Crypto Custody: Adoption Shortcut or Blockchain Purists’ Nightmare?

The major digital asset services platform Coinbase has recently announced the long-anticipated completion of a deal that has been in progress since at least May: the acquisition of Xapo’s institutional business. The move projects Coinbase Custody to the status of the world’s largest institutional digital asset custodian, securing more than $7 billion on behalf of over 120 clients globally. According to some estimates, Coinbase could now be holding over 5% of all Bitcoin in circulation.

Xapo, founded by early crypto evangelist Wences Casares and reported to be stashing cryptocurrency in secure vaults hidden in the Swiss Alps, has stated that the decision was prompted by the need to focus on the firm’s core retail exchange business.

The community response in the wake of the news revealed a complex amalgam of sentiments and considerations with regard to the emerging custody concentration dynamics — ranging from excitement for the upcoming onslaught of institutional investors to concern over monopolistic tendencies to excavation of prophecies from Bitcoin’s early days. 

The role of custody

Put simply, custody is a service of securely storing somebody else’s assets in a way that ensures regulatory compliance and allows users to perform operations — such as on-demand retrieval, collection of dividends or collateralizing derivative instruments, to name a few. While keeping track of where and how their money and stocks reside is easy for most individuals, it is a task traditionally outsourced on an institutional scale.

As crypto assets become a prominent part of the financial ecosystem, with institutional actors leveraging immense volumes of cryptocurrency, the question of how to go about storing and handling digital wealth at scale comes to the fore. However different from traditional financial instruments, blockchain-based assets still need to be secured in an organized manner to ensure a comparable level of compliance and protection. 

Alex Lam, co-founder and CEO of digital asset services platform RockX, observed to Cointelegraph that custodians in the crypto space do for institutional actors what hot and cold wallets do for retail investors:

“For large financial institutions and corporations who trade on a much larger scale than regular market participants, the security provided by trusted third parties bearing the burden of custodianship will give these legacy organizations the confidence and certainty they have come to expect in more traditional markets.”

Legitimizing the asset class

In traditional finance, custody is seen as the layer responsible for security and stability of the system, as it ensures that the assets held are both safe and compliant with the existing regulatory frameworks. Many stakeholders of the digital asset domain expect institutional custody to do the same job in the still-volatile cryptocurrency markets, serving as a legitimizing force for the industry in the eyes of both regulators as well as capital-rich financial firms wary to invest in the space.

Charles Lu, CEO of Findora, a blockchain service for building decentralized financial applications, said in a statement to Cointelegraph that he sees maturing custodial services in the blockchain sector as lowering the barriers for institutional investors to enter the market, which is a welcome development:

“Institutional investors require built-in support for automated compliance, as well as security, privacy and transparency. To succeed, the crypto finance ecosystem needs to listen to the needs of the market. Until more regulated, secure, reputable custodians enter the market, widespread institutional investment in digital assets will remain low.”

Tom Maxon, head of CoolBitX’s operations in the United States, emphasized the role that financial regulators play in shaping the custodians’ business, telling Cointelegraph that:

“Custodians tend to be large and reputable firms that are responsible for holding customers’ assets or securities for safekeeping in order to minimize the risk of their theft or loss. As this role is mandated by regulators overseeing the operations of financial institutions, they are unlikely to abandon the use of a custodian to enter into the cryptocurrency realm.”

Maxon added that the role that centralized exchanges currently perform in the crypto space is similar to that of institutional custodians, although such platforms are not particularly well-equipped for this position, saying, “It is widely-known that centralized exchanges are often hacked, making them unreliable and too risky for centralized crypto exchanges to be considered custodians by regulators.”

Interestingly, while many commentators associate the emerging centralized crypto custody trend with the prospect of a more efficient and straightforward regulatory framework for the industry over time, some are worried about the current lack of oversight. 

For one, entrepreneur and investor Roy Sebag pointed out in a tweet how Coinbase has amassed an enormous pool of value without having to go through standard auditing and financial reporting procedures, which would be unimaginable in the traditional finance.

