What is unique about digital crypto asset custody business compared to traditional finance, and what are the participants in the market?
Excluding private companies, only based on CoinMarketCap's statistical cryptocurrency market value, encrypted assets are already a $130 billion industry . Despite its size, the cryptocurrency market is still in its infancy compared to the broader financial markets. To ensure that cryptographic assets continue to grow, the industry must meet the needs of institutional investors and financial institutions. There are many factors that hinder this growth, and one of the biggest obstacles is digital asset custody.
Compared to traditional financial institutions such as transfer agents, central security depositories, custodian banks and stock exchanges, the digital asset custody area is very different in terms of participants, structure and underlying assumptions.
- Digital Money Hosting Alliance White Paper
- Fidelity is fully introducing digital asset custody and transaction services
I wrote this article, hoping to give a brief introduction to the uniqueness of the hosting business of digital cryptographic assets and to present an overview of the existing players in the market.
Quick start: How to store and protect encrypted assets
Encrypted assets are held and protected by a public-private key.
- The public key is your public address (similar to an IP address) in the blockchain system. The private key is the password that allows you to access the assets on the blockchain.
- The blockchain wallet is nothing more than a storage system for your private key. In general, the wallet does not "store" any data about your assets, all of which is stored in the blockchain itself.
If you need it, you can read this quick start article on how the blockchain works:
Why are the ways to keep encrypted assets different?
An encrypted asset is an unregistered asset, and control of the private key is equivalent to control of the asset. If the private key is lost or stolen, this is equivalent to the loss of the encrypted asset itself. In other words, cryptographic assets have a very high risk of asymmetry.
If you take an analogy of traditional finance, the best example would be to treat the private key as a physical stock certificate. In the past, destroying physical stock certificates is equivalent to erasing all ownership information. Now, losing the private key is equivalent to losing the holding certificate of the encrypted asset.
In contrast, in the traditional financial sector, this form of risk has now been completely passed on to large custodians, insurance markets, and ultimately to governments that support many asset classes. This type of guarantee does not exist in today's cryptocurrency market.
We believe that there are many important businesses that need to be built to provide first-class security and hosting for cryptographic assets. In all other areas, we recognize the importance of security and recognize that more innovation can be made on this basis. This is especially true in the crypto asset market.
Hosted business panorama
Currently, there are roughly three types of places where people store encrypted assets:
Exchanges are the most common place for retail investors to store cryptographic assets. Keeping your assets on the exchange eliminates concerns about private key management, which is psychologically more acceptable. However, since 2011, about 40 exchanges have been hacked, stealing more than $7 billion from exchanges, some of which are even stolen by exchange operators themselves.
In addition to losing this obvious problem, institutional investors who use the exchange as a custodian have to worry about three other core issues:
- Counterparty risk – Some exchanges have previously forced the clearing of contracts, or all users pay when losses occur.
- Asset Mixing – Even if those reputable exchanges do not quarantine user accounts, all assets are mixed at the exchange. This is especially troublesome for cryptographic assets because all historical movements of the cryptographic asset are tied to the asset and recorded on the blockchain.
- Re-collateralization – If the exchange lends assets or runs a reserve-based system, this may mean more ownership debt than unpaid crypto assets.
For all of these reasons, we strongly recommend that if you have a large number of cryptographic assets, you can either keep them on your own or use a third-party custodian that meets higher institutional standards.
The hardware wallet is a small USB-like hardware device that stores your private key. This way, even if your computer is hacked, the private key is still safe in the hardware itself.
Hardware wallets are great for retail investors; however, for institutional investors with cryptocurrency assets, if you have multiple users who need access to these assets, it is not ideal.
Hosting service provider
In order to fill the gap between retail and institutional investors of crypto assets, hosting solutions came into being. Several companies building solutions in this area include Fidelity Digital Assets, Coinbase Custody, Anchorage, Bakkt, and more.
