Why Bitcoin and Institutional Money Don’t Get Along. Yet.

Why Bitcoin and Institutional Money Don’t Get Along. Yet.
I am in the privileged position of being able to bounce ideas off one of the bigger names in the cryptocurrency space without generally coming across as a complete imbecile.

In our latest discussion on commercial developments, we discussed the common myth that institutional money — the ludicrous amounts of dollars, pounds and yen held by pension funds, insurance companies and other financial institutions — will soon flow into cryptocurrency assets in light of the diminishing yields offered by ‘conventional’ investment assets. In this short article, I hope to dispel this myth which has been propagated by enthusiastic crypto-traders who want to believe it because of the perception that such a development bodes well for their cryptocurrency assets.

Disclaimer: The article which follows provides an extremely simplified depiction of the financial markets and the operation of financial institutions. I am writing this article in a personal capacity with the intention of it being educational for laypersons. As such, I do not purport to be writing this in a financial, legal or any other professional capacity.

TLDR: No incomes + High asset volatility = an asset class incompatible with institutional investor aims. Private equity, real estate and even hedge funds are all superior alternative investments providing higher yields. Then again, some hedge funds might venture into crypto — not because of falling yields but because of high profit margins.

Image: techfunnel.com
Interests rates are rising. Bond yields are falling. The equities bull run has come to an end. Perhaps cryptocurrency is the answer — said no fund manager ever.

While cryptocurrency assets have been the hot topic of 2017–2018 and a handful of ambitious hedge funds have decided to start dabbling in the high-volatility assets in pursuit of riches, other institutional investors will steer clear. Falling yields in conventional asset classes will not change that.

Before I move onto the reasons why, I think it might be helpful if I laid out some basic key terms and explanations. I intend for this article to be digestible by as many people as possible — after all its intended audience are amateur crypto-traders who may or may not be familiar with the financial world outside of cryptocurrency. So perhaps these basic explanations might save you the reader a trip to Investopedia. Feel free to skip over this bit if you are more than familiar.

The Basics

Bonds: A financial asset best understood as a loan. A corporation or government that needs money can issue these bonds and you can buy them (thus giving them the loan). Holding these bonds entitles you to ‘coupon payments’ (think of it as interest) and a payment on ‘maturity’ (repayment of the initial loan).

Bonds can generally be bought and sold. That is, you can transfer me a bond in exchange for money and I can then claim the coupon payments and maturity payment from the issuer.

Equities (Shares): A financial asset indicating ownership rights in a corporation. Owning shares entitles you to dividend payments (a share of profits which the corporation makes). Equities may be public or private. Public equities tend to be listed on an exchange and can be traded easily while private equities — as the name suggests — are equity securities not available on the open market.

Interest Rate: The amount charged by a lender in order to lend money. Sorry if I sound insulting defining this but I do know people who can’t conceptualize it right because they are more used to putting money in the bank (and earning interest) without realizing they are effectively lending to the bank. When we talk about the Fed or Bank of England raising rates, we are talking about them raising the rates for banks to borrow money. Which in turn increases how much banks will charge to lend others money.

Liquidity: How easily a certain asset can be turned into cash.

Institutional Investors: Institutional investors are organizations holding pooled funds which they invest on behalf of their members. The largest institutional investors are pension funds, mutual funds, insurance companies and banks. Other institutional investors include hedge funds, private equity funds and commercial trusts.

So now that we have covered the basics, why am I so sure that institutional money isn’t coming into the system because of reduced returns in other areas? The answer is simple: the institutional investors are looking for something that differs from what you, the retail investor wants.

‘Wait Mr Consigliere, I’m getting 40% returns!’ — I hear you say. ‘Why wouldn’t any fund want a 40% return on investment?!’. You’re right — most funds would kill for a 40% return on investment. Like you, the institutional investors are looking for returns — don’t get me wrong. What concerns them is everything attached to your 40% returns.

What do Institutional Investors want?

Like individual investors, institutional investors are seeking yield. But while you are investing into Bitcoin, Ethereum and other random alt-coins seeking maximum returns, the largest institutional investors are only seeking sufficient yield. They will happily welcome anything more than their target return of course but not at the cost of increased risk or reduced liquidity. But to fully understand why this is the case — it is helpful to understand how the three biggest classes of institutional investors operate as businesses.

