Digital assets custodians protect their clients’ assets using tools and techniques taken from the digital assets and traditional financial worlds. This post will give an overview of what digital assets custodians do, how they do it, and why they’re so important.
What does a digital asset custodian do?
The main benefit a digital assets custodian provides is safeguarding digital assets. In this sense a digital assets custodian is the same as any other custodian. However, since digital assets behave differently from other asset classes in several vital ways, it’s important to find a custodian who has the specific competencies to custody digital assets securely, safely and effectively.
Digital assets custodians are important to two main types of investors:
- Investors who want to gain exposure to the digital assets market without becoming involved in the technical complexities of the space (which assets are on which blockchains, and so on)
- Institutional investors who are required by regulators to store their assets with a qualified custodian (see below). In the USA, regulated by an SEC directive promulgated under the Dodd-Frank Act, institutional investors with client assets in excess of $150,000 are required to have them custodied
What is a qualified digital assets custodian?
In general, a qualified custodian is defined fairly broadly in US law. The SEC includes the following institutions in its definition
- Savings associations
- Registered broker-dealers
- Futures commission merchants
- Foreign financial institutions “that customarily hold financial assets for their customers, provided that the foreign financial institution keeps advisory clients’ assets in customer accounts segregated from its proprietary assets”
However, digital asset custody differs from the custody of other assets. It’s technically different in that digital assets exist on blockchains. Unlike other types of digital files, they can’t be endlessly replicated; unlike physical assets, they can’t be physically located and secured.
Digital assets markets are fast-moving and show significant price volatility; custody for these assets often needs to be both secure and responsive.
However, digital assets custody is also different from a regulatory standpoint. The US SEC permits many of the same institutions to custody digital assets as other asset classes, but it’s common for banks and other financial institutions to avoid doing so for lack of technical resources.
In Hong Kong, digital assets trading is regulated under the VASP (Virtual Asset Service Provider) laws, but there are no direct regulations affecting digital assets custody beyond those applying to custodians generally. Hong Kong’s traditions of trust and custody are long-lasting and well-founded, backed by a significant body of caselaw as well as statutory support.
Is a custodian different from a wallet?
Can’t you just keep your digital assets in a wallet? Why use a custodian at all? The big difference between a wallet and a custodian is that a wallet is a tool and a custodian is a partner.
A digital asset wallet comes in several forms, but in essence it’s a storage system for the private key to your digital asset “account”. Unlike systems with underlying centralized data management, like most web-based businesses, digital assets and the blockchains they run on are completely decentralized. If you lose your private key, you lose your wallet forever. If someone else has your private key, they have complete access and can empty your wallet or trade with your assets at will.
The traditional solutions to digital asset security have been a creation of the community, at a time when the sums involved were low, the threat environment relatively low-complexity and easily manageable, and the average user often chiefly concerned with autonomy and separation from the traditional banking system. The hot/cold wallet system was barely adequate to those needs; the requirements of High Net Worth Individuals, institutions, professional investors, and asset-agnostic investors are very different and cannot be met by this system.
But don’t custodians just use this system themselves? Yes and no. Some custodians hold assets and trade proxies. Others custody private keys and directly operate the relevant accounts using the traditional access methods, managing transfers to and from hot and cold wallets. Because of the nature of digital assets, a new procedural solution must be accompanied by a new technological solution; increasingly this takes the form of tools like the Ledger Vault, creating opportunities for new forms of governance and management of custodied assets including:
Separated key share quora, where a given number of a specified group (say, 3 out of 5) are required to make a trade. Each member has a portion of the key, validating them as a signatory, but the key itself remains secure and is never assembled on a single machine
Multisignature quora without traditional multisig tools and procedures, in which groups can be assigned key shares without the slower, more data-heavy transactions associated with multisig
Transactions with non-trusting entities, in which the entities making up a quorum need not be solely from one organization, and non-trusting entities can co-sign transactions without the risk of pure blockchain systems or the delays of the traditional financial system
Blockchain agnosticism, allowing these tools to function as a security layer on top of any blockchain without regard to the structure or nature of the underlying ledger(s)
These opportunities arise as part of the benefits of Multi-Party Computation (MPC): to learn more about how it compares with traditional hardware tools, read this post.
Why is digital assets custody important?
A custodian might custody your wallet’s private key, or discuss with you options for arranging your digital assets in the most secure way across multiple wallets. They’ll then manage those wallets for you.
This isn’t as simple as paying someone to do a job you could just as easily do for yourself. A custodian can work with other financial professionals to trade from your wallet according to your instructions.
A custodian can protect you against accidental loss and deliberate theft. As part of a trust arrangement, or as part of a business financial relationship, custodians contribute to privacy as well as security, managing clients’ assets discreetly, away from the public eye.
And they offer you the security of the traditional financial world, with its separation of powers and professional codes of ethics. For the individual investor or institutional investor, it’s a safer way to gain exposure to digital assets markets. For the space as a whole, it’s a step in regularizing digital assets trading and making it both more accessible and more secure.
Is an exchange like Coinbase a custodian?
Some exchanges will let users keep their digital assets on the exchange itself. In some cases, this simply means an on-exchange hot wallet. In others, the exchange undertakes to custody the user’s digital assets. But does that make the exchange a custodian? Not exactly. These agreements are undertaken without oversight or professional input. The people who run the exchange often have little experience of traditional financial practices. There have been cases of fraud and theft, as well as of mystery. It’s common for exchanges to commingle as well as to practice their own form of fractional reserve lending. This isn’t to say no exchange is reliable — only that in the past, exchange-based wallets have proven a poor substitute for proper custody.
Some exchanges, including Coinbase, have moved to offering custody services to their clients. This goes beyond letting users leave their assets on the exchange, and is being offered as a “custodial wallet” — an exchange-based wallet, managed by the exchange. Coinbase isn’t the only exchange to offer this. It’s an increasingly popular service. But it still doesn’t provide the probity and security of a qualified digital assets custodian.
As a separate offering, many exchanges (including Coinbase) have moved to offer institutional digital asset custody, often by partnering, merging with or buying extant providers. The market for such providers is growing as institutional money enters the digital assets space at an increasing pace, and as it does so, the need for custodians capable of passing the regulatory hurdles and carrying out adequate due diligen
Do custodians offer financial advice or investing advice?
Some custodians might offer services like these, but they’d be metaphorically “wearing another hat” to do so; these services don’t form part of a custodian’s core competency. Custodians carry out investment plans, sometimes including quite complex multistep trades. But they do so on their clients’ instructions. Custodians also liaise with other financial services providers to help maximize benefit to their clients, but again, they’ll do so only on the client’s instructions. (There are financial advisor custodians who integrate both roles, though they’re relatively rare and more usually found in the personal finance space.)
What should I do if I want a digital assets custodian?
If you’re seeking a digital assets custodian, First Digital Trust can help. One of Hong Kong’s first licensed digital assets custodians, and with a team combining the best of the emerging blockchain economy with decades of experience in the traditional financial world, First Digital Trust helps institutional investors, professionals and HNWIs maximize the returns and their security of their digital assets investments.
Contact us to learn more.