How Can Traditional Finance Adopt Crypto?

Friday, September 16, 2022 6:42 p.m.

Charlie Erith

by Charlie ErithCEO of ByteTree Asset Management

Public awareness of crypto is increasing day by day. Yet the gap between institutional investing and digital assets seems to be closing at a glacial pace. This does not mean that there is no institutional implication, only that, in the grand scheme of things, it remains at the margins.

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

Decentralized ledger technology use cases have become the focus of serious observers of this new asset class. If these can be identified and measured, it is possible to make the case for low risk money to create positions. Crypto has been derided as a solution in search of a problem. It now has to prove that it is a growth asset, not just to affirm it.

The main advantages of blockchain technology are decentralization, immutability and instantaneous finality of any transaction. It therefore stands to reason that any activity seeking to use blockchain technology must be deficient in one or more of these areas. Hence, anything whose transactions are slow or expensive, or which have an unnecessary, probably rent-seeking middleman, or where the transactional process itself is unreliable.

Look closely and this applies to a great deal of economic activity. Supply chains, for example, often have disproportionately penalized working capital arrangements. Exchange fees can be incredibly high for what’s at face value – a simple feature. Musicians receive a tiny proportion of the value of their songs released on the platforms. The vast amount of global data is stored by a handful of giant companies. The same goes for controlling social media. The real estate market is opaque and illiquid.

The crypto world started life as an anarchic box of experiments. Although it has made some people fabulously rich, the reverse is also true. There have been undoubted negative externalities, though overall crypto has only harmed those who have chosen to immerse themselves in this strange parallel universe.

I believe that the vast majority of those who have tried it have done so with full knowledge of the risks involved. In this respect, it is no different from any new technology, whether it be the discovery of steam engines, electricity, radiation, or the quest for flight. It all must have seemed terrifying at the time, and it took great resolve on the part of their followers to bring them to a point where they became the norm.

So, can we report the evolution of use cases? The answer is a qualified yes. The ideas are there, and the energy and resources are thrown at them, but they are far from the finished article in most cases. The underlying architecture is constantly being updated and improved, analogous to the fiber optics put in place in the 1990s and early 2000s. The recent Ethereum “merger” is a good example of this, although the Moving to a proof-of-stake consensus mechanism is only 55% of the upgrade, so there’s still a long way to go.

The news from the Defi space (Decentralized Finance) is truly exciting. The tokenization of real-world assets is gaining momentum. KKR, for example, just announced that one of its funds will be partially tokenized on the Avalanche blockchain, a welcome expansion of private equity accessibility. Research developments in synthetic assets, decentralized derivatives, and access to real-world asset pools, as seen on Tinlake. Meanwhile, Starbucks is experimenting with an NFT-based loyalty program using Polygon’s blockchain. The list continues.

The second element is regulation. Institutions will not be interested in crypto without a clear legal framework. The potential benefit of investing in digital assets is overshadowed by the reputational and legal risk of doing so while outside of proper regulation.

The dominance of bitcoin – as a form of alternative currency – has clouded the picture in this regard, as it openly challenges established monetary norms in nation states. It 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 Crypto Asset Markets Regulation (MiCA) is a constructive starting point for asset class oversight. .

The industry itself desperately needs regulation. Not only will regulation build legitimacy, but it will also help weed out bad actors. In the UK, for example, the ban on 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 currently only available to the wealthy, leaving retail at the mercy of fraudsters or sensationalists.

A better understanding of the potential use cases for decentralized ledger technology, coupled with a de-emphasis on its role as an alternative form of currency, is a combination that will make proper regulation inevitable. Once regulations are in place, the growth of professionally managed investment products will channel capital to segments of the asset class that truly deserve it. From both the developer’s and investor’s perspective, this would be a healthy outcome and allow economies to nurture and benefit from the emergence of this new asset class.