Pension funds are the largest class of institutional investors. They operate by collecting regular contributions from workers and their employers, investing these amounts and returning the amounts invested plus interest to workers when they retire.

The next largest class are mutual funds. These are pools of money to which almost anybody can contribute. They are managed by investment professionals who charge a small fee for their services. They generally make low risk investments and investors tend to be able to take their money out of these funds extremely easily.

Finally we have insurance companies. It may come as a surprise to some that an insurance company actually makes no money at all from selling insurance. The premiums insurers charge are actually calculated to offset exactly against the pay-outs they expect to make. If they expect to pay 1 out of 100 people $1000; they will charge each person $10 each. So how do they make money? By investing the $1000 they collect in premiums and making money on that investment before they have to pay out the $1000 to the one lucky (or unlucky) person.

All three of the above classes of institutional investors tend to allocate their capital in similar ways. Simplifying it for the purposes of this article, their allocations tend to be 30–50% investment-grade (very low risk) bonds, 30–60% public equities and 0–25% in alternative investments. I will cover alternative investments toward the end of this article.

Now returning to why cryptocurrency assets are unappealing to these investors, did you notice a similarity in the three classes of institutional investors above? They all have to make regular payments out of the funds. Their entire business revolves around making enough money from their investments to pay off pensioners, investors and insurance claims respectively.

Cryptocurrency assets do not support those business models for two reasons.

Reason 1: Cryptocurrency Assets Do Not Provide (Sufficient) Incomes

Look again at the broad asset allocation percentages I provided. What do public equities (generally) and bonds have in common? They provide incomes — I don’t have to sell my bonds or equity shares in order to get money out of them. The bond issuer will pay me periodic coupon payments and the companies I have shares in will pay me dividends simply for holding those securities.

The paltry sums paid out may seem like nothing to you but for the institutions we listed above, these incomes allow them to make the outgoing payments which they need to make as part of their businesses.

Cryptocurrency assets on the other hand provide no such incomes. The Bitcoin in your wallet gives you exactly zero fiat currency until you sell it. If rent becomes due and you have insufficient fiat on hand, your only feasible way of pulling fiat out of your Bitcoin to pay rent is to sell the Bitcoin on an exchange for fiat. Even gold or a house you live in can provide you with some liquidity if you borrowed money using those assets as security.

But what about staking? Yes — staking coins does allow you to earn an ‘interest’ on your cryptocurrency assets but what coins can you stake? Generally coins that even provide you with an ‘acceptable’ return are random altcoins which you are locked into for a time period that may be worth absolutely zero a week from now. 10% more of a trash coin worth nothing is still nothing. Unless a more ‘stable’ cryptocurrency like Bitcoin itself can be staked (it cannot because Bitcoin rewards people via a proof-of-work system) and liquidated if necessary, cryptocurrency is effectively incapable of generating any sort of meaningful holding returns which institutional investors require.

Reason 2: Cryptocurrency Assets are highly volatile

If North Korea were to issue their own sovereign bonds backed by their potato yields, I can assure you that these assets would be nowhere as volatile as cryptocurrency. 10–20% swings in prices within an hour or two is not uncommon in Bitcoin. When the US equities ‘crashed’ in February; mass panic ensued despite the indexes moving less than 5%. Compare this to cryptocurrency assets — recall the mad bull run to $20,000 in December 2017 before crashing down to less than half of that in early January? If we go even further back — there was that Ethereum flash crash which saw the asset drop to 10 cents from about $380. Don’t even get me started on the dodgy altcoins (more endearingly known as shitcoins).

The point I am making is that cryptocurrency assets are simply too volatile for institutional investors which we have established are interested in stable and sufficient yields. The asset itself does not provide me with incomes. What happens if I desperately need money and decide to sell it? Then I find myself at the mercy of the market. On a good day perhaps, I may find myself closing out the trade with an astronomical profit. On a bad day? I just lost a ton of money belonging to tens of thousands of pensioners. Oops.

‘It’s not all or nothing, is it?’

