I am often heard saying that “custody is the Gordian Knot of digital assets”, and it’s never been more apparent than over recent months. Amid all the excitement of the first futures-backed bitcoin ETF launch and the waning interest from issuers, once the inevitable problems with futures-backed products came to pass, a straightforward fact appears to have become lost. There’s a vast market appetite for exposure to the bitcoin spot markets with one industry insider dubbing the current institutional inflow as a land grab.
Wrangling with the SEC over the legitimacy of a spot ETF isn’t the only way to crack this particular nut. Secure, compliant, integrated, and efficient digital custody solutions will also provide the necessary infrastructure layer to allow institutions to engage with digital assets directly. Gary Gensler recently commented at DACOM 2021 “that progress on custody” to protect against your keys being stolen or lost is a key factor for mass consumer adoption.
The Backbone of the Institutional Ecosystem
The role of custodians in the institutional cryptocurrency ecosystem can’t be underestimated. Digital asset security is notoriously tricky, even for retail investors who are only generally concerned with the most straightforward transactions and approval processes.
Institutions must deal with much greater solution complexity due to compliance and regulatory controls over fund movements, the need to interface with established legacy systems, reporting requirements, and much more. Moreover, the risk of alternatives to custody providers, such as self-custody or exchange wallets, is often deemed too great. In the absence of any immediate solutions, institutions inevitably look to the market.
As such, the rapid surge in interest in digital assets has led to an unprecedented demand for digital custodian services. However, becoming a custodian isn’t for the faint-hearted. As I discovered during a recent discussion with State Street’s Global Head of Digital, Nadine Chakar, it’s also not the sexiest side of the digital asset sector.
Chakar points out, “I started my career in custody, and I’ll tell you, nobody goes to university to become a custodian. Actually, it took six months after I started to figure out exactly what I did. It is such a misunderstood and unknown part of the industry.”
One big reason for this is that custody is one of those tasks that everyone takes for granted, but under the hood, it is far more complex than it seems. The regulatory considerations alone are quite daunting. Digital assets may be considered as securities, commodities, or currencies, depending on the jurisdiction, and the custodian may be responsible for more than one type of asset.
Servicing custody clients in a global context becomes more complicated and the onus is on operators to ensure they comply. There’s also the need for insurances and failsafes, along with an expectation that providers will comply with industry standards.
An Operational Juggling Act
The operational considerations can also be quite daunting. The most fundamental requirements of a custody provider can be at odds with one another. The provider must be able to deliver access to custodied funds on demand or within the bounds of a service level agreement that’s acceptable to the client. At the same time, they must ensure funds are secure, which often means applying multiple layers of security that take time to navigate and unlock.
Institutional clients will also expect that providers to offer some level of integration with established systems and processes, even when the crypto custody providers are not from from the traditional banking world.
Finally, crypto custody providers play an important role in helping traditional market players understand the crypto space, particularly considering the fast pace of development. They must also ensure that they themselves remain on the cutting edge of developments in custody technology, along with regulatory changes in each jurisdiction and industry best practices.
It’s clear that despite its “unsexy” reputation among industry operators, custody is the foundation that underpins the management and safekeeping of assets.
Chakar adds, “[The custodial segment] is really the glue that brings [the broader crypto industry] all together. And custody will continue to play a very critical role – [without it] you can’t have tokenization, you cannot run smart contracts without a really solid custody base.”
Finding the Right Strategy And Partners
Considering less than half a decade ago, the digital custody industry didn’t even really exist, how is it rising to address the challenge? Firms are adopting multiple strategies. Some of the biggest crypto-native firms like Coinbase and Gemini were savvy enough to spot the early opportunity, and new entrants such as OnChain Custodian, founded by industry veterans, developed institutional grade solutions from day one. They’ve also been around long enough to prove their regulatory chops and earn a reputation among investors.
Many firms will prefer to use established partners or trusted brands. Fidelity Digital Assets was the one of the first mainstream companies to move into the cryptocurrency custody space, but it’s since been joined by a host of big name finance firms including ING and Standard Chartered. BNY Mellon entered the market, launching an entirely new business unit dedicated to enterprise digital asset services.
Chakar’s enthusiasm and fresh approach to the emerging crypto and digital assets sector is an inspiration to many in the sector. The approach includes partnering with fintech firms to better improve the State Street offering. Fintechs are not seen as competitors but as collaborative partners that help to accelerate the delivery of state of the art technological solutions that are required to compete in the digital custody space.
“If we as a bank don’t write one line of code, and we can leverage a lot of that great work that fintech firms such as Securrency have done, I think we would have won the day,” adds Chakar.
It’s not just banks who see themselves as a natural fit for the responsibility of crypto custody. Prosegur has roots in the security industry but has now expanded into digital asset security as a new vertical. It recently joined Bit2Me as a cryptocurrency custodian, one of the most competitive companies in security on the Spanish market.
So far, M&A activity in the cryptocurrency space has been mostly one-way traffic – traditional firms buying up or partnering with crypto firms as a way of expanding their expertise. But Celsius, the CeFi crypto lending giant, is one notable exception. The firm recently acquired Israeli crypto custody tech firm GK8 in a deal worth $115 million. Celsius now claims it can offer an “all-in-one platform built for banks and financial institutions” putting the firm in prime position to compete in the rush to offer enterprise-grade custody services.
In a market for services like digital custody, a vibrant and competitive space bustling with players is the best scenario. The firms that can raise the bar for the institutional engagement will be the ones in the best position to lead the market by offering the much desired exposure to the bitcoin spot prices. Looking further beyond cryptocurrency spot markets at the important role digital custody will be critical to competitive survival.
Traditional debt and equity markets, also known as non-native digital assets, are increasingly being digitized into smart contracts and tokenized on distributed ledger technology (DLT), and this will be further extend into the derivatives markets. Traditional derivative markets are well suited for smart contracts and tokenization to move beyond the era of paper contracts. A fully digitized world of smart contract assets and instruments require institutional grade world class digital custody, clearing and settlement to work. A new era of digital financial market infrastructure (dFMI) is being put in place, now.
Institutional executives in financial services are often given the “keys to the kingdom” by fintech entrepreneurs, technologists, venture capitalists, Satoshi, FAANGs (MAANGs?), and are regularly given a full preview of how technology will change their customer offerings over the next decade. Even when executives recognize the value of the future technology, and “get it”, most can do little – it takes time to turn a tanker, and the resistance to new technologies is often high, especially in regulated grey areas.
In 2015, Jamie Dimon famously called fintech warning banking executives, “Silicon Valley is coming, [thanks to] hundreds of startups with a lot of brains and money working on various alternatives to traditional banking.” Few expected bitcoin and the cryptocurrency market to be capping two trillion dollars over five years later with Coinbase’s sensational market debut coming it at $86 billion putting it into the top 20 league table of global financial institutions by market cap.
Digital custody is the key to unlocking crypto spot markets for institutions, and this will further drive the mass adoption of crypto and digital assets for consumers and businesses in a safe and secure way that better meets the requirements of conduct regulators. A handful of institutions have the keys to the kingdom, are ahead of the game, and leading the way here.