Digital Assets

The Digital Asset Custody Landscape

Digital asset custody is a relatively young industry, yet it’s bootstrapping its way into maturity fast, based on increasing investment from institutional investors and the model of the extant traditional custody and trust world.

Gunnar Jaerv   Gunnar Jaerv · Published on 26 February 2020
   

Digital asset custodians are often emerging from the existing financial world: in Germany, for instance, banks can sell, buy and custody digital assets. Some of the shape of the digital assets space in the near future will be determined by differing regulatory environments as states determine their attitudes to digital assets.

In other cases, it’s the available technology that will determine what offerings custodians can bring to the market. But even in the case of startups, spin-offs and digital assets companies building out a financial arm, the traditional finance world’s trust and custody sector will provide the model. What it can’t do, without significant retooling, is provide the services.

How does digital asset custody differ from traditional custody?

Digital assets can be considered bearer assets, in that posession of the private key belonging to an account equates to possession of the digital assets owned by that account. Losing the private key, whether to loss or theft, means losing the asset. While a ledger exists that records transactions on the blockchain and this can be consulted by any network member, it does not link transactions to users; thus, the loss of the private key to a digital asset account is similar to the loss of a stock certificate prior to modern record-keeping, or the loss of money or bullion; it’s permanently gone with no system retrieval possible.

The risk of this type of loss is manageable when the sums involved are subjectively small, and the cost of building infrastructure to prevent it is prohibitively high. For the majority of insitutional investors the situation is precisely the reverse, which is why an international system of custody and record-keeping, aimed at preventing such losses and largely successful at doing so, has been developed by the traditional financial sector.

If an investor owns $1,000,000 in cash, the chances of accidental loss are effectively zero; the same is true of bullion. In the case of stocks, the stocks might lose value, but the certificates proving ownership of the stocks will not be lost or stolen. All these assets are kept physically safe and ownership is protected by a system of record-keeping, as well as custody and trust arrangements and guarantees offered by banks and other institutions.

In the past, this was not true. As late as the 19th century, traditional assets were unsafe. Banks issued their own money based on their own gold stocks in the United States, and sometimes went bust; investors frequently held their own stock certificates in a safe in the office. In the early 20th century, this type of arrangement proved unequal to the modern economy and both the state and the financial sector moved to ameliorate the risk by systematizing it. Currently the risk of loss and theft of traditional assets is underwritten by the banking sector as a whole and ultimately by the state.

The digital assets space is currently undergoing a similar transition. We’re seeing states introduce legislation and repurpose or clarify their existing regulations, often aiming first at risk to the wider financial system or focusing on anti-money laundering and countering the financing of terrorism, but also on protecting investors and nurturing an increasingly vital economic sector.

We’re also seeing the digital assets sector making both systemic and technological moves towards a system that mirrors traditional trusts, but with the unique features required by the new digital asset economy.

These features are:

  • Reliance on cryptography. Even where the underlying value of a digital asset depends on some real asset or some other blockchain consensus algorithm than proof of cryptographic work completed, the mechanism of the blockchain depends on asymmetric cryptography. The result is that the private cryptographic key is the digital asset for custodial purposes.
  • Rapid markets. The flagship digital asset, bitcoin, commonly sees price fluctuations of hundreds of dollars in the course of a single day, and price volatility in the 4% to 8% range is normal. This means that investors whose portfolios are managed will require trading across global markets on short notice; traditional custody arrangements were not designed to facilitate this and are typically not capable of the required responsiveness.
  • Technological foundation. Trading in digital assets is done digitally, and the most common methods of storing private keys are digital also. Digital asset trading and ownership are nonlocal, so custody and management must also be nonlocal, and a technological solution to secure storage is required.

In addition, the traditional finance world operates against a backdrop of fully-mature institutions and systems, while digital asset custodians are operating in a growing vertical whose institutions are still immature. This has profound implications for investors and custodians alike.

How does digital asset custody actually work?

Much of the difficulty associated with custodying digital assets satisfactorily arises from the technical details of the process, so it makes sense to look at what actually happens when a custodian takes custody of a digital asset, trades with it on a client’s instructions or with their authority, and builds an appropriate custody and trust structure for that asset and client.

So does digital asset custody actually simply mean storing private keys? No, but let’s briefly look at how private keys are stored.

Private keys constitute access to an address on a blockchain, and to the digital assets associated with that address. To all intents and purposes having the private key means having the assets. Thus, the main focus of early efforts at custody has been on safekeeping private keys. This has involved using digital “wallets,” code designed to protect the key with additional cryptography, as well as paradoxically low-tech solutions like writing down the key on a piece of paper and locking it in a safe.

Presently, these solutions are being phased out in favor of systems like Ledger’s Vault which permits securely enforcing policies across user accounts, multiple-account signing, and other systems that let users manage multiple wallets from the same platform effectively.

In addition to technological solutions, the space is seeing the emergence of institutional structures mirroring and often directly modelled on those already in use in the traditional asset custody space. Custody was initially provided primarily by exchanges, reliant on the hot/cold wallet system and using small numbers of personnel with ill-defined roles and no oversight. Now, custodians in the digital asset space are starting to utilize the same separation of powers and professional responsibilities used in the traditional finance space, in recognition that structural as well as technological solutions are required.

The emerging digital asset custody ecosystem

Custodians, of digital assets or otherwise, don’t exist in a vacuum. The emergence of a custody ecosystem has long been regarded as a prerequisite for a mature digital asset economy, and for integration with the wider financial world. This is particularly true as increasing institutional investment both demands and facilitates increasingly stringent professional and technological solutions to facilitate multiparty trust. As these providers emerge, they interact.

Industry leaders include Coinbase, Xapo, BitGo and Kingdom Trust, and these together account for $23bn in assets under custody, though this figure also includes non-digital assets. Crucially, some digital asset custodians are emerging direct form the space itself while others are building on traditional finance expertise and managing hybrid portfolios or a mix of digital and nondigital portfolios. The line between digital assets custody and traditional assets custody can be expected to blur

Where next?

Custodianship for digital assets is currently usually discussed in terms of the absolute core functions of a custodian — safekeeping and secure access. However, we can see from the traditional finance world that custodians are capable of offering a far wider range of services, especially when they are also trustees or in partnership with trustees. Already-established functions like proxy voting, dividends, token splits and tax reporting are already emerging as offerings in the digital asset space.

We’re also seeing the emergence of offering such as pensions based on digital assets, indicating that once institutional requirements and investments have helped build a fully-mature digital assets custody industry, retail investors will reap the benefits of the increased professionalism, improved infrastructure and more effective technology.

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