This article was published on Allnews on July 6, 2023.
In May, a debate emerged in the crypto community and among investors about how best to custody crypto assets. The spark was the announcement of a new initiative from a well-known crypto self-custody hardware wallet provider1 that would allow the company to help users recover a lost wallet.
Much of the debate was centered around how secure this new service would be and whether or not it would allow backdoor access to a user’s crypto assets by governments or malicious actors. While this debate will continue, it has served as an important reminder to us of both the challenges of self custody and the benefits of accessing crypto assets through regulated funds that use highly sophisticated custody services. But before exploring these benefits, let’s look at how crypto assets are typically custodied.
An overview of crypto custody
Securing the private keys for crypto assets presents unique custody challenges. The holder of the private key is the holder of the crypto asset, so protecting these alphanumeric keys is critical. There are generally three approaches to crypto custody:
Self-custody can be done by using an external hardware device or managing the private keys yourself (e.g., writing them on a piece of paper and storing that in a secure place). This approach carries significant risks because most blockchain transactions cannot be reversed or altered, so if the private key is lost so is the crypto.
Partial custody refers to software wallets or exchanges that manage private keys. This type of “hot” storage is connected to the internet and vulnerable to things like exchange or wallet hacks. As we saw with FTX, it is not always clear if assets on exchanges are fully reserved, if the exchange is lending your assets, or your assets could be frozen during bankruptcy proceedings.
Full service third-party custody solutions provide the highest degree of security and customization. This approach includes the utilization of “cold” storage, which involves offline devices that prevent network or software-enabled connectivity.
For regulated products like ETPs and ETFs, the only option that meets the fiduciary duties with the highest confidence is a full third-party institutional custody service. ETF providers that use reputable institutional custodians can significantly reduce the risk of loss or theft to investors. These custodians employ cutting-edge technologies and best practices to ensure the secure storage of private keys and employ rigorous protocols for accessing and transferring assets. Furthermore, these solutions typically often offer insurance coverage, further bolstering investor confidence and mitigating potential risks.
The crypto industry operates in a complex regulatory landscape, with varying rules and requirements across jurisdictions. Institutional custody solutions play a crucial role in helping investors navigate this regulatory minefield. Trusted custodians have a deep understanding of compliance obligations and can ensure that investors' assets are held in accordance with relevant regulations. At Hashdex, we follow strict protocols with respect to the custodians we choose to work with that we believe can serve as best practices for our industry. The questions we ask when selecting custodians include:
Can the custodian certify segregation of the ETP/ETFs assets as well as certify its systems are disconnected from the internet?
Does it require multiple signatures and geographic distribution of cryptographic keys to mitigate the existence of a single point of failure and key-man risk?
Is the quality and effectiveness of a custodian’s operational processes attested by an independent accredited auditor?
Does the custodian have insurance policies against private key theft and loss, as well as against fraud and internal theft?
Is the custodian regulated in a strong jurisdiction with clear and specific regulatory requirements for custodians that go beyond just AML and KYC compliance?
Custody solutions that provide detailed reporting and audit trails enable investors to meet their reporting requirements and demonstrate transparency to regulators and auditors. These features not only facilitate compliance but also contribute to the overall credibility of the crypto industry. This level of due diligence is crucial to onboard institutional investors like hedge funds, pension funds, and endowments, who must comply with strict regulatory standards.
Securing crypto’s future
The continued entry of institutional investors into the crypto space, as evidenced by BlackRock and several other large asset managers applying for bitcoin ETFs in the US this month, will drive mainstream adoption and pave the way for wider market participation. However, institutional investors have unique needs and requirements that must be addressed for them to allocate substantial capital to digital assets. Institutional custody solutions offer the necessary infrastructure and safeguards to attract and retain institutional investors.
As the crypto market continues to mature, investors should request that institutional custody solutions be a minimum standard for regulated crypto asset ETPs providers, for the safety of their assets and to minimize operational and reputational risk. These solutions provide essential security measures to protect digital assets from cyber threats, offer compliance frameworks to navigate regulatory requirements, and facilitate institutional adoption by catering to the specific needs of large-scale investors. Crypto asset managers should embrace them to further strengthen the trust and confidence of crypto investors.
“Ledger’s new Bitcoin key recovery feature debate swirls ,” CoinDesk, May 19, 2023
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