Intro to Institutional Crypto Custody

Institutions such as hedge funds, pension funds, and endowments are more willing than ever to engage with digital assets. In a 2022 survey of over 270 global institutional investors conducted by BNY Mellon, 97% agreed that “tokenization will revolutionize asset management” and be “good for the industry.” Furthermore, these investors said they would allocate an average of 29% of their assets to digital assets in the next 2-5 years if the regulatory environment improves. These institutional players, most of whom are not crypto-natives, now need a new set of infrastructure providers to support their transition to a tokenized financial system.

Custody services are the most critical piece of new infrastructure these investors need today. When you are moving hundreds of millions of dollars onto a blockchain, writing down a 12-word seed phrase on paper or buying a Trezor hardware wallet doesn’t cut it. Professional investors need equally professional custody services to guarantee assets are 100% secure and recoverable. With 130+ firms competing in the custody market today, the competition is heating up. 

This blog is a primer on the nascent institutional custody industry. We will provide an overview of the types of players in the space and highlight what we view as a gap for self-custody providers.

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Overview of institutional custody ecosystem

The landscape of cryptocurrency custody providers is diverse, with different types of organizations offering unique services to meet the needs of institutional investors. However, most providers broadly fall into one of three camps: traditional financial institutions, full-service digital natives, and custody aggregators. Let's explore each in turn.

1. Traditional Financial Institutions

Traditional financial institutions, such as banks and asset management firms, have started offering cryptocurrency custody services as part of their broader financial services portfolio. These institutions bring a wealth of experience in managing and safeguarding assets, and their entry into the crypto custody space is a significant step towards mainstream adoption of digital assets.

However, traditional institutions also face the most intense regulatory scrutiny, which can discourage investments in custody capabilities and limit participation. While the OCC noted in Interpretive Letter #1170 that “a national bank may provide… cryptocurrency custody services on behalf of customers, including by holding the unique cryptographic keys associated with cryptocurrency,” subsequent guidance has been more cautious.  In a joint statement by the OCC, FDIC, and Federal Reserve earlier this year, these regulators declared: 

“Issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network… is highly likely to be inconsistent with safe and sound banking practices. Further, the agencies have significant safety and soundness concerns with business models that are concentrated in crypto-asset-related activities or have concentrated exposures to the crypto-asset sector.”

The net effect is that while a handful of TradFi firms are beginning to develop custody offerings, many others are choosing to invest directly in custody start-ups that they likely view as strategic partners.

• Key Characteristics: Established reputation, regulatory compliance, extensive financial services
• Examples: State Street Digital, Fidelity Digital Assets, BNY Mellon
• Advantages: Trust and familiarity for institutional investors, robust regulatory compliance, potential for integrated financial services
• Challenges: Adapting traditional financial systems to the unique requirements of cryptocurrency, staying competitive with more agile digital-native companies

2. Full-Service Digital Natives

Digital natives, with their roots firmly planted in the era of cryptocurrencies, bring a unique blend of agility, innovation, and customization to the table. Their inherent understanding of digital asset markets and technology sets them apart from their TradFi peers. Their smaller size grants them the agility to adopt the latest technological advancements. Many of these firms, such as Coinbase and Gemini, also operate as cryptocurrency exchanges, which enables them to seamlessly integrate additional services like crypto-asset staking and trading into their custody offerings. This amalgamation of native expertise, agility, and ability to offer a wide array of services empowers them to deliver bespoke, cutting-edge solutions tailored to each client's needs. 

However, despite arguably superior custody offerings, digital natives face significant distrust among institutional investors. In the BNY Mellon survey quoted above, 63% of respondents were only comfortable trading tokenized assets with “highly rated traditional institutions,” and 47% stated that interacting at all with digital native firms falls outside of their risk mandate. After the 2022 collapses of BlockFi, Celsius, and FTX, it’s tough to blame them. Combined with the intense regulatory scrutiny by the SEC in recent months, digital natives are hardly the obvious choice for your average pension fund. Digital natives are well-positioned to dominate the custody space, but they have significant reputational work ahead if they want to compete long-term with TradFi offerings. 

• Key Characteristics: Comprehensive solutions, white-glove service, crypto-native 
• Examples: Coinbase Custody, BitGo, Gemini Custody
• Advantages: Customer support, cutting-edge technology, additional crypto services
• Challenges: Building trust with institutional investors, regulatory compliance

3. Custody Aggregators

In the United States, the label of a "qualified custodian" is a prerequisite for any firm intending to custody assets, including cryptocurrencies. Banks, by default, fall into this category, but the designation isn't exclusive to them. Non-bank entities, such as Coinbase, can also attain this status by becoming "chartered trust companies" at either the state or federal level. However, a third category of custody providers has navigated around this regulatory requirement: Custody Aggregators. 

Instead of holding assets themselves, these providers facilitate access to other custody services, sidestepping the need to become qualified custodians. They act as intermediaries, using APIs (Application Programming Interfaces) to integrate various third-party providers, creating a seamless and efficient experience for the user. These aggregation services are highly appealing to a wide variety of investors looking for scalability and choice above all else.

• Key Characteristics: Requires API integrations, flexibility, wide variety of choices
• Examples: Fireblocks, Copper
• Advantages: Ability to choose between different custodians, potential for customization, fast set-up
• Challenges: Dependence on the security and reliability of third-party custodians

Each type of provider has its strengths and challenges, and the choice between them will depend on the specific needs and preferences of the institutional investor. As the crypto custody market continues to evolve, we expect further innovation and diversification in custody services.

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What about self-custody?

Among the 130+ custodians currently on the market, as cataloged by Blockdata, only one targets institutions with tools for self-custody of funds. The prevailing focus on fully custodial solutions is short-sighted, especially as Web3 evolves towards an ecosystem encompassing identity, value, data, and social networks. This evolution necessitates that financial services firms and institutional investors interact directly and autonomously with public blockchain networks.

Decentralized Finance (DeFi) is a clear example that requires the self-custody of digital assets today. PWC's 2022 Global Crypto Hedge Fund Report highlights this need, stating:

"The rise of DeFi presents interesting challenges for custody solutions. Currently, DeFi activities are almost entirely 'on chain,' implying that managers are taking self-custody of assets when it comes to DeFi... A need for a satisfactory custody solution specific for DeFi activities is evident and urgent."

We envision future institutional custody providers not as entities holding assets on behalf of their customers, but as facilitators, enabling customers to self-custody their own assets. At Locksmith, our goal is to design a safer, smoother self-custody experience for retail users, and perhaps one day for institutions as well.  To learn more about our open-source project, check out our whitepaper, sign up for early access, or join us on Discord.

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The institutions are here, now

It's clear that the landscape is diverse and rapidly evolving. Traditional financial institutions, full-service digital natives, and custody aggregators each bring unique strengths to the table, offering a range of services to meet the varied needs of financial institutions and investors. Yet, a significant gap remains in the market for self-custody solutions, particularly as the world moves closer to a fully realized Web3 ecosystem.

Institutional engagement with digital assets is no longer a question of “if” but “how.” As we navigate this new frontier, the choices we make today will shape the future of asset management.

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Sources:

Celent‍

Blockdata: List of Custody Providers

KPMG

PWC

Blockdata: Crypto Custody Report

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