Crypto Custody Conundrum: The Catch 22 for Institutions
The safe and secure custody of client assets is both a salient and well-established action in any developed financial market. It’s crucial that a very new and often distrusted asset class like crypto gets custody right, and if it doesn’t future growth will be significantly curtailed.
Custody is defined as the holding of securities on behalf of a client for safe-keeping. These securities are available to the custodian to sell at the behest of the client, but cannot be used by the custodian for its own account.
In this respect, it is very different from having an account with a bank. Seasoned custodian banks, like State Street and Citi in North America or BNP Paribas in Europe derive substantial fees from their custody operations.
The custodian will also often perform a range of other services, such as the re-investment of interest or dividend payments, or the proceeds of the sale of securities, according to client’s instructions. They may also provide tax support. But the key element is the safe-keeping of assets, which may be held in physical or electronic form.
In the US, under the terms of the Investment Advisors Act of 1940 (generally referred to as the 40 Act) investment advisors with $100m or more under management are obliged to use the services of a so-called ‘qualified custodian’. This rule is enforced by the Securities and Exchange Commission (SEC).
The 40 Act has been updated, modified and clarified several times since 1940, most recently in 2017, but its essence remains unchanged. It is worth bearing in mind that the act was borne out of the multiple bank failures and loss of investor wealth in the 1930s. It was designed to protect investment.
This act is probably the most comprehensive and binding of all regulations concerning custody, but all the leading financial markets have stipulations on custody of some kind. Moreover, it is simply good marketing for any investment manager to use the services of a reputable custodian.
Ease of Cyber Theft
Safe storage of assets has been something of a bête noire for the crypto market. At the end of June 2018, it was estimated that $1bn had been stolen from crypto-currency accounts in the first six months of that year alone, three times the rate of theft in the previous year. And once stolen, there is no getting it back. Crypto is like a bearer bond: possession confers ownership.
It's surprising just how easy it is without any tech skill to commit cybercrimes like ransomware
Carbon Black Security strategist Rick McElroy told CNBC at the time, adding that the necessary malware to conduct such theft sells for an average of $224 and sometimes even comes with customer service.
Crypto - The Haven for Hackers. Image via Copper
The issue of reputable, trusted custody is therefore of great pertinence; but it is different from a regular, vanilla asset. In essence, custody of crypto assets occurs on the blockchain, in the internet. What is important is the security of the key.
As one noted analyst in the field explains:
In the normal world of custody, you’re looking after the assets. In the crypto world, you’re looking after keys. You own the keys, you own the asset.
So protection of the key is the crux of the issue, and the one which would be custodians need to get on top of.
To date, there are basically three options for investors in crypto: self-custody, the use of custodian services provided by the exchange on which the currency is purchased, or the use of specialised custodian.
In the retail market, only the first two are relevant, and both present their own set of advantages and problems. On the face of it, self-custody looks like the most attractive solution and one that is in keeping with the disintermediated, do-it-yourself philosophy of the crypto world. But keeping the key safe is a heavy responsibility.
Any crypto wallet makes it very clear that it is not a bank and that the safe-keeping of assets is not its responsibility. That belongs to the customer, and he or she must keep the private key safe. Very, very safe.
This presents a number of challenges. Should it be stored on a piece of paper? Or in safe deposit box? Or in an USB stick?
None of these are ideal...
Hot Versus Cold Wallets
A better way forward is the use of a crypto wallet of some kind, but this presents pitfalls as well. Offline storage of the key is generally referred to as cold storage, and online storage as hot storage.
The former is safer, as it is disconnected from cyberspace and thus less prone to bitcoin hacking, but what one gains in safety one loses in convenience as trading is only possible when the offline key is plugged into the internet. In as age of mobile devices, this is hardly ideal.
Moreover, one wallet is generally only compatible with one currency; this is far from convenient. As one analyst notes, it’s like having a different remote for every TV channel. To date, the currencies have not evinced a great deal of interest in working with each other to establish common characteristics that would allow one wallet to serve more than one currency.
