The hottest part of the crypto market: companies are building institutional grade infrastructure

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Crypto, Blockchain, and DeFi remain the hottest sectors this year, attracting record amounts of attention and capital. This article is not about investing directly in crypto assets or the appreciation in the price of cryptocurrencies like Bitcoin or Ethereum, but how private investors are funding companies that are building the infrastructure that will support the future growth of crypto assets. and digital. You see, the smartest investors are investing billions in institutional-grade infrastructure for top-notch services like credit, custody and brokerage, tackling the barriers that have held back institutions, especially pension funds. , endowments, hedge funds, family offices and corporate treasurers. In the same way that A16z and Tiger Global funded the first generation of crypto companies like Coinbase that primarily catered to retail investors, they are now turning to funding companies that are building infrastructure for institutional adoption. large-scale of these assets.

Analysis of recent funding arrangements in this sector reveals some fascinating observations:

$ 9.5 billion of VC funds were invested in crypto / blockchain companies in the first quarter of 2021, more than three times the total funding of the 2020s (according to TheBlock research)

There is a clear trend towards building infrastructure and financing services especially for institutions, a departure from the last round of financing, which supported the participation of retailers

Prime brokerage, lending and liquidity provision are the main sectors: 60% of funding went to companies in these three sectors before execution, payments and portfolios

The average funding cycle nearly tripled to $ 15.8 million this year from $ 5.7 million in 2019 (according to PitchBook) due to rising valuations and faster growth, requiring more capital

Almost half of the funding went to start-up / Series A cycles, demonstrating the early nature of this industry and investor belief that there is room for more innovation and capacity for more. participants

Some of the biggest fundraising operations of all time in this industry took place in the first quarter of 2021: Circles $ 440 million, BlockFis $ 350 million, and Dapper Labs $ 305 million. Several companies in this sector have matured enough to be listed via PSPCs at rich valuations: Bakkt ($ 2.1 billion) earlier this year, Bullish ($ 9 billion) and Circle ($ 4.5 billion) expected in the fall of 2021.

You see, the institutional adoption of crypto and (to a slower extent) digital assets will increase dramatically over the next several years, and there will be massive investor interest in funding the companies that are building the infrastructure for this. institutional involvement.

Growing institutional interest and adoption of digital assets

While retail investors have dominated the cryptocurrency market so far, institutions are learning about digital assets, negative perceptions are gradually improving, and companies are increasing their exposure, which has accelerated over the past decade. Last year. According to the Fidelity Investments Digital Assets survey of 800 institutional investors in 2020, 36% of institutions said they already had an investment in digital assets, and 6 in 10 said they would increase their allocations. Crypto hedge funds and venture capital firms hold higher amounts of digital assets than endowments, pension funds, high net worth individuals, and family offices. Over the next five years, 91% of investors who want to invest in digital assets expect 0.5% of their portfolios to be allocated to digital assets. Perhaps more importantly, the overwhelmingly negative sentiment towards digital assets is quickly fading, with 80% of investors finding them attractive for three reasons: low correlation with other assets, high expectations of asset appreciation. award and exposure to innovative technology.

Building Institutional Quality Infrastructure: Overcoming Barriers to Greater Adoption

Three major barriers to greater institutional adoption of crypto and digital assets are: 1) concerns about safety, security, and market manipulation, 2) liquidity aggregation / execution, and 3) lack of institutional grade prime brokerage with reasonable pricing.

But such concerns are due to an immature infrastructure supporting this space and will be addressed over time, paving the way for significantly higher institutional adoption. Investors are already funding essential infrastructure and services like blue chip brokerage, securities lending, credit and risk management, which are improving day by day and addressing institutional concerns. Safe custody and execution with low slippage, two of the biggest issues cited by institutions in 2019, are already being addressed by several FinTechs like Anchorage and FalconX and traditional institutions like Fidelity Investments which now have digital asset platforms. in its own right. That said, institutions are still concerned about 4 major issues that are holding back large-scale institutional adoption of crypto:

Security and Fraud: Major cryptocurrencies trade custodial assets in hot wallets on their platform, which can attract hackers and fraudsters. Despite an impressive number of exchanges like Binance, Coinbase, and Kraken to protect customers from hacking / fraud, trustees of risk-averse institutional investors like pension funds and endowments see this as a major concern and often limit portfolio allocations to these assets. While Mt Gox remains the biggest crypto hack of all time, recent incidents on crypto exchanges and custodians (CoinCheck, Kucoin, and QuadrigaCX) highlight the risk for investors.

Market manipulation: In addition to outright fraud and security concerns, institutional investors are concerned about the high levels of market manipulation in the crypto market, including washout trading, layering and spoofing. identity, and pumping / emptying practices. By some estimates, around 45-50% of crypto transactions undergo some level of manipulation at different times. Manipulative traders take advantage of crypto’s low liquidity to manipulate prices in the spot and futures markets.

Fragmented Liquidity: Unlike equities, there is no regulatory requirement for execution venues or brokers to follow National Best Offer (NBBO) rules (which is common practice in equities). which leads to all kinds of bad trading practices. Despite recent advances in liquidity aggregation using algos and intelligent order routing, finding adequate liquidity with firm prices on different crypto exchanges remains a great institutional challenge, with an issue being addressed by companies like FalconX.

Operational risk and capital brake: The immaturity of decentralized blockchain-based systems and the lack of interoperability between different platforms means that investors must maintain accounts with different custodians, banks and trading platforms. This creates real (and often perceived) operational risk and puts a significant strain on capital, as institutions have to post collateral on every platform / location they trade, discouraging institutional adoption.

In closing

2021 is turning out to be a monumental year for the growth of crypto, blockchain and digital assets. Growing investor allocations, the entry of traditional giants like Fidelity and State Street, and the keen interest from a wide variety of investors in funding this sector are massive tailwinds. While US regulators have yet to pass many regulations, their cautious but open approach to this industry is great benefit and a good omen. This space is maturing quickly, being put to the test in combat, and may be on the cusp of its next stage of growth. One of the most important areas of growth in this industry is the rapid development of an institutional-level infrastructure to support greater adoption of crypto and digital assets. The smartest investors from a16z to Tiger Global are quickly funding entrepreneurs who build such infrastructure. I suggest you educate yourself and get involved early if you aren’t already. Good luck!

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