You are absolutely right. I would be making a strawman argument if I simply interpreted the statement I am challenging as ‘All institutions are going to invest exclusively in crypto-assets because of higher yield’. And now I bring you back to the ‘alternative investment’ allocation.

So what are in these ‘alternative investments’? Some of it may well be crypto — indirectly. But allow me to again identify the big alternative investments (who are themselves institutional investors).

First up we have real estate funds and real estate investment trusts (REITs). At the risk of oversimplifying, these investment vehicles — as their name suggest — invest in real estate. It may invest directly into the real estate and generate income from rent or via mortgage loans in which income is generated from interest payments. These make up a substantial portion of alternative investments — I generally see 40–50% + of alternative investment portfolios consisting of REITs.

Second we have private equity funds. These funds raise money from high net worth individuals or other institutional investors in order to acquire assets which they grow privately over a period of time before selling them on for a higher price. Strategies of individual funds vary from growing small-medium private companies to buying the entire shareholding of public companies (turning them into private companies) in blockbuster multi-billion-dollar deals. Whatever the strategy, private equity funds tend to offer investors an ‘assured return’ (no less than 8% per annum) which eclipses that of bonds and public equities.

Finally — the hedge funds. The out-of-control little brother of the mutual fund, the hedge fund also invests in highly liquid assets and tends to allow its investors to pull out their money on short notice. However, the assets it invests in can range from low-risk to extremely high risk. The riskiness of its investments is compounded by the fact that hedge funds tend to borrow extensively (also known as leveraging) when they trade in order to maximize their profits. Always on the hunt for high yields and profitable trades, the best performing hedge funds can return up to 30%+ per annum. These are the only institutional investors that will come anywhere near cryptocurrency.

So where does Crypto stand in all this?

It stands as a small part of certain hyper-ambitious hedge funds’ portfolios. Recall our earlier discussion on the objectives of the big institutional investors — stable sufficient yields and liquidity. Alternative investments boast higher yields than the conventional assets we discussed earlier but they come at a slightly higher risk. The incomes of REITs are subject to the real estate market while the earnings of private equity funds and hedge funds are very dependent on the abilities of the management team.

If pension funds, mutual funds, and insurance companies start craving for increased yields, they will indeed start increasing the percentage of capital they allocate to alternative investments. But current alternative investments are sufficient to provide them with the increased yield at a risk which they are comfortable with (although they may perhaps twitch uncomfortably at times). Only the most ambitious (or desperate) of hedge funds will hold cryptocurrency assets in the hopes of profiting off the wild swings inherent in the asset class. Even then, I do not expect these hedge funds to allocate significant capital to crypto-assets.

A blessing in disguise?

And all this may be a good thing. For some reason, some crypto-traders are touting institutional involvement as some sort of indicia that Bitcoin is going to the moon. There are even absurd notions that institutions buying in will create an opportunity for current crypto-traders to ‘dump on them’ as asset prices become inflated.

In my opinion, it is far more likely that large-scale institutional involvement at this phase would prejudice current crypto-traders. Cryptocurrency is currently the wild west of the financial world right now and we are all having fun as gunslingers trying to pull the trigger first on each other at the top of the bitcoin bull run or on the next big alt-coin. More institutional involvement could change the game — and not for the better.

Early cryptocurrency traders already know how the entry of just a few hedge funds have changed the trading landscape in relation to assets like Bitcoin. Huge injections of capital have allowed these funds to manipulate the market to their whims. Basic technical methods like supports and resistances (and thus stops) start making less and less sense when savvy institutional investors with large stacks come in to abuse the liquidity pools.

So perhaps it is fanciful to think that institutions coming in will massively drive up crypto-asset prices. For there to be a sale, there must be a willing buyer and I can assure you that institutional investors will not blindly buy up cryptocurrency assets unless they are confident of profit. Thus contrary to the often touted myth, greater institutional investment will only make it even harder for the average retail trader to eek out profits. Because you sure as hell aren’t dumping on them.

But then again — it isn’t all doom and gloom if the institutions do come in. Increased liquidity will naturally arise and with institutions come regulations. Regulations could finally clear up some confusion in relation to cryptocurrency assets and could user in a new era of professionalism and mainstream legitimacy.

For the retail traders however, we should at least for now count our blessings that institutional investors lack the cojones to participate in the wild west.