Investments for Financial Institutions: Digital Asset Infrastructure
Recently, I’ve spoken to legacy financial institutions (FIs), startup operators, and investors to understand the pain points that FIs experience and where the opportunity is to leverage technology for innovation.
One problem that repeatedly came up was core business inefficiencies like reporting, trade settlement and reconsolidation, and auditing. These are basic core business tasks.
For perspective, this is like if you’re an ice cream shop but doing the basic tasks of scooping ice cream, handing it to your customers, and charging them is time intensive and costs you a ton of money.
These core business inefficiencies of FIs create massive middle and back-office expenses.
The solutions in place are band aids to cover the hemorrhaging of expense, latency, and inefficiency that FIs experience. Oddly these fixes have created the larger issue of increased technical debt where, really, enterprise and financial services infrastructure are needed to tackle the inefficiencies of core business functions.
It reminds me of an old Mexican dicho or saying “el burro trabaja doble” translated to “the donkey or the lazy one works two times as hard”.
But don’t worry, this is a problem that has garnered the attention of many investors and although it will take time for innovation, adoption, and implementation, we are on the way to making critical investments in enterprise and financial services infrastructure to address the problem.
However, in the midst of my conversations discussing riveting middle and backend expenses, I did validate an important thesis:
FIs need institutional grade digital asset infrastructure to make the jump into the space.
According to FIs starting in 2020–2021, retail and institutional clients started requesting Bitcoin and digital assets.
If basic core efficiencies of a business are not addressed, it would be challenging to imagine a world where investing in the next wave of emerging technologies is possible.
But, what happens when high net worth individuals like Elon Musk or key institutional investors like the Texas Teacher Retirement Pension Fund request exposure to digital assets and you’re not able to meet the client’s needs? You answer or risk losing their business.
Investing in cryptocurrencies is no longer for only prepubescent young people in basements buying Dogecoin for fun. Exposure to cryptocurrencies in institutional portfolios has demonstrated a significant positive impact on returns according to the Cryptoassets: The Guide to Bitcoin, Blockchain, and Cryptocurrency for Investment Professionals.
In 2022, the CFA Institute conducted a survey that confirmed 94% of state and government pension funds are investing in cryptocurrencies and more than two thirds of institutional investors are investing in digital assets.
The demand from investors to access will continue to climb. This is a missed business opportunity in an ever-commoditizing world to differentiate and serve customers. Additionally, outside of retail and institutional investors requesting digital assets, there are a slew of use cases for FIs to use blockchain — faster transaction times, immutable ledger, encryption, digital identity (one of my personal favorites), and much more.
From my conversations with legacy players, there are three things that stand in the way:
1) Key missing digital asset infrastructure
2) Regulatory and compliance uncertainty
3) Reward > Risk
Key Missing Digital Asset Infrastructure
The first wave of investment in digital asset infrastructure came from a consortium of banks and was centered around private and enterprise blockchains. The drivers of this investment were to keep their MOATs in place and protect their business models from emerging players to eat a share of the market. This is similar to the recent news of US banks building a digital wallet to compete with Apple Pay and PayPal (however, this might be 10 years too late but I’ll be on the edge of my seat watching this play out).
Players like R3 (raised $112M) and Provenance Blockchain (raised $40M) were part of this wave of investment. FIs like JPMorgan with Onyx and Fidelity Digital Asset also became pioneers in the digital assets space allocating resources to this emerging asset.
The second wave of investments in digital asset infrastructure will be centered around having the foundational infrastructure to manage risk for FIs to support customers demanding exposure to the asset class.
The opportunity is vast, and the landscape is new. Critical to the strategy will be to map out infrastructure in the traditional FI market and chart out what is new to crypto. Instead of sharing my market map for FI digital asset infrastructure, I offer you my framework of how I’m thinking about investing in digital asset infrastructure for FIs.
My approach to investing in digital asset infrastructure for FIs is through a systems design point of view and going back to first principals:
What does the world want?
What does the world have today?
What can blockchain / crypto do?
Then build and invest.
Regulatory and Compliance Uncertainty
FIs are highly regulated identities by numerous agencies including the Federal Reserve Board (FRB), the Federal Deposit Insurance Corp. (FDIC), and the Securities and Exchange Commission (SEC). FIs have entire teams dedicated to adhering to the rule of the law. Regulation acts as a guide and provides clarity on what you can and can’t do. Without regulation it’s hard to know what you prioritize.
Understanding the power and importance of regulation for FIs and then adding the recent demise of FTX, Celsius, and Three Arrows as a backdrop, it is no wonder we enter the era of skepticism by FIs around digital assets.
Speaking with digital asset infrastructure startups, they have experienced decreased enthusiasm from FIs and those who continue down the vendor diligence process must have all the FI licenses and compliance in place. This has given rise to startups adhering to the highest licensing and compliance standards as a way of self-regulating without the direction of the law.
It leads to the third obstacle: Is the pain worth the gain?
Reward > Risk
Innovation Departments within financial institutions are tasked with the firmwide strategy of adopting emerging technologies. These are teams that pilot and pitch innovative technology to integrate within the banks business. Innovation Departments report to top FI executives who run the company. The profile of these top FI executives are typically traditional bankers and finance professionals, think of a hybrid of Wolf of Wall Street and Excel zealots. Yikes!
Their framework is: Is the reward > the risk?
The most recent crypto bull market created enthusiasm from FIs to start making real investments in digital asset infrastructure, but in light of the demise of crypto darlings, regulatory uncertainty, and a recessionary environment, there has been a shift in attitude.
FIs see too many risk and compliance challenges.
The businesses that win in this environment will have a very specific use case and crystal-clear benefit. They will provide a balanced elegant solution.
Better, faster, cheaper, easier and no attention from the SEC, OCC, FDIC, or Federal Reserve.
Blockchain technologies and cryptocurrencies will revolutionize financial institutions.
FIs skepticism due to regulatory uncertainty and high risk in a recessionary environment after a brutal beatdown of the crypto market is real and will take time to sort itself out.
However, all FIs that I have spoken to have shared that they see a future in the next 5–10 years when digital asset infrastructure is a key part of their strategy.
As an early-stage investor that timeline aligns beautifully with expected exits of startups in the space. It is yet another indicator that now is the time to build and invest in the future of financial institutions.
If you’re building a digital asset infrastructure company, I’d love to speak!