Can institutions save crypto before retail vanishes?
Samenvatting: From a near-perfect environment for speculative assets before 2022 to the opposite, crypto faces fundamental challenges.
The genesis of crypto: a post-GFC liquidity bonanza
On December 16, 2008, the United States Federal Reserve (Fed) slashed with a stroke of the pen the interest rate to near zero amid the Great Recession. This was the first time in history that the Fed imposed an interest rate below one. To get the economy back on its feet, the Fed followed up with hefty quantitative easing in March 2009 to flood the economy with fresh money and liquidity. Throughout the 2010s, the Fed retained a low interest rate, aside from a few minor interest rate hikes and cuts, while other central banks even enforced a negative rate. To put it frankly, this formed a near-perfect environment for speculative assets to thrive for years to come.
As a peculiar circumstance, hardly two weeks after the Fed slashed interest rates to zero for the first time, the most speculative asset of this epoch – namely Bitcoin – emerged, following its genesis block on January 3, 2009. It was largely a coincidence that Bitcoin mined its first block that close to the Fed imposing zero rates and quantitative easing. However, this environment has been of great significance to make Bitcoin and later crypto as a whole the darling of retail investors it slowly but surely became.
Retail supremacy
In its first decade, crypto derived little if any recognition from the lion’s share of institutional investors and financial intermediaries, other than a few strong advocates. Although the financial establishment would simply not touch crypto with a bargepole, retail participation grew exponentially, making crypto a key playing field for retail investors along with meme stocks and other r/wallstreetbets favourites. The near zero or even negative interest rates in some countries have drawn in retail investors to investable assets, including greatly speculative markets such as crypto to perchance achieve some return on their capital, during times at which interest rates have not given any yield.
The absence of institutions and frequent fear-of-missing-out retail investors have fuelled excessive volatility and various bubbles such as in 2017 and 2021, causing countless cryptocurrencies to unsustainably pump to sky-high prices before dropping like a stone. This volatility has arguably reinforced the desire of institutions to stay away from crypto.
A great business to serve retail
Serving the trading needs of retail in crypto has been an extremely lucrative business for the exchanges that were early movers in the space. In fact, the majority of Coinbase’s revenue is a product of retail trading, although the company has various other revenue streams such as staking, interest rate earnings, commerce gateway, developer tools, and institutional trading and custody. Retail trading of crypto may not pay as many bills at zero-commission broker Robinhood relative to Coinbase, yet, it is still a sizeable part of the firm’s revenue, particularly considering that it offers trading in other assets such as equities and options. This stresses that retail rather than institutions keeps crypto-trading enablers afloat.
Will retail stick around just as interest rates rise and liquidity dries up?
In what felt like a flash in 2022, the macro environment transformed from a near-perfect environment for speculative assets on pandemic-induced liquidity to an ugly reversal. To tame soaring inflation, the Fed raised interest rates from near zero to above 4 percent in the span of less than a year, causing other central banks around the world to follow suit. To make matters worse, the Fed initiated quantitative tightening to decrease the liquidity in markets by shrinking its balance sheet.
The rate hikes in 2022 reduced liquidity and further deflated the frothiest speculative markets of 2021. In hindsight, in early 2021, retail hands had started running dry of fresh ‘free’ pandemic stimulus money to plough into crypto. Note, for example, the first huge peak in Bitcoin and other crypto assets was within several weeks of the last and largest US stimulus check, after which the subsequent volatility saw many crypto traders burning out.
From this point forward, if retail continues to withdraw capital from brokers, the crypto market is likely to be hit the hardest, as crypto has never existed in such a macro environment and because of weak participation from professional and institutional investors. In our view, retail will not likely pull out of the market immediately, as the almost 15-year perception that money is cheap must be erased from the dominant, younger generation of retail crypto traders. If liquidity stays tight as central banks fight inflation, the model of retail supremacy to not only keep the crypto market afloat but also the model of crypto brokers selling shovels in a gold rush will break down.
From retail to institutions
In the past few years, crypto market advocates have touted the impending arrival of serious institutional participation. Relative to the ‘don’t-touch’ attitude that institutions largely held towards crypto until 2020, some respected institutions have dipped their toes into the space, trading the market themselves, offering it to clients, and in some cases executing various transactions directly on-chain. While this is a step in the right direction, the institutional interest in crypto has been relatively modest, as it is still dominated by relatively few institutions. As a consequence, institutions are not likely set to arrive in sufficient force in the near-term to offset retail’s crypto exit, particularly for the smaller and less liquid cryptocurrencies.
Nonetheless, less retail activity may lead the market to a less speculative but more robust and sustainable model long-term, although most cryptocurrencies may not survive the wash-out of speculative activity. To bring about a sustainable model for the market to thrive in the future, crypto must return to its roots by offering unique decentralised use cases and mature into more economically sustainable assets. On the latter, last year was encouraging in demonstrating that cryptocurrencies can be economically sustainable assets by generating dividend-like returns, following Ethereum’s transition from proof-of-work to proof-of-stake last year. During the transition, Ethereum drastically decreased its issuance of new Ether, so it nowadays offers holders a reward of up to 7 percent yearly by verifying transactions but without increasing its supply, as the reward is fundamentally funded by transaction fees. Hopefully, other cryptocurrencies and tokens follow in Ethereum’s footsteps in turning into more economically sustainable assets, altogether leading the space to become less speculative.