Investors inching closer to joining the fray

If digital assets were a dance floor, institutional investors have been mainly sipping punch on the gym bleachers for the last decade.

But now, more institutional investors are putting on their dancing shoes and getting off the bleachers, or at least thinking about tying their laces, sources said.

"We continue to see more demand, we continue to see diversification of demand across institutional client segments, which is also a healthy indicator of where the industry is going," said Tom Jessop, New York-based president of Fidelity Digital Assets, which was launched in late 2018 by Fidelity Investments as the first major firm in institutional asset servicing to offer cryptocurrency custody and trade execution operations.

Mr. Jessop said his company noticed an uptick in interest around the start of the COVID-19 lockdowns in March 2020. The previous fall, Fidelity Digital Assets was granted a charter from the New York State Department of Financial Services to operate as a limited liability trust company.

A spokeswoman declined to provide Fidelity's assets under custody but said its client base quadrupled to more than 100 in December 2020 from the year prior. Fidelity's institutional clients include hedge funds, family offices, registered investment advisers, pension funds, endowments, foundations and corporate treasury departments, the spokeswoman added.

"It went from something that people may have tiptoed (around) or been fearful of, to something that people felt that there was no more career risk associated with being involved in digital assets," said Michael Sonnenshein, New York-based CEO at Grayscale Investments LLC, which touts itself as the world's largest digital asset manager with $50.6 billion in assets under management as of April 14 and 14 cryptocurrency investment products for institutional and accredited investors, six of which trade publicly and are available to all investors.

In 2020, Grayscale brought in more than four times the assets it had cumulatively raised in the prior six years, according to Mr. Sonnenshein. The additional inflows and huge price gains in bitcoin have led to a surge in Grayscale's AUM. In February 2020, Grayscale had $2.6 billion in AUM.

Interest from institutional investors, paced still by hedge funds and family offices, is on the rise among all institutional segments, Mr. Sonnenshein added.

Historically, institutions have kept their distance from digital assets for a variety of reasons, including a lack of custody capabilities, and liquidity and volatility concerns.

"Institutional investors have an understanding that this is a more speculative investment," said Christopher Levell, partner at consultant NEPC LLC in Boston. "It's relatively easy to make the case that bitcoin could be $1 million or it could be zero. It's got a ton of convexity."

TOBAM, a Paris-based asset manager with $10.2 billion in AUM, launched a bitcoin fund in 2017. Yves Choueifaty, TOBAM's president and chief investment officer, said bitcoin, the biggest digital currency, can be a precarious investment on its own, but the risk of an asset should determine the size of the investment, not the investment case itself. He compared bitcoin to chlorine: As a "combat gas, it's very dangerous, but if you put a drop of chlorine in water, it's drinkable." If an investor puts 1% of bitcoin in a 60%/40% portfolio, its volatility won't be felt, he said.

Akbar Thobhani, CEO and co-founder of San Francisco-based cryptocurrency prime broker-dealer SFOX Inc., which offers clients cryptocurrency trading and custody options, said the learning curve for institutional investors has been steep. "When you're investing in the traditional markets, the infrastructure is there, the rules and regulations are in place, and when you come to crypto, it's like a whole new world," he said.

Whereas in years past institutions were merely asking questions trying to figure out what digital assets were, more are now interested in learning the best ways to incorporate these assets in their portfolios, sources said. "If you're a fiduciary, you cannot ignore the reality that the highest-performing asset of the last decade has been bitcoin," said Matthew Le Merle, San Francisco-based managing partner of Blockchain Coinvestors, a blockchain fund of funds. "You could argue that it's not sustainable or intrinsically not appropriate, but at the end of the day your goal is to try and in a disciplined way both protect and manage the assets you have under management and make them grow."

As the digital-asset market continues to mature, the hurdles preventing institutions from getting involved have dissipated, Mr. Jessop said, including prior liquidity concerns. "I think it's a self-fulfilling prophecy, more investors coming into the space attracts more liquidity, which increases the size of the liquidity pool, which attracts more traditional investors, and that's all been very healthy," he said.

Earlier this month, the cryptocurrency market capitalization topped $2 trillion for the first time, according to market tracker CoinGecko.

The perception of digital assets improved in 2020, with 58% of U.S. investors expressing a neutral or positive perception, up from 43% in 2019, according to a Fidelity Digital Assets survey released in June.

And sources expect that perception to continue to warm after recent developments in the space.

The price of bitcoin has surged over $63,000, up from about $8,000 last April, and digital currency exchange Coinbase Global Inc. had a successful initial public offering on April 14, with a market valuation of $86 billion. Also, Tesla Inc. announced in a February Securities and Exchange Commission filing that it had bought $1.5 billion worth of bitcoin.

Also in February, Bank of New York Mellon Corp. announced the formation of a digital assets unit and is developing a multiasset digital custody and administration platform for traditional and digital assets.

And Goldman Sachs Group Inc. is relaunching its cryptocurrency trading desk, Matthew McDermott, global head of digital assets for Goldman Sachs' global markets division, said on a company podcast in March.

"There's a virtuous cycle here where these problems are solving themselves because of the market demand," Mr. Jessop said.

Gary Gensler, whom the Senate confirmed in a 53-45 vote on April 14, is the first SEC chairman with an extensive knowledge of digital assets. The former chairman of the Commodity Futures Trading Commission, and more recently a professor at the MIT Sloan School of Management, has taught classes and testified before Congress on digital currencies and blockchain technology.