Managed service providers are ideal for the following individuals or organizations:
- corporate investor
- When investors who need to access assets are more than one person
- Customers who require more granular access control, permission settings, operational controls, multi-level authentication, multi-user access, reporting, and more.
Digital Asset Hosting Panorama
The following is a more in-depth exploration of the crypto asset agency hosting market:
Chain smell note:
The author of this article, Chris McCann, is based in the Bay Area. The main hosting providers listed in the article are mainly US service providers. In fact, the Chinese market has also appeared for enterprise-level customers and institutional-level cryptocurrency providers.
Institution vs. retail market
At present, the entire crypto assets are mainly represented by retail investors, and institutional investors only account for a small part of the market, which is estimated to be about 3% of the market. One of the core reasons for this is that a trusted hosting organization has not yet been developed, and Fidelity and Bakkt's solutions are still under development.
In addition to hosting, institutional investors need a lot of other infrastructure, including tax and accounting solutions, portfolio management, portfolio reconciliation, portfolio tracking, and prime brokerage.
Only after more infrastructure has been developed will we see large-scale emergence of institutional investors embracing cryptographic assets.
Why is it now?
Hosting has long been considered a service for the crypto-asset industry. Encrypted assets are a $130 billion industry, and we are beginning to see institutional investors interested in them, including Fidelity, NYSE NYSE, Goldman Sachs and JP Morgan JP Morgan.
In addition, a small portion of the crypto-equity hedge fund is ready to become a "beta" customer, fund development, validate the market, and demonstrate the effectiveness of the hosted solution. With the addition of institutional platforms, demand will emerge and this market will expand significantly.
For organizations that use cryptographic assets, having trust is the focus. In a field where trust is scarce, the custodian may become an interface between all institutions and other areas of the blockchain world.
The future evolution of "custodial rights"
Encryption of cryptographic assets is the most common core area of today's talk, including secure storage and providing access to assets.
Some of the basic concepts in the traditional financial industry are still quite scarce for the world of encryption. For example, proxy voting, payouts, token splits, and tax reporting are not standardized features of encrypted assets.
Given that cryptographic assets are inherently programmable, in the future, hosting will be more than just a cost center, but a means for customers to interact with the market.
Typical process of buying and selling encrypted assets
Unlike traditional financial assets, buying and selling encrypted assets has a different set of processes that buyers must typically follow when purchasing, holding, and selling encrypted assets.
Below is a sample process diagram and how the host should join the process. Keep in mind that this process will be different if you interact with an OTC counter or make a purchase directly from a counterparty.
Note: Keep in mind that the following is what XRP wrote before Coinbase was listed. With XRP listing on Coinbase, the process is relatively simple.
As you can see, each transaction is a multi-step process where each step must be completed with zero errors. If the public address is entered incorrectly, this will result in a loss of funds because the encrypted asset is anonymous.
The key to encrypting asset custodians is to strike a trade-off between usability and security.
- Availability: Easy to use and ready to use
- Security: no catastrophic consequences and losses
If you never need to use your crypto assets, that is, they are permanently held, then protecting them is not particularly tricky. However, the more you want to use them actively, the more the risk of hosting increases. Risk is directly proportional to several factors, including:
- Amount: How much the attacker is willing to spend to access your key, proportional to the amount they get by destroying your key.
- The number and frequency of transactions: The more you need to use your cryptographic assets, the more likely they are to be attacked, whether they are sent, acquired, or sold.
- Number of employees: The more people in the company who interact and use with cryptocurrencies, the more likely employees are to make mistakes or steal.
- The number of new activities: The more unusual events such as forks, security breaches, and airdrops occur, the more your hosting solution needs to keep up and evolve.
Note: Chris McCann wrote the first draft of this article on the digital asset custody industry in February 2019. The revised version of the article is now released. All the data and statistics in this article are from February, but they are still correct in the direction. This article was authored by the author to publish a Chinese version by Chain.
Source: Chain smell