The digital asset space has long heralded the unavailability of institution-grade crypto custodial services. This is one of the factors limiting the influx of institutional investors into the crypto market.
Regulators are at a crossroads, and it will take a while before they come up with the appropriate regulations for crypto custodial firms. However, it is imperative to enumerate on the following key takeaways of the explosion digital asset custodial-related developments.
1. The history and technicalities of custodial systems;
2. How traditional custody works;
3. Its impact on the digital assets class;
4. The current regulation governing their operations.
1. A brief overview of the inception of custodial services
Before the advent of traditional asset custodial services, people had to keep documents that certified their rights to claim investments themselves. As you would expect, this method of tracking investment ownership was cumbersome and unsafe. After the stock market crashed in 1929, trust companies and financial middlemen started offering custody services. These entities took it upon themselves to help investors clear and transfer stock certificates.
Like the self-custody method that preceded it, the custody solution that emerged during this period was also cumbersome. Subsequently, the growth of the securities market and the inefficiencies of this paper-burdened custody system led to the creation of the Depository Trust and Clearing Corporation DTCC in 1973. This agency evolved as the de facto issuer of certificates of clearing and centralized ledgers.
Down the line, the proliferation of global investment products caused a domino effect, as a handful of financial institutions emerged as the most prominent global custody firms we have today. However, the creation of bitcoin and the explosion of blockchain-related solutions have changed the whole outlook of the asset custodial market with the innovative culture of the crypto space, and how much resources it has invested in tackling the security frailties of digital assets, making the difference.
2. So what is Custody to begin with?
To get the full scope of the challenges of digital assets custodial services, it is vital to explore the concept of custody in the traditional investment market.
Investing in traditional assets entails that an SEC-licensed Investment professional or institutional investor stores the cash or assets with registered third-party custodians. Unlike the crypto market, it is the registered (qualified) custodian that stores, records, and transfers securities. Furthermore, custodians are required under federal and state law to meet certain criteria that will prevent misappropriation of funds and frauds.
Similarly, custodians issues account statements to investors periodically to update investors on the assets in their custody. As such, custodians are the ones that directly handle assets and not investment advisers.
Current Flow of Assets in Traditional Financial Services
3. Digital assets and its impact on the global custodial market
Not many would have envisioned the explosion of the crypto market when bitcoin first came into the fray. This technology has outperformed expectations, as it continues to reach new highs on two critical fronts — its value as an investment vehicle, and its disruptive force as a viable alternative to traditional systems. In just a decade, the crypto market, as a result of its volatile nature, has attracted investors in their millions, and regulators are concerned, more than ever, over its blistering pace.
As noted, accompanying this proliferation are security concerns regarding the digital nature of cryptocurrency and its unconventional mode of storage. For one, cryptocurrency enables a decentralized network where coin holders have the responsibilities of safekeeping their holdings, as opposed to traditional assets.
As such, cryptocurrency comes with cryptographic features that allow only the holder to access the digital assets by issuing him a private key (similar to a password but more complex). While this is an efficient security protocol, the backdrop is that the loss of a private key would render the digital assets it secures inaccessible and irretrievable.
This downside has motivated developers to introduce various means of private key storage solutions. Presently, there are three major storage systems in use, and they include:
Hot Storage: This storage solution requires that holders, especially crypto traders, keep their private keys online, so they can access them easily. this mode of storage makes digital assets susceptible to hacks
Cold Storage: This solution is an offline storage system like a USB, or specially-made digital asset storage devices. It involves a manual process of accessing private keys, and It is considered a safer alternative to hot storage.
Multi-Signature: Multi-signature is a more flexible system that offers a distributed form of private key storage where more than one entity is required to sign a transaction. In essence, this solution establishes a multi-signatory system, which requires the inputs of all the signatories before approving a transaction.
While these solutions are peculiar to individuals, there has always been a clamor for platforms that would usher in the era of institutional digital assets investment that naturally entails custody. Although crypto custodial services are not new to the crypto space, it wasn’t until 2018 that large financial institutions began to show interest in entering the space. Today, there is a budding crypto custodial market on the horizon with Coinbase, Fidelity Digital Assets (a subsidiary of Fidelity Investments), BitGo, Kingdom Trust, Anchorage, Gemini Trust, and Northern Trust leading the way.
Custodians are working on improving the standard of custodial services as many have introduced insurance and standard boosting initiatives that would ensure that lost assets are refunded. For instance, Gemini Trust is approved as a fiduciary under the New York Banking Law, section 100.
It is, therefore, important to ascertain the regulatory implications of these developments and how institutional investors and financial professionals are adapting to them.
“Fortunately a market of great options is rapidly emerging with firms like Fidelity, Gemini, Coinbase, BitGo and Bakkt offering secure and well regulated custodial options. Additionally, insurance is more readily available at the platform level to protect against losses. For institutional and retail investors alike, the days of security being a barrier to participation in the asset class are behind us.” — BlockFi CEO, Zac Prince
4. The regulatory uncertainties of digital assets custodial platforms
While many have applauded existing and proposed investment products hinging on the performance of digital assets, it is clear that institutional investors are still in the backseat. This is because engaging with such assets entails that they store digital assets with standard third-party custody solutions. And since there are no regulatory reforms by which to measure standards, institutional investors have no other choice but to watch from the sidelines.
More importantly, custodians are skeptical about the implications of the volatile crypto market and how it would respond to common practices like hard forks (the splitting of a blockchain into two independent blockchains). This uncertainty, coupled with the unavailability of tailored regulations for digital assets custodians, has tempered the growth experienced in this space.
In response, the state of Wyoming enacted a regulatory framework that would authorize and govern the operations of a Special Purpose Depository Institution (SPDI) — an institution enabling banks to offer custodial services to licensed Wyoming corporations. Following this development, the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) released a joint staff statement that focuses on custodial requirements, and how it plays into the Customer Protection Rule.
Under this rule, broker-dealers must ensure that their client’s digital assets are safe, and they must separate these assets from the firm’s accounts. By so doing, it becomes possible to return digital assets to the customers when the broker-dealer fails. Also, this rule mandates that broker-dealers physically hold their clients’ digital assets or enlist the services of third-party custodians.
Although SEC and FINRA’s statement was simply an explanatory piece and not an official guide, it's backing of Wyoming’s regulatory framework sets in motion the possibility of a fully structured rule that would establish guidelines for digital asset managers.
”Custody is a critical step toward the institutionalization of [the] crypto economy… it will grow quickly to a point that it’s a meaningful piece of stable, recurring revenue for the company.” Coinbase CEO, Brian Armstrong