This article relates to Shearman & Sterling's upcoming inaugural Digital Finance Summit on November 15-16. Learn more about the Summit.

In September, the much anticipated ‘Ethereum Merge’ led to speculation that the development would be an inflection point for traditional institutional investors’ appetite for the historically volatile crypto sector. The recent launch of BNY’s specialized custodial service offerings for digital assets, a move intended to allow BNY customers to custody and transact with their traditional financial assets and crypto holdings on the same platform, points toward institutional adoption. If, in the weeks and months ahead the shift to the less energy intensive proof-of-stake system proves durable, investors will be able to earn yield from staking Ether that may serve as an attractive investment alternative to conventional financial instruments such as bonds. In fact, the Institutional Investor Digital Assets Study recently published by Fidelity Digital Assets shows that despite market headwinds commonly referred to as a “crypto winter”, institutional investors surveyed in the U.S. and Europe reported increased familiarity, improved perception and more digital assets investments.

However, any significant surge in institutional investment is hampered by regulatory uncertainty. Regulators continue to grapple with the combined risks of fraud, market manipulation, security and systemic disruption that the growing use of digital assets might have on digital markets as well as traditional financial markets. There is also the challenge of crypto’s ethos of decentralization – native crypto market participants' disdain for central control and adoption of self-executing “smart” contracts are a challenge for institutions subject to prudential regulation and for investors accustomed to dealing with regulated institutions. 

According to the White House, around 16% of adult Americans have purchased digital assets, a market it says reached a market capitalization of $3 trillion late last year. However, a significant part of activity in crypto markets arguably remains non-compliant with existing regulations and outside existing supervisory frameworks. Yet crypto and emerging DeFi platforms continue to challenge financial orthodoxy. Innovations such as speed, lower transaction and capex costs, and disintermediation has meant that traditional financial institutions are carefully considering their strategy in crypto markets. And with Ethereum’s energy consumption expected to fall by up to 99.5%, according to The Ethereum Foundation, the ESG constraints that have deterred long term institutional investors such as pension funds and insurance companies are no longer a barrier.

Institutional investors with a greater tolerance for risk including hedge funds and venture capital firms are likely to broaden investment across the sector in the pursuit of yield and diversification. The intrinsic value of this yield will be further bolstered by the deflationary nature of Ethereum’s proof-of-stake network upgrade, as the issuance of Ether [ETH] will be reduced 90% from 13,000 ETH/day to 1,600 ETH/day. A recent report, by management consultants PwC, estimates that more than a third of established hedge funds are already invested in digital assets, almost double that of a year ago.

For Now, Uncertainty Remains

The unpredictable outlook for the regulatory landscape threatens to stifle innovation and undermine U.S. leadership in global financial markets, despite President Biden’s Executive Order in March which focuses on investor protection, financial stability and the prevention of fraud but also on responsible innovation and U.S. leadership and competitiveness.

Six months after the President’s Executive Order and despite issuance of the recent Financial Stability Oversight Council’s Report on Digital Assets, expectations that financial markets would receive clear guidance and a roadmap have yet to be met, with no definitive timing on the horizon.  Further, the current regulatory tilt towards enforcement is an impediment to deeper institutional engagement in the crypto markets. Market participants are not against further regulation of digital assets; what they are demanding however is clarity. Cooperation and agreement between countries is also vital to prevent regulatory arbitrage in a market that trades 24/7 and knows no borders. 

Among the issues that require regulatory clarity and certainty for institutional adoption to take hold are application of AML and KYC regimes, characterization of tokens as securities (especially in light of increased staking activity), as well as treatment of stablecoins and DeFi protocols.  Absent such clarity, significant long-term investments in crypto and crypto-adjacent infrastructure will be a challenge for deep pocketed, traditional institutional investors that have duties in turn to shareholders, investors, clients, customers and other stakeholders.  

Where There is a Will, There is a Way

In spite of the current state of ambiguity, the crypto sector will be active and offer opportunities for both traditional and non-traditional players alike. The ability to scale (e.g., through layer-2 rollups) and increasing collaboration between conventional financial institutions and FinTech’s will drive greater interconnection between crypto-asset and traditional financial markets. A recent report by Hampleton Partners found global FinTech M&A rose sharply in the first half of 2022 with 591 recorded deals, defying the broader M&A slowdown, with particularly strong activity among embedded finance applications, crypto, blockchain and OpenAPI banking services.

So, the question is not if, but when, institutional investors will embrace the crypto ecosystem.  And whether the U.S. will set a standard for responsible innovation or cede a leadership position to others willing to address head on the delicate balancing act between safety and soundness and innovation.