Digital Assets Custody: The Key to Institutional Adoption
Digital assets custody, custody 2.0
As the total cryptocurrency market approaches $2 trillion, with an increasing number of 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.
Digital assets 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 assets custody landscape, the market solutions currently available, and the challenges and uncertainties the industry faces.
Table of Contents
Digital Assets and Custodians
Before discussing further considerations, it is important to understand the role of digital assets custodians in the market, which should be to encourage innovation while 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.
Digital assets 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$1 trillion, as measured by total cryptocurrency market capitalization (excluding Bitcoin), with this figure only looking set to rise further as the adoption of these digital assets becomes commonplace.
The early digital 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.
The Importance of Digital Assets Custody
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 crypto custodian options to help manage the use of digital assets.
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.
How is digital assets custody becoming an essential part of the digital asset landscape?
The importance of digital asset custody has increased significantly in the evolving digital asset landscape, with the need to instill confidence in various investor groups such as institutional investors, financial institutions, and general investors. Digital asset custodians play a critical role in achieving this goal.
The increasing interest in digital assets has led to the growth of custody options, with various types of custody options emerging in the market. The main utility of cryptocurrency custody solutions lies in the safekeeping of cryptocurrency assets, especially given the sensitivity and importance of the private key and the numerous reported hacks and thefts of coins.
There are two main methods of safekeeping: online storage (hot storage) and offline storage (cold storage). While online storage is convenient for daily use, offline storage is a safer and more secure way to hold assets. Cold storage is the only fully secure solution for safekeeping assets, and it is often requested by regulators.
There are currently three main types of cold storage safekeeping solution providers: crypto exchange safekeeping, dedicated safekeeping solutions, and specialist technology providers. Crypto exchanges like BitGo, Gemini, and Coinbase Custody, dedicated solutions like Xapo and Swiss Crypto Vault, and hardware wallets like Ledger and Trezor all offer safekeeping solutions.
Regulation has played a significant role in making custody an essential part of the digital asset landscape, and it will continue to do so in the future. This is exemplified by recent developments in Thailand.
The benefits of digital assets custody
Using digital assets custody services has several benefits, including simplicity, convenience, and increased security.
While self-custody may provide more control, it requires niche technological knowledge to maintain the same level of security over time. With third-party custodians, you get the same results without having to put in any effort. Moreover, these firms have the experience and expertise needed to protect your digital assets from cybersecurity threats.
Digital assets custody : Simplicity and convenience
Outsourcing digital asset custody simplifies the process of safeguarding assets, saving organizations time and effort. Self-custody requires significant technical knowledge to generate and keep track of private keys for each asset owned. With digital asset custodians, organizations can rely on third-party providers to manage and secure their assets with minimal effort.
For larger organizations like banking institutions, which typically hold a large number of digital assets that require more complex processes to be kept safe, digital asset custody provides an efficient and cost-effective solution.
Digital assets custody : Increased security
While self-custody may offer more control, it also poses significant security risks. Businesses face an average of 11-second cyber attacks, and hackers caused a loss of over $10 billion in decentralized finance in 2022.
Digital asset custodians have the security-oriented expertise to more effectively ensure that digital assets are less likely to be stolen or confiscated by unauthorized individuals or parties. With even blockchain technology becoming more susceptible to breaches over time, outsourcing digital asset custody can significantly increase security measures.
Digital assets custody : Reduced risk
The lack of regulation among third-party digital asset custodians has been a significant barrier to institutional investment in cryptocurrencies and other digital assets. However, as digital assets become more mainstream, vendors are offering more attractive offers for digital asset security.
Digital asset platforms like Anchorage have received federal banking charters from the US’ Office of the Comptroller of the Currency. Similarly, in Southeast Asia, Atato is one of the only licensed custodians regulated by an official government agency. By outsourcing digital asset custody to regulated providers, organizations can ensure that their assets are safe in the right hands, reducing the risk of loss or theft.
Digital assets custody : A competitive edge
One of the most important advantages of outsourcing digital asset custody is the competitive edge it provides. More consumers are profiting from digital assets, and organizations that cater to individual digital asset investors or are looking to enter that market can benefit from digital asset custody.
Outsourcing digital asset custody can also help organizations diversify their portfolio with a vast array of digital assets while simultaneously reducing the risks of their trades. By leveraging digital asset custody, organizations can attract investors, ensuring long-term growth and stability.
How will crypto custodians impact traditional 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.”
The market for digital assets custody has so far been dominated by crypto-asset specialists and Fintechs who had a first-mover advantage. However, the situation is likely to change, and traditional players are expected to continue entering the space sooner rather than later to avoid being disrupted. This shift towards traditional players highlights the maturing nature of the digital assets market and the growing demand for custody services.
Despite the growing demand for digital assets custody, the decentralized nature of the DeFi industry brings a higher risk of financial harm due to fraud or theft, loss of private keys, or unintended transfers. These risks require custody businesses to implement deeper procedures and protocols to mitigate them. For example, 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.
Recognizing the importance of digital assets custody, the US Securities and Exchange Commission (SEC) initiated a pilot program to facilitate innovation with digital asset securities. The program seeks to enable a broker-dealer operating under specified conditions, including limiting its business to digital asset securities, to take physical possession or control of customer digital asset securities.
The SEC‘s move to facilitate innovation in digital asset securities is a step towards fostering the growth of the crypto industry. However, the regulatory environment surrounding digital assets custody is still unclear, and regulators should provide regulatory clarity to traditional financial market participants to engage with crypto confidently while complying with regulatory obligations.
How will digital assets custody offering be an integral part of owning crypto in the future?
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.