The Hidden Problems That Could Threaten Crypto's Future | Entrepreneur

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With an estimated 5% of the global population owning some form of crypto, there have been great strides in educating the wider market. Indeed, seeing the growth in institutional investment around crypto is a positive sign. With 86% of institutional investors either planning or already having exposure to digital assets this year, it’s easy to think it’s all plain sailing from here.

But beneath the surface, problems still persist. For institutional investors, clearing and settlement remains a fragmented, risky, opaque process. If left unaddressed, the market could expose itself to significant risk in the future. While it’s easy to focus on increased trading, we need to ensure the back-end of the investment is robust enough to address this demand.

Easiest is not always the best

For traditional investors looking to get involved in crypto, an ETP will likely be a popular choice. It’s familiar, understandable, and — on the surface — seems safe. Indeed, with institutional adoption rates reaching up to 57%, many investors will likely be using an ETP in their trades. However, just because this product is familiar does not mean it is without fault.

Due to its conventional infrastructure, an ETP introduces an additional layer to the trade that requires attention. Regardless of how the issuer operates, the net results of their trades still need to be logged on the blockchain. At the very least, this creates added friction in the trade. At most, it risks making investments lack the transparency that underpins blockchain.

The risks of fragmentation

When investors trade crypto with an ETP, they trade in the shadows. The transaction is logged on a private ledger, not the public blockchain. The issuer’s actual bitcoin holdings may be transparent on the blockchain at the fund level, but individual trades won’t be. Creating this layer of uncertainty puts ETPs at odds with the transparency of the blockchain. In doing so, it starts fragmenting the system — simply because the clearing process has become vague.

While crypto ETPs may try to reassure investors, they can increase risk. As crypto enters into more traditional markets, we will likely see more of these issues arise. While the blockchain may be transparent and immutable, the institutions it is integrating with may not be. But it’s more than trust that’s at stake. A lack of robust clearing and settlement processes slows down trades and ultimately makes them more expensive.

Meeting in the middle

Despite the challenges it presents, it does not mean we need to move away from crypto ETPs. Instead, it’s about reconciling these issues or preventing them altogether. To enable this, we need to establish a decentralized clearing layer for institutional investors. Achieving this requires utilizing two key components: state channels and decentralized protocols.

A state channel would act as a private tab to an existing blockchain. This would allow ETPs to be traded back and forth with transparency. However, unlike logging each trade on the blockchain itself, a state channel would be faster and cheaper for those involved. Using state channels, ETP issuers could have increased trust in the underlying infrastructure of their trade. Issuers can negotiate trades quickly while still providing the transparency of a publicly traded trade. As a result, operational costs can be reduced, and trust increases.

However, establishing state channels in institutional trades is not enough. There also needs to be an objective, robust and fair process to ensure these trades are accurate. Decentralized protocols would remove any single ownership of these trades, creating guidelines and rules that are monitored objectively. In doing so, the clearing process would not be subject to manipulation or error while also being equitable to all users.

By creating these decentralized clearing networks, we create a better environment for institutional investing in crypto. Liquidity can be better linked, frictions can be reduced, and investors can feel safe in their deals.

Looking under the hood

Maturity in any market requires several components to come together. One of those is naturally increased investment and interest from existing institutions. However, when it comes to crypto, that uptick in institutional capital comes with an integration problem. To establish long-term maturity in the crypto market, we need to establish the right underlying processes. Clearing and settlement is a core part of that, and currently, it is a flawed and expensive element of the trade.

Fortunately, we are still in the early stages of institutional engagement. There is still time to establish the best practices that would create a robust foundation for crypto’s relationship with institutional investment. At this point, the traditional finance world and the crypto market must align on this issue. In doing so, they not only build a safer market but also allow crypto to become a more valued sector within the wider financial market.