Bitcoin Custody: The Final Frontier

“Institutional adoption.” If you ask crypto currency investors what single catalyst they expect will reverse the industry’s sliding fortunes, this is the most common 2-word answer. They will show you a consultant’s pie chart of global financial assets (+$100 trillion in total) and draw a tiny slice where cryptos might fit. Even at 1-2%, the upside (so the argument goes) is dramatic.

The problem is that institutions require many more support services than retail investors, and the provision of those is often heavily regulated. We call this the “Plumbing” of the global financial system, because everyone expects it to work flawlessly but very few people know what all the pipes in the system actually do. Moreover, the same inherently cautious rulemaking bodies that govern all other financial assets (think the SEC/FINRA in the US, for example) also hold sway over how institutions can hold crypto currency assets in their portfolios.

The biggest single clog in the crypto “Plumbing” when it comes to institutional usage is actually the most prosaic: the custody of assets. After all, there are exchanges all around the world, and plenty of connections to the global financial system. But once you own a crypto, the challenge is to store it safely and verify that it remains in your possession. Hundreds of wallet hacks over the years highlights the nature of this challenge.

Solving the crypto custody problem means integrating a deeply conservative and traditional system (used for stocks, bonds, currencies, etc.) with disruptive upstarts (wallets and exchanges). On top of that, the custody business is essentially a stable oligopoly with State Street, BNY Mellon, JPMorgan Chase and Citi controlling the US market. You don’t get to sit at the top of the heap in this business by taking undue risk or jumping on the next big thing.

That’s why everyone we talk to in the crypto space thinks Coinbase’s new custody product (named Coinbase Custody) is a big deal. A few points here:

  • Coinbase made 3 acquisitions to cover the waterfront here according to press reports. Keystone Capital is a FINRA regulated broker dealer. Venovate is an alternative asset marketplace, and Digital Wealth is a financial planning company (both also FINRA regulated for their respective activities).
  • They also partnered with Electronic Transaction Clearing, which has a proprietary custody solution called Matrix. We’ll save you the trouble of Googling them and tell you that ETC has a March 2018 censure from the SEC and an $80,000 fine on their record. The full document is here: https://www.sec.gov/litigation/admin/2018/34-82898.pdf
  • Coinbase already had 10 customers for the new service, according to Bloomberg.
  • As for direct SEC approval, a company executive said, “We sort of have an understanding with the SEC and FINRA, and it allows us to execute contracts and take the first deposits.” The ETC arrangement clearly helps here until Coinbase and the SEC work things out.

The key takeaway here is that Coinbase Custody is a good first step, but it is likely too ad hoc for many traditional asset owners accustomed to existing structures. The big players in the custody space don’t seem to be moving quickly here, likely waiting for further SEC and FINRA guidance. Custody – something most institutional investors take for granted – will likely hold up the growth of crypto currencies for at least a few more years.

On a separate topic: Paul Johnson, a long time friend and Columbia/Fordham b-school professor, is doing a series of lectures this summer on everything from the blockchain to bitcoin and ICOs. More details here: https://www.eventbrite.com/e/blockhous-academy-summer-2018-session-tickets-46579041166

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