesitant discussions among family offices and trillion-dollar asset managers to soaring demand for tailor-made investment products and easy access to custody, financing and brokerage services built on regulated infrastructure.

There has never been a stronger drive behind the adoption of digital assets, with institutional investors in particular eager to integrate the new asset class into their operations. A recent study published by Fidelity Digital Assets that surveyed institutional investors showed 52% of respondents were currently invested in digital assets, with 9 in 10 indicating they were actively exploring opportunities. 

Many of the barriers that once held institutional adoption back have fallen. The digital asset market is now equipped with institutional-grade custody and infrastructure providers, regulatory frameworks that provide a greater degree of clarity, and a growing decentralized finance (DeFi) ecosystem that innovates at an incredible pace. Against the backdrop of macroeconomic and geopolitical dynamics, these factors have accelerated the take-up of digital assets as institutional investors explore opportunities to generate alpha.

Before we dig deeper into the catalysts for institutional adoption, let’s take stock of some of the institutional activities we’ve seen this year.

A snapshot of institutional adoption in 2021

In venture capital land this year, funds invested US$17 billion in digital assets, which is well beyond the previous record of US$7.4 billion raised in 2018, according to data provider PitchBook. The prominent venture capital fund Andreessen Horowitz announced the close of its third digital assets venture fund, which at US$2.2 billion represents that largest fund of its kind, according to the firm.

JPMorgan became the first major U.S. bank to provide retail clients access to Bitcoin investment vehicles. In contrast to other banks that have offered similar services, JPMorgan will reportedly not limit access to ultra-wealthy clients alone, but advisors will not be allowed to recommend the investment themselves. Only after a client solicits for exposure to digital assets will their advisor be able to purchase shares of Grayscale’s trusts, such as GBTC, as well as Osprey Fund’s Bitcoin Trust on their behalf. 

DBS has launched its digital exchange to meet the robust demand from corporate investors, accredited individuals and investment firms that manage the fortunes of wealthy families. The DBS Digital Exchange leverages blockchain technology to provide an ecosystem for fund raising through asset tokenization and secondary trading of digital assets. This includes security token offerings (STOs), digital currency exchange and custody services.

After years of development, Japan’s largest investment bank finally entered the digital asset market with Komainu, a joint venture with CoinShares and Ledger. The new business serves as a custodian and provides regulatory compliance and insurance services to institutional investors for their digital asset holdings.

State Street launched State Street Digital, a new unit dedicated to evolving the organization’s role in the digital asset ecosystem, including currencies, tokenization, and central bank digital currencies (CBDCs). Over the next five years, State Street expects digital assets to represent the most significant force impacting the financial services industry, making it critical for any large institutional player to have the tools in place to meet their clients’ increased digital needs.

Top banks investing in digital asset companies include Standard Chartered, BNY Mellon, Citibank, UBS, BNP Paribas, Morgan Stanley, and JPMorgan. Using the size of funding rounds as a proxy for investment, allocations range from US$200 million to US$380 million as reported by Blockdata.

Lastly, as an indicator of the mass transition of wealth moving into digital assets, Grayscale revealed assets under management for its cryptocurrency-related products now stands at US$46.8 billion as of Sept. 6, 2021, attracting nearly US$5.5 billion in August 2021 alone. The firm said that institutional investors accounted for 90% of the total investment activity, along with increased involvement from accredited individuals, retirement accounts, and family offices.

3 themes driving institutional adoption

A common thread across these initiatives is that firms often begin exploring digital assets in response to solicitation from clients. This is certainly one of the factors at play here, but as is typically the case with the exponential adoption of a new trend, there are several catalysts which have converged to increase both the value of and interest in digital assets. 

These generally fall into three themes: the establishment of institutional-grade infrastructure, increased regulatory clarity, and a growing DeFi ecosystem.

  1. Institutional-grade infrastructure

The past few years saw the rise of numerous institutional-grade custody and infrastructure providers. The focus of these providers is to bridge the gap between the digital asset ecosystem and the traditional financial system, starting with custody. Before financial institutions can be comfortable with offering digital asset services, they first need to solve the issue of how to safekeep their client’s assets. 

survey commissioned by Nickel Digital Asset Management covering institutional investors and wealth managers from the U.S., U.K., France, Germany and the UAE revealed that 76% of the respondents describe the concerns about security of digital assets and custodial services as a “significant” hurdle preventing many from investing in digital assets for the first time. It is the fundamental issue that licensed custodians provide solutions for.

As mentioned previously, the serious players that continued to build and refine their products through crypto winter have emerged as leaders in their respective fields, capturing the new institutional-wave. The industry has made steady progress in terms of reinforcing market infrastructure with a range of sophisticated solutions including, distributed keys and multi-party computation (MPC) vaults, core transactional technologies, comprehensive insurance coverage, regulatory compliance tools, and state-of-the-art security frameworks.

