Crypto Custody, introduction to an innovative security system
Digital assets custody and its implication for the future adoption of digital assets is the first article of a series on crypto custody.
The total crypto market is now reaching $US 2 trillion for the first time in history with an acceleration of institutions’ adoption. Companies like Tesla, Square, and Microstrategy publicly reported that they transferred a part of their cash reserve in Bitcoin. With more institutional players entering the market the issues of security, regulatory compliance, and custody of digital assets are the number one questions that need to be answered.
Cryptocurrency custody solutions are independent storage and security systems used to hold large quantities of tokens. This is one of the most important innovations of the cryptocurrency ecosystem considering their potential to not only attract but also facilitate the management of institutional capital into the industry.
In this article, we will explore the impact of Custody solutions understanding how they work, and providing an overview of the current digital custody landscape, the market solutions currently available, and the challenges and uncertainties the industry faces.
Before discussing further considerations, it is important to understand the role of custodians in the market, which should be to encourage innovation whilst balancing the need to protect customers and maintaining financial stability.
With Cryptocurrency, every digital asset owner needs to become its own custodian: “Be your own Bank!”. Such innovation is a drastic change compared to the traditional financial system and it comes with new risks and responsibilities.
Crypto custody, what to expect in the context of digital assets?
First, understanding that the digital assets and their custody are still a nascent market, there are currently many options with differing approaches and strategies particularly relating to keeping the assets safe. As the market evolves, a common approach to custody should emerge, but will require close collaboration between the key market participants; primarily the regulators, providers, and consumers.
In retrospect, even if we took bitcoin out of the picture, the global digital asset market is currently valued at over US$ 1Trillion, as measured by total cryptocurrency market capitalization (excluding Bitcoin), with this figure only looking set to rise further as the adoption of these assets becomes commonplace. The early asset custody providers are beginning to build a burgeoning global landscape, hence why the need to agree on an appropriate regulatory regime is becoming increasingly necessary.
In the longer term, it is crucial for the development of well-structured and safe digital assets that digital custody develops and becomes trustworthy, accessible, affordable, and reliable.
The emergence of custodians is one of the key components in maintaining the growth and adoption of digital assets. With a growing user base that continues to find new use cases for the technology and service, there is an increasing global demand for suitable custodian options to help manage the use of digital assets. However globally there are differing levels of clarity on the applicability of existing regulations towards the custody of digital assets which may potentially impede the development of globalized custodian options.
How is crypto custody becoming an essential part of the digital asset landscape?
Instilling confidence in digital assets becomes necessary to attract and maintain multiple investor groups from institutional investors, financial institutions, and the general day-to-day investor; and the role of digital asset custodians will be critical to achieving this.
The increasing interest in digital assets has incentivized the growth of custody options. As the market evolves, various types of custody options have emerged and new providers are seeking to establish the structures and controls that work best in their markets and for their propositions.
Given the sensitivity and importance of the crypto wallet private key, which is complex and hard to remember, and the numerous reported hacks and thefts of coins. The main utility of cryptocurrency custody solutions — in addition to the services that traditional bank custodians provide to clients — lies in the safekeeping of cryptocurrency assets.
An exchange or a digital asset business often differentiate two main methods of safekeeping:
- Online storage, aka. “Hot Storage” is offered by the main exchange platforms, is considered very convenient for daily use, but vulnerable to theft and hacks as the private key and wallet are connected to the network.
- Offline storage, aka. “Cold Storage” is an approach where the master key and wallet are kept offline avoiding the risk of someone hacking your assets. It is a safer and more secure way to hold assets, but it is costly. It is also less convenient to use as it takes more time to access funds.
The majority of crypto funds have turned to cold storage as it is the only fully secure solution for safekeeping assets. It is also often requested by the regulator to have such an option for the safekeeping of the assets.
There are currently three main types of cold storage safekeeping solution providers:
- Crypto exchange safekeeping: Exchanges have clear that it is essential to beef up their safekeeping offering to attract potential institutional asset flows. To do so, some of them developed cold storage solutions (like BitGo and Gemini), and Coinbase has decided to create a subsidiary dedicated to digital asset custody, Coinbase Custody, in partnership with Electronic Transaction Clearing (ETC).
- Dedicated safekeeping solution: A number of providers have emerged to build dedicated solutions often relying on a mix of technology and physical security to ensure the safekeeping of private keys and assets.(like Xapo and Swiss Crypto Vault). With these solutions, the master key and asset are literally secured in an offline environment, in a physical vault protected by private police. However, it can create other issues, such as access to and transferral of digital assets in a timely manner.
- Specialist technology providers: Hardware wallets like Ledger and Trezor are the two representatives in this category. These solutions combine software and hardware to ensure the safekeeping of the master key and crypto-addresses are held in a physical device.
It’s also worth highlighting the role that regulation has played in making custody an essential part of the digital asset landscape and will continue to do as we are seeing in Thailand.
Custodian services, who are the largest players in this market?
