Sector Thesis

Institutional infrastructure for crypto adoption – Need for custody solutions and beyond

Our thoughts on emerging trends and opportunities in the crypto infra space

Sridhar Sirugudi, Rohit Jain, Published: 22 Mar, 2022

With Digital assets seeing mainstream adoption, the financial services industry is at an inflection point. While Digital assets themselves have been a part of the mix for quite some time, widespread acceptance by institutional players has seen a massive uptick in recent times. A significant driving force for this is the increased demand from businesses and individuals for digital assets such as cryptocurrencies. Despite their high volatility, the returns generated by cryptos in the past year has brought them into the limelight. While it is arguable if cryptocurrencies will replace the sovereign fiat, their acceptance as an asset class is here to stay. This has sent financial institutions sprinting to offer these products to their clientele. 

However, for financial institutions, asset security remains the prime concern. In a survey by Nickel Digital, Europe's largest regulated digital-asset hedge fund manager the following concerns were cited as paramount -

  1. 79% of respondents picked asset security as prime concern
  2. 67% cited price volatility
  3. 49% regulatory uncertainty

The respondents are 50 wealth managers and 50 institutional investors across the US, the UK, Germany, France, and the United Arab Emirates, who collectively manage around $108.4 billion. In response, many players, including major banks, exchanges, and other financial services providers, seek to offer investors the ability to store, buy, and sell digital assets securely. These services are 'custodial' and require specialized technology that combines strong security, speed, scalability, and operational flexibility. Since the availability of these services will drive increased acceptance, digital custody offerings are essential to the ongoing growth of cryptocurrencies as an asset class.

Regulatory concerns surrounding cryptocurrencies coupled with the ever-increasing variety of offerings in the space has not made the job easy for financial institutions looking to roll out these products. As with any other asset class, there is a strong need for institutional-grade solutions to enable institutions to embrace such products. 

Parallels with traditional solutions

In the traditional world of finance, there are custodian banks that hold customers’ securities for safekeeping. They serve an important purpose since financial securities need to be settled and cleared in a defined regulatory procedure. Some of the largest custodian banks include BNY Mellon, Statestreet, UBS, BNP Pariba etc. Traditional custodian banks offer much more than just safeguarding of assets, they provide accounting and settlement services, such as managing dividends or interest that has been distributed to the account or managing stock splits, etc. In a digital asset there are much more nuances that come into play. For instance, can custodians offer staking as a service, if so what are the disclosure policies? If custodians are pooling digital assets for returns, does that mean that they come under securities law?

While the transaction flow and functions remain similar for digital asset custody, the nature of responsibility changes –

Function

Traditional Asset Custodian

Digital Asset Custodian

Asset Security

Custodians participate in the central clearing process and systems. They maintain records of ownership and also hold custody of physical assets in certain cases on behalf of the owner

Custodians are primarily responsible for safeguarding ‘private keys’. These are alphanumeric strings that control access to digital assets. Custodian either hold these keys or technologically enable the clients to hold them securely

Role in operations

Leverage their networks to provide access to other market entities and infrastructure to enable settlements

Provide access to various parts of market infrastructure, e.g.  consortiums or distributed ledger networks for settlement

Value-added services

Settlement and trading systems, advisory services, physical asset support, etc

Staking, crypto payments, institutional grade trading desks, tax tooling, etc

Regulation

Custodians are regulated entities and flows follow defined regulatory procedures

Mix of full regulated and non-regulated players. Non-regulated players provide tech for companies to implement self-custody solutions

 

Building blocks of custody

The basic building block of digital asset custody is the concept of a wallet. As evident from the name, wallets are where the asset owner's cryptographic keys are stored.  Custodian wallets such as Casa store and safeguard the owners' keys using various technologies. This ensures that the account can be restored quickly in the event of loss of private keys. On the other hand, in non-custodian wallets such as Metamask, there is no feasibility for recovery of account in case of loss of keys. Wallets can also be classified basis the nature of their connectivity into Hot and cold 

  1. Hot Wallets: They are connected to the internet. This ensures that trades and transactions are quickly executed and in real-time. On the other hand, this introduces a vulnerability to theft and hacking if the keys are not stored securely or compromised
  2. Cold Wallets: The private keys are stored offline on a physical device. An additional step of human involvement is required to sign off on each transaction digitally. While this maximizes security, the obvious trade-off is the speed of execution.

