By Alex Batlin,  Founder & CEO of Trustology
By Alex Batlin, Founder & CEO of Trustology

Security, compliance, and access to liquidity: Meeting requirements for top class cryptocurrency custodial services

Fund managers are increasingly interested in the benefits that crypto could offer their portfolios, however this requires the value of those assets be custodied and safeguarded much in the same way traditional assets are.  

First Published: e-Forex Magazine 97 / Blockchain and CryptoCurrencies / May 2020

Fund managers are increasingly interested in the benefits that crypto could offer their portfolios given its price volatility as an asset class which can create opportunity in the market for arbitrage plays, high-frequency trading, and hedging /speculating with leverage to support maximising earnings potential.  One thing that is still giving many institutional investors pause to take positions in cryptoassets, however, is the requirement that the value of those assets be custodied and safeguarded much in the same way traditional assets are. Institutions have a need to see a focus on security, compliance, transparency, governance and speed without compromising one for the other to comfortably use and transact with crypto.  

Remarkable progress has been made in solving the pain points of digital asset custody in the blockchain space and here’s what you need to know.  

Finding a reliable security approach 

Financial services is one of the most heavily regulated industries. For many institutional level players who wish to buy and hold crypto assets but lack the expertise to do this in a safe and secure way, at scale and are legally unable to take on this level of risk, it becomes a barrier to participation.  For others, still, who have already entered the crypto realm, the challenge has been around the asset storage considerations themselves that the custodial models provide. 

When it comes to cryptocurrency private key storage and management, funds are either being overly cautious leveraging cold-storage solution providers or not as cautious as they should be storing the majority of funds on a centralized exchange or maintaining funds in self-custody with a hardware wallet solution provider, leaving themselves exposed.  All scenarios come with their risks and drawbacks. 

Digital asset custodians act as trusted intermediaries, providing maintenance and management of customer keys and associated funds. One of the allures of this method of private key management is that the dedicated approach of custodians rarely leaves room for error and removes credit risk.

Custodians can secure private keys in several different ways. Some may opt for cold wallet storage. These endow a high level of security but also produce a relatively sluggish rate of transfer - days or weeks in some instances - and don’t scale. To combat this, others may choose to operate through a hot wallet—a digital vault connected to the internet- which may not be secure and could concede to explicit attack vectors and oftentimes is not insured.   

For those funds choosing to keep assets on exchanges, meanwhile, this often lacks institutional security and compliance controls in place and can be subject to commingling given the omnibus account structure model these services provide.  As a result, commingling can lead to reduced transparency and an inability to easily integrate with third parties such as tax, accounting and fund administrators and decentralised finance applications.  Additionally, it is well known that crypto exchanges are more focused on trading revenues versus custody and security which can lead to funds being exposed to credit risk from margins if they go bankrupt.  As custodians don’t offer leverage, funds are better off leading with a custodial wallet solution.    There is also the risk of exchanges being hacked, as evidenced from the past. 2019, for example, saw 12 crypto exchanges hacked and nearly USD$300 million stolen in assets according to CoinTelegraph. This known risk makes it standard of operations for most experienced crypto traders to only keep a bare minimum of capital on the exchanges with the rest typically in cold storage. The problem with that approach, again, is that this increased security causes a delay when needing to add or remove funds to act on a desired trade.  

Add to that the fact that most custodians in the market today are not operational around the clock, it causes further delays for funds needing to act in the moment. 

Hence what is an ideal custodial solution to support increased institutional adoption in crypto markets as generally, and as evidenced convenience and security are inversely proportional. How can funds look to acquire solutions that are all in one - fast, flexible with easy transaction capability without decreasing security?

Cryptocurrency
An additional challenge that fund managers and institutional investors face is meeting regulatory compliance requirements around Know-Your-Customer

A new breed in crypto custody

All of these issues when combined have prevented most of the traditional fund managers and institutional investors from entering the fray in the crypto markets forfeiting any opportunities to maximise their earnings potential that price volatility in cryptoassets has to offer. The last couple of years during the recent crypto winter the solutions needed by them have been quickly evolving to meet these needs. There also has been a movement towards greater clarity regarding governmental regulations that helps to eliminate the uncertainty that these types of investors generally avoid. The last thing they want is to run afoul of any government and incur the fees and penalties that follow non-compliance. They also are hesitant to act when uncertain which direction the regulations are going to move, towards enabling, or outlawing, these investment classes.

