09.16.2019

Prove Me Wrong: Institutions Won’t Enter Digital Market

By Jason Roth, Digital Asset Expert

Introduction

After speaking with all of the major players from all the major financial institutions, I have concluded adoption of digital assets will only happen after smaller players find ways to work within the existing regulatory rules, deal sizes grow, and the cost of turning a profit on a digitized security is the same as a traditional asset.

To address each of these issues, we must look into:

  • existing digital custodians with weak balance sheets who charge upwards of 30bps to store an asset.
  • prospectuses stating exactly what an investor can investor in.
  • economics of a deal and investment criteria at the largest institutions.

You will fail trying to change the regulatory environment and think investors want to pay more for a deal. You will succeed working in the existing regulatory framework and finding ways to make a profit.

Prove me wrong!

Article

—Can you prove me wrong on this article?

Every time I discuss adoption of blockchain into large institutions I pose the same questions and no one has given me an answer that will pass muster with a low-level banker, let alone a senior banker. All of the firms selling to these institutions such as, new digital exchanges, firms who create digital assets or custodians are all doomed to fail without answers.

Let’s start with addressing custodians and defined tradeable products, which are embedded in the traditional regulatory environment:

  1. Custodians– the SEC states you must have a custodian. “First, with certain limited exceptions, an investment adviser is required to maintain client funds and securities with a “qualified custodian.” Qualified custodians can be banks, registered broker-dealers, futures commission merchants, or certain foreign entities.” – https://www.sec.gov/investor/alerts/bulletincustody.htm
    1. Will the risk teams allow a custodian with a balance sheet of $150mm take a deal worth $500mm?
    2. Digital custody costs are roughly 30 times more expensive than traditional methods, who pays for those costs? (2bps for traditional and 60bps for digitized)
  2. Defined tradeable products in a fund(pension, hedge or mutual) – funds state in their offering memorandum or prospectus, what they are allowed to trade. Here is an example where this fund can only trade ETFs, with some options on the ETF “To maintain liquidity and to fund Investment Fund capital calls, the Master Fund will invest in exchange-traded funds (“ETFs”) designed to track equity indexes and, to a lesser extent, in cash and short-term securities. In addition, the Fund may use derivative instruments, primarily equity options and swaps, for hedging purposes to help protect the value of its ETF investments.” (https://www.sec.gov/Archives/edgar/data/1609211/000119312514215186/d733143dn2.htm)
    1. Will the risk teams of from the major banks allow a deal pass through, if their documentation does not clearly state “you can invest in digitized fixed income”?
    2. How expansive will the legal teams views on terminology be?

Additionally, the smart institutions will always price the following risks into their models:

  1. Counterparty Risk – any investor must calculate how much they will get paid back in the event of default. Dealing with entities who are based in foreign countries you will not be able to use United States laws to get your assets back, assuming your assets are redeemable.
    1. Why take this risk on your money?
    2. Is this risk priced into each venue?
  2. Generate additional revenues– Blockchain has not provided new ways to generate additional revenues. There are sales pitches to help generate revenue, but no single firm wants to create what is needed in an industry, like creating 400 smart contracts based on every major NYC land deal. The blockchain companies expect an institutional investor to foot the bill for this.
    1. Why pay a blockchain company $50k/contract when you can pay a developer $100k/year to write as many as you want?
    2. Blockchain concepts are not new; if the ideas can generate additional revenue they would have found a way of using traditional methods.
  3. Deal Marketing – by creating a digitized asset you do not automatically gain liquidity. Marketing creates liquidity, marketing costs money. When the first ICOs launched marketing was solely based on how much the asset went up, there was no sales pitch or due diligence. If you list a product now, you must pay for marketing. This is what you pay an investment bank for because they have the access to capital and they are a single source of due diligence, providing everyone the go ahead.
    1. Who will eat the cost of marketing?
    2. Can you rely on small investors?
  4. Natural Bitcoin Market – So far, institutions are making a relatively small bet on the adoption of people using bitcoin to pay for products. Although this seems unrealistic, people do not get paid in bitcoin and no transactions are denominated in bitcoin. Each time you do a transaction you have to pay a transaction fee, buy the bitcoin (2% transaction fee) and buy a product (2% transaction fee) leading to a 4% loss of your salary. This assumes bitcoin is pegged to the dollar, which leads to a larger potential loss (or gain).
    1. Who is dumb enough to continue to take this loss?

What To Overcome in Selling to Institutions or Real Money…

Inherently investors are not creative people, they do not feel comfortable making an investment in something they do not know about and they HATE paying attorney fees to get comfortable.

There are no templates or forms to substantiate why the blockchain investment makes you more money or gives you the rights to the underlying asset. All of the additional legal work will have to be done to speed up the due diligence on the side of the investor. Since there are no legal reviews from judges or appellate courts this will add a level of risk in the event the underlying contract is not valid. Although you will dual paper until this happens, which leads to additional costs.

I spoke with two investment groups on this topic.

  • Family offices
    • Are ideal candidates because they have a higher risk tolerance, can make creative investments and are nimble. They also like to invest in what the family knows, so when the family comes in once a year for their investment meeting they find out their team made the 9% the family expects.
    • Investing in a new instrument adds a level of complexity, which increases the costs of due diligence, outside opinions and people time. The family office cares about making a better return, but at what cost to them?
    • Family offices assess deals all day long, they can’t afford to go down a path to find out a deal can’t be done because they don’t have rights to a property in the end.
    • There is an opportunity cost associated with passing up on a deal to work harder on a new complex deal.
  • Bulge Bracket Investment Banks
    • The criteria they look at first are deal size and internal rate of return.
    • Deal size has to be large over $100mm for them to even consider a look.
    • If it meets their initial criteria then it has to go through, credit risk, market risk, regulatory, compliance, legal and investment committee, month’s worth of work.
    • They have the resources and the time to test the idea in a lab.
    • This assumes you are not looking to co-brand with the bank, which adds another level due diligence.

Conclusion

While there are no easy answers to any of these questions, there is a need and with a need there is an opportunity. We must start answering these questions with answers senior bankers and their compliance departments can accept, which is to find ways to treat these assets like traditional products:

  • You can facilitate trades with clients who are in control of their assets using SIPC insured banks and qualified custodians to handle the transactions. You then transfer the assets from the qualified custodian into your own “digital wallet” secured within your network, reducing counterparty risk
  • Create lending facilities between businesses to handle transactions utilizing the regulatory rules from peer to peer lending, this can create a yield you will be happy with for the risk you will take

Of course, the size of transactions will be small, but the overall digital market is small, about half the market cap of Facebook. We must accept this reality and realize the market will move slowly while large institutions get comfortable.

The smart money is already in the space developing solutions to these problems because they are already working within the rules, they found an edge and are generating tremendous returns!

About the Author 

Jason Roth works with the world’s largest financial institutions, helping them understand the benefits and complexities of digital assets.  His expertise in both traditional and digital asset markets is sought out globally.  Jason began his career developing financial software, which lead to an opportunity at JP Morgan. He is the former head of Institutional Sales at AlphaPoint , a white-labeled exchange company and Business Development at the TMX,  Canada’s largest exchange.  Jason holds a Masters in Information Management from Stevens Institute of Technology.  He can explain Blockchain to anyone – from a Fortune 500 CEO to your grandma.

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