Insured Crypto Custody Services: Key to Institutional Investment Growth?

Registered custodial services, which are common in traditional investment classes, have been on the rise in the digital asset sphere, including for cryptocurrencies.

Branding China Group (BC Group) has recently unveiled its plans for an insured custody service specifically for cryptocurrencies. A conglomerate with a diversified portfolio of blockchain-focused businesses in marketing communications and technology, believes its custody service removes one of the key barriers that have prevented professional traders and institutions from adding digital assets to their portfolios to date.

Leading United States crypto exchange and wallet provider Coinbase launched its custody services for institutional investors in July 2018. In an apparent effort to expand on these services, Coinbase is currently in advanced negotiations to buy custody provider Xapo, one of the largest custodians of bitcoin in the world, in a deal reported to be worth $50 million.

Crypto hardware wallet producer Ledger partnered with a Hong Kong trust company, Legacy Trust, to offer insured cryptocurrency custody services.

A number of regulated financial institutions have also opened up digital custodial services, including Kingdom Trust, Germany's second-largest stock exchange Börse Stuttgart, Swiss private investment bank Vontobel, and major investment management company Fidelity.

What are crypto custody services?

Private investors typically have their crypto stored in an exchange wallet, an online digital wallet or an offline hardware wallet. For institutional investors, these storage options are too risky and put too much responsibility on the investors themselves to ensure that the large amounts of funds are stored securely.

Insured cryptocurrency custody services, much like traditional investment custody services, are third-party providers of storage and security facilities with the main purpose of safeguarding investor assets. These services are aimed specifically at institutional investors — such as hedge funds and other investment funds — and hold the digital assets on behalf of the investor in secure storage locations.

Typically, the custodian would be a bank, trust or other regulated financial institution and would also insure investor funds up to a certain amount. However, because of the inherent perceived risk with cryptocurrencies, up until recently, there has been a lack of regulated, insured custodians for cryptocurrencies.

Why do institutional investors need custodial services?

The two main reasons are risk reduction and regulatory compliance.

Typically, the amounts involved in institutional investments are much larger than with private investment. Uninsured online storage, such as exchange and other digital wallets, pose too much of a risk for institutional investors. And while offline, “cold” storage options — such as Trezor and Ledger — are deemed to be more secure, there’s a risk of forgetting passwords or physically losing the device.

With a regulated custody service, the onus to keep funds secure will move from the investor to the specialized custodian. In addition, should anything go wrong, funds will also be insured. Although this does not completely eradicate the risk, it does put it an acceptably low level for institutional investors to enter the market.

The second reason why institutional investors need custody services is to comply with regulation.

Regulatory bodies around the world, such as the U.S. Securities and Exchange Commission (SEC), the United Kingdom’s Financial Conduct Authority (FCA), and the Monetary Authority of Singapore (MAS) require institutional investors to keep customer funds with a regulated custodian. Regulated custodians include banks, savings associations and registered broker-dealers.

In referencing the SEC’s rejection of the Winklevoss twins Bitcoin ETF, Hugo May, an investment analyst at crypto investment firm Invictus Capital, highlighted the importance of insured custody services for regulatory compliance:

“One of the most important regulatory requirements is sufficient custody solutions. The topic has been a very prominent talking point by the SEC in regards to Bitcoin ETF applications.”

Traditional cryptocurrency exchanges and wallets do not necessarily meet these criteria and are not viable options for institutional investors to trade and store customer funds on.

Kara Kennedy, custody product manager at Bank of New York (BNY) Mellon, said in a research article that, although there is an increasing demand in the market for a traditional, established custodian to provide custody of cryptocurrencies, there are some significant hurdles that must be overcome if traditional custody banks are to engage with this emerging asset class. These hurdles include operating models, technology, risk, compliance, and legal and regulatory frameworks. According to Kennedy:

“Given the market interest, custodians should be considering their capabilities in relation to cryptocurrency servicing; but in order to advance, the industry will have to collectively overcome the issues and uncertainties which remain outstanding.”

What is the potential market impact if institutional investors can be lured in?

Whether or not mainstream institutional investment will embrace the cryptocurrency market has long been a debate.

But analysts and cryptocurrency commentators agree that a lack of regulated custody services is one of the main reasons institutional investors are still reluctant to enter the market.

In an interview with Investing.com, Jae Choi — CEO of blockchain-focused crowdfunding platform Pledgecamp — said one of the key missing pieces of safeguarding crypto assets has been a custodian service:

“If you want cryptocurrency to be treated as a traditional asset, you need to offer regulation and custody options that resemble those available for traditional financial instruments or models.”

Blake Estes, co-leader of blockchain and distributed ledger technology (DLT) at Alston & Bird LLP, said:

"For chief investment officers, there's only downside risk in cryptocurrency. It would take a leap of faith with a new custodian with no brand recognition. That presents a real risk for them."

But with the rise in regulated custodians, this might change.

In January, Cointelegraph reported on a survey done by market research company PollRight, which showed a 41% increase expected in institutional investment in the next five years. And in February, pensions and endowment consultancy, Cambridge Associates, said that cryptocurrency represents a sound investment for institutional investors, according to a Bloomberg report.

An analyst at the Boston-based consultancy said:

“Despite the challenges, we believe that it is worthwhile for investors to begin exploring this area today with an eye toward the long term.’’

Although it would be impossible to predict the exact impact of an institutional influx into crypto, the overall consensus seems to be that a boost of capital into the market will bring a significant increase in prices, but with greater stability.

Blockchain and crypto-focused crowdfunding startup MediaShares’s CEO, Gene Massey, said in an interview:

“Blackrock, Vanguard, State Street, and BNY Mellon are recognized as the largest institutional investors and if they adopt Blockchain and Cryptocurrencies, you will see massive new investments from retail.”

In February, Galaxy Digital Holdings Ltd founder and renowned crypto bull Mike Novogratz said in an interview with Bloomberg:

“Over the next six to 12 months you are going to see institutions put a small amount of their assets in digital currencies. A small amount of institutional assets is a lot of money.”

According to Novogratz, that inflow will set the stage for a rally and should push bitcoin past the $8,000 mark in the short term.

A report published in November 2018 by Big Four auditing and consulting firm KPMG argued that, for the cryptocurrency industry to reach its fullest potential, institutional investors must join it:

“Institutional participation is required to facilitate scale and increase trust for this emerging economy.”