Fidelity cryptocurrency move unlikely to start flood

Fidelity Investments' move into custody for cryptocurrencies has opened the door ever so slightly for institutional investment in the nascent asset class, but there are still issues of trust that will keep pension funds and other asset owners from crossing the threshold, industry analysts said.

"An institutional client told me, 'I don't mind investing the money in bitcoin. I just don't want to lose the money,'" Chris Hehmeyer, CEO of Chicago-based crypto trading desk Hehmeyer Trading and Investments, said at a Futures Industry Association conference Oct. 18 in Chicago. "It's all about safety and soundness. People don't trust this. Until they do, they'll hesitate to invest in it."

But asset owners are curious about crypto investing in the wake of Fidelity's Oct. 15 announcement, said Tom Jessop, head of Fidelity's corporate business development and digital asset services, its new crypto custody unit, at the FIA conference. "We're seeing interest from institutions we wouldn't expect, like pension funds and traditional asset managers," Mr. Jessop said, although he would not name the funds or managers that have expressed interest. "It's interesting to see the intellectual horsepower from institutions going into getting into digital assets."

Fidelity Digital Asset Services offers custody and trade execution services for cryptocurrencies for hedge funds, family offices and market intermediaries, but is also looking for asset owner clients as well, Mr. Jessop said.

While Fidelity's new business brings a big-name institutional business into an industry in which existing cryptocurrency custodians are not as well known, panelists at the FIA conference said asset owners and their money managers are looking for the giants in the institutional custody business to create crypto platforms. Those players — State Street Corp., Bank of New York Mellon Corp. and Northern Trust Corp. — have not commented on any plans to create such platforms.

"Traditional (institutional investors) are asking, 'How do I make sure the money isn't going to get lost?'" said Hu Liang, co-founder and CEO of San Francisco-based Omniex, an institutional cryptocurrency trading platform. "They're looking for a State Street, BONY (Bank of New York Mellon) to get into it."

Blake Estes, counsel, financial services, and co-leader of blockchain and distributed ledger technology at the law firm of Alston & Bird LLP, New York, said in an interview that institutional asset owners "will need to feel that any custodian of their crypto assets has its own reputation to uphold. In other words, institutional investors need to feel that the franchise upon which a custodian's business is built is at stake when it seeks to secure a client's assets. That is the case for the established custodians for non-crypto assets — State Street, Bank of New York Mellon and Northern Trust."

Those large custodians "face a lot of reputational risk backing assets without a regulatory infrastructure," added John Lore, managing partner at the Capital Fund Law Group LLP, New York, who advises on cryptocurrency funds. "If they were to act before regulatory concerns are addressed, that would surprise me. Once structures and regulations are set in place, that's when mainstream institutional investors will move in."

New entrants in crypto custody "are largely unknown to the institutional investing community," Mr. Estes said. "There is less trust that the stakes are as high for those new names as they are for the institutions entrusting them with their constituents' assets."

However, Mr. Estes said, Fidelity's entry into crypto custody "presents an opening for greater institutional investment. … Fidelity has such a strong brand that it represents a significant step forward in terms of reducing the perceived risk of investing in crypto assets. It's a name that institutional investors might feel they can trust."

Money managers with cryptocurrency investment strategies said the new custody platform is a game changer for institutional investment.

"For many institutional investors, a trusted custodian like Fidelity entering the space removes a huge obstacle to investing in crypto assets," said Hunter Horsley, CEO of Bitwise Asset Management Inc., San Francisco, whose Bitwise Hold 10 Private Index Fund tracks the 10 largest cryptocurrencies based on market capitalization and trade volumes. "I think we'll look back on 2018, and particularly this moment, as the time that crypto became cemented as a new asset class."

But Akbar Thobhani, CEO of San Francisco-based crypto prime broker-dealer SFOX Inc., said Fidelity's entry into the digital custody market is just the first step in institutional crypto investment. "Fidelity Digital Asset Services' focus on cryptocurrency custody and trading services for enterprise clients showcases the commitment and interest they're seeing from their clients," Mr. Thobani said, "but we'll really hit a turning point when Fidelity offers cryptocurrency to their retail and 401(k) customers."

Fidelity's Mr. Jessop said at the FIA conference that while the firm could reach out to those clients in the future, "we're comfortable with what the pipeline looks like right now," seeing business from high-net-worth and hedge fund investors as well as family offices.

Mr. Lore of Capital Fund Law Group agreed that institutional investor trust in crypto investing will have to be earned.

"What's key is that international standards and enforcement may well have to precede any substantial institutional investment in this space," Mr. Lore said. "Otherwise, instability will continue to plague the asset space. Regulatory enforcement is inevitable, but laws are being broken right now."

According to a University of Sydney (Australia) report issued Oct. 21, about 1 in 4 bitcoin users are involved in illegal activity and about $76 billion — or 46% of bitcoin transactions globally — are for illegal actions, "which is close to the scale of the U.S. and European markets for illegal drugs."

Mr. Lore said that while many people are saying that custody is holding up investment in cryptocurrencies, "in reality, the custody problem is the result of uncertain market infrastructure, regulatory uncertainty and cybersecurity concerns. I think that pension funds should be among the last adopters of cryptocurrency. They should rightly wait for naturally risk-averse parties to join in the market. It's not surprising that high-net-worth and hedge fund investors are the first to do this."

At the FIA conference, David Olsen, president and chief risk officer, Jump Trading LLC, Chicago, said along with the custody issue, the issue of who will manage cryptocurrency investments for institutional asset owners is an "inflection point. People are buying bitcoin, but none are investing through third-party bitcoin managers."

Mr. Estes of Alston & Bird agreed that "most pension funds will wait to do any type of direct investing in crypto assets until the names they know enter the custody space, which will likely happen in time. But I could see pension funds beginning to allocate to the larger, more institutional-focused crypto fund managers as a way of gaining some exposure to the asset class."

"As other institutional players, like some of the largest endowments in the world, start allocating to crypto funds," he said, "I think the draw for pension funds to also chase those returns will be too great to resist."