Why institutional investors are entering the digital asset space – Edward Woodford

MIT Sloan Master of Finance Alumnus Edward Woodford

Digital assets have garnered increasing interest from institutional investors, despite questions remaining around the regulation, security, and reliability of trading venues. Today, the largest trading venues – typically referred to as “crypto exchanges” – serve individual investors and traders, are limited to spot trading, and are often unregulated or based in foreign jurisdictions. What’s more, they often lack the technological infrastructure and depth of liquidity to execute larger orders that institutions require.

As a result, many of these institutional investors – typically those managing large amounts of money – bypass exchanges and turn to the opaque world of over-the-counter (OTC) trading, buying and selling large amounts of cryptocurrency directly with a specific counterparty. Deals are done in the dark, primarily through messaging platforms like Telegram and Skype. We estimate that the OTC market is currently around three times greater than the on-exchange volume.

However, the OTC trading has some considerable downsides compared to on-exchange trading. Participants can see a publicly disclosed order book on exchange, which does not exist OTC. With an order book, there is more transparent pricing, which allows for the best executable price within the market. In addition, contrary to an exchange where the identity of your counterparties is hidden, with OTC, an investor’s intention – to buy or sell – is revealed and thus can cause slippage in price or leakage in terms of your trading intentions.

The fact is that the lack of an acceptable institution-ready exchange is the one of the single largest barriers to crypto asset class growth, as every meaningful financial market is built on a foundation of institutional involvement.

What does the digital asset space look like today?

Today, digital asset trading is dominated by institutions, principally OTC. The type of institutions involved is changing. The early players were proprietary trading firms and family offices, who have the most latitude in their investment mandates. Digital asset hedge funds were also established with specific mandates to trade digital assets. Now, more established funds are entering the space, along with asset managers who’ve had to gain additional comfort.

With solutions like Seed CX and others like Fidelity announcing their brokerage and custody platforms, more institutional investors are willing to enter the space.

People often ask me, “Why are you so confident that digital assets will change the world?” My answer is that at the inception of anything, it’s difficult to predict every potential application. But it’s safe to say that blockchain technology, which is the foundation for digital assets, has tremendous potential to transform the way we do business. It has applications from supply chain management to gold trading to better control over personal data.

To be sure, we’re still in the potential phase. And it’s entirely consistent to be bullish on digital assets without believing that they’ll change every aspect of our lives. The current market cap of digital assets is about $200 billion–one-fifth of the market cap of Apple, but the potential growth is what’s important.

Given this potential growth, we’ve reached the tipping point. Coupled with an increasing momentum of institutions entering the space, including our lead investor Bain Capital, many big investors and asset managers fear losing relevancy if they fail to add such a potentially impactful asset class to their portfolios.

What do institutions need?

We know institutions are interested in exchange trading, but they need an investing experience that’s on par with that of other instruments like equities and commodities. They need:

Custodial solutions  Even though there’s been a shift in the institutional zeitgeist, frictions between the old and the new still exist. The market requires custodial solutions in which financial third-parties act as validation of a market participant’s holdings. This is somewhat contrary to the notion of on-chain settlement based on blockchain’s inherent decentralized system with an immutable and independent verification of assets.

Operational risk safeguards – Many existing platforms for digital asset trading have significant security and stability issues. Institutions need a platform that is robust and scalable. Imagine a portfolio manager being unable to close a multimillion-dollar trade while the market is moving against them because the platform is unavailable.

Efficiency of capital  Many existing platforms have withdrawal limits and require participants to be fully collateralized (i.e., if you want to buy a Bitcoin, you need to post the entire amount). Institutional investors looking to gain exposure to the crypto asset class would rather use leverage backed by sophisticated risk management models.

Institutional technology – Most existing platforms are designed for a retail audience, where the user is a person with complete rights and privileges to trade and withdraw how they want. Platforms must support multiple users–rather than all traders at a firm using the same login–and reporting tools must tie into their existing systems. They also need robust audit trails and market protections on a stable, reliable, and secure infrastructure.

Operational support – Platforms need to provide institutional-grade support, including having someone pick up the phone right away when they call with a question.

Regulatory compliance – Many institutions are hesitant to enter a space with regulatory uncertainty. They want to see regulations solidify around the digital asset market, and they want to see exchanges operate under that regulatory oversight (and even beyond this minimum standard). For example, at Seed CX, unlike most other digital asset exchanges, we don’t trade against our own customers, and we ban employee trading to prevent conflicts of interest.

The institutional demand for digital assets is real and growing. But to take hold in such a way as to push digital assets to the mainstream, institutions need the market structure, oversight, and technology to align more closely to those of existing markets. And those needs will inevitably change, since today’s digital assets are unlikely to be the digital assets ten years from now. As this space evolves and grows, our goal at Seed CX is to meet those needs by providing an exchange that’s safe, reliable, customer-driven and compliant.

Edward Woodford is an alumnus of the MIT Sloan Master of Finance Program. With fellow Sloan graduate Brian Liston, he is co-founder and CEO of Seed CX, the first licensed digital asset exchange to offer institutional trading and settlement. It has raised over $25 million to date and officially launched in November 2018. 

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