Custody is Preventing Investors from Buying Crypto Assets

Written by Jason Yanowitz

Remember in December when everyone said 2018 would be the year institutional investors got into crypto, causing the market to sky rocket?

Well, we're down 70% since then and while money is still flowing into the space, it's not coming from the big names that people had expected.

What we have seen is dozens, if not hundreds, of 'crypto hedge funds' run by 25 year olds who have raised anywhere from ten thousand to a couple million dollars popping up all over the place, but the big players we were hoping to see come into the space, like Fidelity and BlackRock, have remained on the sidelines.

Why?

Because crypto is not a mature asset class (yet).

For cryptocurrencies to be considered a mature asset class, there are a couple factors that need to come to fruition. You can find those in our other post about the timeline of institutional investment in crypto assets.

Let's discuss perhaps the biggest aspect of crypto that is stopping institutional investors from deploying capital in the space: Custody.

Custody refers to a custodian holding a customer's securities.

2 years ago, the institutional infrastructure for access to crypto as an asset class was nearly non-existent. Last year, market demand led to the creation and improvement of several solutions. Coinbase in particular has made great strides towards this end, but it's important to remember that this market infrastructure isn't going to be built overnight.  

While we are on our way, the major players—pension funds, asset managers, endowments, hedge funds, etc.—are not comfortable with the quality and development of the custody offerings that exist today.

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Custody of Digital Assets vs. Traditional Assets

The vast majority of traditional assets are what is called instrument registered. This means that there is a trusted third party source that records on a ledger who owns the asset.

Custodying a digital asset, such as Bitcoin, is much harder because they are bearer assets. A bearer asset means that no ownership information is recorded and whoever physically holds it is presumed to the owner. 

Because of this, custody solutions are basically just "securely storing a secret" (Kayvon Pirestani, Coinbase). As we've seen from the recent slew of high profile data breaches, storing secrets in the digital domain is really hard to do.

Crypto is based on public key cryptography, so custody of crypto really just means storing the private key that unlocks the account. Whoever has the password to unlock the private key now has all the assets associated with the account.

This makes holding digital assets really tough for a couple reasons.

First, whoever holds all of these "secrets," aka private keys, now has a huge target on their back. What hacker doesn't want direct access to a boat load of money? 

Because of this, custody solutions utilize what is called "cold storage." Cold storage is essentially a computer storing a private key without ever being connected to the internet. There are a lot of companies trying to figure out decentralized ways to store the secrets/private keys rather than using cold storage. Like all of this, that will take time.

Second, what if you simply lose the private keys or they get destroyed? There is no "forgot password" button with your private keys. There is no 'Satoshi help desk.' Lost your password? Your assets are gone. I've had it happen. It's a terrible feeling. Now, I didn't lose very much thankfully. But imagine if Coinbase, who custodies $20 billion of crypto, were to lose a large insitutional investor's private key. Yeah, not good.

What does this mean? The liability associated with custodying digital assets is huge!

So even if you have the perfect custody solution from a technological standpoint, you need a very large balance sheet to be able to insure whatever crypto assets you're holding for the client.

Leap of Faith?

Will the Fidelities and BlackRocks of the world become comfortable with the leading solutions in the crypto ecosystem (i.e Coinbase)? Or are they waiting for the names they are comfortable with–the BNY Mellons and State Streets of the world—who have historically held all of their assets to announce their own crypto custodial solutions?

On the one hand, if you're a player like BlackRock and you want to invest, one option is to figure out the best solution right now, take a leap of faith, and store your crypto with them. Or you could wait until the space is more mature and other big players have come in. By that point though, a lot of the price appreciation may be gone.

At some point, the BNY Mellons and State Streets will figure it out. At some point, the Fidelities and BlackRocks will invest and put their name, and their assets, behind a couple solutions. We're not far from this. Even in a bear market, Circle, one of the best-funded blockchain start-ups, saw a 30 percent uptick in institutional investors on-boarding to its "Circle Trade" platform in May.

Custody is one of the biggest issues holding fund managers back from deploying capital in cryptocurrencies.

Aside from custody, there are issues like being to borrow and lend crypto, institutional ready exchanges, regulation, and more that are preventing institutions from coming in. To learn more, see our other post about "When Are We Going To See Institutional Money Move Into Crypto Assets?"

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