Within the cryptocurrency ecosystem, very few mainstream banks offer custodian services custody platforms that help in eliminating any fears that investors may have because they are designed specifically to prevent the loss of one’s savings due to wallet thefts, misplaced private keys, etc. The top traditional custodian banks are:
- Bank of New York Mellon
- State Street Corporation
- J.P. Morgan
Additionally, a fair few banks have reportedly been testing and rolling out their very own custody platforms. For example, Swiss bank Vontobel launched its Digital Asset Vault, which provides its clients with access to more than 100 banks and wealth managers — primarily as a means of giving instructions regarding the purchase, custody and transfer of digital assets using the institution’s existing infrastructure and regulated environment. — Similarly, German stock exchange Börse Stuttgart, State Street, as well as Institutional-grade asset security providers like Fidelity also envision a future where all types of assets are issued natively on blockchains or represented in tokenized format. Offering a full-service, enterprise-grade platform for securing, trading, and supporting investments in digital assets.
Nevertheless, Coinbase is dominating the digital asset custody market. One of the major players in the cryptocurrency custody space is Coinbase Custody as previously mentioned, the popular digital currency exchange entered the institutional-grade custody solutions area buying up acquisitions like California’s Keystone Capital, a registered broker, as well as the institutional business of storage provider Xapo. Coinbase Custody Accounted for 11% of All Cryptocurrency Assets in 2020 has taken its assets under custody to nearly $90 billion in the last quarter of 2020. Those deals have made Coinbase Custody, the world’s largest crypto custodian, and cryptocurrency alone accounted for approximately 70% of the total crypto assets at Coinbase custody in 2020.
Coinbase Custody currently serves as a qualified custodian under the SEC definition for Grayscale Investments. While they offer a custody solution designed from the ground up for the unique challenges of storing crypto assets, they operate very similarly to traditional custodial services and are overseen by the same regulators, held to the same capital requirements, and audited in the same way as a traditional financial custodian.
Qualified and regulated custodians are likely to become the norm in each country with a clear regulatory framework for digital assets.
How crypto custodians will impact the traditional custodian banks ?
Gongpil Choi, director of the Korea Institute of Finance — an agency that works hand-in-hand with the local government to research and evaluate financial policies that are designed to strengthen the country’s financial sector — was quoted as saying: “Even the traditional financial sector has seen the establishment of the custody market. Cryptocurrencies are more risky than traditional assets and the custody market in crypto will become a rapidly growing market.”
Not surprisingly the market has been dominated by crypto-asset specialists and Fintechs, that obviously had a first-mover advantage. However, the situation is likely to change, and traditional players are likely to continue entering the space sooner than later in the aim to avoid being disrupted.
Recently, the US SEC initiated a pilot program that seeks to facilitate innovation with respect to digital asset securities in which a broker-dealer operating under specified conditions, including limiting its business to digital asset securities, will be able to take physical possession or control of customer digital asset securities.
Digital assets that are issued or transferred using distributed ledger technology may not be subject to the same established clearance and settlement process familiar to traditional securities market participants. The decentralized nature of the DeFi industry brings with it a greater risk that a broker-dealer maintaining custody of this type of asset, as well as the broker-dealer’s customers, counterparties, and other creditors, could suffer financial harm. This opens a new scenario to be considered by custody businesses and therefore involving deeper procedures and protocols from a custody provider perspective. For example, the broker-dealer could be victimized by fraud or theft, could lose a “private key” necessary to transfer a client’s digital assets, or could transfer a client’s digital assets to an unintended address without the ability to reverse a fraudulent or mistaken transaction. In addition, malicious activity attributed to actors taking advantage of potential vulnerabilities that may be associated with distributed ledger technology and its associated networks could render the broker-dealer unable to transfer a customer’s digital assets.
“Regulators should commit themselves to providing regulatory clarity so that traditional financial market participants can engage with crypto with confidence that they are complying with their regulatory obligations.” states the SEC letter. The SEC subtly suggests that state and federal regulators are also to work together — which consequently lead us to think that it would be the case to help foster the growth of the crypto industry.
How digital assets custody offering will be an integral part of owning crypto in the future?
According to a research piece released by the Bank of New York Mellon, the demand for crypto-centric custody solutions is currently at an all-time high. This is because many analysts believe that such offerings will help bridge the gap that currently exists between the institutional investment market and the digital industry.
Investing in cryptocurrencies is a big step for any institution, crypto-first or traditional. It raises unique operational, marketing, and security challenges: the technology is new, the regulations aren’t explicit, and the risk is perceived as higher than that of traditional securities investing. While the crypto market has evolved over more than a decade and now offers dozens of assets attractive to professional-grade investors, custody also remains a first-order barrier to institutional investment.
In the face of this uncertainty, crypto-first institutions may feel they have no choice but to self-custody their crypto assets. Institutions that are new to crypto, on the other hand, might have custodial services already but aren’t sure how to approach a net-new asset class with entirely new security risks.
On top of this, unattractive vendor choices may force institutions into making trade-offs between security, asset availability, and trustworthiness, limiting their ability to make large investments in crypto. This is where Digital asset Custody plays a fundamental role to solve those issues and enhance digital asset adoption and Blockchain in general.
In a second part we will focus on Thailand and what changes will the regulation bring to the Thai digital assets landscape.