The role of crypto custodians in the industry

Crypto is on the bleeding edge of innovation, and while we all love the upside what that means, the great technological advancements come with increased risks as well. We’re not talking about risks such as mere price volatility – that simply comes with the territory of an entirely new asset class.

The types of risk that exist on the bleeding edge, where we experiment with new technologies leading to changes in what is considered best practice, run much deeper than that.

Milo, get the keys! The keys not the cheese!

We’ve all heard the countless stories around exchange hacks, protocol breaches, and straight up rug pulls. While all these incidents were slightly different, both in what went wrong and how much was stolen, what they have in common is a lack of security – either operational or technical.

The Mt. Gox exchange, handling 70% of all BTC trading volume at its peak, collapsed in 2014 after hackers breached the link between the exchange’s hot and cold wallets, siphoning off bitcoin as they moved between the two.

The QuadrigaCX exchange closed down after it came to light that the founder, who had passed away, had sole control over the exchange’s keys which meant neither remaining staff nor customers were able to retrieve the $190M in missing funds.

The DAO hack tells the tale of hackers exploiting vulnerabilities in the code base of an Ethereum-based project, stealing 3.6 million Ether in the process which eventually led to a hard fork in the Ethereum blockchain.

We rarely hear stories like these coming from traditional finance, including FinTech which broadly speaking is built on the same back-end infrastructure within the same regulatory framework. Of course, cybersecurity is a major concern for everyone, but retail investors getting shafted to this extent is rare. If your favorite stock trading app were to close down tomorrow, your funds would still be safe. That’s because of the niche but critical role custodians have in the financial services industry.

A custodian or custodian bank is a financial institution that holds customers’ securities for safekeeping to minimize the risk of theft or loss. Depending on industry sector and jurisdiction, some service providers are required by law to store customer assets with a qualified custodian.

Now that financial institutions are increasingly eager to generate yield with digital assets, the need for crypto custodians that offer best practice security measures is becoming more urgent.

What crypto custodians do for their customers

In simple terms, crypto custodians are third party providers of storage and security services for all types of digital assets. They mainly serve large financial institutional players, like hedge funds or pension funds for example, as well as family offices, crypto exchanges, protocols, and whales (not the animal).

The main utility of custody solutions lies in the safeguarding of cryptocurrency assets. Private keys, which are used to conduct transactions or access crypto holdings, are a complex combination of alphanumerics, extremely difficult to remember, and can be stolen or hacked. You could store private keys offline, on a hard disk or even paper for example, but losing physical custody of the storage device (or simply forgetting a password) is a very real possibility in which case there is virtually no way to recover access to the funds.

Crypto custodians solve for this problem using a combination of hot storage and cold storage. However, besides safekeeping, custodians must also provide flexibility when it comes to accessing funds and supporting new tokens or digital asset categories like NFTs. The result is a fairly complicated range of service levels a crypto custodian provides, mapping wallet solutions to user permissions, transaction authorizations, multi-signatures, on-premise hardware infrastructure, identity verifications, and comprehensive insurance policies.

To the average trader, this may seem like overkill. But when a financial institution, like say a pension fund, owns digital assets it cannot afford losing the funds due to an exchange hack, compromised private keys, or employee dishonesty. The financial, reputational, and regulatory risks are simply unacceptable.

Plus, in some jurisdictions, it’s simply a matter of compliance. Each jurisdiction has its own methods of incorporating custodians into the framework of trading financial assets. In the US for example, SEC regulations stipulate that institutional investors that have customer assets worth more $150,000 are required to store the holdings with a “qualified custodian.”

Why this matters to you

The last few years have certainly been positive in terms of crypto adoption, with more people than ever now buying into Bitcoin, altcoins, DeFi services, NFTs and more. There have been announcements from major companies, some in financial services but not all, opening up to crypto one way or another. While Tesla’s play is perhaps bittersweet in hindsight, most of these company moves have been positive for crypto markets.

Getting even more companies to buy into crypto in a meaningful way, a few components that build on each other need to be in place. Financial regulators are always behind schedule when it comes to innovation, especially with crypto as it evolves so fast, but we are starting to see more concrete and comprehensive regulatory frameworks on the drawing boards. Some of those rules may not be to the liking of retail traders or early crypto veterans, but if Big Money is to sit down at the table, crypto needs to not be a dirty word anymore.

The second is reliable crypto custody solutions. It is vital for the institutional space that there are safe ways to store digital assets. If the growth of secure cryptocurrency custody can expand to a place where enterprises and institutions have security options that they can rely upon without having to be hesitant, the push for crypto will skyrocket as these businesses will know that their funds are safe and secure.

All of this will channel a serious amount of capital into crypto markets that will dwarf what has happened in the last few years. Ultimately, more companies buying crypto leads to additional retail interest as the people that are currently still on the fence will be a lot more at ease.

If we are indeed entering an uncertain time in the market, it may just be the perfect time for crypto custodians to lay the bedrock supporting the next massive upwards market move. As institutional money starts buying big time, a new wave of retail traders could follow soon.

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