The developing world of crypto custody
04 September 2018
Industry participants discuss the development of crypto custody and the role it might play if cryptocurrencies were to be accepted into mainstream thinking
Image: Shutterstock
How would you define crypto custody?
Graham Rodford, Archax: The act of storing and safeguarding the private keys needed to access digital assets in a secure way.
Steve Swain, Lendingblock: A crypto custody is similar to the service that a traditional custodian provides. A crypto custodian would provide security and would safeguard clients’ digital assets. This would be facilitated by a third-party trustee who would hold these digital assets either directly or indirectly. This would help minimise risk, loss, and theft on behalf of institutions and individuals that are dealing in digital assets.
How will it differ from traditional custody?
Rodford: Most digital assets tend to be akin to simple bearer instruments. Therefore, the holder of the private key has full control over the assets. With a private key, bitcoin could be moved from holder A to holder B with the transaction being totally public, unstoppable, and immutable. Once this has happened, there is no realistic way to undo the transaction due to a core tenet of this new asset class, decentralisation.
Swain: The concept of a third-party crypto custody, in theory, is similar to a traditional custody service. The difference is the assets that are accepted. For example, a crypto custodian would hold digital assets such as bitcoin, ether, and XRP, whereas a traditional custodian bank would accept stocks, bonds, commodities, and currencies. A unique aspect of crypto custody is hot versus cold storage, which currently necessitates a trade-off between security and convenience. Hot storage, also known as a hot wallet, stores the assets online and consequently allows assets to be more easily transferable yet prone to attacks and theft.
To minimise this risk, protections of hot wallets are managed by each institutions’ own information security and technology teams. On the other hand, cold storage takes the assets offline and typically stores them on memory devices in vaults, which require multiple signatories to access. It is not feasible to keep custody of crypto assets secure at all times in cold storage, as there will be times in which the assets are in transit. Transfer out of cold storage can take up to a day.
Lendingblock has been assessing companies such as VOLT and DACC for its crypto asset custodian and provider of a deep cold storage vault. We will be working with some of the best providers in the industry in order to deliver a secure and resilient custody solution for our institutional clients.
Crypto custody and the crypto post-trade environment is a relatively new service, which is being applied in the crypto markets. Therefore, firms such as Lendingblock will also be offering a component of fund administration and reporting. However, services such as clearing and settlement are still under review.
Why do you think crypto custody is important?
Rodford: Most institutions that are considering operating in the crypto space will be forced to look for institutional methods to custody their assets. Since they often have fiduciary responsibilities to their clients, custody is key.
Swain: Crypto custody is a fundamental next step for the development of the crypto post-trade environment. It would be a vital service for supporting wider market adoption among institutions who are already dealing in digital assets or for those that are considering becoming active in crypto markets. This is because it brings a more secure and trusted structure when transacting in these assets. For example, 40 Act Funds in the US, which is a large amount of US investment vehicles, are required by the regulators to maintain their investments with custodians, which are designed to ensure the safety of the fund’s assets.
At Lendingblock, we believe that crypto custody could play a role that is systemically important for wider institutional adoption of cryptocurrencies. It is an immediate area to be addressed if we are to see a significant upgrade in the strength of the post-trade environment for cryptocurrencies.
Some might feel that it is impossible to provide custody for non-existent assets. How would you respond to that suggestion?
Rodford: The storage for the private key allows access to the crypto wallet. There are many different types of solutions operating in the market at the moment for vast amounts of money.
In applying this logic to the traditional world, envisage an individual storing a key which can unlock a door to a room that contains a gold bar. This room is impenetrable and can only ever be opened by this key (the room represents the decentralised immutable blockchain that is bitcoin).
The individual may store this key underground in a vault, or cut this key up into five pieces and glue it back together, should they ever need to use it to access this room. Once they have this key, nothing can stop them from taking the gold bar. However, the transaction of moving the gold bar out of the room is recorded on a public blockchain for all to see.
