Custody of digital assets and digital securities has come a long way but we might still be in the first few miles of a marathon. In this article we take a look at all things custody and what’s needed for it to get to true institution-ready scale. Prior to some new entrants by larger institutions such as Fidelity Digital Asset Services, the types of custody solutions that have been long available for stocks, bonds and other traditional asset types were not available for digital assets. Still, we are just at the beginning.
At TokenSoft, we’re currently working with large institutions on digital security issuances, firms that are working on gaining comfort with the risks and unknowns of new horizons. In the Technology Adoption Life Cycle from Crossing the Chasm, these are Innovators. We know that it’ll take a lot more to cross the “chasm” to address the wide audience with the promise of the emerging technology.
The first issue that prevents more institutions from trusting that their digital asset or digital security will be safeguarded securely is the overall security problem the industry still faces. According to CipherTrace, hackers stole $1.7 billion in cryptocurrencies from investors in 2018.
The second largest challenge is overall user experience. Cold-storage solutions have traditionally been onerous to use. Plus, the storage and management of private keys pose risk along with longevity challenges. For example, Quadriga, a Canadian crypto exchange, told shareholders in early February that their founder died and he was the only individual with the passwords to the wallets, which were holding approximately $190 million USD in cryptocurrency and fiat. While Quadriga’s example is not unique, it will hopefully become rare as time goes on. With many institutional digital wallet providers and exchanges, there are steps to verify identity and allow access recovery if keys or passphrases to an account are lost or otherwise unknown.
Asset transferability is another part of user experience that is limiting today. In fact, you can see unique silos across the digital asset custody landscape which prevent ease of transfer from one silo to another. For a true marketplace of digital securities to be enabled, we’ll need connected digital security infrastructure.
While custody infrastructure needs more maturity for the digital security industry to scale, there are early use cases emerging that show the promise of the next horizon. Let’s take a look at what it takes to move from digital asset custody to digital security custody and administration.
Custody of digital assets that are not securities is a fairly straightforward endeavor, with send and receive functionality being sufficient. Regulations are also fairly straightforward, allowing trusts and firms with a money transmitter license in the US to serve as custodian of assets such as Bitcoin and Ethereum.
In fact, when Bitcoin first traded, there were no offline storage products or third-party custody services to keep it safe. The ecosystem for safeguarding grew as the digital asset industry took hold. Still, security breaches caused concerns and the rise of institutional-grade, secure storage for digital assets and beyond.
Custody of digital securities requires adherence to more regulations and functionality in line with institutional custody for traditional securities. For instance, issuers of digital securities need to have the ability to transfer, manage security splits or their cap table, make redemptions, and take other actions relating to their digital securities. In addition, transfer rights, including access eligibility and revocation, need to be fully available through custody administration. From a technology and infrastructure standpoint, all of this requires more specialized tooling that is growing in scope as the industry matures. If outsourced to third parties, these services require licensed securities intermediaries or financial institutions.
Institutional custodians, such as Fidelity Digital Assets and Coinbase Custody, continue to build their services for large institutions which require highly available, trusted, enterprise-grade services to store, transact, and service their digital investments.
Custody solutions for large enterprises and institutional investors are still in development. Solving the challenges of custody for institutional investors is required for this emerging asset class to flourish with scalability and more widespread adoption. It will take more custody solutions and surrounding tools being built to cross the chasm.