The ABC of crypto custody

Mainstream adoption of the crypto ecosystem is dependent of the growth and developments of custody and insurance. While a lot of progress has been achieved, more work is required on regulation, AML/CFT standards, services and technological advances.

Photo source: Pexels.com

The promises of cryptocurrencies to remove the inefficiencies of the financial system will only be possible if there is mainstream adoption. Wide adoption will only happen if cryptocurrencies can be safeguarded securely. Whether cryptocurrencies have a payment, utility, or security purpose, their private keys need to be kept somewhere protected. Therefore, the developments in custody and insurance will influence the growth of the crypto sector.

As of now there are two main approaches to custody: self-custody and third-party custody. Self-custody is more aligned with Bitcoin and the peer-to-peer system vision, while third-party custody is similar to the way financial markets currently work. Within third-party custody we can also differentiate between institutional custody services or custody for consumers.

Self-custody is more aligned with the peer-to-peer system vision, while third-party custody is similar to the way financial markets currently work

Self-custody wallets have all forms: desktop, mobile, smart contracts and hardware wallets. This approach is the closest to keeping cash in your pocket or under the mattress, with the risks this entails. Smart-contracts companies allow for improved security features such as programable withdrawal limits and wallet recovery. For example, Argent introduced the so-called Argent guardians, through which, clients give trusted people, devices or third-party services the limited power to authorize recovery.

Third-party custody was created to help crypto become mainstream. It facilitates the secure safeguard of private keys so that the customer does not need to safekeep them. The custodian will keep the keys in either online or offline storage. Online storage, also called hot storage, has been vulnerable to large hacks in the past because the key and wallet are connected to the network. Therefore, the majority of assets under custody are now kept using offline or cold storage, which means storing them in a computer not connected to the network.

Third-party custody is essential for institutional investors to participate in the blockchain ecosystem, but more advancements need to be made in regulation and AML/KYC procedures

Third-party custody is also essential for institutional investors to participate in the blockchain ecosystem. In the traditional financial sector, these institutions are required by regulators to have their customers’ assets above a certain threshold with a “qualified custodian", therefore, the same is expected for crypto. Today, this qualified custodian service is being provided by native crypto companies (BitGo, Gemini, Coinbase) and traditional financial entities (Fidelity, ICE), but further regulatory clarity in the blockchain space as well as increased AML/KYC procedures promise much more development in the sector.

Regulatory clarity is improving with BaFin and US annoucements allowing banks to provide crypto custody

Progress on regulatory clarity is slowly trickling in. German Regulator BaFin incorporated crypto custody business into the German Banking Act as a new financial service in December 2019, and two months later, 40 banks declared their intent to offer crypto services. It is still to be seen what the result will be from the announcement of US OCC allowing nationally chartered banks in the U.S. to provide crypto custody.

Regarding AML/CFT, there have been advances, but the implementation of certain requirements such as the travel rule are still delayed. According to Financial Action Task Force (FATF), 35 out of 54 reporting jurisdictions have implemented the standards on virtual assets and virtual assets providers, but there are still problems with consistency of definitions across countries and the scalability of solutions to implement the travel rule.

Insurance is needed to complement custody, but its development requires more data and research

Finally, the custody ecosystem will not be able to be complete without insurance. Lloyd’s of London already started exploring insurance for bitcoin in 2015, Swiss insurance broker Aon and Marsh began offering crypto services in 2019, and, at the end of 2019, Hong Kong’s Securities and Futures Commission published a requirement for virtual assets exchanges to have insurance for both hot and cold storage. As of now many custodians and self-custody wallet companies such as Coinbase, Civic, and Anchorage offer insurance, but the fine print is what each of these insurance plans exactly covers: hacks, loss of private keys, smart contract bugs, black swan events, company going out of business, etc.

However, crypto insurance is still not straightforward. Very large price swings and lack of insurance statistics makes it difficult to price premiums. Crypto poses risks that are different than traditional finance and there is still a large education gap. The sector needs more research and market testing.

In conclusion, custody can take many forms, but it is essential for the growth of the crypto ecosystem. More specifically, institutional custody and insurance will make the industry take off but more work is required on regulation, AML/CFT standards, technological advances, research and education to make sure investors are comfortable.