Crypto assets are no longer an exotic instrument in the expansive alternative investments industry. The market has embraced blockchains, tokens and crypto assets, seeing their potential benefit to the global economy, commerce and trade. In fact, crypto assets are attracting institutional investors, prompting financial institutions, including banks, custodians, broker/dealers and exchanges, to launch new crypto products and services.
As crypto continues to immerse itself into the global financial system, one area stands out as a critical need: custody. Every new participant in the market needs a way to safely store and move their crypto assets. Institutional investors, in particular, will not risk owning crypto assets if the assets’ value cannot be safeguarded in the same way their traditional assets are.
Identifying a custody solution for crypto assets can be challenging as digital asset custodians don’t technically store any of the assets. Why? Because the transactions themselves exist on a public blockchain. Crypto custodians safeguard users’ private keys, the critical part of a crypto wallet that grants access to the assets held in it.
Crypto custodians are essential for the widespread adoption of digital assets. A report by Blockdata shows the size of digital assets under custody grew sevenfold between January 2019 and January 2022, from $32 billion to $223 billion. Despite this growth, only a few established financial institutions are currently offering institutional custody services to crypto investors.
Types of Crypto Custody
There are two main types of crypto custody: self-custody and third-party custody. Let’s explore each of these solutions further.
Self-Custody: Self-custody solutions are generally off-the-shelf software that store and protect crypto assets. With self-custody solutions, the asset owner has complete control over their wallet, but it also means they bear all the risks. If you forget your private key, for example, you may not see your crypto assets again.
Third-Party Custody: Third-party custody providers deliver fully managed custody services to institutions that own and trade crypto assets. They are registered, regulated financial institutions that have a license to act as a custodian. They maintain control of private keys as part of their role alongside the record of asset ownership which ensures the security of the holdings.
There are three different kinds of third-party crypto custodians:
Exchanges: All centralized cryptocurrency exchanges take care of their customers’ crypto custody. When assets are held on a centralized exchange, the asset holder doesn’t have the private keys to the exchange wallet. This could potentially expose the customer to losses if the exchange is hacked.
Digital Asset Managers: Since cryptocurrencies have become their own asset class, digital asset managers that act like banks for crypto holders have emerged. These institutions are regulated and licensed to offer crypto custody.
Custodial Banks: In July 2020, The Office of the Comptroller of the Currency (OCC) declared that every custodial bank in the U.S. can custody cryptocurrencies. Institutions including BNY Mellon, Fidelity and Citibank entered the space. These larger crypto custody providers often provide services to institutional clients. Seeing an opportunity to fill the void, other custodians emerged with solutions for retail investors.
Choosing the Right Crypto Custody Provider
Although crypto custody solutions have evolved to better safeguard investors’ crypto assets and offer solutions for retail and institutional investors, more work needs to be done. When weighing which crypto custody solution to choose, consider your needs and risk tolerance. Then weigh the pros and cons of each custody solution to determine the right provider for your firm and investors. It is also advisable to conduct due diligence on the custody providers’ security protocols. Many custodians’ security processes mirror those of offsite business continuity centers —military-grade security and biometric scans and specialized security devices such as hardware security modules — are not uncommon.
Swiss Financial Services is positioned to provide introductions to service providers and experts who can assist in the decision making. Contact us to learn more about how we partner with private fund managers to help them identify the right solution for their business.