Institutional investors and bitcoin: a financial analysis
When we analyze the future of bitcoin market, the “institutional investors” play a decisive role. This article aims to provide a detailed analysis about who they are, how they could buy Bitcoin and what effect they could have on the cryptocurrency market.
Who are the institutional investors?
Institutional investors are individuals who gather and invest other people’s funds. This definition includes, for example, hedge funds and pension funds.
They are “sophisticated” investors who mostly use quantitative techniques (i.e., statistical and mathematical analysis of various kind). They manage large sums of money; the value of their portfolios varies greatly, but, in most cases, it’s in the order of billions of dollars and more. Just to give an idea, the OECD estimated that the total value of the asset they manage is near to 100 thousand billion dollars. We’re talking about the core players in the current financial system: they are the main investors in any known asset class (shares, bonds, etc.), and when one of them buys or sells, he can move the market significantly.
Therefore, it’s clear that if they were to invest even a small part of their capital in the crypto market, for the effects would be enormous. So, let’s see what the institutional investors need to enter the crypto market, and what could be their impact.
What do institutional investors need for buying Bitcoin?
We won’t consider legal and juridical issues, even if important (for example, concerning possible taxes on the capital gain in cryptocurrency), and we’ll focus on some more technical aspects. These difficulties can be partially overcome with the introduction of a Bitcoin ETF, but are however very important for the future of the market
High liquidity: institutional investors move very large amounts of money, therefore, they need high liquidity within the markets they enter. Otherwise, the price would fall as they try to sell, and it’d rise as they try to buy, killing off any profit. High liquidity can help to reduce these effects (see here for more explanations about market liquidity). To this end, they need platforms with high volumes, ideally reserved exclusively for them.
Performing platforms: it seems obvious, but it’s not. Institutional investors often use data-intensive techniques and may require very demanding technical solutions.
In both respects, crypto market has strongly grown in recent years. But why should institutional investors consider Bitcoin? Today, Bitcoin is still much more volatile than stocks, bonds, and all other categories of investment available. Nevertheless, it’s also an asset that, right because of its volatility, can offer very high returns (as long as you accept the risks). This was the main reason for the introduction of Bitcoin Futures. And, while poorly linked to the events of traditional markets, Bitcoin allows you to diversify your portfolio. As we’ll see shortly, it’s not assumed that this won’t change in the future, but, for some kind of portfolios it can be a rather realistic hypothesis.
Generally, institutional investors are keen to act – beyond that prescribed by law and other similar constraints – by following the “prudent person standard”, defined as follows:
“A fiduciary must discharge his or her duties with the care, skill, prudence and diligence that a prudent person acting in a like capacity would use in the conduct of an enterprise of like character and aims.” (Source)
This is a very vague definition, which in many cases is interpreted as: “if this is normal for other fund managers, then it’s acceptable to me too”. As a consequence, the more institutional investors enter Bitcoin, the more are convinced that Bitcoin is a reasonable investment (even if in small quantities compared to the total portfolio, since it’s always very risky).
How do they enter the market?
To enter the crypto market, institutional investors need a channel to buy cryptocurrencies and a secure storage medium. To hold them, they can use custody services such as Coinbase Custody, which aims to store clients’ cryptocurrencies with a degree of security compatible with institutional investor standards.
The big problem with purchasing instead is to buy large quantities without moving the market too much. There may be many strategies to achieve this goal, such as splitting purchases on multiple Exchanges or using OTC services like the one offered by Bitfinex, where large investors agree to buy and sell Bitcoin.
The alternative to this – simplifying – is to unite purchase and custody in one single service: we’re talking about ETFs and Futures. With ETFs and Futures, a counterparty (for example, the CME for futures and perhaps Bakkt for ETFs) offers an investment product that follows the performance of Bitcoin. In the case of ETFs, the value is linked to Bitcoins held in reserve by the ETF manager. Bitcoin futures, on the other hand, are contracts which, at maturity, give the right to receive a payment equal to the value of Bitcoin.
This is a fundamental distinction: ETFs allow to increase the demand for Bitcoin, while futures are like “paper bitcoins”: institutional investors can buy them instead of Bitcoin, creating additional supply. As a consequence, how institutional investors enter the market is very important: they might enter without creating any further demand in the “real Bitcoin” market. Although it seems strange, it should not be taken for granted that new investors mean new investments: it all depends on what instrument they choose.