Hardware security meets software flexibility 

We’re seeing more sophisticated custodial models emerge with abilities to effectively combine cold and hot storage protocols, achieving a comfortable middle ground. By harnessing a mix of front-end software flexibility in conjunction with end-to-end hardware security such as mobile phone secure enclaves to hardware security modules and secure data centres, it becomes possible to engineer a fully automated solution process that reduces operator risk and transaction delays. This, combined with additional security controls such as multi-signature and white lists and insurance allows these types of custodians to support the current shortcomings of the market, giving investors the reassurance they need. 

There is greater flexibility regarding access and authorization of the movement of funds without compromising on security. There is also an added assurance that these types of custodians have established relationships with insurance companies that will cover any potential losses incurred due to theft or malfeasance giving funds more peace of mind.

An additional challenge that fund managers and institutional investors face when it comes to operating the fund is meeting regulatory compliance requirements around Know-Your-Customer, KYC, and Anti-Money Laundering, AML, regulations. They are often required by law to know the identities of all trading parties. Also often their legal advisors will advise them to document the source of funds AND the transaction histories, sometimes all the way back to the genesis block, for all the trades made with their counter-parties. These compliance costs by themselves can easily add a 5% premium, or more, to the expense of trading these asset classes. 

By leveraging these newer models emerging in crypto custody, funds can expect to partially outsource their KYC/AML obligations as these solutions come ready made with built in compliance controls. 

Improving liquidity - enabling faster projection of capital as desired on exchanges
The expression “Money loves speed”, is a well known aphorism when it comes to building wealth. Liquidity matters, not only when moving one’s own funds, but also when transacting both on and off exchange.

Crypto markets are traded around the clock worldwide, while many of the crypto custodians in the market today do not.  As such, for traders looking to act on arbitrage or margin trades or to implement hedging strategies through the futures and options derivative markets in order to lock in the acquired capital gains and control risk, they require fast action and quick movement of capital.  If their custody solution can’t provide this 24/7, it poses a significant challenge and risk. 

Cryptocurrency
The movement towards Central Bank Digital Currencies by many governments are increasing confidence that crypto investments are not going to be outlawed

With the newer crypto custody models of today, funds can look to enable the highest levels of security, while simultaneously enabling faster projection of liquidity as desired.  Enhanced automation and new features such as alerting systems or on-exchange wallets which look to provide funds with enforced transactional controls such as multisig and whitelists to effectively create a “walled garden” environment are proving beneficial to funds looking to prove mitigating holding and fiduciary risks while keeping on top of margin calls. 

With control measures like these, funds can improve their ability to act on low risk arbitrage plays without pre-committing excessive liquidity to a venue. Or  actively speculate on price movements using leverage on margin, which often arises a need to quickly increase margin deposits. This must be done in order to keep from having a margin call force their exit from a position before they want to do so. Many custodians are also establishing relationships with select exchanges to help decrease transaction clearance times and fees. In effect, they are performing a sort of escrow service, holding the private keys themselves as collateral, and establishing a line of credit with the crypto exchange.

Final thoughts

Now that we are entering crypto spring, more than one government has begun passing crypto specific laws granting more regulatory clarity. The movement towards Central Bank Digital Currencies by many governments are likewise increasing confidence that these types of investments are not going to be outlawed. Likewise, decisions regarding which assets are going to be classified as securities have begun rolling out, eliminating the risks of investing in projects that may fall apart because they’ve not themselves followed the necessary processes to launch their projects.

All the foundations necessary to alleviate the concerns of these investors have been built and laid over the last few years. Custodians that provide flexibility, security, insurance, and liquidity have arrived on the scene. Many governments have provided some inclination as to the direction they’re headed with their regulations. 

Exchanges have begun implementing solutions allowing for cheaper and faster movement of capital, both into, and out of these asset classes. Taken altogether it is becoming easier and more likely that many of these fund managers and institutions will begin allocating larger portions of their portfolios into these assets given the confidence custodians are aiming to bestow.

With the infrastructure in place, and the protections large capital fund managers require established, it is only now becoming possible for complex high-rise investment structures to be built upon them. The first movers that choose to take the risks of doing so may find themselves reaping great rewards for leading the way. Those that choose to play it safe, let others carve the path forward, and wait until the risks have been decreased even further, may find out that they’ve missed the boat on the greatest transfer of wealth that the world has ever known.

Fund managers and institutional investors are faced with a decision. There will be costs no matter the choice made. Each one will have to decide which entails greater risk, continue as if the world is as it has ever been, or adapt to these historical changes and possibly achieve greater capital gains, monetary freedom of choice, and international freedom of movement never known in traditional asset classes.