Qualified Crypto Custody: Final Step for Institutional Adoption
There is one big challenge that many institutional investors are facing now: Crypto Custody.
More specifically, institutional investors with large Assets Under Management (AUM) have to entrust their assets with what is called a “qualified custodian”.
The only problem is where to find a custodian that is sufficiently “qualified”. One that you trust to look after an asset which is easier to steal and lose than bonds, stocks and commodities.
So, could this be a barrier to large scale institutional adoption to crypto?
What is a Custodian?
Quite simply, a custodian service is one that looks after an asset on behalf of a client. They can be sold only on the request of the client and cannot be used for any part of the custodian’s business.
In traditional financial markets, these custodians will hold a plethora of different assets. These include assets such as cash, bonds, precious metals, equities and other liquid securities.
Having a custodian look after the funds is not a matter of choice – it is the law.
In the US, the SEC mandates through the Investment Advisor Act that those firms with over $100m in AUM are required to use the services of a custodian.
This Act has its origins in the 1940s and was borne out of the unpleasant experiences that numerous investors were put through in the great depression.
Given the amount of funds that are looked after by these custodians, they tend to be highly reputable banks with an established track record in looking after these assets.
Essentially, no investment manager really wants to take a risk on the “new kid on the block” when it comes to their asset safety.
This of course creates a natural barrier for the crypto industry as there are no firms with said track record. Heck, the asset class itself is only just a couple of years old.
Moreover, the nature of cryptocurrency presents unique challenges that are not faced with other assets…
Why Crypto is Different
Cryptocurrencies are unlike most other financial assets. They exist as a record on a public blockchain and can only be accessed through a signature that is signed with a unique private key.
They can be stored on a single thumbdrive or even a piece of paper. Loss of these private keys can lead to the loss of all of the coins. These can essentially be locked away for ever in a permanent state of blockchain purgatory.
On the other end of the spectrum, once someone has access to the private keys in question, they can easily transfer the assets out and make it nearly impossible to recover them. This is why crypto theft is so lucrative for the online hackers.
It is because of these challenges that the traditional custodian solutions have not stepped into the gap provided by crypto custody. And, although there are crypto custody options, they cannot offer these Asset Managers the assurances of a custodian with a long track record.
The Status Quo – Far from Ideal
Of course we do know that there are numerous asset managers that have entered the crypto markets. In fact, by some estimates there is now $3.5bn in estimated assets under management at over 250 dedicated crypto funds.
These funds are very unlikely to keep large holdings of coins on any crypto exchange. There have been a number of examples of cryptocurrency exchanges either getting hacked or even the founder dying with the private keys and taking the coins to his grave (see QuadrigaCX).
So, as a result, most of these funds will practice their own self-custody solutions. This usually includes a combination of secure cold storage and multi-signature wallet technology.
While this is still a risk for these funds, they are not required by law to seek a custodian. If they have less than $100m AUM then they do not meet the criteria that is laid out in the Investment advisor act.
What we have is a situation in which even if large institutional asset managers want to dip their toes in cryptocurrency assets, they cannot find a reputable custodian solution.
Essentially, it is a catch 22.
No solutions with a track record exist because the industry is so new. In order to create this track record the custodian needs clients to start using their services in the first place, track record or not.
So, are there any solutions that could potentially shift this status quo?
Up until quite recently, the only firms that were offering custodian solutions were the cryptocurrency exchanges as well as more bespoke crypto storage solutions.
However, it was recently announced that Fidelity, the most well-respected financial custodian, is launching a crypto alternative. According to the Fidelity CEO, Abigail Johnson:
“Our goal is to make digitally native assets, such as bitcoin, more accessible to investors”
Fidelity is perhaps a staple name in the investment management industry and looks after over $7.1 trillion in client funds. They are well regarded by not only regular retail investors but also by fellow investment managers.
They bring that “qualified” component that they seek from their custodian.
Apart from the name recognition that comes with these custody solutions, it will also have strong technology. It will use cold storage protocols as well as multilevel physical and cyber controls.
Indeed, it seems as if Fidelity is not alone in their ambitions to offer such services.
For example, firms such as Nomura, JP Morgan, Bank of New York Mellon and the Northern trust Corp are all considering their own crypto custody solutions.
All of this is probably being spurred on by the intense demand that these firms are observing. For example, according to this BNY Mellon report:
“There is increasing demand in the market for a traditional, established custodian to provide custody of cryptocurrencies”
This is all very encouraging and for many it could be the bridge that will allow those institutional investors on the edge to jump into the crypto pools.
While it is still early days for the cryptocurrency custody industry, it is encouraging to see that there are firms that are bringing forward potential solutions.
Of course, one cannot realistically expect a custody solution to be the prime impetus for a rally in crypto. The investment managers still have to have a positive view on the markets in the medium term.
However, if things do start to turn and these same investment managers decide to invest in crypto, they could have a range of secure and reliable storage options at the ready.
So, with the right conditions, these qualified custodian solutions could pave the highway to mass institutional crypto adoption.
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