The 4th era of crypto: Crypto-institutionalization.

Every crypto era has its driving force. The first was Bitcoin, then came Altcoins, then the utility tokens and platforms. The next era is being led by traditional financial institutions, banks, and even central banks. They are bringing big money with them, but they are also taking crypto and making it more like the old financial system.

First, there was Bitcoin (2009). Then came Altcoins (2011–2014), Followed by tokens (2015–2018, Also known as Utility tokens).

The second and third eras, both came with a promise to replace or fix the first generation’s (AKA Bitcoin) misbehaving. Although it might still be early to call out for the third generation (the patient is lying on the table, struggling with life support), we can safely assume that both have failed to deliver on their promise, at least for now.

Now, following the so-called demise of ICOs alongside the rise in traditional finance solutions like stable coins, ETFs and other financial instruments such as Citi’s new DARs, we see the signs of birth to a new crypto era — the era of crypto-institutionalization.

At the beginning of the year we’ve witnessed the peak of the third crypto market cycle (Crypto Tokens), led by the flash rise in Bitcoin’s price, followed by a surge of ICOs, who are now living on residual fumes of what is left of their treasury after the collapse of the market (and ETH along with it).

In the background, quietly (with only a few leaks here and there), we’ve been seeing the old incumbents trying to understand this new beast. Understanding how to handle new forms of money isn’t an easy task. Mastering a new kind of asset that doesn’t uphold traditional rules or one that doesn’t have a centralized control mechanism they can use, is akin to trying to tame a wild horse. While not an easy task, one with enough experience and the rights tools, can tame even the most savage of them all.

Exchange Traded Funds

Exchange-Traded-Funds (or ETF in short) are financial instruments developed by institutions that track an index, a commodity, bonds, or a basket of assets. They were created to provide investors with easier access and liquidity for the underlying assets. While I won’t go into details of how ETF works (This is a great explanation), the general principle behind them is that the operating entity of the fund can create shares for the ETF as long as they represent the underlying asset.

From 2013 when the first Winklevoss ETF was first submitted for SEC approval, there have been 25 more attempts (including one more by the Winklevoss twins) to submit ETFs for SEC approval. All but one (who is currently still waiting for a decision) have been denied by the SEC, for different reasons, among them are the inability to regulate the market, massive price manipulations and lack of institutional-grade custodianship solutions.

Some say that the approval of a Bitcoin ETF is inevitable. People want access to the cryptoasset market and institutions are working their way to get there. The interesting thing to see here is that for an ETF to get approval, the entire market would need to be “tamed.” Markets will need to be “regulated” and subjected to the same “controls” traditional financials do. Regulation will also introduce “qualified custodians” third party companies that will “safeguard” institutional funds, just like in traditional finance.

As mentioned above, the purpose of such ETFs is to provide investors with easier access to the underlying assets, in our case, Bitcoin. Most institutional investors are not equipped with the knowledge, understanding or investor mandate to invest in Bitcoin or any other crypto asset. Through Bitcoin ETFs, Investors can gain exposure to the crypto market, and enjoy the benefits (as well as the risks) of a new type of asset as part of their portfolio diversification strategy. This, supposedly, should also lead to a high incoming cashflow into Bitcoin, driving up both adoption and price.

But institutional-grade financial instruments have been in existence for years. Mutual funds, index funds, ETNs, and even future contracts were introduced late last year, in the highly-regulated exchanges of the CBOE and CME. If institutional investors had wanted to get exposure to crypto assets, they could have done it months if not years ago. So why didn’t they?

While the answer for this questions would be an interesting debate among both traditional and crypto market people, we won’t dive into this discussion for now.

Stable Coins

Stable coins are a hybrid type of crypto asset. They are crypto token by definition, but their goal is to maintain the stability of value, in contrast to “native” crypto assets which are considered highly volatile.

At the beginning of 2018, there were five different stable coins projects, with the most (in)famous one being Tether, the Dollar-pegged durable coin created by Bitfinex to provide a stable alternative for exchanges that don’t have Crypto-fiat trading ability.

In the first nine months of 2018, we’ve seen over 30 new stable coin projects. Some of these projects have raised substantial financing rounds from respectable investors (Such as Basis with $133M in funding, Terra Money with $32M in funding and SAGA with $30M in funding). Others were built, just like Tether, by well-established crypto-exchanges or liquidity providers (USDC byCircle, GUSD by Gemini, Paxos standard by Paxos, formerly ItBit).

Without going too much into the technicalities of stable coins (If you want to learn more, I recommend this introductory guide by Myles Sinder from Multicoin Capital), there are four different kinds of stable coins:

1. Asset-backed stable coins: Every token is back by a physical asset such as fiat currency, precious metal, etc). For example Tether, TUSD and Alprockz.
2. Crypto-collateral stable coins: Each token is back by another, more significant, supposedly more stable cryptoasset, usually with a liquidation premium). For example MakerDai and Haaven
3. Mechanism design: Central bank mechanism that is designed to control the token’s price stability the same way central banks do). For example Basis, Carbon, and Kowala.
4. Hybrid stable coins: based on a combination of two or more of the previous models. For example, SAGA combines the asset-backed approach with a central-bank-like mechanism design for fractional reserve management.

