Written by: Chris McCann, general partner of blockchain investment fund Proof of Capital.
Translated by: Zhan Juan
Excluding private companies, encrypted assets are already a $130 billion industry based on the market capitalization of cryptocurrencies on CoinMarketCap. Despite its size, the cryptocurrency market is still in its infancy compared to the broader financial market. To ensure the continued growth of crypto assets, the industry must meet the needs of institutional investors and financial institutions. There are a number of factors hindering this growth, one of the biggest being digital asset custody.
Compared with the traditional financial infrastructure of transfer agents, central safe depository institutions, custodian banks, and stock exchanges, the digital asset custody space is very different in terms of players, structures, and underlying assumptions.
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Quick Start: How to Store and Secure Crypto Assets
Encrypted assets are held and protected by public-private keys.
The public key is your public address (similar to an IP address) in the blockchain system. A private key is a password that allows you to access assets on the blockchain.
A blockchain wallet is nothing more than a storage system for your private keys. Generally speaking, wallets do not "store" any data about your assets, all of this data is kept on the blockchain itself.
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https://medium.com/s/story/how-does-the-blockchain-work-98c8cd01d2ae
Why custody of crypto assets is different
Encrypted assets are bearer assets, and the control of the private key is equivalent to the control of the assets. If the private key is lost or stolen, this amounts to a loss of the crypto asset itself. In other words, cryptoassets have very high asymmetric risks.
If you take traditional finance as an analogy, the best example should be to think of private keys as physical stock certificates. In the past, destroying physical stock certificates was equivalent to erasing all ownership information, but now, losing the private key is equivalent to losing the certificate of holding encrypted assets.
In traditional finance, by contrast, this form of risk is now fully offloaded to large custodians, insurance markets, and ultimately governments that support many asset classes. This type of guarantee does not exist in today's cryptocurrency market.
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Hosting business panorama
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exchange wallet
Exchanges are the most common place for retail investors to store crypto assets. Leaving your assets on an exchange, thereby removing worries about private key management, is much more psychologically acceptable. However, since 2011, some 40 exchanges have been hacked, and more than $7 billion has been stolen from exchanges, some of which was even stolen by the exchange operators themselves.
In addition to the obvious problem of being lost, institutional investors using exchanges as custodians have three other core concerns:
Counterparty risk - Some exchanges have previously done mandatory liquidation of contracts, or asked all users to pay for losses.
Asset Mixing - Even those reputable exchanges do not segregate user accounts, where all assets are mixed with each other. This is especially troublesome for encrypted assets, because all historical movements of encrypted assets are pegged to the asset and recorded on the blockchain.
Rehypothecation – If the exchange is lending out assets or running a reserve-based system, this could mean more claims on ownership than cryptoassets outstanding.
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hardware wallet
A hardware wallet is a small USB-like hardware device that stores your private keys. That way, even if your computer is hacked, the private key remains safe within the hardware device itself.
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Hosting service provider
Custody solutions have emerged to fill the gap between retail and institutional investors in crypto assets. Several companies building solutions in this space include Fidelity Digital Assets, Coinbase Custody, Anchorage, Bakkt, and others.
corporate investor
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When more than one investor needs access to the asset
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Panorama of Digital Asset Custody
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The author of this article, Chris McCann, is based in the Bay Area. The main custody service providers listed in the article are mainly American service providers. In fact, there have also been cryptocurrency custody service providers targeting enterprise-level customers and institutional levels in the Chinese market. Here are some addenda:
-Cobo Custody Business: Cobo is a digital asset management and storage platform founded by F2Pool founder Shenyu and former Facebook senior scientist Jiang Changhao. "Cobo Custody" service, the company has offices in Beijing, Seattle, Shanghai, and Xi'an. According to the company, Cobo hosting can provide customized collaborative hosting services and full hosting services (the main difference is the private key custodian), has a global emergency response and multiple security protection systems, and can provide API, multi-signature and other solutions for institutional customers , currently can access more than 30 public chains and manage more than 700 tokens.
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Institutional vs retail market
At present, the entire encrypted asset is mainly represented by retail investors, and institutional investors only account for a small part of the market, estimated to account for about 3% of the market. A core reason for this is that a trusted custodian has not yet been developed, and Fidelity and Bakkt's solutions are still in development.
In addition to custody, institutional investors need many other infrastructures, including: tax and accounting solutions, portfolio management, portfolio reconciliation, portfolio tracking, prime brokerage, etc.
Why now?
Why now?
Custody has long been considered a service that the crypto asset industry needs. Cryptoassets are a $130 billion industry and we are starting to see interest from institutional investors, most notably Fidelity, NYSE, Goldman Sachs and JP Morgan.
Beyond that, there is already a small group of crypto asset hedge funds ready to become “beta” clients, funding development, validating the market, and proving the effectiveness of custody solutions. This market will expand significantly as institutional platforms join and demand arises.
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The future evolution of "custodianship"
Custody of cryptoassets is the most talked about fundamental core area today, which involves securely storing and providing access to assets.
Some basic concepts in the traditional financial industry are still quite scarce in the encrypted world. For example, features such as proxy voting, dividend payouts, token splits, and tax reporting are not yet standardized features of cryptoassets.
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Typical process of buying and selling crypto assets
Unlike traditional financial assets, buying and selling crypto assets has a different set of processes that buyers must generally follow when buying, holding and selling crypto assets.
Below is an example diagram of the process and how the host should be involved in the process. Keep in mind that the process will be different if you are interacting with an OTC desk, or buying directly from a counterparty.
NOTE: Keep in mind that the following is what XRP was written for before it was listed on Coinbase. With XRP listed on Coinbase, the process is now simpler.
As you can see, each transaction is a multi-step process where each step must be completed with zero errors. If the public address is entered incorrectly, this will result in the loss of funds since crypto assets are bearer.
The key for crypto asset custodians is to strike a balance between usability and security.
Usability: Ease of use and ready-to-use
Security: no catastrophic consequences and losses
If you never need to use your crypto assets, i.e. hold them forever, securing them is not particularly tricky. However, the more actively you want to use them, the more the risk of hosting increases significantly. Risk is proportional to several factors, including:
Amount: How much an attacker is willing to pay to gain access to your key is directly proportional to the amount they can gain by compromising your key.
Volume and frequency of transactions: The more you need to use your crypto assets, whether to send them, take a stake, or sell them, the more likely they are to be attacked.
Number of employees: The more people in a company who interact with and use cryptocurrencies, the greater the chances of employee error or theft.
The amount of new activity: The more unusual events like forks, security breaches, and airdrops happen, the more your hosting solution needs to keep up and evolve.
Note: Chris McCann wrote an initial draft of this article on the digital asset custody industry in February 2019. A revised version of this article is now published. All data and statistics in this article are from February, but are still directional.
