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The cryptocurrency market has continued to witness remarkable growth over this past decade. However, the safe custody of digital assets remains a pressing concern for all kinds of investors. This especially holds significance in the wake of the FTX implosion and similar security breaches.
As Stephan Nievergelt, product manager of custody at Crypto Finance AG, said at the inaugural TokenizeThis conference by STM:
“The main purpose of a custodian is to provide trust to the investors, because if you don't trust someone, then you don't give them your money. So, trust is the most important asset of a custodian, and then, of course, it safekeeps assets for you.”
With that, the concept of self-custody has gained significant traction, but of course, it comes with its own set of challenges, including human error and operational complexities.
For large institutional investors seeking to enter the crypto market, self-custody challenges are even more pronounced. Moreover, as regulatory frameworks have begun to emerge in key global jurisdictions, it has become essential to establish clear rules and guidance around custody requirements. In fact, 35% of institutional players identify security as a significant investment hurdle within digital assets, as per Fidelity's Institutional Digital Assets Study.
This has resulted in a growing demand for specialized crypto custody service providers, and the number of regulated third-party custodians has doubled to 100 in the last six years, according to CCData's latest research, “Crypto Custody: An Institutional Primer.”
As demand for third-party custodian services for digital assets is heating up, banking giants like BNY Mellon, State Street, JP Morgan, Citigroup, HSBC, Deutsche, and Northern Trust have been showing special interest in servicing this demand.
Talking about the purpose of a custodian on the “Custody of Digital Assets” panel at the STM conference, Timo Lehes, Co-founder of Swarm, noted that it all “comes down to safeguarding assets first and foremost.” With that as the most important function of a platform, you need “all the auxiliary functions,” such as being able to support transactions and asset servicing.
While it looks like basically cold storage, just for storing assets, Lehes said:
“There's so much more to it once you start looking at what the requirements are on the institutional side.”
Custody of Crypto Assets & Tokenized Assets
In the world of traditional finance (TradFi), custody refers to the services offered by a bank or institution that manage and protect a client's cash or securities. In the crypto industry, custody refers to different methods used to secure digital assets.
Even in crypto, there is a difference between custody of crypto and tokenized security. The bearer instrument nature of crypto makes it a special thing to custody. So, the solutions from a technology standpoint look very different when you look at bearer instruments on chain compared to digitized securities where you basically have an owner registry, and there's more recourse to handle different types of situations on the digital security side than it is on the crypto side, explained Nievergelt.
The tokenization of security and other real-world assets (RWA) has been an emerging trend within the space. In 2023 alone, the total value locked (TVL) in RWA protocols has risen tenfold, with investors utilizing this technology on-chain to invest in alternative asset classes. According to Citi's GPS report, the $1 trillion of the repo, securities financing, and collateral market is expected to be tokenized by 2030.
A custodian's role is just as crucial in tokenization as in crypto, with responsibilities varying based on the assets in custody and the engaged service.
Lehes's regulatory-compliant firm, Swarm, allows users to trade real-world assets on-chain and supports tokenized public stocks and bonds on the custody side. These tokenized assets “are basically depository receipts for an underlying real-world asset such as a bond ETF or a Tesla or Apple stock.”
Talking about the transaction flow of such an asset, Leches explained that when somebody wants to buy one of these RWAs, which it supports from a USDC deposit point of view, on the platform's DeFi infrastructure:
“It becomes an atomic swap into our smart contract that then triggers software purchase of the underlying security, which then triggers the purchase of that security, which gets into custodial accounts. And once the purchase has been completed, that gives the clearing signal to issue the deposit to the receipt token on the other side.”
“This is so the DeFi world can enjoy non-correlated assets that are outside of the crypto ecosystem,” said Lehes. “We think that's a really key building block because that's one of the ways that we can expand the universal value in DeFi.”
As for Crypto Finance AG, the financial technology company mainly serves banks in Switzerland, which are not looking into DeFi. “DeFi is a topic which might come in the future, but there are no use cases at the moment,” said Nievergelt, adding they are looking into solutions for on and off-chain account and sub-account structures to help their clients to provide “more simple and more structured” services to their clients.
