Institutions want crypto clarity before diving in

While some institutional investors are interested in digital assets, the majority are still holding off due to a lack of regulatory clarity and ongoing turmoil in the space, industry experts said.

"Institutions need legal certainty; they need very clear and precise rules and an understanding of the law," said David Adams, Washington-based counsel at Goodwin Procter LLP. "And until they can get that in the United States, I think it's going to be very difficult for them to get comfortable with crypto."

In Washington, cryptocurrency has been a major focus for both Congress and federal agencies in recent weeks. On June 5-6, the SEC filed enforcement actions against major crypto exchanges Binance and Coinbase, feeding into what some Republican lawmakers and industry players have called a "regulation by enforcement" approach.

Just a few days prior, House Agriculture Committee Chairman Glenn "GT" Thompson, R-Pa., and House Financial Services Committee Chairman Patrick McHenry, R-N.C., released a 162-page discussion draft on digital asset regulation, which, along with a host of other provisions, gives more authority to the Commodity Futures Trading Commission to regulate the digital commodity market.

On June 6, CFTC Chairman Rostin Behnam told lawmakers the agency needs that authority to fill a gap in digital asset regulation, though it cannot do so without legislation and proper funding.

Historically, the SEC and the CFTC have disagreed on what constitutes a digital commodity vs. a digital security, which Mr. Behnam said is simply a difference of opinions that's "fine" and "healthy."

However, Mr. Adams said, "It's not great for institutional investors because they don't like this chaos that they're seeing in the current space."

In general, sources agreed that institutional investors are hesitant to enter the digital asset space because of the uncertainty that still plagues the industry.

"Institutional investors, obviously, cannot put money into an industry where there's no clarity as to whether an asset is a security vs. a commodity because there's a lot of consequences with respect to whether these assets can be traded in compliance with the law," said Dario de Martino, New York-based partner at Allen & Overy LLP and co-head of its blockchain and fintech practice.

"We have noticed quite a decline in client interest in cryptocurrencies over the past year or so," said Alison Adams, Portland, Ore.-based managing principal and research consultant at Meketa Investment Group, in an email.

In 2021 and early 2022, there was some client interest in the asset class, Ms. Adams said, though Meketa did not recommend investing in cryptocurrencies.

"In our cryptocurrency discussions with clients, we emphasized the evolving regulatory environment and potential risks to investors where regulatory oversight was unclear," Ms. Adams added in the email. "In retrospect, our caution on the possible risks associated with cryptocurrencies and regulatory change appears sound."

One of the issues the discussion draft in Congress seeks to address is clearly defining a digital commodity vs. a digital security, which could help solve jurisdictional issues between the SEC and CFTC, sources said. Specifically, the bill calls on the SEC and CFTC to create a joint rule-making on the issue, as well as separates the CFTC's authority over digital commodity markets from the SEC's authority over digital securities.

"I think that the legislation has a really artful way of kind of giving each agency their lane with respect to what constitutes a digital asset security and what constitutes a digital asset commodity, and how different digital assets can sort of evolve over their life cycle," said Brett Quick, Washington-based head of government affairs at the Crypto Council for Innovation.

Ms. Quick added that it's "really a positive sign" to see two committee leaders join forces in moving a piece of legislation through Congress. Ms. Quick, Mr. de Martino and Mr. Adams all said the bill is a step in the right direction.

However, when the House Financial Services Committee discussed the bill at a hearing on June 14, there were differing opinions, mostly along party lines. While Republicans were generally supportive of the bill, Democrats on the committee had concerns.

In her opening statement, ranking member Maxine Waters, D-Calif., said the bill "could reward bad actors (in the crypto industry) with a 'get out of jail free' card and allow them to continue harming consumers and investors."

Meanwhile, Aaron Kaplan, founder and co-CEO of Prometheum, who served as one of five witnesses at the hearing, told lawmakers, "New legislation is not in the best interest of the investing public or the blockchain industry."

The Financial Industry Regulatory Authority, a self-regulatory organization that operates under the SEC, recently gave a first-of-its-kind approval to Prometheum Ember Capital, a subsidiary of Prometheum, allowing the company to operate as a special purpose broker-dealer for digital asset securities. This means Prometheum Ember Capital can serve as a custodian for digital asset securities for both institutional and retail investors.

Mr. Kaplan said in an interview the process to gain approval as a special-purpose broker dealer "is complex and has a lot of requirements that must be met," but ultimately contended that "the bar is high" because approval comes with significant responsibility.

"The danger of new laws is the possibility they will reward the entities who have had previous violative conduct at the expense and to the victimization of the general public," Mr. Kaplan added.

During the hearing, Mr. McHenry emphasized the bill is just a draft, and while he is open to changes, he plans to hold a vote on the bill after the July Fourth recess.

"Any measure that really gets traction and moves forward is going to ultimately need to be bipartisan," Ms. Quick said, adding that she hopes Democrats will get on board with the bill.

Despite ongoing uncertainty, some institutions are still expressing interest in digital assets. On June 15, BlackRock, the world's largest money manager, filed with the SEC to offer a spot bitcoin ETF, which Ms. Quick called "a really important development and a strong signal."

Since BlackRock, several asset managers have renewed their filings for bitcoin ETFs, including Bitwise Asset Management, WisdomTree and Invesco. The SEC has denied every application for a bitcoin ETF thus far.

And bitcoin has surged on the news. It surpassed $31,000 on June 23 to reach the highest level in more than a year, up about 25% from a recent low on June 14.

Based on his own experience as a lawyer in the space, Allen & Overy's Mr. de Martino said blockchain and digital asset-focused funds are still being formed, and "people are still building infrastructure."

But sources were generally hesitant to say that institutional investors are ready to go all in with crypto.

"The reality is that, (in) the industry, there's very broad agreement that the digital asset space needs a comprehensive federal regulatory framework," Ms. Quick said. "And absent that, there's going to be some trepidation about being associated with the sector, and how deeply you're getting into it."

According to Mr. Kaplan, Prometheum's approval as a special-purpose broker-dealer shows a path toward compliance under federal securities laws, which could lead to "the next wave of institutional adoption."

However, Mr. Adams disagreed, adding, "There are still real inhibitors to, particularly, companies that are already in the market and trying to follow Prometheum's example and register under the special-purpose broker-dealer guides."

For the time being, Mr. de Martino said crypto's confusing regulatory landscape in the U.S. is accelerating movement offshore.

"What's going to happen in the short term, and what I already see happening in my practice, is that a lot of capital that was being deployed in the U.S. is now being deployed outside of the U.S.," and companies that were operating in America are now relocating outside of the country, he said.

Mr. Adams agreed, stating that countries that are already moving toward cryptocurrency regulation, like the U.K., are attracting "financial institutions that may want to facilitate trading in these products" as well as investors that are worried about the future of crypto trading in the U.S.

The movement outside the country is "a temporary move," according to Mr. de Martino, "because there's no other market (that) will ever replace the United States."

Domestically, Ms. Quick said that comprehensive regulation could kick-start institutional interest.

"When (institutional investors) see that there is sort of a regulatory structure, I think that the interest will peak back up," Ms. Quick said. "I don't think it's waned completely, but I think that there's anticipation of seeing something happen to really put some guardrails around the way that these companies operate."