Additional layers of security 

Two additional security technologies that are currently being leveraged are:

  1. Multisignature (multi-sig): Instead of relying on a single key, multi-sig requires multiple private keys to authorize a transaction. The keys can be distributed across several different systems. Organizations can design a multi-sig arrangement that would require multiple employees to approve each transaction. This ensures that no single individual has total control over funds. Structured as an M-of-N arrangement, where N is the total number of authorized keys for a signing off an asset and M is the threshold/minimum number of keys required to approve each payment.
  2. Multi-party Computation (MPC): MPC splits a private key into multiple pieces that can be distributed across multiple physical devices. Think of this like puzzle pieces, all of which are required to unlock the asset. Ensures that a hacker cannot obtain the full key by compromising a single device. As with multi-sig, this approach means a company can require multiple authorizers for transactions

Trends shaping up 

The digital asset custody space has seen large investments and capital inflows in 2021. The space is in a state of frenzied activity in terms of both investments and M&A. Notable trends observed in this space are - 

  1. Pure-play custodian firms are fortifying their existing offerings
    1. They are adding layers of value-added services such as lending, trading, staking, payments
    2. For instance, NYDIG, the Bitcoin custody giant, acquired Bottlepay, a crypto payments solution provider and Digital Assets Data, an enterprise-grade data, research, and analytics company
  2. Cryptocurrency businesses are branching out into custody. This includes CeFi firms who started with other primary offerings now focusing on custody
    1. Galaxy Digital's acquisition of BitGo and PayPal's acquisition of Curv were leading headlines
    2. Leading CeFi firm Celsius acquired custodian GK8 to move custody in-house.
    3. Coinbase, which already has an established institutional arm for trading, also offers custody and has now indicated a potential move into staking solutions for institutions
  3. Firms offering self-custody/direct custody technological solutions have been on the rise
    1. For instance, Fireblocks, a self custody provider, does not store their clients' assets, but they provide the technology to their clients to do it themselves 
    2. Fireblocks does so by developing secure software and APIs, through which the clients interact and manage their digital assets

 

Market landscape for Retail and Institutional custody 

 

 The current custody providers landscape has three distinct classes of players - 

  1. Service providers (highlighted in red)
    • They are customer facing and focus mainly on providing a user-friendly customer experience. They might not hold the crypto-assets themselves but work with other parties offering custodian solutions. To improve the customer stickiness and experience, they tend to bundle and offer a suite of value-added services such as compliance support, tax toolings, portfolio analytics solutions, insurance
  2. Technology providers (highlighted in purple) 
    • These companies specialize in technical integration, infrastructure, storage and security. Self-custody providers such as Fireblocks fall into this category. Though Fireblocks also is directly customer-facing, they are not a regulated "qualified custodian."  
  3. Full-stack providers (highlighted in blue) 
    • As the name suggests, they offer a complete suite of services and also provide custody. A notable player here is Coinbase, which serves both Retail and Institutional clients while offering a range of services right from trading to custody

 

Potential range of value-added services 

While institutional-grade Custody solutions are pivotal for the digital asset space to take off, Custodian-focused companies are building value-added services on top of their core solutions to improve their overall value proposition. Extending services such as trading and lending to diversify revenues is usually the first step in this direction. Few other innovative services that could be interesting in this space are - 

  1. Tax Tooling layers
  2. Crypto payments as a service 
  3. Token lifecycle management (Mint to Burn) 
  4. Infra for Crypto rewards and loyalty 

 We are excited about this space because as institutions increasingly move into the digital assets space, they require solutions tailored for their scale, size and security. Two exciting areas here would be - 

  1. Building suite of value-added layers over custody. Institutional grade solutions are the need of the hour. While pure-play Custody solutions aim to solve this, it becomes imperative that they differentiate themselves through additional offerings
  2. The second piece are direct/self-custody solutions that enable FIs to retain tighter control over risk and compliance operations and deliver a supreme user experience

 

The Indian context

Notwithstanding, the regulatory uncertainty, India is home to the second largest base of crypto users and with institution interest spiking, the ecosystem is primed for growth. It is imperative that India first solutions are built for retail crypto investors. For many domestic investors crypto has been their first investment asset class and the ecosystem needs plays that help the users on their journey of building financial wellness, in a crypto native fashion. On the other hand, institution piping is being laid out by the larger exchanges, and this is where domestic custody providers will become an inevitable cog owing to anticipated regulatory response. We believe, domestic custody solutions (mix of self-custody and sub custody) will mature and begin to offer a range of additional services to their clients.

If you are a founder building out institutional solutions, we would love to hear from you. Please feel free to reach out to Sridhar to brainstorm, discuss developments or opinions at sridhar@pravegavc.com