Making Bitcoin Bankable for Institutional Investors, Asset Managers, and Banks
Some years ago, mainly retail investors invested in crypto assets. Increasingly, institutional investors such as banks, family offices, asset managers, and insurance companies are getting interested in Bitcoin, Ethereum, and other crypto assets. For these types of investors, regulatory requirements, risk management, and traditional investment processes need to be met. The digital asset ecosystem has grown and developed rapidly and now provides the required legal certainty that we have known from the traditional financial markets for decades. But institutional investors that seek to invest in crypto assets need the technical infrastructure to manage them easily, efficiently, and securely. Depending on the type of investor, different solutions are available. Typically, an order routing system is required to execute orders on a larger scale, so that prices are not affected due to low market liquidity. These systems become even more powerful if they are connected to institutional-grade crypto custodians that provide reliable storage and security services for the purchased assets. In addition, a broker-dealer license could streamline the investment process. And ultimately, Bitcoins and other crypto assets could be converted into bankable assets: this requires the structure of a Special Purpose Vehicle (SPV), which incurs additional costs, but also allows larger asset managers to invest, as they need assets that are “bankable”. — Authors: Philipp Sandner, Christian Labetzsch, Thomas Faber
Lately, curiosity and interest in Bitcoin and Ethereum have been growing again. A few years ago, only technology-driven retail investors were interested. The last hype at the end of 2017 was followed by a downturn and a period of stagnation. During this time, not only more private investors improved their knowledge and gained interest in Bitcoin and Ethereum, but increasingly banks, asset managers, and institutional investors as well.
While financial institutions largely ignored or rejected Bitcoin a few years ago, the employees of such companies — including decision-makers — are now expressing interest and starting to ask questions. The next step is for banks, asset managers, and institutional investors to decide whether to invest in Bitcoin and Ethereum. Interestingly, Ethereum is also increasingly regarded as a global asset management platform: security tokens, for example, are securities in the form of a token and run on a blockchain system. In most cases, the “cryptocurrency” Ethereum is used as a base layer on which such tokens are deployed. Large banks such as Santander and Societe General also deployed debt instruments on the Ethereum platform. This underpins the increasing interest of non-retail investors.
There already is an answer to questions arising about electricity consumption, network stability, and KYC/AML of Bitcoin and Ethereum. But there is an important question that has remained largely unanswered: How can banks, asset managers, and institutional investors invest in Bitcoin and Ethereum? Or how can they do this on behalf of third parties that demand exposure to this asset class?
Can we observe an institutionalization of crypto assets such as Bitcoin and Ethereum?
There are different segments of investors that have invested in crypto assets or seek to do so. Figure 1 presents different types of investors and our observations on how they currently invest.
Type 1: retail investors
Bitcoin, Ethereum, and other crypto assets (e.g. Basic Attention Tokens) have been interesting for retail investors for quite some time. The typical retail investor is between 18 and 40 years old, male, and tech-savvy. According to estimates, there are about 800,000 such retail investors in Germany, who mainly own Bitcoin. These retail investors register directly with the crypto exchanges (see type 1 in Figure 1). The Stuttgart stock exchange with its retail business “Bison”, for example, has taken 60,000 retail investors on board in the last 8–9 months. Most crypto exchanges are usually based in the USA or Asia.
Type 2: institutional investors using an order routing system directly
For institutional investors, “traditional” crypto exchanges often do not offer the right package. There are considerable spreads between bid and ask prices; “market” prices vary between exchanges, and KYC is difficult for corporations — just to name a few reasons.
Institutional investors often have higher order volumes, such that an order routing system is required (see type 2 in Figure 1). Order routing systems are well-known from traditional capital markets. They connect to multiple exchanges and aggregate order book and trade execution in a single API. When an institutional investor seeks to invest, the order is routed to multiple exchanges to allow the investor — with its relatively high investment volume compared to market liquidity — to acquire assets at prices that are not artificially inflated through its own demand. Along with other providers, Blocksize Capital offers such an Order-Routing-System.
Order routing systems are even more powerful if they not only connect crypto exchanges for trading, but also custody providers to which the purchased assets can be moved and where they can be safely stored. Think of a middleware that not only connects exchanges but also custody providers. The assets can be obtained at the individual exchanges and “parked” with several connected custody providers. Although a single custody provider can offer a high level of security, it can be desirable to “fragment” the purchased assets and forward them to multiple custody providers to achieve the highest level of security. Blocksize Capital offers a fully compliant infrastructure for storing, trading and managing digital assets. Connected to over 50 exchanges, they cover more than 99% of all relevant trading pairs and trading venues. Type 2 institutional investors can leverage such order-routing systems, but a significant drawback remains: these investors have to register with the individual crypto exchanges and custody providers directly. Since these trading venues are distributed worldwide, the institutions could have difficulties in getting a legal entity from a selected country on board due to the KYC/AML requirements.