Cryptocurrency stakeholders say Mr. Gensler's background is a positive for the industry.

"For someone to do a good job in this space they have to understand the past, and they have to understand the future and they have to be able to move regulation in the right direction, and Gensler is clearly very qualified on both of those dimensions," said Blockchain Coinvestors' Mr. Le Merle.

SEC Commissioner Hester M. Peirce, during a January webinar hosted by the U.S. Chamber of Commerce, said she is optimistic the agency will provide clarity for stakeholders interested in cryptocurrency assets with Mr. Gensler at the helm.

There are currently questions about how digital assets should be stored and whether a given cryptocurrency should be treated as a security. The SEC does not consider the two biggest cryptocurrencies — bitcoin and ethereum — to be securities, but there is less certainty regarding smaller cryptocurrencies.

In a February 2020 speech, Ms. Peirce, who is often called "Crypto Mom" for her longtime advocacy of these assets, outlined a proposal to establish a three-year safe harbor for cryptocurrency firms interested in offering tokens so they "could facilitate participation in and the development of a functional or decentralized network, exempted from the registration provisions of the federal securities laws," as long as certain conditions were met.

On April 13, Ms. Peirce unveiled an updated version of her proposal that would require semiannual updates and an exit report requirement at the end of the three-year grace period. The exit report would include either an analysis by outside counsel explaining why the network is decentralized or functional, or an announcement that the tokens will be registered under the Securities Exchange Act of 1934.

"Now, as a new chairman is coming into the SEC with a new agenda, is the perfect time for the commission to consider afresh how our rules can be modified to accommodate this new technology in a responsible manner," Ms. Peirce said in a statement posted on the SEC's website.

More recently, Ms. Peirce said the SEC has moved too slowly in approving investment products that incorporate bitcoin. To date, the SEC has not approved a bitcoin exchange-traded fund, though several applications for approval of such funds are currently pending.

"Although well-intentioned, our wariness with regard to crypto deprives investors of access to products and services that they want," Ms. Peirce said during a speech at a British Blockchain Association conference in March, according to a transcript posted on the SEC's website. "Moreover, caution-motivated delay makes it more difficult for us to change course should we decide to do that. If we have said no to one product sponsor, how can we say yes to another seeking to offer a similar product? Meanwhile, the market engineers around our denials by creating substitutes that do not require SEC approval."

Firms like VanEck Associates Corp., New York Digital Investment Group LLC, Valkyrie Digital Assets and WisdomTree Investments Inc. have bitcoin ETF proposals before the SEC.

Both VanEck and WisdomTree intend to list shares of their ETFs on the Cboe's BZX Exchange. Cboe made filings to the SEC in support of both proposals.

"We believe (ETFs are) a better wrapper than other options where investors are obtaining exposure to bitcoin," said Laura Morrison, New York-based senior vice president, global head of listings at Cboe. "The ETF in general is typically less expensive, the management fees are typically lower than say what you might be willing to spend on other options that are available in the U.S. today, such as trading in your Coinbase account or an OTC product, (where) they charge a hefty management fee."

The underlying liquidity of bitcoin has grown in recent years, which makes a bitcoin ETF more workable, Ms. Morrison said. "There are a number of data points that we plan to present to the SEC in conjunction with our issuer to reinforce why this asset class is mature enough and is best offered within a regulated, on-exchange listing," she added.

FD Funds Management, a subsidiary of Fidelity, made an initial filing at the SEC for a bitcoin ETF last month. Though separate from Fidelity Digital Assets, Mr. Jessop said a bitcoin ETF, "Given that it's an investment vehicle that's widely understood, it's an investment vehicle that investors of all types are comfortable with, it can only be positive for the industry."

Canadian regulators earlier this year approved the first bitcoin ETF in North America, the Purpose Bitcoin ETF, which had C$1.2 billion ($950 million) AUM as of April 7. Grayscale in an April 5 blog post said it is committed to converting its Grayscale Bitcoin Trust into an ETF. "Converting Grayscale Bitcoin Trust to an ETF would enable a much larger pool of investors to access the benefits of bitcoin exposure in the form of a familiar and regulated security," Grayscale's Mr. Sonnenshein said. Grayscale Bitcoin Trust, a publicly traded bitcoin fund with $37.2 billion in AUM as of April 7, became the first digital currency investment vehicle to attain the status of an SEC-reporting company in January 2020.

Mr. Sonnenshein said it's not a matter of whether a bitcoin ETF gets approved in the U.S., but when. "While we believe the market has and continues to mature, it may be too early to know whether all of the dynamics in the market that our regulators would like to see mature have got to a place where they're ready to make that kind of approval," he said of the current proposals before the SEC. "Over time we certainly believe that will be the case."

On the whole, regulators should commit to providing regulatory clarity so that traditional financial market participants can engage with cryptocurrency assets with confidence that they are complying with their regulatory obligations, Ms. Peirce said in her March speech.

"Legacy financial institutions and traditional investors that have sat on the sidelines until now are likely to push us to allow them to play a more active role," she said. "Meanwhile, some crypto-native firms are now large companies that are woven into the fabric of the broader economy and so also will command more regulatory attention. A final regulatory lesson then is that the regulatory work is only just beginning."