Green Light to Invest $423B in Crypto Can ‘Increase Demand’ for Them But Pose ‘Significant’ Liquidity Risks: Fitch

One of the ‘Big Three credit rating agencies’ doesn’t expect large volumes in crypto-exposed funds in the next one to two years, but if other regulators follow Germany’s suit, AUM could eventually reach levels sufficient to pose greater financial stability risks.

One of the ‘Big Three credit rating agencies, Fitch Ratings, says German funds' crypto investments will pose liquidity risks.

This is regarding the new regulations that came into force on August 2 applying to Spezialfonds, reserved for institutional investors with insurance companies and pension funds dominating their investor base, allowing them to invest up to 20% of their assets in cryptocurrencies.

Open-ended Spezialfonds had 2 trillion euro (nearly $2.35 trillion in USD) assets under management at end-March 2021, implying a maximum crypto-investment of up to EUR360 billion (almost $423 billion), which compares to Bitcoin’s current market cap of $845 billion and the total crypto market cap of $1.95 trillion, noted Fitch in its report.

However, the firm does “not believe that allocations to crypto-assets will reach close to the 20% threshold, considering the traditional risk-averse asset allocation patterns of the main institutional investors in Spezialfonds, as well as other regulatory restrictions on their asset allocation.”

According to Fitch, these regulatory changes can “increase demand for cryptocurrencies” but at the same time pose significant risks, notably liquidity risk, for the funds that invest in such assets.

These changes bring cryptocurrencies into the traditional and more regulated financial system. They could result in increased exposure for crypto assets to retail investors whose assets, such institutions, manage insurance policies and retirement benefits.

Still, volatility in crypto will present challenges for these fund managers, according to Fitch.

Interestingly, amidst these concerns for volatility and riskiness of crypto from the traditional markets, Japan’s new 10 trillion yen ($90 billion) university fund is looking to invest in alternative riskier assets as it seeks returns that would beat those of the country’s more conservative pension funds.

But Fitch feels managing the liquidity risk of mutual funds invested in such highly volatile assets would be important for these managers. These liquidity risks could increase if crypto investments become material in the asset class.

“If these factors caused a temporary suspension of fund redemptions (known as ‘gating’), or fund failure, this could result in reputational damage to the relevant fund managers,” that could potentially heighten regulatory scrutiny, said Fitch while noting that these risks are not limited to crypto-asset funds, several European funds investing in traditional assets gated in March 2020 due to material price movements.

Overall, the rating agency doesn’t expect large volumes in crypto-exposed funds in the next one to two years. Still, if other regulators follow suit, AUM could eventually reach levels sufficient to pose more significant financial stability risks.

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