Approaches to Cryptocurrency Custody
Crypto custody companies are growing to meet the needs of institutional investors, including hedge funds, who are patiently waiting to pounce on the digital currency. However, custody solution will vary depending on whether you are a retail grade consumer, a high net worth individual, an asset manager, a corporation or a recently minted project with a cryptocurrency in your treasury. While self-care is the preferred method for individuals, institutional money needs institutional level care, but the question remains, what is the best solution for crypto custodian service?
Institutional investors use custody solutions in the traditional fiat world designed around the regulatory frameworks, crypto funds are already providing a variety of custody solutions for institutional investors, including insurance and the consultative approach.(1) In addition, established crypto players are developing their own custody offers to increase the confidence and to attract the more players to enter the market, either through internal innovation or acquisition.
One such example is Apex Crypto. Apex Crypto offered custody service and clearing to early digital consultants such as Wealthfront (which now self-custodies), Mr. Capuzzi, CEO of Apex Crypto believes that the company will respond to the next generation of providers. On the other hand, Pinnacle Advisory Group director of wealth management Michael Kitces says that while cryptocurrencies may be in demand from digital advice firms, he doubts traditional advisers are ready to switch custodians over Bitcoin. (3)
Nonetheless, Boston-based State Street, the world’s second-largest custody bank, has already announced their consideration in safeguarding clients’ digital assets in a move that would see it become the first major global bank to provide services for bitcoin-related investments. State Street, which has around £24 trillion ($31.8 trillion) in assets under custody and administration, said growing demand from its largest clients to invest in digital currencies led it to consider offering related services.
In May, 2018, J.P.Morgan created a new position - Head of Crypto-Assets Strategy - and set insider Oliver Harris to seek out crypto projects with market appeal. BNY Mellon - the world’s largest custodian bank and asset-service company, with $33.3 trillion of assets under custody as of December 2017 - is reportedly interested in offering digital custody services. Goldman Sachs launched a crypto-based business in May, 2018 - not direct trading in cryptos but derivatives and other crypto products. “A good healthy [cryptocurrency] ecosystem would have multiple custodians, from big ones to boutiques,” notes Fitzgerald. (4)
Is there a regulatory requirement to use a third-party custodian when you establish either a BVI or a Cayman fund that invests in digital assets? When it comes to current market practice, it’s clear that there is no “one size fits all” policy for custody of digital assets. For Cayman, the answer is “no”. For BVI, the answer is a little more nuanced and depends on the precise type of fund structure used. BVI “incubator” and “approved” funds do not require a custodian, whereas BVI “private” and “professional” funds do. However, even where a custodian is required for a BVI “private” or “professional” fund, there is always the possibility of an exemption being granted by the BVI Financial Services Commission (FSC). "Indeed, I met with the FSC a few months’ ago to discuss this very question and they made it clear to me that they are well aware of the commercial realities involved and have, in principle, no objection to granting exemptions on a case-by-case basis," said Philip Graham, Partner at Harneys. (5) Instead, each manager must develop their own policy based on their specific fact set and designed to address the risks of ownership.
Sam McIngvale, product lead at Coinbase Custody, spoke with The TRADE Crypto in Vienna about what the company is doing as institutional investors are on the brink of moving their money into the space. (6) "I don’t think CoinBase Custody or CoinBase institutional really wins if all we ever service is crypto-first hedge funds and family offices; our goal is absolutely to service mainstream finance across the globe."
Most solutions that are being offered use some combination of hot and cold storage, along with multi signature wallets and monitored concentration limits to mitigate risk. One such option for institutional investors that combines the benefits of both approaches is vault storage (vault storage is a combination of both types of crypto-crypto-currency solutions), in which most funds are stored offline and can only be accessed by private key .in which an exchange creates a private key offline. This reduces the risk of hot storage, making it easy to send purchased cryptocurrency to the public address but harder to move it from the account using the private key.
Still, these kinds of solutions can seem clumsy to experienced investors used to a much smoother system for regulatory-compliant trading. Established crypto players are coming up with their own solutions to target security-conscious potential investors. One recent example is BitGo’s recent acquisition of digital asset custodian Kingdom Trust, which holds more than $12 billion in assets. We may expect to see other crypto exchanges making similar purchases so that they can offer more to customers. Development of blockchain-based technological solutions, such as the Glacier Protocol, will be part of the mix as well as they are adapted to serve the needs of institutional investors.
Regulators will also have their part to play. In traditional markets, custody solutions have been designed around regulations, and crypto markets can be expected to follow suit once the rules for crypto are clarified. The SEC has begun consulting with more than 100 crypto funds. Custodianship will undoubtedly be covered. (7)
Plutux's Wallet Infrastructure
Hierarchical Deterministic Wallets (“HDW”)
HDW’s layered wallet design allows for Separation of Security Concerns (if a part of the system is compromised, the other parts remain safe) and Security Breach Isolation, as the Hierarchical Deterministic algorithm generates all DAs and WAs with one master key. Plutux must only maintain security for this single master key instead of the public and private key pairs of all DAs and WAs. Additionally, HDWs separate the security concern by generating extended public key and extended private keys of a hardened child. The extended public key is a public key capable of generating a vast amount of additional public keys if given additional information, such as a user ID. The extended private key works in a similar way, which allows us to generate the private key of the DAs of any user, which users keep themselves for future withdrawal purpose.
Multi-Signature Central Deposit Accounts ("CDA")
Plutux CDA Bitcoin Wallet has a multi-signature address with a certain number of keys required to perform any transaction. To move cryptocurrencies from the CDA Bitcoin Wallet to the WA Bitcoin Wallet, a certain number of authenticated persons carrying the private keys, which are stored in offline hardware devices to prevent external malicious attacks, must jointly submit the signatures to the Bitcoin blockchain. Plutux CDA Ethereum Wallet also has multi-signature functionalities provided by a smart contract. Similarly, the system requires a certain number of authenticated persons carrying the private keys, stored in offline hardware devices, to submit signatures authorizing transfer cryptocurrencies from the CDA Ethereum Wallet to the WA Ethereum Wallet.