Cryptocurrency Custody Solutions
Custody solutions for institutional investors have become a significant priority following Bitwise Asset Management’s rejection from the United States Securities and Exchange Commission in October. The Bitcoin ETF Platform was rejected because of concerns that SEC has regarding the custody of cryptocurrency. The Chairman for the commission noted his concerns weeks before the rejection was formalized. However, there has never been a moment where cryptocurrency custody has been more available to investors. Unfortunately, it isn’t enough to satisfy the SEC.
Jay Clayton spoke Bob Pisani, a Reporter with CNBC. The two spoke on how the cryptocurrency industry is coming closer to meeting the commission’s concerns, but that there are still things that need to be accomplished. He proposed a question onto investors, asking them how they all will know when they have a hold of digital assets. There are other concerns regarding the low percentage of investors using the already available custody solutions.
The United States Financial Industry Regulatory Authority issued a joint statement with the Securities and Exchange Commission regarding their decision of cryptocurrency custody. That statement read: “The ability of a broker-dealer to comply with aspects of the Customer Protection Rule is greatly facilitated by established laws and practices regarding the loss or theft of security. This may not be available or effective in the case of certain digital assets.”
One of the most significant pain points facing the cryptocurrency industry was the lack of crypto custody services. It historically has caused numerous investors to lose out on thousands in held digital currencies. Multiple analysts believe that 2019 was the year were multiple custody solutions became viable for the cryptocurrency industry. If those analysts are correct, there could be an institutional capital increase coming in 2020. After the increased custody solutions, the market itself has drastically improved since 2018. Exchanges like ICE, Coinbase and Fidelity maintain their respective solutions. Still, this hasn’t stopped 92% of investors from keeping their crypto assets on centralized exchanges, with those being the more reliable and standardized systems.
One of the leading exchanges worldwide completed a survey regarding how investors store their cryptocurrency assets. Binance Research’s Survey noted that institutional investors are maintaining their funds on exchanges and opting out not to use third-party services. Following the release of their survey, the research team released a public statement regarding their findings.
That statement reads: “76 participants across our English and Mandarin surveys primarily composed of firms and institutions with respective allocations to crypto-assets ranging from $100K to more than $25M. Exchanges remain as the most popular choice for crypto asset storage amongst our institutional and VIP clients at 92.1%. When moving to self-storage, cold wallets are the second most favoured choice, given their improved safety and control. Third-party custody services were the least popular option at 2.6%.”
The results of this survey came as a shock to most, with it being believed in the past that holding funds on a centralized exchange wasn’t safe. This hasn’t changed, with investors and traders still vulnerable to an array of issues. Those include technical failure, outside attacks from hackers and the mishandling of exchange funds. However, advancements in digital currency technologies have enabled these exchanges to become better prepared for future attacks. There are also insurance funds to return lost funds to players, which explains the high percentages of stored funds seen on centralized exchanges.
There have been numerous examples of attacks happening to cryptocurrency exchanges, with some being recent and others outdated. Coincheck, the Japanese-located cryptocurrency exchange had $530 Million stolen last year from a series of hackers. Another instance was when QuadRigaCX’s Chief Executive Officer passed away in 2019, taking the exchanges private keys to the grave. Other clients were also affected by hacks at Bithumb and BitGrail. It should be noted that since an increased presence of hackers, there have been numerous exchanges to receive Theft Insurance. However, QuadRigaCX’s clientele hasn’t received any form of compensation for their lost funds. It’s estimated that without Theft Insurance, traders and investors would be more inclined to look into additional cryptocurrency custody solutions.
The Crypto Valley Association
There have been executives in the cryptocurrency industry to speak out on the conditions of the market and why investors shouldn’t trust centralized exchanges. One such individual is Daniel Haudenschild, the Chief Executive Officer of Sibex and the Chief Director for the Crypto Valley Association. He has worked in the marketplace for more than a decade, maintain a firm that develops new arbitrage opportunities for investors. During these comments, he noted that this survey display’s essential data, but that it doesn’t account for specific sub-markets with institutional cryptocurrency investing.
Daniel Haudenschild stated: “Many companies are getting exposure to crypto through CFDs, tracking products and ledger trading solutions. These solutions do not see actual on-chain transactions take place, so it is difficult to measure the correct exposure. It is clear though that there is significant exposure to centralized counterparties.
