The incredible rise in popularity of cryptocurrencies from a small group of techno-anarchists into a worldwide phenomenon surprised everyone in traditional financial circles.
But after many of those former traditionalists saw the light and embraced Bitcoin and other digital assets, hundreds of companies sprung up to provide the financial ecosystem needed to support these investments.
One of the core components is custodial services. Most financial advisors are not permitted to invest client funds in assets that are not supported by their custodian. This makes custody a critical piece necessary for the widespread adoption of digital assets.
Enter digital asset custodians, like BitGo, Coinbase and Gemini, who have built technology infrastructure that provides secure custody of cryptocurrencies and allows financial advisors to centrally manage these assets without having to deal with exchanges or other insecure venues.
NBCNews reported 20 incidents in 2021 where hackers stole more than $10 million from crypto exchanges and crowd-sourced projects, with six of them over $100 million. The largest was a $196 million heist from crypto exchange Bitmart in December.
Clearer guidance from regulators are making digital custodians more commonplace. As part of a broader discussion on crypto separately managed accounts (SMAs), BitRIA CEO and co-founder Dan Eyre hosted a discussion with several industry executives to discuss how advisors can expose their clients to crypto assets in a safe and secure manner.
In this portion of the webinar, Dan was joined by Gemini director of business development for wealth management Kristen Mirabella to discuss how digital custodians enable advisors to efficiently manage their client’s digital asset portfolios.
We’ve summarized a few of the most salient points from the webinar and split it into three parts (you can read the first and second parts here on 3iQ’s Chris Matta’s comments on crypto SMAs).
Should clients hold their own crypto keys or use a custodian?
A recent Deloitte white paper listed risk, security, recourse, reliability, and efficiency as five reasons digital custodians are becoming increasingly important. Employing a custodian to manage digital assets lowers risk, and custodians use far stricter security measures to protect assets than individual investors would.
As we’ve already said, online wallets aren’t as secure as using a digital custodian. However, Crypto investors use these wallets heavily as they’re the most convenient method. But for HNW investors, who can hold a significant amount of crypto at any given time, online wallets can be a huge security risk.
Offline (hardware-based) wallets fix the security issue but still put the onus on the individual to ensure that keys are managed appropriately. That doesn’t always happen, and at least $140 billion in Bitcoin is considered “lost forever” due to misplaced keys. That’s not counting lost keys from any other cryptocurrency, so the actual total of “lost” investments is likely far higher.
Following a hack, lost keys, or other loss events, individual crypto investors don’t often have recourse to recoup their losses. A licensed digital custodian carries insurance, providing the investor with some peace of mind. Unlike crypto exchanges, custodians have built infrastructure that focuses on security first including multi-sig security protocols and enterprise-grade segregation of individual client accounts.
There’s also the efficiency of using a custodian to manage investments. US Bank found out in a survey of its clients that there is significant demand for digital custodial services to manage their crypto private keys.
“When you couldn’t trust a centralized platform, a hardware wallet made sense,” Mirabella said. “You knew if you kept that wallet in your drawer, it wasn’t going to be subject to some widespread hack.”
U.S. Bank is one of the nations oldest, having been founded during the Civil War, and is a top 10 custodian by assets with over $8.6 trillion. “There’s something about the potential of this asset class and the underlying technology that would be prudent for us to stand up support for it,” explained Gunjan Kedia, vice chair of the bank’s wealth management division.
These days, there are many digital custody options for financial advisors. New players like Gemini, which has more than $200 million in cold storage insurance coverage, as well as traditional custodians who have added support for crypto including Bank of New York Mellon, State Street and Northern Trust.
Are Crypto Native Custodians a Better Choice?
Mirabella recommended choosing a regulated custodian that is “crypto-native” (primarily focused on crypto investing). Gemini is regulated by the New York Department of Financial Services, and others are regulated by their local financial authorities. These firms follow the same standards, like Know Your Customer (KYC) and anti-laundering efforts, as traditional custodians do.
Additionally, Mirabella recommends that advisors seek digital custodians that offer SOC 1 and SOC 2 reports, which grades your firm’s processes to keep clients’ information and assets safe. SOC 1 covers financial reporting, while SOC 2 covers operations and compliance.
She said that advisors should also select digital custodians that segregate their client’s assets and are diversified across various crypto asset classes.
However, a diversified offering shouldn’t be the sole factor in making a decision, and exchanges that take a “list everything” approach are taking a significant risk, Eyre added.
“Gemini is taking a very thoughtful approach to the listing of assets and what they make available,” Eyre said. “That should give some comfort to advisors.”
Regulations will drive advisors to adopt digital custodians
Cryptocurrency’s rise hasn’t gone unnoticed by regulators. As the market matures and traditional investors flood in, the SEC and other government agencies want to ensure that safeguards are in place. Efforts are already underway to regulate digital assets.
One of the most controversial topics SEC regulators are debating is whether or not cryptocurrencies are considered a security, which by law must be held by a qualified custodian. With traditional securities, advisors themselves don’t hold these assets. They turn to custodial services from companies like BNY Mellon, Fidelity, and Schwab. Digital custodians aim to offer a similar asset management platform.
This goes against what some crypto purists believe directly should be a completely decentralized system contradicts crypto’s decentralized nature. However, Coinbase’s Christopher Robbins writes that while Bitcoin and Etherum don’t meet current SEC guidelines to be considered a “security” and are closer to a commodity, tokens and other altcoins do. SEC chair Gary Gensler has said that many tokens do meet those guidelines, making them subject to the SEC’s custody rules.
Mirabella said that at the moment, the concept of custody in crypto is different from a traditional custodial relationship. While advisors may think of things like asset movement, reporting, and fees, up until now, digital custodians didn’t handle much more than the managed safekeeping of crypto assets.
Increasing government oversight is changing that. In June 2020, the Office of the Comptroller of the Currency (OCC) ruled that traditional banks can provide digital custody services. In October, FDIC chair Jelena McWilliams told Reuters that regulators would soon provide more explicit guidance for banks and clients, acknowledging the confusion.
Digital custodians monitor these shifts and changes in crypto regulation and are starting to offer services that look much more like a traditional custodial relationship. Crypto custodians will move beyond storage to more traditional custodial roles as the market matures. While regulations aren’t clear now, they will become clearer soon.
“The functionality gap is closing,” Mirabella said. “You’re seeing more functionality that promotes ease of use in making that allocation and taking that first step. As that gap continues to close, you’ll see more features across the custodial landscape that look more familiar.”
