Crypto, blockchain, and DeFi remain the hottest sectors this year, drawing record amounts of attention and capital. This article is not about investing directly in crypto assets or the rise in the price of cryptocurrencies like Bitcoin or Ethereum, but rather how private investors fund companies that build the infrastructure that will support the future growth of crypto and digital assets. You see, the smartest investors are investing billions in institutional infrastructures for services like credit, custody, and prime brokerage to overcome the barriers that have held back institutions like pension funds, foundations, hedge funds, family offices, and corporate treasurers. Just as a16z and Tiger Global funded the first generation of crypto firms like Coinbase, aimed primarily at retail investors, they are now turning their attention to funding the companies that are building an infrastructure for large-scale institutional rollout of these assets.
The analysis of recent financing agreements in this sector reveals some fascinating observations:
● In Q1 / Q2 2021, $ 9.5 billion in venture capital flowed into crypto / blockchain companies, more than three times the total funding of 2020 (according to TheBlock research).
● There is a clear trend towards building funding infrastructures and services specifically for institutions, a departure from the last funding cycle that supported retail involvement
● Prime brokerage, lending and liquidity provisioning are the top sectors: 60% of the financing went before execution, payments and wallets to companies in these three sectors
The average round of funding nearly tripled this year to $ 15.8 million, down from $ 5.7 million in 2019 (according to PitchBook) due to rising valuations and faster growth that requires more capital
● Almost half of the funding flowed into Seed / Series A Rounds, demonstrating the early stages of this sector and investor belief that there is room for more innovation and capacity for more participants
● Some of the biggest fundraising deals of all time in the sector were made in Q1 / Q2 2021: Circles $ 440 million, BlockFis $ 350 million, and Dapper Labs $ 305 million. Several companies in this sector are mature enough to be listed at high ratings via SPACs: Bakkt ($ 2.1 billion)
You see, institutional adoption of crypto and (to a lesser extent) digital assets will increase significantly over the next few years, and there will be massive investor interest in funding firms that are building the infrastructure for that institutional engagement.
Growing institutional interest and acceptance of digital assets
While retail investors have dominated the cryptocurrency market so far, institutions are becoming more familiar with digital assets, negative perceptions are gradually improving, and companies are increasing their 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 were already invested in digital assets and 6 out of 10 said they would increase their allocation. Crypto hedge funds and VCs hold higher amounts of digital assets than foundations, pension funds, high net worth individuals and family offices. Over the next five years, 91% of investors looking to invest in digital assets expect to allocate 0.5% of their portfolio to digital assets. Perhaps most importantly, the extremely negative sentiment about digital assets is quickly waning, as 80% of investors find them attractive for three reasons: low correlation with other assets, high expectations for price increases, and exposure to innovative technology.
Building an institutional infrastructure: removing barriers to greater acceptance
Three main barriers to greater institutional uptake of crypto and digital assets are: 1) concerns about security and market manipulation, 2) liquidity aggregation / execution, and 3) a lack of institutional prime broking with sensible pricing.
However, such concerns stem from the immature infrastructure that supports this space and will be resolved over time, paving the way for significantly higher institutional acceptance. Investors are already funding critical infrastructure and services like prime brokerage, stock 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 issues identified by institutions in 2019, are already being addressed by several FinTechs like Anchorage and FalconX and traditional institutions like Fidelity Investments, which now have full-fledged digital asset platforms. However, institutions are still concerned about 4 main issues holding back large-scale institutional adoption of crypto:
Security and fraud: Large cryptocurrencies exchange custody values in hot wallets on their platform, which can attract hackers and fraudsters. Despite an impressive track record from exchanges like Binance, Coinbase and Kraken to protect clients from hacking / fraud, the trustees of risk averse institutional investors like pension funds and foundations see this as a major problem and often limit portfolio allocation to such assets. While Mt Gox remains the biggest crypto hack of all time, recent incidents on crypto exchanges and custodians (CoinCheck, Kucoin and QuadrigaCX) underscore the risk for investors
· Market Manipulation: In addition to open 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 at various times. Manipulative traders use the low liquidity of crypto to manipulate prices on the spot and futures markets.
Fragmented Liquidity: Unlike stocks, there are no regulatory requirements for execution venues or brokers to abide by the National Best Bid Offer (NBBO) rules (which is common practice with stocks), resulting in all kinds of bad trading practices. Despite recent advances in liquidity aggregation using algos and intelligent order routing, finding adequate liquidity at fixed prices on various crypto exchanges remains a major institutional challenge, an issue addressed by companies like FalconX.
Operational risk and capital burden: The immaturity of blockchain-based decentralized systems and the lack of interoperability between different platforms mean that investors have to keep accounts with different custodian banks, banks and trading venues. This creates real (and often perceived) operational risk and puts a significant drain on capital as institutions are required to post collateral on every platform / place where they do business, preventing institutional acceptance.
2021 will be a monumental year for the growth of crypto, blockchain and digital assets. Growing investor allocations, the entry of traditional giants such as Fidelity and State Street and the strong interest of a large number of investors in financing this sector are generating massive tailwinds. While US regulators have not yet enacted much regulation, their cautious but open-minded approach to this sector has great advantages and bodes well. This space is rapidly maturing, battle-tested, and could be on the cusp of its next growth. One of the biggest growth areas in this sector is the rapid development of an institutional level infrastructure to support greater adoption of crypto and digital assets. The smartest investors, from a16z to Tiger Global, are quick to fund entrepreneurs who build such an infrastructure. I suggest that you do your research and join in quickly if you are not already. Much luck!