Going forward, the “ability to handle both crypto as well as tokenized assets” will be “critical, according to Lehes. This is because ‘In the end, when everything gets digitized someday, you need to be able to support pretty much everything and all types of assets.'
As such, building more and more bridges between TradFi and DeFi is the critical component so users can start constructing portfolios that move seamlessly between those two walls, per Lehes. Having said that, the crypto industry isn't “anywhere close to that yet,” he added.
Serving the Traditional Finance Clients
When it comes to custodial services in crypto, custodial banks, and digital asset managers are the ones that mainly cater to institutional investors and offer more tailored services and corporate controls. When using these third-party custody arrangements, one relies on an independent qualified custodian to take control of the private keys associated with their crypto.
When working with institutions, the first point to focus on is “integration costs,” said Nievergelt. It's very important to have a crypto offering where they don't need to invest a lot into infrastructure, program, endpoints, or connectivity, Nievergelt added, that you want to make sure you're keeping your old traditional system but able to integrate easily with other players that are going to enable and enhance.
In agreement with Nievergelt, Leches further pointed out that it's really important to be able to integrate and adapt to the institutional client processes and fit into how they want to build and deliver their services. “Account structuring always gets a little bit more complicated when you're dealing with institutional clients,” he added.
Custodial offerings available today vary from custodial technology providers to hybrid and regulated custodians with a strong interest in regulated entities. The entry of TradFi institutions into crypto has also called for the need for multi-jurisdictional licensing and robust institutional backing.
The thing is, regulators have vastly different rules and requirements, which means where the custodian is licensed may impact the level of security. In the US, the Securities and Exchange Commission (SEC) is making it more difficult for cryptocurrency firms to serve as digital asset custodians.
Earlier this year, the SEC proposed that in order to become a “qualified custodian,” firms would need to not only be registered but also ensure that all custodied assets are properly segregated and follow transparency measures like providing annual audits from public accountants.
Meanwhile, in Germany, the country's Federal Financial Supervisory Authority (BaFin) allows companies to provide custodial services only if it has “necessary authorization” from the agency.
Noting Germany's need for BaFin-based crypto custody license as well as the transactional licenses, Lehes said, “It's interesting that Germany was so early” with its categorization of digital assets being regarded as financial instruments, and therefore, any activity related to them should be a regulated activity. “So, they were really clear early on in terms of how they wanted to handle this, and that's helped a lot. That clarity actually helps in acquiring the right type of clients,” he added.
Switzerland also has “very advanced” regulations with its financial markets regulator FINMA, starting early with the DLT law and not working towards staking and looking into other topics. This is why “we also see a lot of banks coming to Switzerland,” said Nievergelt. According to him, regulators have been more careful after what happened with FTX, “so they really want to understand what's behind the scenes, which slows down the approval process.” But with the European Union's comprehensive MiCA legislation, it is expected to bring “a bit more speed into the game,” allowing banks to “speed up their game as well, and crypto really starts to move again all over Europe,” Nievergelt added.
As such, custodians with multiple licenses are able to provide additional coverage and regulatory certainty to entities, along with helping them expand into new locations as they scale.
For instance, this week, British banking giant Standard Chartered's crypto security firm Zodia Custody announced its expansion to Hong Kong, the latest move in its focus on the Asia-Pacific region after extending its services to Japan and Singapore recently. Julian Sawyer, CEO of Zodia Custody, which specializes in providing crypto storage solutions to financial institutions, attributed the Hong Kong government and regulators' progressive stance toward digital assets as the reason for this move.
While regulatory compliance remains a key point, Nievergelt believes the most important thing for the industry remains making it easier to access crypto.
“In general, the crypto industry is still young, needs to evolve and mature, and the access for the normal investor needs to get more simple in the future.”
We should work towards that, then I think the people will get more used to it, Nievergelt added.