“The fact that most institutional investors trust centralized exchanges is indicative of the immaturity of the market. High-net-worth individuals are pushing their financial institutions for access to crypto against a backdrop of prolonged negative interest rates. Few institutional investors have had the foresight to invest in the necessary infrastructure and talent to handle the demand. Many are now playing catch-up, using interim tactical steps to do so.”
“Utilizing centralized functions for storage is not recommended for crypto as it introduces significant unnecessary counterparty risk. This behaviour shows clearly that many investors do not yet understand this market and struggle to identify the risk vectors and severity associated with digital assets. The learning curve will be steep as loss events take down entire ecosystems. Most traders use cryptocurrency as a tool for profiting off of the price volatility, not for the underlying properties of peer-to-peer trading.”
In context, Daniel is stating that custodial-over-reliability from apparent institutional investors that operate through cryptocurrency exchanges, is a sign of changing times. He is exemplifying that there will be a new market, as the best practices haven’t been established yet. However, the severe issues prompted by the interim period could be significant.
Understanding the Solution
Some are publicly going against the comments made by Daniel Haudenschild. One of the best minds in the industry, Kiara Bickers, who authored the novel Bitcoin Clarity: A Guide to Understanding. She noted that the way institutional traders are holding their funds on a cryptocurrency exchange is a sign of their involvement within the space. She mentioned that the majority of traders maintain their cryptocurrencies for tools of profit against price volatility and not peer-to-peer trading, as Daniel believes.
Additional individuals opposing Daniel was Alex Kruger, an Economic in Europe. He took to Twitter, making a similar point to Kiara Bickers. He noted that Cryptocurrency EFTs had received hardly any interest from investors or traders. Alex formulated that the institutional investors that engage with Bitcoin and other digital currencies don’t usually use third-party custodial services for prolonging solutions. The reliance and trustworthiness of those services are lacklustre in comparison to name brands like Binance or CoinDesk.
Therefore, to understand the solution for cryptocurrency custody, institutional traders must learn that for third-party solutions must be integrated with exchanges. This is the only way to improve the safety of funds, with Kiara Bickers mentioning that she would like this exchange to provide detailed reports on the cold storage of funds. Unfortunately, Kiara won’t receive her request until traders themselves begin demanding more insight on how their funds are stored. Considering how many have lost their funds through attacks, it’s shocking that the demand isn’t already prevalent.
Haudenschild formulated that the current situation with markets is the fault of the exchanges themselves. Daniel believes that exchanges spend more time increasing their trading volume than wondering how they will maintain that following basis of clients. Regardless of the opinion, the demand to resolve cryptocurrency custody solutions cannot be put entirely onto the exchange themselves. This will be an overbearing burden, which could collapse exchanges over time.
Daniel Haudenschild stated: “Now that investment into digital assets has grown beyond the early adopters and tech enthusiasts, in many cases, the retail investors are driving the institutional investors. However, few HNW and Ultra high-net-worth individuals understand the space well enough to manage their infrastructure. They place trust in their wealth and asset managers as they have for generations, which is ok until it isn’t. It would be good if this statistic 92% is an interim step. One would hope institutions offering exposure are also taking the strategic steps to provide in-house custody.”
He didn’t finish his comments with CIBC Reporters there, as he also pointed out that there has been a significant culture adjustment for asset management. His official comment reads: “Most financial services companies have been spending the last ten years moving into a cloud architecture. Digital assets are one place where this trend is starting to reverse. Crypto is one area where companies should be maintaining their in-house, on premise, custody solutions. The most effective move centralized exchanges can make is to invest in decentralized solutions.”
After these statements were made, Daniel was then asked by reporters what he believes the ultimate solution for the custody problem could be and if it will move away from the centralized model. Daniel Haudenschild said: “Centralized exchanges, like brokers, are an interim step to market adoption. Centralized exchanges perpetuate a model with a fatal flaw; they need to grow to get liquidity, and the more they grow, the more they become more of a honeypot for hackers, and subsequently they become more of a target for regulators.”
He finished his statements with CIBC Reports by saying: “This not only increases the cost profile, but it is also a model that is pockmarked with major loss events that can close out entire markets from crypto investments. The market is moving towards decentralized infrastructure and peer-to-peer trading. The most effective move centralized exchanges can make is to invest in decentralized solutions.”
Regardless of how institutional investors want to look towards the market, decentralized solutions are more advanced and secure. It places the responsibility of funds onto the investor or a third-party custodian. This has its risks but avoids the attacks of hackers. It also assists exchanges by allowing them to focus directly on trading volume growth.