Given all the attention out there around every little move in bitcoin prices — as well as the now-they-like-it, now-they-don’t noise around crypto in general — how might institutional investors think about investing in crypto assets?
This question is top of mind for many institutional asset managers: I saw it firsthand having recently spent months on the road meeting with a myriad of institutional investors as part of a fundraise for a cryptonetworks-dedicated venture capital fund. [To be clear, that fund is not seeking investors (and investment in any fund advised by them may not be made without first getting final offering docs and diligence materials anyway); please see full disclosures here.]
But the answer to the question still remains elusive for many institutions.
It doesn’t have to be. The confusion, I believe, stems from the lure of the liquidity of publicly traded crypto assets; that is, anyone can (seemingly) invest directly, so why not do so? Yet, that siren song may be leading investors astray, for it belies the depth of the broader market opportunity beyond the liquid markets. And, I’d argue that institutional investors already have a very well-defined playbook for how to invest in such markets: It’s called asset class diversification across listed and private assets.
Defining the investable universe
Some of the challenge in how to think about crypto investing may be definitional. While the popular narrative highlights only the current liquid alternatives — Bitcoin, Ethereum, Ripple, Bitcoin Cash, EOS, etc. — there are actually more than 1,500 “liquid” coins listed on CoinMarketCap.com from which institutional investors can theoretically choose to build a portfolio. And even all those listed coins represent only a fraction of the investable universe.
More broadly than just cryptocurrencies, cryptonetworks are a new way to build digital services, where those services are owned and operated by a community of network participants rather than by a centralized corporation. Think about all the internet-based applications and services we have today, and about what it took to get here — layers of infrastructure, storage, compute, native apps, more — and now, imagine a decentralized version coming for each of those. In addition, think about all the as-yet unknown applications that may be uniquely possible due to the underlying technology. Much like the early architects of the internet could not have predicted ecommerce at the scale of an Amazon, social networking at the scale of a Facebook, content creation and distribution at the scale of a Netflix or YouTube — all of which were only made possible once we had building blocks like payments, mobile, and bandwidth in place.
So where do tokens/coins come in? They introduce the economic incentive for network members to develop and govern those networks appropriately. As such, the tokens in cryptonetworks perform a series of functions: as value exchange (for paying or receiving services); as a method to reward developers and other maintainers of the network; as a draw for early community members or beta users; and so on.
Thus, tokens are the glue that binds the various stakeholders in a cryptonetwork and aligns incentives among all participants. The bigger picture here is that cryptonetworks are about building the next phase of the internet, powered by software and these economic incentives. Together, these have given us a new, potent, way to build digital services.
Back to asset classes
However, most of these digital services are still being built, and will continue to be built out over the next several decades — they’re not yet listed on any exchange or market. And this is where the confusion lies for many institutional investors.
If you ignore the fact that the ultimate tradeable asset of many cryptonetworks will be tokens instead of equity securities, cryptonetworks are simply a replay of two well-known assets classes familiar to institutional investors: the illiquid private equity market; and the liquid, publicly listed market.
Today, institutional investors get exposure to the latter a couple of ways: Just as they can directly hold Apple stock, they can also hold at least the most liquid of the listed crypto tokens. But they often choose to use outside managers for publicly traded stocks like Apple — why? Because presumably an outside manager who focuses on the listed market full time is likely to have an advantage in generating alpha relative to a pure passive index strategy or an internal-only active management function.
Arguably the same applies to cryptoasset markets. Just as a good active public equities manager incorporates lots of independent data points into her analysis of whether or not to buy Apple stock at a particular time, any good cryptonetworks manager will do the same. She may spend a majority of her time talking with the entrepreneurs building new cryptonetworks to understand which tokens they’re building their new services on (to develop insight into the future appreciation opportunities of the listed tokens) as well as other key aspects of the networks (such as scaling, governance, design, and code). They’re constantly meeting with the community of developers using tokens and building apps to more deeply and broadly understand the backdrop cryptocurrencies are playing out against, much of which is invisible to the “listed” market.
This is precisely the activity of venture capitalists, who are as much in the “engineering talent” business as they are in the investment business. By definition, VCs have to evaluate the talent flows into new areas of technology to assess the viability of that talent for delivering on the promise of the investment, especially when they’re pre- product/market fit (taking at least 5-10 years to play out). For crypto, one similarly needs the skills of vetting talent, product, and more. In fact, this is just good old-fashioned early stage venture: investing in pre-product teams (ideally with entrepreneurs participating in network usage and governance); going after big, risky opportunities; and taking a long-term, patient view (vs. short-term speculation).
Institutional investors should therefore first figure out their allocations to venture more generally, and then decide whether they want exposure to crypto as a subset of that VC allocation. This is no different from how institutional managers invest in other domain-specific subsets of VC such as life sciences, fintech, artificial intelligence, semiconductors, and so on. All involve deep domain expertise and an understanding of the broader ecosystem.
* * *
None of this is to say that exposure to cryptonetworks is appropriate for all institutional investors. As with any decision to invest in any asset class, there are a whole host of risks that need to be carefully weighed relative to the potential return potential of the investments and other allocations in one’s portfolio. But beware the siren song of the listed markets: It may lead investors into the shallow end of the water only — ignoring the developing private market — or worse, belie the attendant risks to investing in liquid assets without the benefit of the full set of information available to active managers in the cryptonetworks space.
Because crypto — while an important, new, and different trend in the evolution of computing — is not that different when it comes to VC investing, at least. Beyond regulatory considerations and important consumer protection concerns in the case of individual/retail investors, it should not be treated differently from how institutional investors engage in other traditional asset classes. Ironically, the more things change, the more they stay the same.