Institutional Adoption drives Digital Asset Companies to become more like Regulated Financial Institutions, i.e. banks
Sygnum
Institutional flows will continue to gain momentum
A major difference between the current digital asset rally and the bubble of 2017, is institutional participation. As central banks continue to inject capital into economies globally, institutional investors are increasingly turning to digital assets as safe-haven alternatives – especially Bitcoin, which has been likened to the new “digital gold”.
Influential investors like Paul Tudor Jones, Bill Miller, and Stanley Druckenmiller have made positive statements about Bitcoin, while listed companies such as MicroStrategy, Square and Tesla have started to invest a portion of their treasury assets into Bitcoin. And there are more and more signs that it may just be the beginning.
Once a certain critical mass is reached, the institutional rally will further intensify and become self-sustaining. Therefore, the bulk of institutional fund flow is yet to come, and when it does it will change the landscape of the digital asset economy.
Greater regulatory oversight
With institutional adoption driving market values of digital assets to new heights, media attention and regulatory scrutiny on the asset class has likewise risen. Financial regulators are more open to digital assets than they were before, but they are now taking active steps to provide guidelines and oversee companies providing digital asset services.
In Switzerland, parliament adopted the Federal Act on the Adaptation of Federal Law to Developments in Distributed Ledger Technology (DLT) in September 2020. Part of this act came into force on 1 February 2021, with the rest to follow later this year. Governments in other parts of the world are taking similar steps, although the pace and level of progress varies.
In the United States, lawmakers have recently proposed a bill to create a working group for the evaluation of cryptocurrency regulations. At the same time, there has been heightened scrutiny into companies that may have violated existing laws while operating in the digital asset space. In October last year, the Commodity Futures Trading Commission (CFTC) charged crypto trading platform BitMEX with facilitating unregistered trading and other indiscretions. Its founders and one of its executives were also charged with violation of the Bank Secrecy Act. In another example, payment processor, Stripe, was investigated for its role in processing the payments from a fraudulent initial coin offering (the company settled with a payment of USD 120,000).
Institutional investors require institutional-grade infrastructure
Institutional involvement entails institutional requirements and responsibilities, which will be defined in part by regulation. The dual forces of institutional adoption and greater regulatory oversight is thus likely to change the digital asset services landscape and compel companies to become the very thing they used to rail against philosophically – regulated financial institutions, i.e. banks.
Brokerage and custody providers will need infrastructure which provides the highest level of security. As institutional players are often fiduciaries of third-party funds, the service providers that they use will have to fulfil strict due diligence requirements in this area. These solutions must also have the capacity to support the higher volumes that come with institutional investment.
Another important dimension will be compliance with Know Your Customer (KYC) and Anti-Money Laundering (AML) standards. This means defining and implementing a robust framework for onboarding of customers, identifying the source of assets as well as ongoing transaction monitoring. Lastly, it also means having proper operational set up with certified processes and controls as well as robust risk management for fraud prevention.
Institutional adoption will greatly accelerate the growth of the digital asset market. However, serving institutional clients can place onerous requirements on digital asset companies, and we expect that much of the future inflow will be directed towards those companies which are licensed and set up to meet these demands.
Digital asset companies need to evolve or become extinct
This shift will by necessity lead to the sorting of the sheep from the goats within the digital asset services industry. Above all, players whose business models are not able to meet the evolving needs of the market will be challenged, even if they have innovative technological solutions. We therefore expect a significant pick up in partnership and M&A activity across traditional financial intermediaries and digital asset-oriented fintech companies as they bring together their complementary skills.
In 2021, and in the short to mid-term, we can still perhaps expect the traditional players try to capture their share of the ever-increasing client demand through acquiring innovative startups. But in the coming years, when additional market depth and scalable infrastructure solutions call for a leap in client and user-loading, this may no longer be the case.
Darwinian law very much applies here – evolve now, or become extinct.