The cryptocurrency market has continued to experience remarkable growth over the past decade. However, the secure custody of digital assets remains a pressing concern for all types of investors. This is of particular importance following the FTX Implosion and similar security breaches.
As Stephan Nievergelt, Head of Custody Product at Crypto Finance AG, said during the inaugural ceremony TokenizeThis conference by STM:
“The main purpose of a custodian is to give investors confidence, because if you don’t trust someone, you don’t give them your money. Trust is therefore the most important asset of a custodian and, of course, it protects the assets for you.
With this, the concept of self-custody has gained popularity, but of course, it comes with its own set of challenges, including human error and operational complexity.
For large institutional investors looking to enter the cryptocurrency market, the self-custody challenges are even more pronounced. Additionally, as regulatory frameworks have begun to emerge in major global jurisdictions, it has become essential to establish clear rules and guidance regarding conservation requirements. In fact, 35% of institutional players identify security as a significant barrier to investing in digital assets, according to Fidelity Study on Institutional Digital Assets.
This has led to a growing demand for specialist crypto custody service providers, and the number of regulated third-party custodians has doubled to 100 in the last six years, according to the latest research from CCData: “Cryptocurrency Custody: An Institutional Introduction.»
As demand for third-party custody services of digital assets intensifies, banking giants like BNY Mellon, State Street, JP Morgan, CitigroupHSBC, Deutsche and Northern Trust have shown particular interest in responding to this request.
Speaking about the purpose of a custodian on the “Digital Asset Custody” panel at the STM conference, Timo Lehes, co-founder of Swarm, noted that it “all comes down to asset protection first and foremost.” Since this is the most important function of a platform, you need “all the ancillary functions” such as the ability to support transactions and asset management.
Although it essentially looks like a cold storage warehouse, intended solely for asset storage, Lehes said:
“There’s a lot more to do once you start looking at what the requirements are on the institutional side. »
Custody of crypto assets and tokenized assets
In the world of traditional finance (TradFi), custody refers to the services offered by a bank or institution that manage and protect a customer’s cash or securities. In the crypto industry, custody refers to different methods used to secure digital assets.
Even in crypto, there is a difference between crypto custody and tokenized security. The bearer instrument nature of crypto makes it a special thing to hold. So the solutions from a technology perspective look very different when you look at on-chain bearer instruments versus digitized securities where you basically have a registry of owners, and there’s more recourse to handle different types of situations on the digital security side than on the digital security side. the crypto side, Nievergelt explained.
Tokenization of security and other real-world assets (RWA) is an emerging trend within space. In 2023 alone, the total value locked (TVL) in RWA protocols increased tenfold, with investors using this on-chain technology to invest in alternative asset classes. According to Citi’s GPS reportthe $1 trillion repo, securities financing and collateral market is expected to be tokenized by 2030.
The role of a custodian is just as crucial in tokenization as it is in crypto, with responsibilities varying depending on the assets in custody and the service engaged.
Lehes’ regulatory-compliant company Swarm allows users to trade real-world assets on-chain and supports tokenized public stocks and bonds on the custodial side. These tokenized assets “are essentially certificates of deposit for an underlying real-world asset such as a bond.” ETFs or a Tesla or Apple stock.
Speaking about the transaction flow of such an asset, Leches explained that when someone wants to purchase one of these RWAs, which it supports from a USDC deposits perspective, on the platform. Challenge Infrastructure:
“It becomes an atomic swap in our smart contract that then triggers the software purchase of the underlying security, which then triggers the purchase of that security, which goes into custodial accounts. And once the purchase is completed, it gives the clearing signal to issue the deposit on the receipt token on the other side.
“This is how the DeFi world can take advantage of uncorrelated assets that are outside of the crypto ecosystem,” Lehes said. “We think this is a really key piece, because it’s one of the ways we can expand the universal value of DeFi.”
