Trading places – the rise of the institutional investors in crypto derivatives trading
by Kok Kee Chong, Chief Executive Officer, AsiaNext
Around two decades ago, when the term FOMO was first used, market conditions were different from what they currently are. We were on the precipice of the first-ever systematic financial crisis, and the words “crypto” or “blockchain” would have raised a few eyebrows, and little more.
Fast forward to 2023 – the financial world has changed ever since. Investors across the spectrum are suffering from serious FOMO as they don’t want to miss the crypto wave. Given the volatility in the market over the last few years, this makes sense. It’s hard to blame them when no other asset class can claim the upswings that digital assets have – with Bitcoin’s spot price averaging an annual return of a staggering 1,576% from 2010 to 2021.
Yet, despite this bull market over the past few years, institutional investors have remained on the crypto sidelines. The very same volatility that retail investors have embraced has, to an extent, had the opposite effect on institutional investors who worry about the downside risk.
That said, while the crypto market has largely been an arena for retail investors looking to make a quick buck, the tide is changing this year as institutional investors seek more exposure to the nascent sector.
A catalyst for change
Recent events in the crypto industry have played their role in amplifying voices of concern in the industry. These views were justified as we witnessed the collapse of the Terra Luna ecosystem, as well as the crypto hedge fund Three Arrows Capital – both of which unleashed a tidal wave of contagion across the digital assets markets. Then there was the epilogue, played out in the form of the collapse of FTX, which highlighted what can happen when regulation, compliance, and governance are not present in a financial market.
With such events, those reluctant to invest in the asset class have been mostly right, considering the industry’s regulatory and governance standards have failed to match those seen in traditional financial markets.
However, and interestingly, many institutional investors have been undeterred by these recent hiccups and are gearing toward increased crypto adoption.
According to a recent survey of the Acuiti Crypto Derivatives Expert Network, institutional investors have raised (or planning to raise) exposure to crypto derivatives over the next 12 months as they increase trader headcount, trading technology, and gear up to increase budgets. Another recent survey shows that financial advisers – including broker-dealers and institutional investors – are looking to increase exposure to crypto this year.
We’ve already seen the market for crypto derivatives grow over the past couple of years as it peaked at $4.96 trillion in 2021. This trend is continuing this year as, in January, crypto derivatives volumes were up 76.1% from December, which is the largest increase since January 2021.
Sure, there’s still some scepticism – driven in part by the performance of the underlying crypto coins – such as Bitcoin losing over two-thirds of its value last year. Under these circumstances, it’s vital that the industry learns from its previous mistakes and creates a space where institutional investors feel safe to invest in digital assets, as only then will we see crypto achieve its potential. But what can the industry do to support these investors?
Changing of the guard
There are a number of measures to ensure that institutional adoption continues to rise throughout this year. At the heart of this is the growing spotlight on governance and regulatory standards which will contribute significantly towards the increased institutional appetite for crypto.
Unlike most retail investors, institutions demand a high level of regulatory and governance standards before committing to a market – and this has been a missing piece of the crypto puzzle since its origin in 2008. Importantly, what derived from the events at the end of last year was that new asset classes cannot be constructed without regulation and collaboration with traditional markets, so we must seek to rectify this.
As well as placing responsibility on global regulators, the onus should also be on exchanges to create a safe venue for market participants. Corporate governance, regulation, and high licensing standards – all standard practices for traditional institutional exchanges – must be replicated to ensure crypto adoption can reach the next level.
Once this has been achieved, we will see an influx in institutional crypto investors as they feel safer gaining exposure to crypto assets without burdening their portfolios with the risks that have plagued retail investors for over a decade.
In short, regulation is a powerful enabler, and there’s little doubt that it will play a seminal role in shaping and accelerating institutional adoption of crypto derivatives this year.
Safeguards and standards won’t be the only drivers of institutional adoption, as innovative market infrastructure will act as the catalyst that encourages and retains institutional interest. Investment banks, prime brokers, hedge funds, and market makers will all be seeking a competitive edge in crypto, and it’s up to the exchanges to provide a marketplace that can keep up with the demands of these investors. One example is helping participants reduce counterparty risk through innovative offerings such as 24-hour liquidity and more frequent intra-day margining.
As is often the case, evolution is borne from a blend of crisis, maturity, and innovation – and crypto is at the intersection of all three. This year, we’ll see this evolution come to life in the digital asset space as institutional investors feel safe realising the benefits of crypto, while minimising the downside risk.