This is especially true for legal entities embedded in more complex corporate hierarchies. For example, a family office wishing to invest in Bitcoin might have several subsidiaries while these subsidiaries operationally buy and sell the assets. If this family office decides to purchase Bitcoin, it must have several — sometimes foreign — crypto exchanges on board. This is a process that often takes weeks or even months. Only after successful registration they can enter their account credentials into the order routing system so that it can be used with the above-mentioned advantages. To counter this cumbersome process, institutional investors can also invest according to type 3.
Type 3: institutional investors relying on brokers
As indicated by Figure 1, there is also the possibility that institutional investors rely on a broker to buy, sell, and securely hold the crypto assets. In this case, the broker himself has registered once with several trading venues and custodians, allowing institutional investors to avoid this time-consuming task. The broker has a so-called Broker-Dealer License, which he has applied for at the local financial market authority and which allows him to buy and sell assets as a third party on behalf of the institutional investor.
Put differently, the order routing system is combined with an adequate financial market license, which allows such institutional investors to focus on their trading decisions while avoiding overly cumbersome onboarding processes. Also, such investors do not have to take care of technical details as they can participate in crypto markets with an out-of-the-box solution. The same holds true for the custody of assets given the required custody license exists.
This solution makes sense for family offices or smaller funds that can execute their trades via a single front-end user interface. In the background, the order routing system addresses the individual trading venues as well as the custody providers to fulfill the investor’s decisions. Blocksize Capital will soon be able to operate this model with a broker-dealer license.
However, this structure is not sufficient for larger asset managers (including banks, insurances, etc.). These institutional investors of type 4 need a different solution tailored to their needs.
Type 4: institutional investors requiring bankable assets
Due to regulatory requirements and accounting, larger asset managers (e.g. banks, insurances) can only invest in Bitcoin, Ethereum, and other crypto assets if these assets have been “packaged” into bankable assets. Stocks and bonds are bankable assets, as they fulfill all regulatory requirements. For example, bankable assets have been assigned an International Securities Identification Number (ISIN) to identify the asset through ordering terminals, accounting procedures, etc.
Larger asset managers require assets to be bankable in order to be processed in internal IT systems and, in addition, because they fulfill all regulatory requirements. How can Bitcoin and Ether become bankable assets? It might sound overly complicated, but a Special Purpose Vehicle (SPV) needs to be set up. The SPV is contracting a broker with a broker-dealer license and an order routing system. A managing director is responsible for the operations of the SPV and acts on behalf of the owners of the SPV. Compliant to all regulatory requirements, an ISIN is assigned to the SPV. Now, the asset manager can invest in Bitcoin and other crypto assets by referring to this very ISIN in its accounting systems. When investing in the SPV, the asset manager indirectly invests in the crypto asset. Of course, this structure implies some administration costs. However, these costs become negligible with assets under management (AuM) exceeding $1M-$2M, or above. Blocksize Capital also offers an off-the-shelf solution for this structure which allows Bitcoins and other crypto assets to become bankable for larger scale asset managers.
Some years ago, mainly retail investors invested in crypto assets. Now, as the interest from family offices and other asset managers in Bitcoin, Ethereum, etc. increases, the regulatory requirements, risk management, and traditional investment processes need to be met in order to comply with the demands of institutional investors. Depending on the type of institutional investor, different solutions are available. Typically, an order routing system is required to execute larger scale orders without affecting prices due to low market liquidity. These systems become even more powerful if they are connected to institutional-grade crypto custodians that provide reliable storage and security services for the purchased assets. A broker-dealer license might ease the investment process. Ultimately, Bitcoins and other crypto assets can be turned into bankable assets. As outlined above, this requires an SPV structure which induces costs but allows larger asset manager to also invest they require assets to be “bankable”.
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Prof. Dr. Philipp Sandner has founded the Frankfurt School Blockchain Center (FSBC). From 2018 to 2021, he was ranked among the “top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. He has been a member of the FinTech Council and the Digital Finance Forum of the Federal Ministry of Finance in Germany. He is also on the Board of Directors of FiveT Fintech Fund, 21e6 Capital and Blockchain Founders Group — companies active in venture capital financing for blockchain startups and crypto asset investment management. The expertise of Prof. Sandner includes crypto assets such as Bitcoin and Ethereum, decentralized finance (DeFi), the digital euro, tokenization of assets, and digital identity. You can contact him via mail (firstname.lastname@example.org) via LinkedIn or follow him on Twitter (@philippsandner).
Christian Labetzsch is Managing Director of Blocksize Capital and Co-founder of its affiliated company micobo. His main areas of expertise includes the application of Distributed Ledger Technology in capital markets. You can contact him via email and LinkedIn.
Thomas Faber is a research fellow at the Frankfurt School Blockchain Center and a project manager at the International Token Standardization Association (ITSA). He holds a B.Sc. degree in Management, Philosophy & Economics as well as a M.Sc. degree in Management with a focus on digital business models from the Frankfurt School of Finance & Management. You can contact him via email and LinkedIn.