As for Crypto Finance AG, the fintech company primarily serves banks in Switzerland, which are not interested in DeFi. “DeFi is a topic that might appear in the future, but there are no use cases at the moment,” Nievergelt said, adding that they are looking for solutions for account and sub-account structures in on-chain and off-chain to help their clients provide “simpler and more structured” services to their customers.
Going forward, the “ability to manage both crypto and tokenized assets” will be “critical,” according to Lehes. Indeed, “ultimately, when everything is digitized one day, you will need to be able to support just about anything and every type of asset. »
As such, building more and more bridges between TradFi and DeFi is the essential element for users to start building wallets that move seamlessly between these two walls, according to Lehes. That said, the crypto industry is not “close” to it yet, he added.
Serving traditional financial clients
When it comes to custodial services in the crypto space, custodial banks and digital asset managers are the ones that primarily cater to institutional investors and offer more personalized services and corporate controls. When using these third-party custody arrangements, one relies on an independent qualified custodian to take control of the private keys associated with their crypto.
When working with institutions, the first thing to focus on is “onboarding costs,” Nievergelt said. It’s very important to have a crypto offering where they don’t need to invest a lot in infrastructure, programs, endpoints or connectivity, Nievergelt added, and you want to make sure that you keep your old traditional system but you can integrate it easily. with other actors who will enable and improve.
In agreement with Nievergelt, Leches further emphasized that it is very important to be able to integrate and adapt to the processes of institutional clients and to adapt to the way they want to build and deliver their services. “Structuring an account always becomes a little more complicated when it comes to institutional clients,” he added.
Custody offerings available today range from custody technology providers to hybrid and regulated custodians with a strong interest in regulated entities. The entry of TradFi institutions into crypto has also necessitated the need for multi-jurisdictional licensing and strong institutional support.
The fact is that regulators have very different rules and requirements, meaning that where the custodian is licensed can impact the level of security. In the United States, the Securities and Exchange Commission (SEC) is making it more difficult for cryptocurrency companies to serve as custodians of digital assets.
Earlier this year, the SEC proposed that to become a “qualified custodian,” companies would not only have to be registered, but also ensure that all assets held are properly segregated and follow transparency measures such as completing Annual audits by public accountants.
Meanwhile, in Germany, the Federal Financial Supervisory Authority (BaFin) allows companies to provide custody services only if they have “necessary authorization” from the agency.
Highlighting Germany’s need for a BaFin-based cryptocurrency custody license as well as transactional licenses, Lehes said: “It’s interesting that Germany was so early” with its categorization of digital assets as financial instruments, and therefore any activity related to them should be a regulated activity. “So they were very clear from the beginning about how they wanted to handle this, and that helped a lot. This clarity really helps in acquiring the right type of customers,” he added.
Switzerland also has “very advanced” regulation with its financial markets regulator FINMA, starting very early with the DLT law and not working on staking or examining other topics. This is why “we also see a lot of banks coming to Switzerland,” explains Nievergelt. According to him, regulators have been more cautious after what happened with FTX, “so they really want to understand what’s going on behind the scenes, what’s slowing down the approval process.” But with the European Union’s comprehensive MiCA legislation expected to bring “a little more speed to the game,” allowing banks to “step up their game as well, and crypto really starts to move again across Europe “, added Nievergelt.
As such, custodians with multiple licenses are able to provide additional coverage and regulatory certainty to entities, while helping them expand into new locations as they scale.
For example, this week, British banking giant Standard Chartered’s crypto security company, Zodia Custody, announced its expansion into Hong Kong, its latest move in its focus on the Asia-Pacific region after recently expanding its services to Japan and Singapore. Julian Sawyer, CEO of Zodia Custody, which specializes in providing crypto storage solutions to financial institutions, attributed the move to the Hong Kong government and regulators’ progressive stance towards digital assets.
Although regulatory compliance remains a key point, Nievergelt believes that the most important thing for the industry remains facilitating access to crypto.
“In general, the crypto industry is still young, needs to evolve and mature, and access for the normal investor needs to become simpler in the future.”
We should work in this direction, and I think people will get more used to it, Nievergelt added.
