Build your own bank for digital assets.
When institutions enter the digital asset market, they expect the same level of service available to them in banks. Clients may be concerned about security issues, reliability of asset storage, compliance with regulatory standards of various jurisdictions.
Another thing that matters is how seamless the proposed solutions are. Apart from identical work with assets of different blockchains, custodians should also allow their clients to manage funds according to the market standards. These standards include trading on exchanges, lending, staking, transferring funds to any address within the entire blockchain.
Prospects for Banks in the Field of Crypto Custody
Currently, banks can legally enter the custodial storage market to start competing with the current leaders. According to the Office of the Comptroller of the Currency (OCC), US national banks can provide custody services for crypto assets from 2020. And at the beginning of 2021, banks received permission to store and issue stablecoins. Regulators support banks entering the custodial market as they already have relevant well-established practices.
Moreover, according to the Investment Advisers Act of 1940, institutional investors and investment advisors must use qualified custodians to hold clients’ assets in the US under the SEC. Crypto assets are no exception. Since banks are already qualified custodians, they do not need additional storage permits. Consequently, last year US Bank, the fifth-largest bank in the US, announced the launch of its custody service for fund managers. BBVA and BNY Mellon also announced the launch of similar services.
High market demand caused increased competition in the custodial storage sector. As of mid-2021, more than $370 billion worth of crypto assets were under management. Since 2020, this figure has increased by $300 billion, or more than 5 times. But this is still just the beginning. By comparison, in September 2021, $259 trillion worth of assets of all types were held in bank deposits.
How to Become Custody
To enter the custodial market, a bank or other company must decide whether to store crypto assets on their own or use ready-made solutions. Depending on this choice, we can divide custodians into three common types:
- Direct custodians
- Technology providers
- Mixed type
Ownership of a digital asset, in contrast to the ownership of a physical asset, usually means the possession of a private key to funds management. That’s why direct custodians and providers are not the same.
Direct custodians take complete control of the digital asset’s private key management and safety. They earn a commission that depends on the funds stored, deposits and withdrawals, and additional services. The clients of such firms can be companies that either find building their systems for storing digital assets too expensive or inexperienced institutions that cannot quickly create the necessary infrastructure. Thus, to some extent, they transfer responsibility for the safety of funds to a third party.
This solution may be optimal for most companies entering this market with custodian insurance. The prominent representatives of this segment are Coinbase Custody, Copper, GEMINI, and NYDIG that partnered with US Bank.
As for the custodian, accepting such responsibility is also a critical decision. Initially, being a small startup, you take responsibility for the funds of the largest financial institutions.
Technology providers are taking a different path. They enable technical and software solutions, allowing their clients to organise the storage of digital assets independently. These providers do not need to store the private keys of the clients.
The leading players in this segment are Fireblocks and Ledger. Fireblocks recently completed its Series E round. They received $550 million and now value $8 billion, rising from $700 billion over the past year. Revolut and BNY Mellon banks have already become their clients. Ledger, in turn, raised $380 million Series C investments in 2021.
Mixed custodial companies provide both storage services and self-custody technology solutions. BitGO, Hex Trust and TANGANY offer the full set of services.
Safety of Assets
To increase confidence in the safety of funds, most companies provide insurance options as no government insurance currently covers digital assets. Custodial companies offer an individual set of insurance options that can be expanded for each client. From the basic options, Ledger, for example, provides coverage of up to $150 million for the following cases:
- Third-party theft of the master seed and private keys following a physical breach of a hardware security module in a secure data centre
- Secure transmissions of the master seed fragments as part of the client onboarding
- Insider Ledger employee theft caused by collusion
There is also another way to prove reliability. Audit procedures can objectively assess the existing methods of storing funds and user data. The most common audit options are SOC 1 and SOC 2.
SOC 1 applies if the company’s services affect the financial reports of its customers. SOC 2 is used when it is necessary to prove the reliability of storing user data that is not directly related to finance.
Both types of audit have two options. Type 1 involves taking a snapshot and testing the current state of the organisation’s controls and procedures. Type 2 is focused on testing the same controls over a period of time greater than six months. Most companies in the market try to pass these audit procedures or their equivalents.
The more institutionals will come to the crypto sphere, the greater the amount of capital will be concentrated in vaults. The task of storing digital assets becomes complex when we want to not only store assets but also actively use them to increase capital. The more freedom of action and speed of work with the assets we expect, the greater the risk of losing funds at some stage is. In 2021, hacker attacks resulted in the theft of about $10 billion worth of crypto assets.
More and more institutional companies will want to use the new opportunities of DeFi and NFTs. Ensuring the security of all these transactions will require new solutions from custodians. Foundations also understand this. In 2021, custodial companies received nearly $3.5 billion in investments, almost five times more than the previous record year.
Currently, the primary consumers of custodial services are crypto exchanges and investment funds. But when banks enter the market, we may see a significant shift in the volume and the number of services provided to end-users.