Show Me the Money

How can traditional finance embrace crypto?

Public awareness of crypto grows by the day. Yet the gulf between institutional investment and digital assets seems to narrow at a glacial pace. That’s not to say that there is no institutional involvement, only that, in the bigger scheme of things, it remains at the fringes.

What, if anything, will accelerate institutional interest adoption? The answer falls into two main categories: emergence of use cases, and regulation.

Use cases for decentralised ledger technology have become the laser focus for serious observers of this new asset class. If these can be identified, and measured, a case can be made for lower risk money to build positions. Crypto has been derided as a solution looking for a problem. Now it has to prove it is a growth asset, not just assert it.

The central advantages of blockchain technology are decentralisation, immutability and instant finality of any transaction. It therefore stands to reason that any activity looking to employ blockchain technology must be deficient in one or more of these areas. Anything, therefore, where transactions are slow, or expensive, or have an unnecessary, probably rent-seeking middleman or where the transactional process cannot be trusted.

Look carefully and this applies to a large slice of economic activity. Supply chains, for example, often have disproportionately penal working capital arrangements. Foreign exchange fees can be crazily high for what is at face value a simple function. Musicians receive a vanishingly small proportion of the value of their songs being played on platforms. The vast amount of the world’s data is stored by a handful of giant companies. The same applies to the control of social media. The property market is opaquely priced and illiquid.

The crypto world has started life as an anarchic box of experiments. While it has made some people fabulously wealthy, the reverse is also true. There have been undoubted negative externalities, although in the main, crypto has only harmed those who have chosen to immerse themselves in this strange parallel universe. It’s my belief the vast majority who have dabbled have done so in the full knowledge of the risks involved. In this regard it is no different to all new technologies, whether they be the discovery of steam engines, electricity, radiation, or the quest for flight. All must have seemed terrifying at the time, and it required great resolution from their proponents to bring them to a point where they became the norm.

So can we point to evolving use cases? The answer is a qualified yes. The ideas are there, energy and resources are being hurled at them, but they’re far from the finished article in most cases. The underlying architecture is being constantly upgraded and improved, analogous to the optic fibre put in the ground in the 1990s and early 2000s. The recent Ethereum “Merge” is a case in point, although the move to a Proof of Stake consensus mechanism represents only 55% of the upgrade, so there’s more to go.

News from the Defi (Decentralised Finance) space are genuinely exciting. The tokenisation of real world assets is gaining traction. KKR, for example, just announced that one of their funds would be partially tokenised on the Avalanche blockchain, a welcome expansion in accessibility to private equity. Look out for developments in synthetic assets, decentralised derivatives, and access to real world asset pools, such as appear on Tinlake. Meanwhile Starbucks are experimenting with an NFT-based loyalty programme using Polygon’s blockchain. The list goes on.

The second piece is regulation. Institutions will not take an interest in crypto without a clear legal framework. The potential upside of investing in digital assets is dwarfed by the reputational and legal risk of doing so while it lies outside proper regulation. The dominance of bitcoin – as a form of alternative money – has obscured the picture in this regard, because it openly challenges the established norms of money in nation states. That is a very difficult battle to win. But other digital assets are far less controversial. As use cases emerge and adoption grows, it will be harder to argue that this is a rogue asset class. The good news here is that at least regulators are working hard to understand what they are dealing with and in Europe the Regulation on Markets in Cryptoassets (MiCA) is a constructive starting point for the supervision of the asset class.

The industry itself is desperate for regulation. Not only will regulation enhance legitimacy, it will also help to weed out bad actors. In the UK, for example, the banning of access to crypto ETPs (exchange traded products) leaves unregulated access as the only option for retail investors. This is naturally fraught with danger. Sophisticated digital asset funds are only available to the wealthy at the moment, leaving retail at the mercy of fraudsters or sensationalists.

Greater understanding of the potential use cases of decentralised ledger technology, allied to a de-emphasis of its role as an alternative form of money, is a combination that will make proper regulation inevitable. Once regulation is in place, the growth of professionally managed investment products will channel capital into those parts of the asset class which genuinely merit it. From the perspective of both developer and investor, this would be a healthy outcome, and enable economies to nurture and benefit from the emergence of this new asset class.