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Enabling Institutional Participation in Cryptocurrency Markets: Custodial Services
Institutional participation in cryptocurrency markets has been widely discussed over the past decade. Following the creation of Bitcoin, the cryptocurrency market has grown exponentially, which in turn has fuelled tremendous global interest and participation. However, the bulk of this hype is generally fuelled by retail participation rather than institutions. There are clear barriers to entry for institutional investors, given the lack of uniform regulations, inadequate liquidity, extreme volatility and an immature market infrastructure. These challenges have made it difficult for institutions to sink their teeth into this nascent industry.
As the market evolves, however, there are indications that as the industry matures over the next few years, institutional participation may be ramped up. As the cryptocurrency infrastructure is slowly established and tested, institutions would theoretically be incentivised to participate in the cryptocurrency market. It is clear that institutional participation is crucial for mainstream appeal and the adoption of cryptocurrencies as a legitimate asset class. One vital infrastructural component that is required to foster institutional participation is custodial services.
Importance of Custodial Services
A custodian refers to a licensed and regulated third party that securely holds users’ financial assets for safekeeping purposes, to prevent theft or loss. Custodial services are an integral component of traditional financial markets since they not only ensure that institutional assets are securely safeguarded, but also facilitate client access and participation across the global financial system. Traditionally, custodians were usually a bank, a trust, or another licensed and regulated financial institution that safeguarded investors’ assets and insured those assets up to a certain amount. Custodians enable institutional clients to connect with a greater network of participants and most importantly, facilitate the efficient deployment of capital. This consequently enhances economic activity and supports overall market growth.
Custodial services for institutions are even more important in the cryptocurrency sphere, given the high risk of theft and loss. Blockchain is a relatively new technology that is sophisticated and complex. Therefore, dealing with cryptocurrencies — in terms of storage — could be a technical ordeal for both institutional and retail investors. The cryptocurrency market is filled with a wide range of high-profile hacks in exchanges. In fact, there have been more than 36 cryptocurrency-related exchange heists since 2011, equalling billions of dollars worth of coins stolen or lost. It is therefore imperative for institutional players that a regulated and safe mechanism to safeguard their assets be in place. Once established, custodial services would remove a major barrier that has prevented institutions and professional traders from participating in the cryptocurrency markets.
The two main reasons for having an established custodial service are:
1. Regulatory Compliance
It is mandated by regulatory bodies around the world that institutional investors are required by law to store their customers’ funds with a regulated custodian. This is a common statute enforced by bodies such as Singapore’s Monetary Authority (MAS), the Securities and Exchange Commission in the US and the Financial Conduct Authority (FCA) in the United Kingdom. In these cases, custodians have to acquire the appropriate licenses and include institutions such as banks, registered broker-dealers and savings associations.
2. Risk Reduction
Institutions are usually involved with larger amounts of capital compared to retail or private participants, usually in the millions or billions. It would therefore be extremely risky for institutions to store their assets in unregulated exchanges or custodians. Even storing their assets on their own would be risky given the technicalities and potential risk vectors that could be exploited. In addition, the lack of insured custodian facilities poses a critical risk for institutions, which would have no recourse if their assets were compromised. Having a network of credible and regulated custodians would enable institutions to offload the onus of safeguarding their assets and be protected by the insurance mechanism.
Budding Custodial Services
The natural evolution of the industry is now geared towards providing core services for institutional players. Currently, there are several prominent entities that are offering institutional custodial services in the hope of attracting institutional funds into the market.
One of the largest and best-known exchanges in the cryptocurrency space, Coinbase became a registered custodian under US law in July 2018. When it launched, Coinbase Custody successfully onboarded ten hedge funds and family offices. Coinbase Custody was designed to provide secure financial controls for institutions seeking to trade and store digital currencies. After less than a year of operations, it has managed a staggering $1.3 billion in assets under custody, with plans to further expand its reach and operations.
Coinbase Custody’s unique staking services allows clients to tap into rewards offered by coins that run on the Proof-of-Stake consensus mechanism, meaning that client funds can be independently managed to earn additional coin, by investing in coins that have staking functionality, much like keeping money in the bank and earning interest on the funds. Staking services have the ability to protect investor funds from inflation, as well as providing a safe avenue (risk-free) for capital appreciation.
Founded in 2018 by Intercontinental Exchange (ICE), Baakt is a digital assets platform and Bitcoin futures exchange. Baakt is a highly-awaited platform both in cryptocurrency circles, as well as mainstream, traditional audiences and its development is being spearheaded by the third-largest exchange group in the world. ICE is also the parent company of the New York Stock Exchange (NYSE). Given the credibility and established user base (both retail and institutional) of ICE, Baakt is poised to become one of the leading digital assets platforms globally. Baakt has established partnerships with BCG, Microsoft and Starbucks, and in anticipation of the prominence of institutional funds, Baakt has also acquired Digital Asset Custody Company (DACC), a custodial service provider for institutions.
3. Branding China (BC Group)
BC Group is a publicly listed company in Hong Kong, focusing on trading and asset management, with several forays into the cryptocurrency and blockchain space, through its ventures Anxone (a cryptocurrency trading platform), and OSL (a digital asset brokerage). In April 2019, BC Group launched the first insured custody service for digital assets in Asia, paving the way for institutional actors and professional traders to store and safeguard their assets using military grade security protocols. This infrastructural component features as the bedrock for both Anxone and OSL. A critical feature of the custodial service is the crime protection insurance policy, which is delivered through a separate third-party entity called Aon, a leading provider of risk solutions. The insurance protection scheme covers a wide variety of related risks such as destruction, damage, loss or theft of digital assets. This scheme is not only limited to their cold storage facility, but also towards their hot wallets, a feature often leveraged by almost all cryptocurrency exchanges globally.
Fidelity, the world’s fifth-largest asset manager, launched its custodial services in March 2019, and has over $2.5 trillion in assets under management (AUM). Its custodial service allows large financial institutions, including pension funds, hedge funds, family offices, and endowments, to safely store their digital assets and facilitate trading. Fidelity engaged in an internal interview with approximately 450 institutions and found out that 22% of the respondents already owned cryptocurrencies — a positive find. In fact, the respondent that own cryptocurrencies expect to double their allocation over the next five years, which further strengthens the need for established custodial services.
Implicit Institutional Participation
Institutional participation should not be assessed in a limited capacity of only direct investment of digital assets; there are other forms of institutional participation in the cryptocurrency market. A major indicator could be direct investments in cryptocurrency-based market entities. For example, a US cryptocurrency exchange focused on the institutional market has garnered tremendous interest for its vision. The exchange, called ErisX, is focused on being an integrated market infrastructure for the trading of cryptocurrencies in a regulated environment. The largest brokerage firm globally, TD Ameritrade and the biggest stock exchange, CBOE, are among those that have invested in ErisX. In fact, TD Ameritrade explicitly mentioned that its investment in ErisX was strategic, aiming to provide access for its current consumer base to the cryptocurrency market in the near future. In all, the cumulative investment that ErisX has acquired from a host of institutional entities amounts to a respectable $47.5 million. The participation of prominent market players in upcoming cryptocurrency-based projects such as ErisX are a testament to the growing presence of traditional entities in the cryptocurrency market.
A lack of regulated custody has certainly been a major hindrance to institutional participation in the cryptocurrency market. Many believe that an established custodial service represents one of the key missing pieces in the cryptocurrency space. At the start of 2019, market research carried out by PollRight found out that there is expected to be a 41% increase in institutional investment over the next five years. This is a welcome statistic for the market, since institutional participation will enhance market stability and foster mainstream traction, particularly in traditional financial circles.