Crypto Cold Storage: Keeping it Offline. Image via Copper
Understandably, a lot of retail customers find dealing with these issues too burdensome. After all, not many people choose to store their savings in cash under the bed. That is what banks are for. So, they have turned to the exchanges to perform custody. Coinbase, for example, unveiled a custody solution in June of last year, which is aimed principally at the retail market.
Some exchanges offer a multiple signature solution, so that there are, say, three keys and two have to be used at the same time for an account to be activated. One would be stored with the custodian, one with the customer and the last with a third party emergency contact.
While this takes away the responsibility from the customer, it isn’t ideal either.
Issues with the Status Quo
Exchanges don’t often have the sort of controls and separation of roles that institutional investors in particular want to see. Custody desks and OTC trading desks are sometimes on the same floor, maybe even a few feet away. It makes information leakage, and at its worse front-running of client orders, quite possible.
This isn’t what traditional investment managers are used to seeing from a custodian, and retail clients should be quite concerned too. Nor are the exchanges or the newer custodians the sort of names that major institutional investors are used to dealing with, and this is a market where tried and trusted counts for a lot.
New crypto hedge funds, as well as traditional hedge have been active in the crypto market for some time, and in fact provide a great deal of its liquidity. According to a Morgan Stanley document reported on in October 2018, there is now $3.5bn in estimated assets under management at over 250 dedicated crypto funds.
Because of the inadequacies of custody provided by exchanges, most practise self-custody, and they of course have the technology and resources not available to a retail buyer. According to one analyst, fast money accounts have become quite adept in their use of keys and dongles.
Issues of Governance
But effective, secure self-custody becomes more difficult if funds have several crypto accounts that need to be managed. These accounts have to be segregated, which poses not only technological hurdles but also ones of governance.
All this means that there are opportunities for both new custodians and traditional custodians to produce effective solutions. Indeed, it is the interest shown by hedge fund clients in crypto assets that has encouraged Goldman Sachs to indicate its interest in the space. In August 2018, Goldman announced that it was looking at a crypto custody solution, saying
In response to client interest in various digital products we are exploring how best to serve them in this space
However, by the end November, the investment bank admitted that it was no closer to being able to provide this service for clients.
“One of the things they ask me is ‘Can you hold our coins?’ and I say ‘No we cannot.’ One of the things we have to take into consideration when building our business is what we can and cannot do from a regulatory perspective,” said head of digital asset markets Justin Schmidt, at a conference in New York.
Global Governance Loopholes. Image via Copper
Fidelity, one of the most well-established and reputable custodians which administers more than $7.1trn in client assets, unveiled a crypto solution in mid-October 2018, making it the first mainstream firm to establish a foothold in this market. Its custody product includes vaulted cold storage and multilevel physical and cyber controls.
The firm said at the time that though crypto is a new asset class, Fidelity has been dealing with issues of security and safety for a long time, and was able to “repurpose” that knowledge to the crypto world. It remains to be seen whether Fidelity’s product will gain traction.
State Street has also announced that they’re looking at custody for crypto currencies, but, in general, most major custody providers all holding off at the moment. The sum total of crypto AUM is estimated to be between $10bn and $15bn and the market is seen as too small and too risky to justify investment, suggest reports.
Crypto's Catch 22
But until established and trusted custody solutions are in place, the market won’t grow by leaps and bounds as institutional accounts stay on the sidelines.
It’s crypto’s Catch 22.
The decision to invest in crypto assets is a big one in itself, and it’s not made any easier by the lack of custody names with which these managers are familiar and comfortable.
It is something that the market needs to get right. As Justin Schmidt was reported to say at the conference in New York last November:
“Custody is this foundational piece that is absolutely necessary. Custody is part of an overall integrated system where different parts need to work well with each other and safely with each other and you have to be able to trust all the different parts in the chain, from buying something to transferring it to storing it for the long term.”
Featured Image via Copper
Disclaimer: These are the writer’s opinions and should not be considered investment advice. Readers should do their own research.