In 2023 the institutions that matter embrace Bitcoin
February 9, 2023
2023 will be the year that the institutions that matter embrace Bitcoin. We recently learnt a painful lesson in why professional institutions are required to build healthy crypto markets. If most market participants are ‘yolo long,’ volatility is extreme. If enough sophisticated actors pursue market neutral strategies, volatility will dampen. This year, traditional hedge funds and market makers will take over in crypto markets. Especially as global recession fears set the stage for market neutral strategies to shine. With this solid institutional basis in place, we’ll be in a good spot to be cautiously optimistic about 2024 and beyond.
We need smarter institutions to participate
Over the past year, we learnt a painful lesson in why professional institutions are required to build healthy crypto markets. As inflation started picking up in the US two years ago, analysts baptised Bitcoin as a new global reserve asset. Tesla and Square (now Block) bought a lot of BTC as reserve asset and times seemed good. However, the crypto markets weren’t mature enough for Bitcoin to serve as a true reserve asset. As interest rates rose, BTC fell and the largest crypto hedge fund (Three Arrows Capital) and the largest crypto market maker (Alameda) both came crashing down. The idea of a reserve asset is that it can be sold at any time with minimal impact on the price.
In sophisticated markets, a bit of selling won’t lead to a blowup of the largest hedge funds and market makers. If anything, those players should stand to gain from price movements as they pursue market neutral strategies and trade volatility. The problem that crypto markets faced in 2022 was that its hedge funds and market makers weren’t market neutral. They had started taking directional exposure blinded by the idea that we were in a ‘forever up only supercycle’.
2023 is the year for smart institutions
In 2023, traditional market makers and sophisticated hedge funds will silently move to the centre of crypto markets. As the economy slows down, market neutral strategies will begin to shine.
Not all traditional market makers and hedge funds will be deterred by the FTX blow-up. Just days after FTX filed for bankruptcy, we saw the largest traditional market makers take out loans to boost their market making efforts. Most of these TradFi market makers have already been actively participating in the crypto markets for a while. Yet it’s taken these firms a considerable amount of time to scale up their activity. Building robust trading systems from scratch for an entirely digitally native asset class takes time. The same goes for the entity structures that are required to operate in a space that lacks regulatory clarity. Now that most TradFi market makers have their act together, they are ready to take a leading role.
The same can be said for traditional hedge funds. Bitcoin and crypto are no longer markets with their own laws of gravity, but have become part of the broader macro picture. As a result, most traditional hedge funds will start trading crypto majors (like BTC and ETH) if they haven’t already. It also helps that many ex-CeFi employees seem to have moved to companies that help hedge funds access crypto markets.
If there’s one thing that could slow sophisticated institutional adoption, it would be lacking access to leverage. Both market makers and hedge funds need leverage to do their work well. Market makers borrow funds to ensure they move enough volume between trading pairs to ensure stable prices. Hedge funds borrow funds to take advantage of market inefficiencies at scale. In traditional finance, the prime brokerage divisions at big banks supply these players with access to leverage. However, big banks don’t lend out digital assets - and won’t for a while.
Over the past few years, CeFi lenders like BlockFi and Genesis fulfilled the role of lending digital assets to market makers and hedge funds. Yet, bad incentive structures led to undesirable risk management. Now that many of these CeFi lenders have gone bust, it’s up to builders to fill the gaps to allow the institutions to access leverage responsibly with appropriate risk management. This is why Zest Protocol exists.