Therefore, a custody solution in the digital asset space is focused on the safekeeping of the key. Essentially, we are highlighting that there is a lot of good which has been built in the traditional world, which should not be forgotten about when designing this new world.
Swain: The lack of a physical presence does not necessarily translate to a lack of tangible value which doesn’t need protecting. This is part of a broader transition from a physical world to one that is digital. Appropriate measures to safeguard and avoid the misuse of personal data, cloud storage, or internet browsing history are expected.
Likewise, cryptocurrencies are a digital representation for value transfer, record keeping, and so forth. As such, crypto custody is a natural next step and it will provide an additional layer of security and it will also provide post-trade support for institutions and individuals who are transacting in this space.
Assuming that it does become a reality, what might the role of traditional custodians be in helping cryptocurrencies by providing crypto custody?
Rodford: Custodians have been providing services to traditional asset classes for many years, and their controls and processes are built around running these businesses in a regulated and professional manner. They will need some to adapt to cryptocurrencies but fundamentally, the principles are the same. If a private key is a piece of digital information, then the custodian needs to keep it safe.
Swain: If traditional custodians accepted cryptocurrencies as assets, this would be an early step in the wider industry acceptance and adoption of digital assets. We are already seeing the likes of Northern Trust exploring ways of holding digital assets for their hedge fund clients. They bring an existing framework that works in the traditional space. Some customisation will be needed due to the unique nature of cryptocurrencies, however, they bring value as a benchmark along with their years of experience operating in safe custody of assets.
Do they have the relevant skills and tools? Or might they have to build them? Or will new players emerge?
Rodford: The institutions that we have spoken to are in different stages of research. Most institutions have financial technologies or blockchain centres which are exploring the asset class. Nearly all of them already have the foundations from the traditional assets upon which they can build. They will certainly need to enhance or adapt their traditional offering. New specialist players are entering the custody, bank, and prime brokerage space.
Swain: As with all emerging market trends and opportunities, there will be winners and losers. Traditional custodians will be considering how they can keep up and stay relevant, so that they do not lose out to the agiler and digitally focused smaller players. We see a lot of the big banks testing and developing use cases for how the technology that underpins the crypto market—blockchain—can enhance or expand their current services, such as foreign exchange payments or the settlement of securities.
While the larger companies have the budgets and resources, the question will be whether they can move quick enough to compete with the fintechs and smaller, more nimble companies. Management expertise, funding, and bringing a solid product quickly to market is what a lot of the smaller players are competing against, and we will definitely see some winners and losers here as well.
Where will new players emerge from?
Rodford: Many new entrepreneurs are entering the digital asset space to help build the infrastructure for the future.
Do you think the geographies that are lacking legacy systems, traditions, and practices could leapfrog more developed markets?
Rodford: There are some less well-known jurisdictions that are trying to take the initiative and leapfrog the more developed markets by implementing a regulatory framework. This may help to allow them to be competitive in the future.
Swain: Not necessarily. The majority of flows in the current financial system occur in regions with robust legal systems and property rights, trading documentation, and have minimal friction in conducting business. Whilst a region lacking legacy systems may quickly implement the technology and an execution platform, it won’t draw flows away from the developed markets if the appropriate safety engineering isn’t there.
How prepared is your own institution?
Rodford: Archax understands these requirements and is developing an institutional custodian as well as a segregated offering as part of our exchange.
Swain: As the institutionalised platform for cryptocurrency lending, Lendingblock is bringing crypto to crypto securities lending to hedge funds, exchanges, market makers, asset managers, and banks. This is an important piece of market infrastructure, which ensures that liquidity is transferred to where it is needed and that all market directional views are captured in the price of an asset. Until now it has been easy to open up long exposure to cryptocurrencies.
However, the channels for hedging have been almost non-existent and the same is true for those looking to short digital assets—needless to say, this has resulted in asset price bubbles.
Our team also has long-standing experience in finance and technology, and we understand the needs and challenges of institutions. This skill set means that as well as providing the platform, we also bring the necessary risk management, legal structure, and regulatory compliance, which is paramount for providing a healthy financial market.
