[ I N - D E P T H |
C R Y P T O C U R R E N C Y
U
nlike some of the other capital
markets functions, custodian
banking is yet to break into Hol-
lywood as the subject matter for a feature
film. Investment banking, hedge funds
and derivatives trading have all secured
star roles over the years, while there was
even a steamy bathtub scene for mort-
gage-backed securities in The Big Short.
For custodians though – as the infa-
mously ‘un-sexy’ side of banking – staying
out of storylines like these is part of the
business. Safety, security and discreetness
is in the DNA of a custodian bank whose
job it is to protect assets. The only time
Spielberg would likely come calling is if
the vaults were ever breached, setting
up a storyline that would blow the $160
million Oceans 11 heist out of the water –
for context, the likes of BNY Mellon and
State Street sit on over $33 trillion worth
of assets.
“Because it’s crypto, there are
these hackers around and
you open yourself up.”
CARL KRUGER, HEAD OF OPERATIONAL
DUE DILIGENCE, LUMX GROUP
Of all the financial themes to prop
up the next markets blockbuster, the
shortest odds must be on Bitcoin. In a
rags-to-riches biopic of the burgeoning
cryptocurrency, the grand finale could
easily involve a custodian bank, for the
security and safekeeping of these digital
assets may be the only thing holding them
back from becoming a fully-fledge asset
class, traded by not only retail clients, but
the world’s largest institutional investors
alike.
Billions of dollars-worth of the crypto-
currency have been stolen since Bitcoin’s
inception, with $1.2 billion pirated away
since 2017 alone, according to estimates
from the Anti-Phishing Working Group.
Hackers have taken aim at anyone
holding digital assets due to the lack of
safekeeping, and comparatively insecure
online storage of cryptocurrencies.
Safety first
“Because it’s crypto, there are these hack-
ers around and you open yourself up,” ex-
plained Carl Krug er, head of operational
due diligence at LumX Group, speaking at
Cryptocurrency Fund Forum in London.
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Global Custodian
Summer 2018
C U S T O D Y ]
“Anyone who say’s I’m a crypto fund: you
are inviting people to come in and look
under the hood.”
A simple Google search of ‘crypto’ and
‘hackers’ will provide numerous stories of
millions - and sometimes billions - being
stolen in all sorts of creative ways, from
hijacking government websites to hacking
during live streams on YouTube.
It’s got to the point where many retail
investors who have struck gold through
the Bitcoin bull run and earned inter-
views with popular media outlets won’t
disclose their earnings due to concerns
about being targeted by hackers.
For major investment companies pub-
licly announcing their intentions to trade
crypto, they could be placing a target on
their head. So quite simply, security is the
Achilles heel of cryptocurrencies.
The options available for the safekeep-
ing of cryptocurrencies take two forms,
self-custody and independent custody.
The former involves hot and cold storage
wallets – whereby the assets are stored
online and offline, respectively - while
the latter could be provided by a coin
exchange or a traditional custodian.
“When you have a currency you have a
token – you have two sides – the public
key and private key – when someone
is holding the custody of assets they
have your private key,” explains Teana
Baker-Taylor, CMO of cryptocurrency
exchange, Coinfloor.
“A significant number of exchanges hold
private keys online allowing you to move
it around, but it means you are at risk of
a hack.”
Tentative custodians
The hot storage Baker-Taylor describes
essentially trades heightened security for
convenience, in that the assets are easily
accessible as opposed to cold storage, in
which customers deposit directly to an
offline address, so they are never held on-
line. “When they want to withdraw them
or call them up then we have to physically
get them from cold storage,” she says.
“We hold assets literally in multiple
vaults and in addition we provide a
multiple signature service, meaning that
multiple signatories from our side need to
validate that key,” Baker-Taylor adds.
A hybrid of the two, known as ‘warm’
storage also exists, with extra safety and
accessibility, but not in the same time-
frame as hot wallets.
The issue for many institutional inves-
tors is that neither provide the security
and big-name assurance which traditional
custodians provide for traditional assets,
and these incumbent banks have been
tentative in their approach to entering the
cryptocurrency servicing world. For 40
Act funds in the US , they are required by
regulation to maintain their securities and
other investments with certain types of
custodians designed to assure the safety
of the fund’s assets.
But they are undoubtedly taking an
interest, whether it’s just keeping an eye
on developments or actively trading -
though this is mostly coming from new
crpyo-dedicated hedge funds right now.
“The most interest right now is from
crypto first hedge funds, and family
offices and the next wave are pension
funds and endowments, who are starting
to ask questions, then at some point in
the future the traditional asset managers
like the Vanguard’s and BlackRocks of the
world,” explains Sam McIngvale, product
lead at Coinbase Custody.
Nomura became the first bank to offer
custody services for digital assets in May
2018, while State Street has previously
said to Global Custodian that “servicing
cryptocurrencies – whether it is from
a custody, depositary or administration
perspective – is something we would
consider.”
Providing access to these networks rais-
es several know you customer (KYC) and
anti-money laundering (AML) challeng-
es, as well as exposure to high volatility,
which have put off many banks.
Kruger added that funds need to respect
the wishes of these large and experienced
institutions.
Respect their wishes
“If you meet a bank or custodian and they
say ‘we don’t want to touch crypto’, for
them they will have a very thin slither
of exposure to crypto compared with
the big business of traditional assets,” he
explained.
“If something goes wrong over there it’s
way too much risk on their business and
you have to respect that.”
A report from McKinsey in March, how-
ever, said that custodians brave enough
to venture into the cryptocurrency asset
servicing world could be rewarded with
significant revenues.
The report argued that securities servic-
es providers could play an important role
as custodians for crypto assets, which as