cryptocurrency, bitcoin, ethereum, crypto
One of the biggest problems facing the digital asset industry currently is custody. But what does that exactly mean?
“Custody” means what you would expect – how something is held or kept safe.
Most existing ways to "custody" or hold crypto are imperfect. Hot storage (i.e. crypto wallets that are connected to the internet) can be hacked. Cold storage (i.e. crypto wallets that are not connected to the internet) requires protecting and maintaining the hardware. Storing your Bitcoin or Ethereum on Coinbase is probably safer than storing it on a computer in your basement but, á la Nick Szabo, trusted third parties are security holes.
Better yet – any trusted humans are security holes.
No solution will ever be perfect, and there are increasingly better options like multisig wallets (i.e. wallets that require multiple private keys to access them). But, compared to the traditional securities world, crypto custody lacks standards, transparency, and is young and untested. All of those factors create a very uncertain future. What will custody look like in six months? Are multisig wallets really that safe? What would “institutional grade” cold storage look like?
Why Custody Matters
The uncertain state of custody has become a big bottleneck in the growth and adoption of digital assets. Institutional investment firms have duties to their investors. Family offices aren’t as risk seeking. These types of investors can bring significant capital to the cryptoscape, but they won't risk making investments if how those investments are custodied is uncertain. The best standards today may be easily hackable tomorrow. Time will ease custody concerns, but we just don’t have the certainty the industry needs yet.
Another good example is the “qualified custodian” requirement for certain investment advisers. For example, investment advisers (think: hedge fund manager) that are required to register with the SEC (aka, they have more than $150MM in assets under management) must hold assets with a “qualified custodian”.
The term “Qualified Custodian” (“QC”) is defined in Rule 206(4)-2 of the Investment Advisers Act of 1940. It generally means a bank or savings association with FDIC insured deposits, a registered broker-dealer, a registered futures commission merchant, or foreign institution that typically acts in a similar custody role.
In simple terms: a qualified custodian is usually an entity like a bank, that is subject to robust regulation and compliance requirements.
As of the date of writing, only Kingdom Trust is the only self-advertised crypto QC (but there is some debate on whether it actually is a qualified custodian, which means there may not actually be any QCs). But even then, Kingdom Trust's offerings are limited to crypto like Bitcoin, Ethereum, and ZCash.
Many institutional investors are staying out of crypto because they have to hold assets with a QC...but there aren't great QC options right now (in fact, there may not actually be any options). However, there are lots of promising efforts underway, like those by Coinbase and BitGo.
Custody also matters for crypto startups. They need think about how they should properly custody tokens in an industry without clear standards. Exchanges need to have sufficient protocols and protections in place to protect assets, and need to account for situations like how tokens will be held in bankruptcy.
Time Will Tell
The standards for crypto custody will become clearer over time, but they’re something the industry needs to focus on and develop. Recent developments are promising, however. For example, the Winklevosses (…Winkevai?) have gotten support from a CFTC commissioner for their proposed self-regulatory organization, which would help establish regulatory standards for the crypto industry.
Reginald Young is a licensed attorney in California, where he works with private investment funds and startups in the crypto industry. You can connect with him here.