By Wang Zelong
Editor Tong
Source PANews
While traditional institutions are expecting to enter the crypto space, crypto custody solutions, as the important foundation to keep digital assets safe, have been on the rise and further pave the ways for institutional participants.
Precondition for a Mature Industry
Custodial service has been regarded as a precondition and an infrastructure for a mature and thriving blockchain industry for a long time. The main reasons lie in its offering of capital inflow channel secured by multi-party trust and the safeguarding of crypto assets.
Institutional capital flows are often related to multiple entities. A sound security mechanism is essential for multi-party trust.
“In some token fund of this industry, a trustee may hold tens or hundreds millions of funds. While in a formal financial market, large amounts of money are scarcely likely to entrusted to one single entity to manage. The introduction of custody mechanism, in which tokens are stored in hot and cold wallets and private keys are well protected, could reassure all parties,” said Xu Bin, Founder of InVault.
Frank, Founder of AlphaCoin Fund, shared a similar opinion that, “Compliant and custodian solutions are the basic infrastructure and precondition for the large-scale entry into the crypto market for institutional players.”
Only by the adoption of reasonable custody mechanism and building of multi-party trust, can activate massive inflows of institutions.
The custody of token is more complicated than that of traditional assets, and is associated with more problems. Users can’t remember clearly/forgot or even lose their private keys. Users may hold their assets with their ‘main’ trade-exchange for convenient purpose. But exchanges are susceptible to hacking. Token fund/ hedge fund may lose their investors’ assets. According to Hacker Noon, as of September 2018, there were already 466 emerging hedge funds.
Professional custodial services will help to reduce the risk of loss and theft of assets. For example, BitGo claims that their cold-stored assets will be put into Swiss military-grade vault.
In addition, professional audit and legal services provided by custodians can help to reduce the compliance risk and thus ensure the security of assets.
Industry Landscape
As of June 2019, early custody-related solution providers have formed an ecosystem:
The leading custodians include Coinbase, Xapo, BitGo and Kingdom Trust.
Coinbase holds $1 billion in assets under custody, while the latter three are estimated to respectively have $5 billion, $5 billion and $12 billion in assets (including digital and non-digital assets).
Kingdom Trust, the earliest crypto custody provider, founded in 2010, chartered, did not obtain external financing yet. In last January, there was news that BitGo would acquire Kingdom Trust, but in May, BitGo terminated its acquisition with Kingdom Trust and declared to build its own custodial solutions.
Xapo, unqualified, raised $40 million in two rounds of financing since its founding in 2012. According to sources, Coinbase is in advanced talks to buy Xapo for about $50 million.
BitGo, a qualified custodian, established in 2013, has raised a total of $84.5 million in four rounds, in which the Series B round was led by Goldman Sachs.
Taking a closer look at China, Chinese custodians set foot on the filed relatively late, basically after 2016. They do share some features, including late start, small scale and insufficient compliance. Among them, InVault, Cobo and Jade Poolare relatively more influential custody providers.
Keystore and Wetez are also custodians originated from China without qualification, according to public information and the survey by PANews. Some institutions explained to PANews that Chinese compliance regulator has not yet caught up crypto custody advances. Institutions can only seek regulatory approval overseas.
In addition, since PRC Government has a tendency in tightening cryptocurrency rules, the above custodians usually set up a company in Hong Kong in addressing compliance concerns.
Three Options in Entering the World of Custody
Both leaders in traditional realm and crypto companies have already or have been trying to get into the custody race.
There are mainly three kinds of options for those custodians: self-built custody solution, technical service providing and joint management and development.
Self-Built Custodial Solution
Binance and Coinbase are typical exchange custodian examples, while BitGo, Bakkt, Xapo, Cobo and InVault are dedicated ones. Wall Street giant Fidelityhas also engaged in the ecosystem. Coinbase offers two distinct custody solutions: a depository account and a custody account.