Kevin Sekniqi, co-founder and chief protocol architect at AVA Labs, and Amani Moin, the company’s chief protocol architect for cryptoeconomics, noted to Cointelegraph in a joint statement to Cointelegraph that there are certain scenarios that are likely to engender the increased likelihood of consolidated crypto custody:

“Concentration of custody in and of itself is not necessarily disastrous, but concentration of assets increases the impact of black swan events. Given the lack of clear regulations in the crypto space, this risk is heightened even more than in traditional finance.”

Diverging assessments

As there seems to be some degree of agreement among industry experts with regard to what is happening on the crypto custody front, opinions differ considerably about what the consolidation trend means for the industry. Generally, the valence of evaluations hinges on whether the speaker views the arrival of traditional financial institutions in the crypto space as a positive thing or otherwise.

Jill Carlson, the co-founder of Open Money Initiative, articulated the feelings of the angst-ridden part of the community, wondering if the trend toward consolidated crypto custody was a step in the direction of “recreating the same, broken financial system.” Mike Poutre, managing partner at a blockchain-focused hedge fund Terraform Capital told Cointelegraph that he sees the Wall Street agenda behind the growth of crypto custody sector, saying:

“The big banks and brokerage firms want to introduce custodial relationships so they can produce more products to sell their existing customers. Their motivation is revenue based – pure and simple. Governments want to introduce custodial relationships so they can maintain their control over their citizens — pure and simple. Crypto purists should be very worried. Wall Street will most likely win this. Coinbase’s recent acquisition shows the writing on the wall.”

Lars Seier Christensen, chairman of the blockchain network Concordium, is skeptical about the very idea of outsourcing the custodial function to a third party in the domain of crypto finance. According to Christensen’s statement to Cointelegraph:

“It is a somewhat strange discussion as one of the main advantages with crypto is that you are your own custodian, per definition. Picking an external custodian is just introducing another point of failure and risk. This is only relevant for non-professional players in the industry — which may of course include some institutions that are not very serious about the space. In my view the role of being a custodian is vastly overestimated and there are far too many of those projects out there compared to potential clients.”

Institutional investment vs. ideological purity

Paradoxically, in order to get anywhere close to making the dream of an open, decentralized financial system come true, the crypto industry has to cooperate with the old guard that it aspires to eventually take down. Some experts who spoke to Cointelegraph on the matter saw the expansion of concentrated custody as a compromise between the crypto movement’s foundational ideas and the need to funnel institutional money into the space for the sake of mainstream adoption. RockX’s Lam said:

“Concerns that this marks a centralization of the cryptocurrency market are, to an extent, valid. However, if we are truly dedicated to bringing the cryptocurrency revolution mainstream, it is necessary to welcome institutional actors into the space.”

If the cryptocurrency industry is indeed hoping for institutional investors to join in, then the infrastructure has to be present. Maxon of CoolBitX commented regarding this:

“If we are aiming for cryptocurrency to become a viable alternative to the existing financial system, regulated custodian services will become necessary. With that, however, the industry could come to resemble aspects of the old order to which it was born to oppose.”

Other observers contend that adding a centralized layer on top of the crypto ecosystem’s decentralized foundation is nothing criminal, as Hans Sundby, head of crypto for blockchain protocol Geeq, told Cointelegraph, “A custodian is just a third party that offers a regulatory compliant, secure and efficient way of handling large investments and holdings.” CEO and founder of the Credits Blockchain platform Igor Chugunov told Cointelegraph that custody is something the crypto community will have to accept:

“It is not an attempt to copy someone, it is an attempt to cope with the issues that concern the audience of new investors, which the market of crypto needs. Moreover, we should take into account the strict security requirements demanded by regulators. Application of custody makes sense to me: the end justifies the means.”

Twitter user Oded Leiba noted that the emergence of crypto custodians is in line with the renowned computer scientist Hal Finney’s 2010 prediction that “Bitcoin banks” would arrive at some point, creating an arrangement in which the original cryptocurrency is used for interbank transactions while consumers deal with the second-level, derivative digital asset system. Perhaps far-fetched 10 years ago, such a prophecy doesn’t sound unfeasible today.