Updated: Jun 28, 2021
This article was originally published in Blockchain Industry Review - a Crypto Curry Club Magazine published monthly and available in soft copy and the printed version.
Written by Guest Contributor, Alex Batlin,
Founder and CEO of smart crypto custody platform, Trustology
The market cap of crypto assets markets is growing fast—over $2 trillion. Institutional interest is rising, and players view the industry as an opportunity for growth compared to traditional financial markets.
Crypto assets are based on a fundamentally different technology (blockchain) as compared to traditional financial rails. As such, brand new infrastructure is required to safeguard and administer traded crypto assets. In addition, new decentralised financial services, known as DeFi, are on the rise, offering new trading, lending, and hedging venues as well as passive yield opportunities.
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. However, custodying and safeguarding assets much in the same way traditional assets are is still giving many institutional investors pause. Institutions have a need for 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 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 centralised 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.
Hence what is an ideal custodial solution to support increased institutional adoption in crypto markets where convenience and security are not inversely proportional? How can funds look to acquire solutions that are all in one - fast, flexible with easy transaction capabilities without decreasing security?
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 that can support better monitoring of direct transactional exposure risk instead of having to manually perform pre-flight checks, saving them time, cost and effort.
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. Traders looking to act on arbitrage or margin trades or to implement hedging strategies through the futures and options derivative market 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.
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 allow lists to effectively create a “walled garden” environment where all exchanges traded on can be viewed and accessed from a single view. Capabilities such as this are proving beneficial to funds looking to demonstrate 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.
Decentralised finance (DeFi) has grown to $60 billion in total locked value, totally exceeding the $5 million mark prediction of 2020. However DeFi is a broad and complex playing field, where institutions can easily lose their assets or fall foul of regulation if they don’t know what they are doing. Now with more companies entering the DeFi ecosystem in the hopes of maximising earning potential and growing their investments through staking, lending, hedging or yield farming, ensuring the safe custody of private keys across multiple chains is a necessity and priority. In the current DeFi landscape, interactions are anonymous and there is a big AML/KYC question yet to solve, which doesn’t work for regulated funds needing transparency to comply with regulatory requirements. This is where custodians like Trustology can help, adding layers of utility and security such as multisig, allow lists, co-signing and DeFi Firewalls along with effective private-key storage.
All the foundations necessary to alleviate the concerns of institutional investors have been built and laid out over the last few years with more change yet to come. 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 faster movement of capital, both into, and out of these asset classes. Taken altogether it is becoming easier and more likely that many 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.
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.