Why custody is crucial for cryptocurrency adoption

The safeguarding of cryptocurrencies by custodian banks is the only way institutional investors can begin their journey with the much-hyped digital assets. So will traditional custodians step up to the plate, and could they partner with crypto trading venues? Jonathan Watkins investigates.  

Custodian banks are the backbone of the financial industry, safeguarding trillions of dollars’ worth of assets for the world’s largest investors. Impeccable security, safety and discreetness is in their DNA, elements the cryptocurrency ecosystem is crying out for.

Billions of dollars-worth of the cryptocurrency have been stolen since Bitcoin’s inception, with $1.2 billion pirated away since 2017 alone, according to estimates from the Anti-Phishing Working Group. Hackers have taken aim at anyone holding digital assets due to the lack of safekeeping, and comparatively insecure online storage of cryptocurrencies. 

“Anyone who says I’m a crypto fund: you are inviting people to come in and look under the hood,” explained Carl Kruger, head of operational due diligence at LumX Group, speaking at Cryptocurrency Fund Forum in London earlier this year.

A simple Google search of ‘crypto’ and ‘hackers’ will provide numerous stories of millions – and sometimes billions – being stolen in all sorts of creative ways, from hijacking government websites and kidnapping, to hacking during live streams on YouTube. 

Major investment companies publicly announcing their intentions to trade crypto are therefore potentially placing a target on their head.

The options available for the safekeeping of cryptocurrencies take two forms: self-custody and independent custody. The former involves hot and cold storage wallets – whereby the assets are stored online and offline, respectively – while the latter could be provided by a coin exchange or a traditional custodian. 

Hot and cold

“When you have a currency, you have a token – you have two sides – the public key and private key – when someone is holding the custody of assets they have your private key,” explains Teana Baker-Taylor, CMO of cryptocurrency exchange, Coinfloor. “A significant number of exchanges hold private keys online allowing you to move it around, but it means you are at risk of a hack.” 

The hot storage Baker-Taylor describes essentially trades heightened security for convenience, in that the assets are easily accessible, as opposed to cold storage, in which customers deposit directly to an offline address, so they are never held online. 

“When they want to withdraw them or call them up then we have to physically get them from cold storage,” she says. “We hold assets literally in multiple vaults and in addition we provide a multiple signature service, meaning that multiple signatories from our side need to validate that key,” Baker-Taylor adds. 

A hybrid of the two, known as ‘warm’ storage also exists, with extra safety and accessibility, but not in the same timeframe as hot wallets. The issue for many institutional investors is that neither provide the security and big-name assurance which traditional custodians provide for traditional assets, and these incumbent banks have been tentative in their approach to entering the cryptocurrency servicing world.

For 40 Act funds in the US, they are required by regulation to maintain their securities and other investments with certain types of custodians designed to assure the safety of the fund’s assets. 

Nomura became the first bank to announce it would offer custody services in May, partnering with Ledger, a security and infrastructure provider for cryptocurrencies, and Global Advisors, a bitcoin-specialist investment manager, through a new venture called Komainu.

Big names enter the fray

In July, The TRADE Crypto reported that SIX will launch a fully integrated trading, settlement and custody for digital assets in 2019, while in August we wrote that Northern Trust is exploring a way to hold and secure digital assets and cryptocurrencies for its hedge fund clients.

Just this week, a Bloomberg article claimed Goldman Sachs was considering launching a custody services.

Providing access to these networks raises several Know Your Customer (KYC) and anti-money laundering (AML) challenges, as well as exposure to high volatility, which have put off many banks. 

Speaking at Crypto Fund Forum, Kruger added that funds need to respect the wishes of these large and experienced institutions: “If you meet a bank or custodian and they say ‘we don’t want to touch crypto’, for them they will have a very thin slither of exposure to crypto compared with the big business of traditional assets,” he explained. “If something goes wrong over there it’s way too much risk on their business and you have to respect that.” 

A report from McKinsey in March, however, said that custodians brave enough to venture into the cryptocurrency asset servicing world could be rewarded with significant revenues. 

The report argued that securities services providers could play an important role as custodians for crypto assets, which as of early March, held a market capitalisation of $355 billion. “Risk-taking firms have an opportunity to tap these new revenue pools by expanding the classic custodian value proposition to include this new [crypto] asset class,” McKinsey said in the report. 

Potential partnerships

Currently cryptocurrency exchanges such as Coinbase, Bitstamp and itBIT offer custody services of private keys and cold storage for digital assets. However, for fund managers who have to justify moves to their own investors, an established name such as Nomura, SIX or State Street would ease safety concerns with a bank guaranteeing asset administration and fund management services. 

The Kentucky-based custodian Kingdom Trust, which holds over $12 billion in assets under custody, established itself as one of the only institutional options for holding digital assets, and was subsequently purchased by blockchain security company BitGo in January, pending regulatory approval. Since then, BitGo has made an effort to appeal to institutional investors with a new line-up of custodial services. 

“BitGo provides proper custodianship for institutional investors, which means we are independent of the exchange,” Robin Verderosa, VP of product marketing, tells The TRADE Crypto.

“The custodian’s role goes beyond regulatory compliance. The custodian makes money safe because it separates ‘exchanging the asset’ from ‘holding the asset’ and distributes responsibility across different parties.

“We see a great deal of interest from institutional investors on how to best enter this market that safeguards and secures their assets, similar to the way other asset classes are protected. Besides security and protecting holdings, investors have expressed the need to find a solution that supports a diversity of coins and tokens.” 

Coinfloor’s Baker-Taylor believes there might be opportunities for partnerships between new cryptocurrency exchanges and established custodians moving forward: “A financial institution – custodian bank on its own – is either going to need to attract additional talent that understands the differences in fiat versus crypto, and/or partner with a crypto company that has that technical knowledge,” she adds. “Because we don’t want to get this wrong, if one thing goes wrong then the confidence will be dented. 

“We are talking to a number of people about what that would look like. Different custodian banks will be looking at different things from us. Do you want to hold onto the customer and do the tech and we’ll do all the KYC? How are we going to passport clients across? 

“I am really encouraged that we are having these conversations and the fact that these banks are asking the questions is a big start.”