FTX debacle: End of the bromance between institutional investors and crypto? 

CRYPTOCURRENCIES have long been derided as a Wild West frontier: One enters at one’s own risk. The FTX debacle has given more ammunition to the critics and brought about a crisis of confidence about the industry itself. The massive failure also raises many legal and policy issues, including the need for regulation, the dangers of regulatory capture, the role of offshore finance havens (or so-called permissive jurisdictions), and how to best enhance retail investor protections.

But there is also another important dimension that warrants examination: Institutional investors’ embrace of crypto.

Main street financial institutions have been warming up to cryptocurrencies and started dipping their toes into the crypto creek. For example, Fidelity Investments has begun to offer crypto trading to US retail investors. BNY Mellon offers custodial services for cryptocurrencies Bitcoin and Ether. State Street and the Nasdaq have made similar plans. Even BlackRock, whose chief executive officer Larry Fink has publicly criticised crypto and questioned its utility, has partnered with Coinbase to let its clients trade bitcoin.

Plenty more Wall Street firms have gotten into the crypto action. Even pension funds, large and small, have been unable to resist the temptation. For example, the Ontario Teachers’ Pension Plan wrote off its US$95 million investment in FTX. The Fairfax County Police Officers Retirement System and the Houston Firefighters’ Relief and Retirement Fund, too, have invested in crypto assets. Even if you have not personally invested in crypto, some of the institutions that you trust with your retirement money may have been dabbling in crypto assets.

So what explains this interest in crypto from institutional investors?

First, there is the lure of outsized returns. The eye-popping rise in the prices of cryptocurrencies such as Bitcoin and Ether, all in the proverbial blink of an eye, made the returns on traditional financial assets such as equities and bonds look like rounding errors.

In January 2021, coin market capitalisation, or the total notional value of the crypto coins, had crossed US$1 trillion. The global financial industry is always on the lookout for new and promising asset classes – so it was no surprise that crypto, having crossed this threshold, became too big of an asset class to ignore.

Clearly, a high-return asset is attractive to institutional investors, but sophisticated investors also consider factors such as diversification potential, inflation hedging, and price volatility. From 2013 to 2019, Bitcoin had very low correlation with US equities and commodities and could be considered a portfolio diversifier. It was also hoped that the scarcity of Bitcoin (the supply of bitcoins is limited to 21 million by design) could serve as an inflation hedge, just like gold.

The high price volatility of cryptocurrencies is all too well known. There are risky assets, riskier assets, and then there are cryptocurrencies.

Compared to traditional asset classes, price decreases are far too frequent and much deeper for cryptocurrencies. For example, between June 2010 and March 2022, Bitcoin lost 25 per cent or more value in a three-month period 25 times – versus just once each for equities and commodities.

Prior to FTX-gate, the crypto industry suffered from several other prominent scandals, hacking and security incidents, regulatory uncertainty, technology glitches, and other challenges. But the potential for outsized returns was irresistible, and such concerns were overlooked as long as the price of cryptocurrencies kept increasing.

Alas, in today’s rising interest rate environment, the appetite for high-risk assets has decreased. The crypto market cap has fallen from a high of US$3.2 trillion in November 2021 to about US$1 trillion by August 2022 and now to about US$800 billion in November 2022.

Also, since 2020, the correlation of crypto with traditional asset classes has increased and has been consistently positive, diminishing its utility as a portfolio diversifier. With such tailwinds and, more importantly, the price crash, institutional interest in crypto is bound to wane.

On top of these shifting sentiments, the FTX meltdown should give pause to institutional investors. It’s not just the hoped-for high returns that are in question. Post-FTX, the crypto industry risks becoming radioactive and poses dangerous reputational risks for fund managers and regulators alike.

It may well be a career-limiting move for “true believers” to advocate for crypto assets. The FTX debacle may have ended the budding bromance of institutional investors and crypto.

Kashyap Kompella, CFA, is CEO of RPA2AI Research and visiting faculty at the UK’s Institute of Directors. James Cooper is a professor of law at California Western School of Law in San Diego and a research fellow at Singapore University of Social Sciences.