Why Custodians Are Coming To Crypto

For many of us in crypto, hearing the word “counterparty” is enough to set off a mental alarm in our minds. Third parties? No thanks. We’re immediately skeptical, and generally, for good reason. When it comes to fiduciaries, however, a third-party custodian is required to meet compliance and legal requirements where they operate their business.

In January 2018, before crypto-specific custodians existed, the SEC raised concerns in a letter asking how a fund would prove ownership and safekeep digital assets. All past regulation, from the Securities and Exchange Act to Dodd-Frank provide a potential blueprint for digital assets, but many questions remain.

Matthew Unger, CEO of iComply Investor Services Inc. says,

While cryptocurrency exchanges may sound like they are stock exchanges, they are not exchanges from a definition or regulatory standpoint. Cryptocurrency exchanges in North America, when regulated at all, are subject to the same standards as a street-corner payday loan shop as money services or money transmitters. A stock exchange however, is subject to capital requirements, insurance requirements, custodial, transfer, clearing and settlement.”

While the crypto industry takes aim at mass adoption and mainstream finance, Unger says most of its technology isn’t accommodating regulations.

Unger tells me,

Unfortunately, right now the crypto industry is still building with the mindset that they can skirt regulation, with few seeking to program it into their technology or implement it within their businesses — this is the single largest factor limiting the success of this industry. That being said, in the USA and Canada, the industry has been reaching out to regulators for almost a decade with almost no response, guidance, or engagement until mid 2017.”

Today, centralized exchanges are adapting, by adding third party custodians or registering as custodians themselves. Whether intentionally or not, crypto exchanges have been acting as custodians by default. Because customers store funds in a wallet right on the exchange, the exchange holds custodial access.

Decentralized exchanges remain an exception because an individual maintains custody until they swap their funds. Bottom line, unless you are the only person with access to your private keys and you’re using a non-custodial wallet, someone is acting as custodian of your funds.

Custodians are another piece of the financial puzzle worth addressing, particularly because of the confusion around their role and their ability to protect crypto-assets in particular. This piece seeks to reconcile why custodians are needed in fiduciary transactions, noting they might be helpful for some investors but not necessary for everyone.

Following The Fiat Exchange Model

Today, centralized cryptocurrency exchanges are making the shift, adding a counterparty in the form of a third-party custodian or becoming a registered custodian themselves. This separation of roles is part of a greater underlying theme says Tim Enneking, Managing Director of Digital Capital Management.

Enneking says,

Crypto is working towards the same desired end-state of where we are today with fiat currency exchanges. The market is forming the same separations of parties to create the triumvirate of broker dealers, qualified custodians, and exchanges working together.”

Coinbase became a registered custodian in July 2018, filing with New York State regulators and partnering with SEC-registered broker-dealer Electronic Transaction Clearing. The law states institutions with $150 million or more in assets must keep them in custody under the Investment Advisers Act if 1940.

The US laws around custody have a long history starting in the 1930s in response to the financial system collapse of the Great Depression. These laws are intended to protect investors, particularly consumers, from losing their investments. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 are continuations in this direction.

The SEC “requires advisers that have custody of client securities or funds to implement a set of controls designed to protect those client assets from being lost, misused, misappropriated or subject to the advisers’ financial reverses.” (17 CFR 275 § (2003))

Unger says,

The Depression was a primary factor for the Securities and Exchange Act. Dodd-Frank has only just started to impact the [crypto] market. I saw this back in 2014–2016 in the traditional financial sector. Now, in decentralized financial markets, a few participants are only beginning to take this legislation into consideration. We have seen a tremendous amount of infrastructure begin to be deployed in the past 12 months including custody, trustees, auditors, and payment agents beginning to roll out solutions. By the end of 2019, we will start seeing these solutions being used in major firms.”

Does Everyone Need A Custodian?

The needs of a retail investor, holding or trading cryptos out of their own interest are very different than large institutions and fiduciaries. As retail investors, we have the option to custody our own funds in non-custodial wallets by learning the ins and outs of hot and cold wallet storage.

Custodians, on the other hand, secure millions of dollars in crypto in cold storage, such as hardware and paper wallets inside bank-grade vaults or safes. Though regulation for crypto isn’t fully defined, for now, at least, getting a custodian is step one for institutional investment in digital assets. The Investment Advisers Act of 1940, requires fiduciaries to use a custodian if they hold more than $150 million in assets, and many think digital assets will fall into this category.

BitGo Chief Compliance Officer Shahla Ali says,

There are crypto industry arguments that having a third party provide custody removes the autonomy and privacy of crypto market participants who want to hold and control their own assets — but the reality is that institutional market participants, especially those who manage other people’s money, simply cannot do this from a regulatory and fiduciary standpoint.”

This fact presents a lucrative business for custodians able to provide more than just checking the box on compliance, but actually able to offer services tailored to digital assets. Custodians like PrimeTrust, ItBit, and BitGo all offer a singular service, but some exchanges are also working on becoming the Merrill Lynch of the crypto space.

Coinbase recently acquired two broker dealer licenses and a registered investment advisor (RIA) license, while both Gemini and Coinbase also offer custody services. “We may see the crypto exchanges gather all these services first. In this case, centralization is a good thing, allowing people with the most expertise to put it all together first.”, says Enneking.

Not everyone agrees. Ali says,

Crypto exchanges are far too centralized offering trading venues, trading themselves, sometimes serving as broker dealers, and acting as custodian, where the traditional financial regulatory model would require a separation of these roles. There is a need in crypto markets for custodians who are laser focused on one thing — the custody and security of customer assets.”

Will custodians help institutions expand their investment into crypto pensions and retirement plans of the future, or will new regulations change this dynamic?

By Leslie Ankney