The typical example is IBM, who provides technical support instead of custody solution. IBM developed a hardware security module (HSM) built on FIPS 140-2, level 4 based technology, in which their clients can keep their own keys on the cloud.
Joint Management and Development
Two typical representatives are the partnership between Ledger and Nomura together with Global Advisors and Bakkt’s collaboration with BNY Mellon.
The former three announced in 2018 May to create Komainu - a project aimed at bringing the institutional investors into crypto space, paving the ways for secure and compliant investment in digital assets. It is reported that the project adopted HSM initiatives from IBM.
Bakkt and BNY Mellon have been working closely on setting up geographically-distributed private keys storage. Specifics of that storage have not yet been disclosed.
It is worth noting that many custodians employ more than one solution options.
Coinbase, as mentioned before, in addition to self-built custody solution, may acquire Xapo, one of the heavy players in crypto custody.
Similarly, except offering hot and cold storage-as-a-service, Bakkt acquired Digital Asset Custody Company (DACC) in April.
Competitive Differentiators
Inevitably, the main selling point is around securityin the infancy stage of crypto custody. But in the long run, these service providers must move towards transforming and upgrading.
Proof of Capital believes that there will be future demands for features such as staking, delegated voting (i.e. governance), forks and tax filling.
In the customer side, the core appeal of staking (adoption of PoS consensus, one of the most popular blockchain protocols today) lies in value-addition.
Coinbase made a massive expansion on custody this year, invested staked.us in early February and announced Coinbase Custody to support Tezos staking features in cold wallet on March 29.
Chinese staking peers include Wetez, Jade Pool and HashQuark by which 5%-25% of annualized return are provided.
In addition, some providers have unique services. Xu Bin revealed to PANews that InVault, secured a trust license from the Hong Kong financial regulator, offers custody solutions for both digital assets and fiat.
From InVault’s planning, the overall business will be more diversified with the expansion of assets under custody. For example, the aggregation of multiple type of B-end users may create investment-banking opportunity.
Compliance Path Becomes Increasingly Clear
Putting large volume of assets under custody not only shows investors’ demand for asset security and other value-added services, but also a route exchanges and other custody providers must take to become regulatory compliant.
On November 1, 2018, the Hong Kong Securities and Futures Commission (SFC) issued a conceptual regulatory framework for virtual assets trading platforms.
The SFC has clearly stated that as an intermediary, a platform operator is required to comply with the SFC regulation (Client Money Rules Cap.571), including the requirement to establish and maintain one or more segregated accounts for clients’ money and ensure that whether clients’ virtual assets are “securities” or not.
The framework also states that a platform operator is expected to store a sizable amount (for example, 98%) of clients’ virtual assets in cold storage to minimize exposure to losses.
Though there is no explicit regulation on licensed assets custody, in practical operations, some trustees may oftenapply for trust license from regional administration authority from the concern of advanced business planning or from the professional habit in financial sector.
In a recent interview during Consensus with Rich Teo, Co-founder of Paxos, he revealed that Paxos has already begun to apply for a trust license from New York State Department of Financial Services (NYDFS) since end of 2013 or early 2014 and finally got authorized in 2015 after a lengthy process.
Vice versa, Xu Bin of InVault also shared with PANews that it took them 7 months to get the trust license and a guarantee fund was transferred to Hong Kong regulator.
Regarding the impact of the recently-issued Financial Crimes Enforcement Network (FinCEN) guidance on crypto custody solution, Sheldon Xia, Founder & CEO of BitMart, commented to PANews that at present, crypto assets custodians are usually applying to be state-level trust company to run custody business in the United States, such as Coinbase, Itbit, Bakkt and other trading platform.BitMart was registered as Money Service Business (MSB) under FinCEN.
“According to FinCEN, banks (including trust companies) under the definition of CFR § 1010.100, are not required to registered as MSB under FinCEN. New York State, North Dakota, and Wyoming have custody-friendly policies at present,” Xia added.
