How Bitcoin ETFs Are Changing the Risk-Reward Ratio for Institutional Investors

Significantly, gaining SEC approval for a bitcoin product has shifted the risk-reward balance, making crypto an attractive investment option for institutions once again. This renewed interest is leading some firms to resume paused projects and enticing new ones to join the conversation. Essentially, the pathway into mainstream finance has been restored.

Note: The views expressed in this column are those of the author and do not necessarily reflect those of CoinDesk, Inc. or its owners and affiliates.

3 dimensions of risk

As a financial analyst, I can tell you that when it comes to managing risk for institutional investments, we consider various aspects. Among these dimensions are the risks associated with the specific investment products, the counterparties involved, and the inherent risks of the underlying assets. In traditional finance, we have a solid grasp on all these risk factors.

As an analyst, I’ve observed that the market has reached a point where products have lost their unique selling points and have become interchangeable among various firms. This commoditization is due to the widespread availability of similar offerings. The counterparties, which include market makers, custodians, clearinghouses, and other essential players in the trading ecosystem, are well-established entities. Their roles in managing risk have been clearly defined over time. Furthermore, the various asset classes we deal with are not new to us. We’ve developed proven methods for assessing the risks associated with each class based on historical data and market trends.

For several decades, the risks and market fluctuations have been significantly reduced in the system. However, it’s unforeseen, rare events – or “black swans” – that can cause issues. The risk level is minimal, but so are the potential gains. It becomes challenging to identify opportunities to outperform the market.

In the cryptocurrency sector, a string of unfavorable occurrences has emerged, which, albeit predictable due to the industry’s regulatory void, have presented an unacceptably high level of risk for institutions pursuing substantial returns.

Reducing the risks

The bitcoin ETFs reduce risk across all three dimensions.

ETFs (Exchange-Traded Funds) have been a part of the U.S. investment scene for over three decades. The concept is well-known and straightforward to most investors. Instead of purchasing bitcoin in its raw form, ETFs provide a more streamlined approach. By investing in an ETF that tracks the price of bitcoin, investors can avoid the complexities of directly handling custody, settlement risk, and other operational aspects associated with buying and owning bitcoin outright. In exchange for a management fee, they entrust these responsibilities to professionals, thereby reducing their personal risk involvement.

Having well-known traditional finance institutions such as BlackRock and Fidelity on board in the crypto space decreases the risk of dealing with unfamiliar counterparties. While there is an abundance of crypto custodians, liquidity providers, and market makers, their recognition within the TradFi realm is limited.

See also: Bitcoin ETFs Also Owned by Steven Cohen’s Point72

ETFs bring trusted intermediaries from the crypto sphere to the attention of mainstream investors. The fact that these entities have undergone rigorous scrutiny by Traditional Finance institutions lessens investor apprehensions. Additionally, such partnerships offer a potential avenue for investors to engage in holding and trading digital assets directly.

The SEC’s decision to allow Bitcoin as an underlying product for ETFs lessens the fundamental risk related to the asset class, alleviating concerns about a potential ban in the US. While increased regulatory clarity could further mitigate risks, market demand has compelled the SEC to address significant questions and encouraged ETF issuers to incorporate standard features that institutional investors look for, thus reducing overall risks associated with these investment vehicles.

As a researcher exploring the world of digital assets, I can’t stress enough the importance of establishing trust in this market. Trust is the foundation for bringing crypto into the mainstream. While there may be an abundance of ideology, jargon, and technical terms surrounding cryptocurrencies, at its core, it’s simply another asset class that employs innovative technology.

Before FTX, many individuals neglected potential risks and focused primarily on price growth and entering the market. Following FTX, however, there’s a new trend: people want to participate but require a basic level of protection. ETFs can provide this security while exposing institutional investors to crypto’s dependent counterparties. In essence, they’re helping steer the industry back towards a positive trajectory.

See also: Bitcoin ETF Holdings Disclosed by Morgan Stanley

Institutions face two primary reasons for their reluctance towards digital assets at present. The first reason is philosophical in nature; some institutions hold skepticism or disbelief towards cryptocurrencies like Bitcoin. A second group of institutions finds the risk-reward ratio unsatisfactory, making it challenging to stay away from the market. However, as ETFs gain traction and more clients express interest in crypto products, the pressure on these institutions to join the digital asset bandwagon increases.

In due time, the primary concern regarding Bitcoin and other digital assets will shift to their fundamental performance at the core level, mirroring the risk dynamics in Traditional Finance (TradFi). It won’t be a single regulation or innovation that brings about this change. Instead, it’s going to be an extended journey, after which concerns over products, counterparties, and regulatory frameworks will gradually diminish.

The only question will be, do you want to invest in digital assets, or not?