Regulation will be catalyst to entice big institutional fish into crypto pond

15 May, 2024

By Kok Kee Chong, CEO, AsiaNext (This opinion-editorial was originally published on Reuters)

The crypto sector is approaching a critical juncture in terms of institutional adoption. Just days ahead of the next bitcoin halving, Sam Bankman-Fried, the co-founder of FTX, was sentenced to 25 years in prison, once again highlighting the vital importance of risk management, experience and knowledge.

Bankman-Fried's imprisonment underscores the vulnerabilities associated with digital assets and their supporting infrastructure, particularly the lack of financial risk-minded expertise in this sector. To foster a safer and more resilient ecosystem, this gap must be addressed without delay.

As markets gear up for the bitcoin halving later this month, exposure to bitcoin can no longer mean exposure to the likes of Bankman-Fried if crypto's true potential is to be realised. There is no better time than the present to enact change.

Halving to drive adoption across financial instruments

Historically, the past three bitcoin halving events have seen bull runs drive its value to historic heights. The imminent fourth halving is more than a simple numerical adjustment with price impacts; it is a pivotal moment in mainstream crypto adoption. While market activity has largely revolved around the trading of the U.S. Spot Bitcoin ETF over the past few months, the halving event could inject an additional dose of volatility into crypto derivatives trading.

Despite the recent plummet, professional traders will likely speculate on potential price increases, and derivatives contracts will be instrumental in doing so. These financial instruments are used mostly by institutions for price discovery and hedging.

With regards to crypto, distinguishing market-driven volumes from self-driven ones can be problematic, to put it diplomatically. Price discovery plays an important role, as it will reflect the collective sentiment of market participants, providing insights into their expectations, confidence and willingness to buy or sell.

Options can also be used to manage the cost of entering the asset class, and given crypto options are a relatively small market, this could be the space to watch as institutional adoption grows. Indeed, in January, the total derivatives trading volume by institutions on CME rose 35.2% to $94.9 billion, while BTC futures volumes on the exchange rose by 42.4% to $74 billion.

Beyond feeling equipped to successfully navigate market-moving events such as the halving, institutional investors will demand a regulated and compliant marketplace. The provision of institutional-grade market infrastructure is essential to achieving this, and there is certainly no shortage of appetite to offer it. More exchanges built for institutions are entering the fray, creating market depth and growth.

Clear regulation will be essential

While this suggests a significant shift toward institutional adoption, two important pieces of the puzzle remain missing: the implementation of an effective global regulatory framework to help govern the rise of digital currencies and an influx of financial risk veterans to the sector.

In terms of regulation, the digital asset sector is crying out for a framework akin to the EU Markets in Financial Instruments Directive II (MiFID II), which sought to increase transparency within European equity markets, ultimately enabling fairer price discovery.

It is hoped the EU Markets in Crypto-Assets Regulation (MiCA) could be the answer, for Europe at least. Expected to be fully implemented by December 2024, the landmark regulation aims to set licensing requirements for cryptoasset service providers and issuers while also promoting consumer protection through transparency and risk disclosures.

Its success will ultimately depend on how well it is adhered to, and this will be determined by the proficiency of those tasked with ensuring alignment with the framework's requirements. Ideally, these will be financial market veterans with extensive risk management and control knowledge and a granular understanding of risk and governance protocols, from value-at-risk (VaR) calculations to stress testing and enterprise risk management. A workforce comprised almost entirely of technology enthusiasts with CVs similar to Bankman-Fried's can no longer fit the bill.

In Singapore, meanwhile, the expanded scope of the Payment Services Act, introduced by the Monetary Authority of Singapore, will help with the industry's progress. Clear regulations safeguard investor assets held by custodians.

Market participants will be closely monitoring bitcoin's price movements before and after the halving. While this event has likely been priced in and may not significantly impact bitcoin's price, the greater institutional investor confidence in the long-term viability of bitcoin seems set to attract an influx of capital and enhanced liquidity.

Crypto derivatives market infrastructure entities, not least those tasked with regulating digital assets, must be poised for this heightened adoption, particularly if large institutions will be confident enough to enter the crypto market in the post-FTX era.