- Institutions have started getting exposure to the digital asset class, but factors such as unclear regulations, poor liquidity, and a lack of crypto custody and banking solutions are holding them back from increasing their exposure.
- The biggest differences between retail and institutional investors are investment size, trading and investment strategies, the level of acceptable risk and adherence to regulations.
- For institutional investors to increase their activity in DeFi, the widespread implementation of KYC and AML compliance checks will need to be implemented.
For the majority of the time that Bitcoin and other digital assets have been around, retail investors have dominated the market. A lack of regulatory clarity and the overall volatility of the crypto market kept many larger institutional investors from delving into this nascent asset class as there were just too many unknowns.
Over the past few years, as cryptocurrencies have gained notoriety around the world, institutions have begun dipping their toes into the market for a chance to take advantage of the asymmetrical risk/reward ratio that some projects offer.
The entrance of institutional investors in crypto has long been heralded as the thing that will elevate the DeFi market to new heights and give it increased legitimacy to the asset class on the world stage – helping to initiate a new era for the cryptocurrency market.
Here’s a look at the role that institutions play in the crypto market and how they can help transform the digital asset class by incorporating the best pieces of CeFi into the growing DeFi marketplace.
How Institutions Differ From Retail Investors
As it currently stands, there are several major differences between retail and institutional investors in the cryptocurrency market.
Investment size is the primary thing that sets institutions and retail investors apart. Institutional crypto investment managers tend to have a large pool of funds under management that allows them to make larger size investments. This can greatly affect the spot prices of the crypto being purchased if the trade is not conducted over the counter, so it's something retail traders need to be aware of.
Trading and Investing Strategies
The difference between the trading strategies employed by institutions and retail is stark. Retail traders tend to utilize simple trading strategies focused on entry and exit points while institutions use advanced analytics-driven trading and investment strategies. Their larger bankroll allows them to access high-quality financial data, access the best trading research to make better-informed decisions and utilize automated trading tools to simplify the process.
While many traders in the retail crowd are considered degen – meaning they will jump into the latest hot token without performing the necessary due diligence to reduce risk – institutions direct a lot more attention to managing risk and are far more cautious in their investment approach. Apparently managing someone else’s money encourages a greater level of care and aversion to loss.
While investing exposes both retail and institutional investors in cryptocurrency to some level of risk, the appetite for risk tends to be noticeably lower with the institutional crowd.
Asset Custody, Compliance, and Governance
Institutions tend to have strict corporate rules that must be followed as opposed to retail investors who are free to do as they please. Having both clients and state agencies watching every move and providing oversight means that institutions tend to closely adhere to governance and compliance rules.
Custody can be a more nuanced topic as clients are technically the owners of the assets held by institutions, but certain stipulations in user contracts can mean in certain situations (such as in the case of bankruptcy) the institution can use any deposited funds to repay any obligations.
On the retail side of things, it's much simpler as the individual investor typically owns the assets directly.
Index funds offer a simple way for individuals to passively invest with lower fees. The entrance of more institutional investors into the crypto space will facilitate the creation of index-like vehicles in the crypto space that can benefit both retail and institutional investors alike.
The volatile nature of the crypto market makes index funds even more appealing to the conservative institutional crowd who want some exposure to the upside offered by high-yielding crypto tokens with limited risk. The ability to track an entire segment of the crypto market, such as DeFi, rather than just one individual crypto project is a more appealing endeavor for the risk-averse.
While the U.S. still does not currently have any form of a spot crypto exchange-traded fund, large money players are likely to exert extra pressure on the government of the U.S. to approve a spot crypto ETF or index fund to simplify the crypto investing experience.
Institutions and DeFi
Decentralized finance is one sector of the crypto ecosystem that has significant potential to initiate changes in traditional finance. Builders and innovators in the crypto space are already hard at work creating solutions to the biggest issues that institutions face – especially when it comes to compliance.
As DeFi gains in adoption, the top protocols have seen the writing on the wall and have begun integrating things such as KYC and AML checks in order for users to access advanced functionality on their platform.
There are projects that have been developed specifically with institutions in mind to include things like permissioned liquidity pools that are isolated from the regular pools so that institutions can access DeFi without violating compliance rules.
Larger centralized platforms are also expanding their offerings for institutional investors in cryptocurrency and offer institutional-grade custody solutions that meet the compliance requirements that the entities must abide by.
Further developments are still needed, however, in order for institutional crypto trading to legally be able to access all that DeFi has to offer. Once these mechanisms are developed and put in place, there’s a good chance that a significant amount of money will flow into the DeFi arena.
What Is Needed for Institutions to Invest in Defi
Along with KYC and AML compliance, there are several other services that are needed to meet institutional demands and requirements.
The addition of more legitimate digital asset custodians are needed in the space. They are specifically tailored to serve the institutional crypto crowd and offer things like insured cold storage custody and peer-reviewed multi-signature security.
An increased number of crypto banking options are also needed as many existing companies cannot meet the needs of widespread institutional crypto adoption.
Over-the-counter (OTC) Markets
As mentioned above, the deep pockets of institutions can wreak havoc on the spot crypto market as large orders can significantly alter prices, especially in the more illiquid markets. OTC desks are ideal for these players as opposed to centralized exchanges for this reason.
Transaction Bridging Services
Institution-complaint wallets are needed to provide the same functionality as normal wallets but with additional integrations that help facilitate optimized trade flows and remain in full regulatory compliance. These institutions should offer additional features that can serve the needs of institutional crypto trading clients.
Factors Holding Institutions Back
The biggest factor cited by crypto institutional investors as to why they have not gotten more involved in cryptocurrencies is a lack of regulatory clarity. Without clear regulatory guidelines, institutions will opt to play it safe and stay out of the market so as to not risk running afoul of regulators like the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission (CFTC).
Another factor that influences the decision of institutions to get involved in crypto is liquidity. With a large pool of capital to work from, crypto institutional investors need to know that there is sufficient liquidity in the markets they participate in to execute trades with speed at the prices they desire.
With the global equities market cap currently standing at $125 trillion and a similar valuation in the bond market, the $850 billion valuation of the entire crypto market (as of December 2022) is but a drop in the bucket of global finance. Any large player trying to enter the market in a big way would likely cause prices across the crypto market to rise significantly.
Concerns related to market manipulation and other questionable practices, such as wash trading, will also need to be addressed before institutions will feel comfortable putting larger amounts of money into the crypto market.
And finally, a more established implementation of know-your-customer (KYC) and anti-money laundering (AML) practices in both CeFi and DeFi is needed to ensure that institutions remain in compliance and are able to determine who is on the other side of a trade. While many in the crypto crowd will protest the integration of such measures into DeFi, they are necessary for the long-term health and survival of the ecosystem at large.
Slowly but surely these factors are being addressed and it's only a matter of time before the rapid and substantial inflow of institutional investor funds into the cryptocurrency market takes place – an event that will raise the crypto market's valuation into the multi-trillion dollar range.