Graham Rodford, Archax: The act of storing and safeguarding the private keys needed to access digital assets in a secure way.
Steve Swain, Lendingblock: A crypto custody is similar to the service that a traditional custodian provides. A crypto custodian would provide security and would safeguard clients’ digital assets. This would be facilitated by a third-party trustee who would hold these digital assets either directly or indirectly. This would help minimise risk, loss, and theft on behalf of institutions and individuals that are dealing in digital assets.
How will it differ from traditional custody?
Rodford: Most digital assets tend to be akin to simple bearer instruments. Therefore, the holder of the private key has full control over the assets. With a private key, bitcoin could be moved from holder A to holder B with the transaction being totally public, unstoppable, and immutable. Once this has happened, there is no realistic way to undo the transaction due to a core tenet of this new asset class, decentralisation.
Swain: The concept of a third-party crypto custody, in theory, is similar to a traditional custody service. The difference is the assets that are accepted. For example, a crypto custodian would hold digital assets such as bitcoin, ether, and XRP, whereas a traditional custodian bank would accept stocks, bonds, commodities, and currencies. A unique aspect of crypto custody is hot versus cold storage, which currently necessitates a trade-off between security and convenience. Hot storage, also known as a hot wallet, stores the assets online and consequently allows assets to be more easily transferable yet prone to attacks and theft.
To minimise this risk, protections of hot wallets are managed by each institutions’ own information security and technology teams. On the other hand, cold storage takes the assets offline and typically stores them on memory devices in vaults, which require multiple signatories to access. It is not feasible to keep custody of crypto assets secure at all times in cold storage, as there will be times in which the assets are in transit. Transfer out of cold storage can take up to a day.
Lendingblock has been assessing companies such as VOLT and DACC for its crypto asset custodian and provider of a deep cold storage vault. We will be working with some of the best providers in the industry in order to deliver a secure and resilient custody solution for our institutional clients.
Crypto custody and the crypto post-trade environment is a relatively new service, which is being applied in the crypto markets. Therefore, firms such as Lendingblock will also be offering a component of fund administration and reporting. However, services such as clearing and settlement are still under review.
Why do you think crypto custody is important?
Rodford: Most institutions that are considering operating in the crypto space will be forced to look for institutional methods to custody their assets. Since they often have fiduciary responsibilities to their clients, custody is key.
Swain: Crypto custody is a fundamental next step for the development of the crypto post-trade environment. It would be a vital service for supporting wider market adoption among institutions who are already dealing in digital assets or for those that are considering becoming active in crypto markets. This is because it brings a more secure and trusted structure when transacting in these assets. For example, 40 Act Funds in the US, which is a large amount of US investment vehicles, are required by the regulators to maintain their investments with custodians, which are designed to ensure the safety of the fund’s assets.
At Lendingblock, we believe that crypto custody could play a role that is systemically important for wider institutional adoption of cryptocurrencies. It is an immediate area to be addressed if we are to see a significant upgrade in the strength of the post-trade environment for cryptocurrencies.
Some might feel that it is impossible to provide custody for non-existent assets. How would you respond to that suggestion?
Rodford: The storage for the private key allows access to the crypto wallet. There are many different types of solutions operating in the market at the moment for vast amounts of money.
In applying this logic to the traditional world, envisage an individual storing a key which can unlock a door to a room that contains a gold bar. This room is impenetrable and can only ever be opened by this key (the room represents the decentralised immutable blockchain that is bitcoin).
The individual may store this key underground in a vault, or cut this key up into five pieces and glue it back together, should they ever need to use it to access this room. Once they have this key, nothing can stop them from taking the gold bar. However, the transaction of moving the gold bar out of the room is recorded on a public blockchain for all to see.
Therefore, a custody solution in the digital asset space is focused on the safekeeping of the key. Essentially, we are highlighting that there is a lot of good which has been built in the traditional world, which should not be forgotten about when designing this new world.