Anyway, the presence of institutional investors in the cryptocurrency market would mean that, in case of price manipulation by malicious parties, institutional investors could suffer huge losses, creating risks for the whole financial system. For this reason, a greater presence of institutional investors could coincide with an enforced regulation for Exchanges and the whole crypto market, in terms for example of better protection from market manipulation and KYC (know-your-customer) measures. A safer environment for a lot of users.
The possible effects on Cryptocurrency market
That said, let’s see what could be the effect of a massive presence of institutional investors in the Bitcoin market.
Befor any other consideration, remember that Bitcoin has historically encountered major problems during high market activity because network can’t handle a great number of transactions. High speculative movements of Bitcoin between wallet and exchanges can slow Bitcoin network and in the worst case scenario temporarily freeze it for some hours, with very hard consequences, as happened in december 2017. So, scaling will be a even more urgent priority. But let’s check financial consequences:
1) Greater correlation with the traditional market.
Most institutional investors pursue strategies that involve setting specific “counterbalances” on their portfolios: this means to combine different investments to guarantee diversification of the objectives. For example, a fund could use an algorithm that suggests a portfolio composed of 60% bonds and 40% equities tends to be less volatile than others: in this case, the fund would try to maintain these proportions; if equities would rise too high in value (and thus become more than 40%), it sells some of the shares to buy bonds.
What does that mean applied to the crypto market? If an institutional investor owns Bitcoin and Stocks, and the stock market falls, he’ll sell Bitcoin to buy stocks. So, when the stock market goes down, Bitcoin goes down too, and vice versa if the stock market goes up. This, in finance, is called “contagion”: a crisis that spreads from one market to another. To better understand this concept, we can look at the way Bitcoin drops lead to the collapse of altcoins: this is a good example of contagion. A recent study has shown that the contagion between stock markets and Bitcoin has increased after the introduction of Bitcoin futures, a sign that the market has become populated with players who also operate in traditional markets.
We have two notable examples of this phenomenon:
The “Bull Run” in 2017: the market rally in 2017 also saw the entry of many institutional investors, which helped to increase the correlation between the cryptocurrency market and the stock market. In particular, the correlation between Bitcoin and S&P500 reached new highs between late 2017 and early 2018, as evidenced in a study by Bitmex Research. This event left many traces, as one of the triggers of this event was the introduction of Bitcoin futures.
Below we have a chart reported in the Bitmex study in which you can see how Bitcoin price (blue) and S&P (white) have moved together in 2017/early 2018. The common trend of the two markets is evident.
The events of Covid-19: the global coronavirus pandemic was a shock to financial markets around the world. The stock markets collapsed and the contagion affected all major asset classes, including gold… and even Bitcoin. Again, the timing was very similar: Bitcoin and SeP500 both had a kind of plateau in February 2020, followed by a slump that began in late February and reached new lows around mid-March (March 16 for cryptocurrency, March 23 for stock markets). It was a traumatic movement: around midnight on 13 March, BTC/USD had lost 45% on a daily basis. At the same time, all the top 10 cryptocurrencies per market capitalization recorded losses of more than 30%. Panic was rampant in cryptocurrency market too.
2) More efficient markets, harder gains.
Institutional investors have only one goal: to make money. They employ PhDs in finance, physics, and mathematics, and they use the most advanced methodologies in terms of artificial intelligence and machine learning. All this with one goal: to identify market anomalies to exploit. If there is a way to make a profit, they have a very good chance of finding and exploiting it before you do. The market is a continuous hunt for bargains, and entities such as institutional investors obviously have all the skills to exploit them, leaving the rest of the market dry-mouthed
This is a phenomenon already seen in traditional markets: in the 1970s, it was found that there was a weekly seasonality in the stock market, so investors started buying before the days when the price statistically went up, and vice versa for the days when the price statistically went down, and this anomaly slowly disappeared. In the same way, it’d become much more difficult to take advantage of certain opportunities in the crypto market if institutional investors will enter it.
At the same time, the market would become much more efficient: institutional investors react more promptly to the news and – where possible – they could decide to sell projects considered useless and/or with poor future prospects.
In short, institutional investors could create a market that is more difficult to exploit but also more mature and efficient, able to more quickly react to the news, in an ecosystem in rapid evolution: a very interesting perspective! What do you think of this? Let us know in the comments!