Institutional interest in crypto grows – with caveats …

Crypto may still be a new and volatile asset class. But institutional interest is showing clear signs of awakening.

The crypto market has flourished post-Covid. The fact that cryptocurrencies can be traded from anywhere in the world was a boon to potential liquidity constraints seen during the health crisis.

And now, traditional hedge funds are increasingly embracing cryptocurrency investments – albeit tentatively.

But they are keeping their exposure limited as the market continues to mature.

These are the findings of PwC’s just published Annual Global Crypto Hedge Fund Report 2022. It found that 38% of traditional hedge funds surveyed are now investing in digital assets such as Bitcoin (BTC), compared to 21% a year ago.

It noted too that most are still doing so circumspectly. This is via ‘multi-strategy’ hedge funds, followed by macro strategy and equity strategy firms.

Similar findings are seen in research by none other than the world’s largest hedge fund, Bridgewater Associates. It has $150 billion in AUM. As yet, it is only dipping its toes. Rather than directly investing in crypto, it is planning to back an external vehicle.

However, its new report, The Evolution of Institutional Investors’ Exposure to Cryptocurrencies and Blockchain Technologies, shows the direction of travel ahead.

It states: “Although these remain small markets relative to the most liquid markets in the world, we believe crypto markets are now large enough to allow for positions in sizes relevant to institutional investors.”

It adds: “At a high level, we see institutional investors as still being at the very early stages of developing exposures. But adoption looks likely to pick up in the coming years.”

The report concludes that on net, Bridgewater estimates that ~1 million bitcoin (around 5% of total issued supply, ~$42 billion by current prices) are now held by institutional-level players via custodial intermediaries.

Crypto-specific hedge funds are also arriving. Most are specializing in strategies mainly intended to access crypto assets directly on native platforms. In some cases, too, they are to bridge inefficiencies between crypto-linked assets in traditional finance and their corresponding on-chain products.

Overall, crypto’s ability to generate stunning returns makes them a potential asset in a successful portfolio.

But investors still recognise that these returns mean volatility is a given that has to be managed. A case in point is the trajectory of Ethereum. Even after becoming the second biggest cryptocurrency, it lost more than 50% in Q2 2021.

In 2021, the crypto market's value skyrocketed from $965 billion to as much as $2.6 trillion. This is according to a Morningstar analysis of data from CoinGecko. The market capitalisation now sits around $2.1 trillion.

But crypto's limited history makes quant investment strategies challenging and backtesting difficult.

And while it is increasingly becoming adopted by professional investors, crypto is still seen as a black box. Worse, it is one that carries regulatory risk.

Central banks remain wary and worried about losing control over the supply of their money and payments systems.

The fact that China banned all crypto activity in September 2021 to promote its own central bank digital currency will have done little to reassure investors.

Indeed, PwC’s report saw respondents cite “regulatory and tax uncertainty” as the single greatest barrier to investing.

All of which begs the question what regulatory certainty is ahead? Thus far, regulators have taken a wait and see attitude and clear rules are still in development.

But they are coming. The future regulation of cryptos remains unclear. But the Basel Committee on Banking Supervision says they should carry the toughest bank capital rules of any asset.

New regulation could bring the promise of more stability to the crypto market.

But many worry that they could be an oxymoron.

Will they will hinder innovation and destroy the main tenet of cryptocurrency, which has decentralization at its core?