FTX collapse could trigger decline in institutional capital in crypto funds

In the aftermath of the FTX collapse, institutional investors are likely to pull back or eliminate their already-small allocations to cryptocurrency companies.

In October 2021, the Ontario Teachers' Pension Plan, one of the world's largest pension plans with around $242.5 billion in AUM, invested $75 million in FTX International and FTX.US. In January 2022, it made an additional investment of $20 million in the cryptocurrency exchange's US entity.

Last week, FTX collapsed and filed for bankruptcy protection, rocking the crypto world and undermining the asset's credibility with investors, regulators and the public. The company's CEO, Sam Bankman-Fried, who was, until recently, seen as a leading figure in bringing crypto into the mainstream, resigned in disgrace.

The meltdown—which followed May's sharp declines in the price of bitcoin and the bankruptcy filing of crypto lender Celsius Network in July—has forced institutional investors to reconsider their exposure to the asset. Notoriously risk-averse, pension plans and other institutional investors have slowly been dipping their toes in the cryptocurrency waters over the past few years. Crypto funds lured institutional investors with visions of high returns and minimal correlation to other assets—a potential goldmine for pensions facing ever-increasing return mandates to account for growing, aging populations of beneficiaries.

Recent surveys show the extent to which institutional investors have opened their portfolios to crypto. In the CFA Institute's 2022 investor trust survey, 94% of state/government pension plan sponsors said they are currently investing in cryptocurrencies. Positive perception of digital assets among institutional investors grew six percentage points from 2021 to 2022, according to responses to a Fidelity Digital Assets survey of over 1,000 global institutional investors.

Still, institutions proceeded with caution, allocating only miniscule portions of their portfolios to crypto, typically through venture capital funds. Last year for instance, the Houston Firefighters' Relief and Retirement Fund blazed a trail in the pension world when it announced it purchased $25 million worth of bitcoin and ether for its portfolio—about 0.5% of its $5.2 billion portfolio.

OTPP took a similar approach with its investment in FTX: "While there is uncertainty about the future of FTX, any financial loss on this investment will have limited impact on the Plan, given this investment represents less than 0.05% of our total net assets," OTPP said in a statement last week.

That caution is likely to increase in the aftermath of the FTX debacle, diminishing some of the institutional confidence and resulting in a pullback in the funding of crypto funds.

"This is going to make it very difficult for crypto [companies] to get institutional capital," Patrick Ghali, managing partner and co-founder of Sussex Partners, a hedge fund advisory firm, told PitchBook.

Some industry providers argue that the collapse had nothing to do with the inherent value of bitcoin and other cryptocurrencies, but is instead a product of venture funds failing to conduct due diligence on their portfolio companies.

"That transcends crypto," said Bill Barhydt, founder and CEO of Abra, a crypto platform.

One lasting effect of FTX's crash will be increased due diligence on crypto investments and their VC fund vehicles. For example, crypto companies typically don't have boards, but Robert Le, senior analyst at PitchBook, said he expects LPs to begin to require VC funds to sit on the boards of their crypto and blockchain portfolio companies as a layer of oversight.

The FTX collapse will also likely accelerate calls for clearer accounting rules and standards for cryptocurrency companies, said Marcia Wagner, founder of the Wagner Law Group, which specializes in employee benefits, compensation and investment management law. Wagner said the collapse of FTX was the type of "worst-case scenario" that the Labor Department had in mind when, in March, it warned fiduciaries to "exercise extreme caution" when considering adding a cryptocurrency to a retirement plan's investment portfolio.

In the short-term, Wagner said this month's crypto meltdown makes it likely that the Labor Department will discourage plan fiduciaries from including any type of cryptocurrency asset to their investment platforms and will advise plans holding any type of crypto asset to either reduce or eliminate it from their portfolios.

In the longer term, increased regulatory oversight may eventually lead to cryptocurrencies becoming a trusted asset for fiduciaries. Still, the total impact of FTX's downfall is yet to be felt as the reverberations of its crash ripple through the market.

Featured image by ImageFlow/Shutterstock

This article originally appeared on PitchBook News