Financial institutions are warming up to the idea of using cryptocurrencies as an investment asset. They are motivated by the increasing demand from their clients and by their desire to use it as a hedge against inflation.
Ten years ago, when bitcoin started to garner some interest from its early adopters, no one could have predicted that its market valuation would reach $1tn by 2021. The cryptocurrency sector, which was initially overlooked by banks, has become too big to be ignored, and many are now looking for an opportunity to enter the sector.
In recent years, there has been a growing interest from financial institutions in the cryptocurrency sector. In 2021, firms such as BlackRock and Morgan Stanley announced that they will introduce cryptocurrency funds for their customers.
Morgan Stanley will offer three bitcoin investment funds that will only be available to wealthy customers with a high risk appetite, due to bitcoin’s volatility. These asset managers decided to get involved with bitcoin because of the increasing demand from their customers who want to participate in the market, especially since the pandemic.
Bitcoin increased by more than 400% between March and December 2020, the most significant increase since its inception. This could be an ideal investment for investors who are looking for exposure to crypto assets but don’t want to go through a crypto exchange such as Coinbase or are not interested in directly holding the cryptocurrency itself.
A Fidelity survey revealed that 36% of financial institutions had some exposure to cryptocurrency and are planning to increase their investment, with growth projected for the market for at least the next five years. These institutions are investing in bitcoin to use it as a hedge against inflation, believing that bitcoin can be a better treasury reserve than fiat currencies.
The market adoption of cryptocurrencies as a means of payments has so far proven to be a failure. Banks and other investors see more value in using them as trading assets and are trying to capitalise on the volatility of the sector before the potential burst of the crypto bubble.
The main reasons preventing financial institutions from fully participating in cryptocurrency are the high volatility of the sector and the lack of regulations.
The high volatility of crypto such as bitcoin can represent a risk exposure for banks or the customer’s portfolio. Banks would therefore need to increase their capital requirements to cover any provisional losses.
It is also difficult to predict in which direction the future value of bitcoin will go. Some bitcoin investors believe that it can be used as a hedge against inflation, but there is no conclusive evidence that it rises when the inflation rate increases.
An international regulatory framework would need to be implemented in order to standardise crypto assets, which should give banks clear guidelines on how to operate with them.
There is concern that implementing regulations will affect the valuation of the cryptocurrencies and bring their value down or make it difficult to trade. According to Reuters, India will propose a bill to ban cryptocurrencies.
If implemented, this law can have a negative impact on the cryptocurrency market, and if other countries follow suit, it would make the ownership of cryptocurrencies illegal.
The interest in the cryptocurrency sector by financial institutions is mainly driven by banks who want to use bitcoin as a hedge against inflation and provide to their clients some exposure to crypto assets.
Cryptocurrencies failed to fulfil their goal of being used as an alternative means of payments competing with fiat currencies. Before we see an adoption through the all banking sector, regulations on the industry will need to be implemented.