HomeBusinessFinanceThe Hottest Part Of The Crypto Market: Firms Building Institutional-Grade Infrastructure

The Hottest Part Of The Crypto Market: Firms Building Institutional-Grade Infrastructure

Crypto, Blockchain, and DeFi remain the hottest sectors this year, attracting record amounts of attention and capital. This article is not about directly investing in crypto assets or the price appreciation of cryptocurrencies like Bitcoin or Ethereum, but how private investors are funding companies that are building the infrastructure that will support future growth of crypto and digital assets. You see, the smartest investors are plowing billions into institutional-grade infrastructure for services like credit, custody, and prime brokerage, addressing the obstacles that have held back institutions, including pension funds, endowments, hedge funds, family offices, and corporate treasurers. The same way that a16z and Tiger Global funded the first generation of crypto firms like Coinbase that mainly catered to retail investors, they are now shifting attention to funding the firms that are building infrastructure for large scale institutional adoption of these assets. 

Analyzing recent funding deals in this sector reveal some fascinating observations:

●   $9.5B of venture funding went into crypto/blockchain companies in Q1/Q2 2021, more than three times 2020’s total funding (according to TheBlock research)

●   There’s a clear trend towards funding infrastructure and services being built especially for institutions, a departure from the last funding cycle, which supported retail participation

●   Prime Brokerage, Lending, and Liquidity provision are top sectors: 60% of the funding went to companies in these three sectors ahead of execution, payments, and wallets

●   The average funding round has almost tripled to $15.8Mill this year, up from $5.7Mill in 2019 (according to PitchBook) due to rising valuations and faster growth, which demands more capital

●   Almost half the funding went to Seed/Series A rounds, evidence of the early-stage nature of this sector and investor belief that there is room for more innovation and capacity for more participants 

●   Some of the biggest fund-raising deals of all time in this sector have occurred in Q1/Q2 2021: Circle’s $440Mill, BlockFi’s $350Mill, and Dapper Lab’s $305Mill. Several companies in this sector have matured enough to get listed via SPACs at rich valuations: Bakkt ($2.1Bill) earlier this year, Bullish ($9 billion), and Circle ($4.5Bill) expected in Fall 2021. 

You see, institutional adoption of crypto and (to a slower extent) digital assets will grow significantly over the next few years, and there will be massive investor interest in funding firms that are building the infrastructure for this institutional involvement. 

Growing Institutional Interest and Adoption of Digital Assets

While retail investors have dominated the cryptocurrency market until now, institutions are getting more familiar with digital assets, negative perceptions are gradually improving, and firms are increasing exposure, which has accelerated over the past year. According to Fidelity Investments’ Digital Assets survey of 800 institutional investors in 2020, 36% of institutions said they are already invested in digital assets, and 6 out of 10 say they would increase allocations. Crypto hedge funds and VCs hold higher amounts of digital assets than endowments, pension funds, high-net-worth individuals, and family offices. In the next five years, 91% of the investors willing to invest in digital assets expect to have 0.5% of their portfolios allocated to digital assets. Perhaps most importantly, the extreme negative sentiment around digital assets is receding quickly with 80% of investors finding them appealing for three reasons: low correlation with other assets, high expectation for price appreciation, and an exposure to innovative technology.  

Building Institutional-Grade Infrastructure: Addressing Obstacles to Greater Adoption 

Three major obstacles to greater institutional adoption of crypto and digital assets are: 1) concerns about safety, security, and market manipulation, 2) liquidity aggregation/execution, and 3) a lack of institutional-grade prime broking with sensible pricing. 

But such concerns are due to immature infrastructure supporting this space and will get resolved over time, paving the way for significantly higher institutional adoption. Investors are already funding critical infrastructure and services like prime brokerage, securities lending, credit, and risk management, which are getting better by the day and addressing institutional concerns. Safe custody and execution with low slippage, two of the biggest problems cited by institutions in 2019, are already being addressed by several FinTechs like Anchorage and FalconXand traditional institutions like Fidelity Investments that now have full-fledged digital asset platforms. Having said that, institutions are still concerned about 4 major issues that is holding back large-scale institutional adoption of crypto: 

·       Security and Fraud: Major crypto exchanges custody assets in hot wallets on their platform, which can attract hackers and fraudsters. Despite an impressive record of exchanges like Binance, Coinbase, and Kraken to safeguard clients from hacking/fraud, trustees of risk-averse institutional investors like pension funds and endowments consider this a major concern and often restrict portfolio allocations to such assets. While Mt Gox remains the largest crypto hack of all time, recent incidents at crypto exchanges and custodians (CoinCheck, Kucoin, and QuadrigaCX) underline the risk for investors

·       Market manipulation: Besides outright fraud and security concerns, institutional investors are concerned about high levels of market manipulation in the crypto market, including wash trading, layering and spoofing, and pump/dump practices. By some estimates, almost 45-50% of crypto trades experience some level of manipulation during different times. Manipulative traders take advantage of low liquidity in crypto to manipulate prices across spot and futures markets. 

·       Fragmented liquidity: Unlike equities, no regulatory requirement exists for execution venues or brokers to follow National Best Bid Offer (NBBO) rules (which is standard practice in equities), causing all kinds of bad trading practices. Despite recent progress in liquidity aggregation using algos and smart order routing, finding adequate liquidity with firm pricing across different crypto exchanges remains a big institutional challenge, a problem being addressed by firms like FalconX. 

·       Operational risk and a drag on capital: The immaturity of blockchain-based decentralized systems and the lack of interoperability between different platforms means that investors must maintain accounts with different custodians, banks, and trading venues. This creates real (and often perceived) operational risk and is a significant drag on capital as institutions have to post collateral on every platform/venue they transact on, discouraging institutional adoption. 

In Closing

2021 is turning out to be a monumental year for the growth of crypto, blockchain, and digital assets. Growing investor allocations, the entry of traditional giants like Fidelity and State Street, and keen interest among a wide variety of investors to fund this sector are massive tailwinds.  While US regulators haven’t enacted much regulation yet, their cautious yet open-minded approach to this sector are big pluses and augur well. This space is maturing rapidly, getting battle-tested, and could be at the cusp of its next leg of growth. One of the biggest growth areas in this sector is the rapid development of institutional-grade infrastructure to support greater adoption of crypto and digital assets. The smartest investors from a16z to Tiger Global are rapidly funding entrepreneurs that are building such infrastructure. I suggest you get informed and quickly get involved if you aren’t already. Good luck!

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