Swain: The lack of a physical presence does not necessarily translate to a lack of tangible value which doesn’t need protecting. This is part of a broader transition from a physical world to one that is digital. Appropriate measures to safeguard and avoid the misuse of personal data, cloud storage, or internet browsing history are expected.
Likewise, cryptocurrencies are a digital representation for value transfer, record keeping, and so forth. As such, crypto custody is a natural next step and it will provide an additional layer of security and it will also provide post-trade support for institutions and individuals who are transacting in this space.
Assuming that it does become a reality, what might the role of traditional custodians be in helping cryptocurrencies by providing crypto custody?
Rodford: Custodians have been providing services to traditional asset classes for many years, and their controls and processes are built around running these businesses in a regulated and professional manner. They will need some to adapt to cryptocurrencies but fundamentally, the principles are the same. If a private key is a piece of digital information, then the custodian needs to keep it safe.
Swain: If traditional custodians accepted cryptocurrencies as assets, this would be an early step in the wider industry acceptance and adoption of digital assets. We are already seeing the likes of Northern Trust exploring ways of holding digital assets for their hedge fund clients. They bring an existing framework that works in the traditional space. Some customisation will be needed due to the unique nature of cryptocurrencies, however, they bring value as a benchmark along with their years of experience operating in safe custody of assets.
Do they have the relevant skills and tools? Or might they have to build them? Or will new players emerge?
Rodford: The institutions that we have spoken to are in different stages of research. Most institutions have financial technologies or blockchain centres which are exploring the asset class. Nearly all of them already have the foundations from the traditional assets upon which they can build. They will certainly need to enhance or adapt their traditional offering. New specialist players are entering the custody, bank, and prime brokerage space.
Swain: As with all emerging market trends and opportunities, there will be winners and losers. Traditional custodians will be considering how they can keep up and stay relevant, so that they do not lose out to the agiler and digitally focused smaller players. We see a lot of the big banks testing and developing use cases for how the technology that underpins the crypto market—blockchain—can enhance or expand their current services, such as foreign exchange payments or the settlement of securities.
While the larger companies have the budgets and resources, the question will be whether they can move quick enough to compete with the fintechs and smaller, more nimble companies. Management expertise, funding, and bringing a solid product quickly to market is what a lot of the smaller players are competing against, and we will definitely see some winners and losers here as well.
Where will new players emerge from?
Rodford: Many new entrepreneurs are entering the digital asset space to help build the infrastructure for the future.
Do you think the geographies that are lacking legacy systems, traditions, and practices could leapfrog more developed markets?
Rodford: There are some less well-known jurisdictions that are trying to take the initiative and leapfrog the more developed markets by implementing a regulatory framework. This may help to allow them to be competitive in the future.
Swain: Not necessarily. The majority of flows in the current financial system occur in regions with robust legal systems and property rights, trading documentation, and have minimal friction in conducting business. Whilst a region lacking legacy systems may quickly implement the technology and an execution platform, it won’t draw flows away from the developed markets if the appropriate safety engineering isn’t there.
How prepared is your own institution?
Rodford: Archax understands these requirements and is developing an institutional custodian as well as a segregated offering as part of our exchange.
Swain: As the institutionalised platform for cryptocurrency lending, Lendingblock is bringing crypto to crypto securities lending to hedge funds, exchanges, market makers, asset managers, and banks. This is an important piece of market infrastructure, which ensures that liquidity is transferred to where it is needed and that all market directional views are captured in the price of an asset. Until now it has been easy to open up long exposure to cryptocurrencies.
However, the channels for hedging have been almost non-existent and the same is true for those looking to short digital assets—needless to say, this has resulted in asset price bubbles.
Our team also has long-standing experience in finance and technology, and we understand the needs and challenges of institutions. This skill set means that as well as providing the platform, we also bring the necessary risk management, legal structure, and regulatory compliance, which is paramount for providing a healthy financial market.
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