To be clear, the underpinnings of the ecosystem are still maturing, but they check enough boxes to increase the confidence levels in the institutional sector which, along with the emergence of institutional-grade and fully licensed custodians, has been one of the primary drivers of adoption.

  1. Increased regulatory clarity

Ever since the first Bitcoin was mined in 2009, regulators globally have been challenged to provide the relevant frameworks due to the varied and novel qualities of digital assets. Depending on their structure and utility, digital assets can display attributes that overlap across multiple asset classes. The lack of clarity in certain jurisdictions has played a role in holding investor appetite back. However, in recent years regulators have been moving in a positive direction in terms of providing the clarity required for institutional involvement. 

In Asia, Singapore has started granting regulatory consent to service providers of virtual assets, including digital payment tokens (like Bitcoin) under the Payment Services Act, and security tokens under the Securities and Futures Act. China has gone in another direction with its recent announcement clarifying all crypto-related transactions in the country are illegal, including services provided by offshore exchanges.

In Europe, Switzerland has implemented comprehensive laws on distributed ledger technologies, and the European Commission has drafted the Market in Crypto-assets (MiCA) proposal to provide a single licensing regime across all member states by 2024. 

In the U.S., no single regulator oversees all aspects of digital assets. It is however expected that Gary Gensler, the new chairman of the Securities and Exchange Commission who is very knowledgeable of the space, will provide a clearer regulatory framework that will make it easier for institutional investors to engage in the digital asset industry. Meanwhile, the regulators themselves have adapted by further clarifying the rules surrounding digital assets and taking steps to establish their place within the regulatory environment. For example, the U.S. Office of the Comptroller of the Currency recently approved the use of stablecoins for the settlement of financial transactions by federally chartered banks.

Regardless of the specific set of rules and regulations, the movement towards regulating digital assets provides a positive push for institutional adoption. Like any other asset class, digital assets require clear regulatory frameworks in order to thrive.

  1. Growing DeFi ecosystem

Another factor that has sent demand for digital assets soaring is the rapid evolution of the DeFi ecosystem. It has only been a formal concept for a little over two years, but during that time the peer-to-peer decentralized financial ecosystem has seen an explosion of innovation. We now have dozens of blockchains, hundreds of interchain solutions and thousands of decentralized applications. The entire financial system is being rebuilt from first principles with more security, transparency and interoperability baked in from the start. 

The radical innovation pushing DeFi forward at incredible speed has attracted sizable capital in a relatively short period of time. Total value locked (TVL) across DeFi currently stands at US$275 billion from US$21 billion at the beginning of the year, with the Ethereum blockchain still leading the market accounting for about 70% of assets locked on platforms. At the same time, the 10-year U.S. Treasury rate continues to hover below 2% as consumer inflation expectations hits an 8-year high, threatening to debase the value of the dollar. Compared to the stablecoins that could yield up to 20% APY, and esoteric DeFi protocols that can yield north of 100% or more, it is clear why institutional interest is at an all-time high.

Both the infrastructure as well as the financial products in DeFi have advanced significantly since the early days to provide access to institutional finance: from permissioned applications that require “know you customer” (KYC) and on-chain asset management to enterprise-grade layer-1 blockchains and layer-2 scaling solutions. Indeed, institutional investors played a major role in the adoption of DeFi as the data shows.

According to a report from blockchain intelligence firm Chainalysis, large institutional transactions, meaning those above US$10 million accounted for over 60% of DeFi transactions in Q2 2021, compared to under 50% for all cryptocurrency transactions. The report suggests that large transactions make up a much bigger share of DeFi activity, indicating that DeFi is disproportionately popular for bigger investors compared to the wider digital asset market as a whole.

But tapping into a new decentralized financial system that innovates at such a rapid pace can pose a challenge for traditional financial institutions as they often require ample time to adapt to new technologies and products. The solution lies in finding trustworthy providers that offer the full suite of services, including the ability to integrate new digital assets as they emerge and adapt to the fast-paced digital asset environment, all while meeting compliance standards within an evolving regulatory framework.

Entering the next stage of adoption

We are only at the very beginning of this generational transformation and cryptocurrencies, stablecoins and NFTs are just part of the story. Security tokens for example could well represent an evolutionary step forward for traditional financial markets, enabling greater efficiencies and reduced costs associated with trading. CBDCs, which 81 countries are already exploring, will enable governments to leverage blockchain technology while remaining in control of their own sovereign currency. The same goes for the 1.7 billion people who are unbanked, where a simple mobile wallet enables them to send and receive money instantly, at a fraction of the cost from traditional banks. The list of use cases goes on.

Altogether, digital assets are here to stay and financial institutions have recognized the transformative potential and started to take part in this dynamic new landscape. Some are still observing from the sidelines while others have already jumped at the opportunity. But as we enter the next stage of digital asset adoption, getting involved early secures long-term competitive advantage.