So how are stable coins take part in crypto-institutionalization? The first order consequence of stable coins is creating a better gateway from the fiat world into crypto, allowing better liquidity options and facilitating inter-exchange settlements. This can also ease manipulation concerns between exchanges and can convince the regulators to approve a crypto ETF.

Most people stop here and don’t look at the second and third order consequences, which are what the stable coins are pegged to, and the effect of bringing what is basically a private version of Crypto-fiat into the crypto ecosystem.

Stable coins are built to be pegged in value, usually to an existing form of fiat currency. While this might be a good thing in times when the bears are coming for the crypto market, it also means that the value of those same tokens suffers from the same disease our traditional fiat money suffers from, AKA inflation.

Bringing stablecoins into the crypto world provides governments the coveted control they are looking for on the crypto world. If they can’t control Bitcoin, they’ll create a meaningful alternative, enjoying all the new benefits of digitalization and tokenization, keeping centralized control and printing capabilities in their hands. Better yet, let the private sector do it for the government so it won’t look like they are trying to interfere with the free market.

Bitcoin disappearing as a function as stable coins becoming a thing is probably not something that is going to happen. Bitcoin still fulfills a real need in the world (at least right now), which is a censorship-resistant non-sovereign store-of-value. But, it is essential to see the second and third order consequences of stable coins. I am not saying they are necessarily bad, but they are a considerable step in basically creating government controlled crypto assets, with everything that comes with it.

Digital Asset Receipts

While the first time we heard the name Digital Asset Receipts (or DARs for short) was just this last weekend, We’ve seen different incarnations of it going back almost a year in other big financial institutions, both in the US and in Europe. The concept behind DARs is to create a new way to invest in cryptoassets without owning. The current implementation of DARs are structured much like an existing financial instrument called American Depository Receipt (or ADR) which provides US-based investors the ability to invest in foreign stocks are not traded in US exchanges.

Based on the way ADRs work, we would assume that DARs are re-introducing the traditional concepts of rehypothecation and fractionalizing assets in between the custody and the instrument. Basically, it is a form of receipts issued to a retail or institutional buyer, as proof of ownership, while a “qualified custodian” is holding the asset itself.

Again, on a first glance, this might appear to be something good for the crypto market. Bringing in new investors and new money could drive prices and maybe even adoption in the near future. On a second glance, what happens here is that we are again, falling back to the same mechanisms the traditional economy works on, where users are not the real owners of their assets, the financial institutions are.

Such a move has good consequences since 99% of the world’s population don’t want to be the real owner of their assets, with all the risks associated with it — Think of your mother losing her private key for the account holding all her savings. Having said that, DARs bring us one step closer to fractional banking. When DARs become a reality, there would be nothing stopping Citigroup from deciding they’ll start lending DAR’s based on a whichever fractional reserve ratio they decide. If history teaches us, the next step would be hoarding all Bitcoins and making only the overlying assets such as DARs available to the public (let’s call them notes) and unpeg them completely, going back to original fiat money, now only in digital form.

The good, the bad and the ugly

All the financial instruments detailed here are just examples of the more significant trend we started our discussion with. During the last few months, we are witnessing the giant incumbents, financial institutions, major banks and even central banks making their way slowly into the field.

The arrival of giants is a great sign of the market becoming more mature, with more explicit rules and regulations, basically making the market more accessible to both institutional and retail investors. This, in turn, can lead to vast sums of money flowing into the crypto market, hopefully making both prices and adoption soar and everyone will live happily ever after.

But will they?

Part of the instruments we’ve described above strip the most basic essence of Bitcoin, physical ownership. Through ETFs, DARs and similar financial tools, the institutions are basically taking away the physical ownership of the assets, leaving us with “notes” or “receipts” we might (or might not) be able to use in the future to redeem the physical asset behind them. Last time that happened with gold, we all remember how that story ended.

Other instruments like fiat-pegged stable coins drag inflationary fiat currencies into the crypto world, while other stable-coins are just trying to create a private central bank using an algorithm.

Institutionalization is coming, whether you like it or not. It will probably take the market by storm and be the moving factor of the next big cycle. The question is what will happen to Bitcoin as we know it today in the process, and which kind of “Bitcoin” and other “crypto-assets” will the world actually see after.

This article was originally published on Medium. Want to keep track of the crypto and blockchain industry? Sign up for my daily crypto briefing.

I would like to thank Tuur Demeester, Nic Carter, Jackson Palmer, Kyle Samani, Tony Sheng, Dan McArdle, Mike Dudas, Nathaniel Whitmore, Ran Goldi, and Maya Zehavi for reviewing earlier versions of this post and providing invaluable feedback on some of the facts and conclusions detailed here.