How Banks And Hedge Funds Are Solidifying The Cryptocurrency Market

News, Opinion | January 29, 2021 By:

MicroStrategy bought 70,470 BTC. worth US$2.3 billion – that’s greater than the GDP of 35 countries in the world. Paul Tudor Jones invested in Bitcoin, PayPal is supporting Bitcoin-purchases, 170-years old Massachusetts Mutual insurance company is investing in BTC, Guggenheim Partners is allocating 1% of new funds to BTC, and many other similar developments became cryptocurrency market headlines in the second half of 2020. While professional financial companies and hedge funds tapping into cryptocurrencies is a nice-looking news title, the average crypto investor, especially the newcomers, will be left thinking: so what?

So why is this important? Three major parts should be considered, namely: economic perspective, psychological, and regulatory.

The economic implications of professional financiers entering cryptocurrencies are pretty obvious to some – funds, banks and insurance companies are the new buyers, and based on economic principles: that higher demand means a higher price. However, that is only on the surface, without consideration of the nature of institutional investors. Most of the institutional investors are multiple times larger than the typical crypto-investor, or even the typical crypto investment fund. That means that with greater crypto adoption among traditional financiers with capitals of billions and trillions of Dollars, even 1% allocation of their AUM (assets under management) means billions of fresh, unallocated capital, as opposed to the millions of dollars which the typical crypto investment fund would bring to the table.

Most traditional financiers are not short-term oriented. While the typical Bitcoin investor would be looking for capital appreciation in a one-year period at most (apart from Bitcoin evangelists and true HODL-ers), for a traditional investment fund, the short-term period would be 3-5 years, and sometimes even more. And the same goes for long-term periods – the typical Bitcoin investor would consider 3-5 years a pretty long period, while an asset manager such as BlackRock or Guggenheim Partners would be thinking in terms of 50+ years.

Traditional finance investors have deeper liquidity available, deeper pockets and wider fundraising opportunities. They simply wouldn’t need to sell at every market correction to cover the short-term liabilities as pre-institutional era Bitcoin investors would. Ultimately, that means the purchased Bitcoins are locked for quite a long time from regular market participants. Last, but by no means of least significance, is the magnitude of possible price changes. If the cryptocurrency market is filled with average people with US$100-1,000 maximum balance, for a professional fund manager it simply doesn’t make sense to enter such a market, because he or she would buy the entire market supply, and then probably won’t be able to exit.

For typical cryptocurrency investors, a price increase from US$1,000 to US$1,500 with a market cap of US$100,000,000 might represent a highly liquid and very promising market. For a hedge fund, however, that would be meaningless because it couldn’t buy the entire market, but would instead need to follow regular internal processes. Generally one man cannot make investment decisions over night, thus the allocated investment would be insignificant, wasted resources, including time, would be significant, and investment size marginal to the fund’s portfolio would be pretty small. Therefore, for some firms it will make no economic sense to enter such a market until it reaches a certain threshold in market capitalization.

The second aspect that is important to consider is the psychological effect on the global market when well-known finance professionals enter the market. You can simply imagine the effect by considering this example: if some IT student or your neighbour Joe tells you there’s a great investment opportunity in the market and he bought 100 of X-coins, what is your reaction? And how about Bloomberg reporting that Elon Musk or Ray Dalio personally invested in Y-coin, or said that “Y-coin over the last ten years established itself as an interesting gold-like asset alternative”?

Which opinion do you care more about, or who are you likely to trust? Someone who can hardly pay their own rent, or someone who is on the Forbes top-20 richest men in the world? The answer should be pretty obvious, and it has the same effect not only on John Doe getting interested in cryptocurrencies, but on the other finance professionals too, which all together ultimately drive demand even higher. It’s commonly known as herd effect when the majority of people tend to follow the KOL (key opinion leader) irrespective of the context or of the actual opinion.

Some tend to listen to Greta Thunberg because she is the KOL in an area, someone will listen to a girl on Instagram or a sport coach on YouTube, others will listen to Ray Dalio and alike. Therefore, for many newcomers still considering if Bitcoin is a good investment or not, hearing an opinion from their own KOL is a way of confirming their own expectations, and serves as a hedge of risk in a way that “I might be wrong about Bitcoin’s future, but Elon Musk cannot be wrong because he is so rich.” And the greater the assets of the opinion leader, hedge fund or a bank, the greater the psychological effect it will have on a wider market. That’s especially true in a market as sensitive to PR as cryptocurrencies.

Another important aspect is the regulatory perspective. While small-sized investors participate in a certain area, for regulators who are highly risk averse it’s simply easier to ban an area which is new, they cannot control or fail to understand, rather than developing the whole new regulatory framework for small investors, because “no asset – no problem”. However, as more institutional or even systemically important institutions start to advocate for the new asset, lobby for it, or even invest in it, regulators are forced to adopt it.

The reason for that is quite simple – higher stakes are at play. While the potential loss of hundreds of US$1,000 worth of investors is a sad story, the potential loss of a US$1 billion investment fund or US$1 billion of banking assets is an entirely different story, and might quickly turn into the system-wide crisis for the entire country. Banks and investment funds are not individuals and their primary business lies in asset and risk management, they take or borrow others’ assets for long-term and aim to make profits in the shorter-term by investing in other assets.

Therefore, a bankruptcy of one financial institution could result in financial distress of hundreds of other institutions and consequently of millions of people, as opposed to individual losses of hundreds of individual investors. Therefore, it can be said that banks and hedge funds are simply more important to regulators, and regulators are more likely to adapt to them, more than to small individual investors.

The above effects work in tandem and typically serve to create a self-fulfilling prophecy, whereby people claim that “the institutions are coming,” resulting in banks, insurance companies and hedge funds actually investing in cryptocurrencies. Yet, other effects might be at play too.

Traditional financiers are no fools. They would not do publicly, nor say publicly, anything which wouldn’t be to their benefit. No hedge fund would say that they are considering buying an asset, which would ultimately raise the price of their own purchase. That means that before they say something or make a public announcement, they will have already bought that asset in advance. The announcement serves to raise the price of their already existing holdings, which helps to vindicate the action for their own investors who approved the transaction, by showing them quickly realized profits.

The good news is that we are likely to hear more and more announcements that X institution, bank or hedge fund has purchased or is considering purchasing cryptocurrencies. That means that they are already in the market for some time, even if we don’t know that yet.

With all above factors, we are sure to see new all-time highs from major cryptocurrencies, and consequently further solidification of the market. That will lead to greater liquidity, better regulation, more participants, and more efficient asset pricing. That virtuous cycle will repeat itself multiple times until cryptocurrencies establish themselves not as a shady side-play for small investors, but as globally recognized alternative investment assets.