By Obi Nwosu, CEO and co-founder of the cryptocurrency exchange, Coinfloor,
It has been a challenging financial environment for investors since the financial crisis, and difficult to achieve returns on deposits and short term investments. In response to this, many have been seeking alternative investment vehicles to diversify their portfolios. Bitcoin is never far from the media headlines – but what will it take to convert this volatile retail bet into a viable investment option?
The key lies in stablising its price. Cryptocurrency is, of course, decentralised, which means there is no central authority putting measures in place to govern its price or manage volatility. This instability is currently preventing cryptocurrency from acting as a store of value, and subsequently achieving its originally intended purpose as the future of money.
The appetite for cryptocurrencies exists amongst institutional investors and moreover, it is these institutional investment flows and volumes which will help bring the necessary stability to cryptocurrencies. However, before investors of this scale can commit with confidence, there are a few key factors that must be in place – a clear regulatory framework, appropriate infrastructure to allow investors to hedge risk, and institutionally focused security checks and balances, to ward off concerns around market abuse or slippage at point of settlement of the contract, for those who are looking to convert fiat into bitcoin.
The crypto-asset landscape is still very young, and there isn’t yet internationally agreed legislative or regulatory frameworks to protect its reputation and support its sustainability. Policymakers are learning in real-time, and working hard to get their arms around this new technology and its market implications. Through consultation with other regulators and market participants, the goal is to shape appropriate and balanced regulation that will cement the future of cryptocurrency in our economy.
Regulation is sometimes criticised as a hindrance to innovation. However, in this instance, it’s the lack of regulation that is holding progress back. A clear framework would help drive certainty into the market, thwart unscrupulous actors and ensure that market participants adhere to common standards of best practices. The current lack of consumer and investor protection will also be concerning to institutional investors - halting their investment into the market. Principle based regulatory frameworks could allay many of these concerns.
A market-based solution to curb volatility
The arrival of physically delivered futures contracts will have a major role to play in making cryptocurrency a more viable and attractive option for large-scale investors. They bridge the gap between the traditional finance industry, and the emerging cryptocurrency markets.
In comparison to cash settlement which is based on an index price created from pricing across crypto spot exchanges, physical delivery of the underlying asset prevents price slippage on trades at point of settlement, as well as price manipulation risk. This market-based approach also allows institutional investors to hedge their risk against a volatile asset class, allowing them to lock in prices over long periods of time. This functionality is critical for those trading in large volumes. The creation of a strong futures market will dampen price volatility, increase liquidity and enable true price discovery of this emerging asset class.
Top grade security
Of course, confidence in the institutionally-focused compliance and security mechanisms of exchanges will be critical. Large scale investors will be looking for measures such as 100% cold storage of cryptocurrency, to help safeguard client portfolios from theft, loss or other security issues, such as counterparty risk, as well as rigorous on-boarding processes. These will need to be modelled strictly against current regulatory standards for AML and KYC.
Balancing risk and reward
Institutional investors, like any other, must carefully consider risk and return, ensuring that their chosen investment vehicles strike an acceptable balance for their clients and their organisation's risk appetite. Whilst some remain concerned about asset classes with high volatility, others are already leaning in to the opportunities that volatility can present.
There is a clear advantage for those who can offer their clients innovative investment options, benefiting from an early adopter advantage to lead the way with their own brand reputation amongst their competitors. As we see new investors coming through, including self-made millennials who are less constrained by traditional views of what an asset class is, we can expect to see this journey accelerate. With new investment structures in place, and regulation under the spotlight, institutional investors will quickly gain confidence as they look to capitalise on cryptocurrency.