Exploring Digital Asset Custody in New Asset Classes admin 22.03.2022

Exploring Digital Asset Custody in New Asset Classes

Since the release of the Bitcoin whitepaper by Satoshi Nakamoto, the digital asset industry has rapidly transformed. The peer-to-peer system was defined as a way to introduce an alternative technology. Today, the applications of blockchain technology range from smart contracts to cutting-edge digital applications that tap into the core transformation outlined in Satoshi’s original paper. The revolutionary potential behind the technology has paved the way for the creation of an entirely new industry segment backed by blockchain technology. 

Existing Digital Asset Landscape – Scale of Adoption 

According to leading platform CoinMarketCap, over 1600 crypto tokens have managed to gain public transactions over the past few years. 

The figure represents unprecedented growth for the entire crypto segment in a short time. Key factors behind the growth have been attributed to the disruptive technology behind the cryptocurrency phenomenon. With the evolution of crypto as a whole, the industry has managed to take its shape as a parallel investment class similar to other conventionally traded asset classes, including stocks, commodities, and bonds.

Leading organizations worldwide are aggressively researching the infrastructure of the crypto industry to recognize digital assets as a viable investment avenue. Digital assets have the potential to become the next stable investment platform with seamless tradability on global exchanges. The formalization of the industry will also lead to a significant increase in the involvement of individual and institutional investors in the industry. Similar to other asset classes, formal regularization of the industry will pave the way to increased trust. 

Core Priorities for Institutional Investors 

For institutional investors, the most important concerns are to ensure the safety of digital assets. Comprehensive institutional solutions are required to provide the required asset security similar to the framework currently followed for other asset classes. Currently, most crypto assets serve as bearer instruments with cryptographic protection. This means that once the keys are lost, the assets are unrecoverable to the original owners. Custodial requirements for these technologies are particularly technological and require a new approach by institutional investors. 

Existing Custody Model 

Across stocks and commodities, financial management companies merely serve as asset managers that secure the investments made by consumers. Currently, four key banks provide the custodial requirements for global assets with over $114 trillion in assets managed. These models pose a significant barrier of entry for new entrants and limit the custodial management to selected few companies. 

On the other hand, Bitcoin presents a decentralized model with a different perspective on asset ownership and custody by presenting a peer-to-peer structure to safeguard digital assets. The ability to instantly determine ownership without the involvement of a 3rd party verification service will have a transformative impact on financial clearing and settlement. The blockchain architecture also has the potential to radically transform the trading mechanism for securities. 

The transformation will unlock the following benefits.

  • Reduced Systematic Risk – By shifting away from the centralized model of custodial management, systematic risk will be averted in the decentralized management model. 
  • Increased Transparency – Increased accessibility of investments would enhance systematic transparency across the financial industry and prevent fiscal mismanagement like the 2008 crisis. 
  • Lower Management Cost – The existing custodial model requires constant oversight from the centralized entities in charge of asset security. The shift away from the centralized structure would reduce the settlement and clearing fees associated with the process.

Addressing the Unique Challenges of Digital Assets 

The custodial requirements of digital assets are very different in contrast to the security requirements associated with stocks and other conventional assets. The nature of these assets differs because of the technological nature of crypto assets and the evolving nature of storage and management technology. 

Here are the key challenges associated with the custody of digital assets. 

  • Management of Private Keys – The security of private keys is the biggest challenge currently existing in the digital asset space. These private keys are numbers generated by digital wallets that are mathematically generated to protect the wallet. These private keys are a way to confirm ownership of digital assets and verify ownership through digital signature technology. Private keys are never shared publicly because they represent ownership. The platforms providing connection options to consumers allow them to sign in to the platforms using their private keys. The decentralization network then verifies the details and adds the details into the blockchain ledger.

 Exchange Security Management – According to a recent study, over 70% of digital asset exchanges maintain custody of private keys for their customers. This is a significant security landscape because exchanges need to safeguard private keys and prevent breaches that can impact customer assets.

Options to SafeGuard Private Keys 

Currently, users can take several different approaches to safeguard their private keys. These approaches are categorized into hot and cold storage categories. Online storage formats are called hot storage, whereas offline storage options are called cold storage. 

Hot Storage Options 

Most existing web exchanges provide consumers the ability to configure online wallets. These hot storages simplify access to digital assets by maintaining the private key online. However, the downside to the hot storage is the present risk of security compromise because the platforms are accessible online. To ensure safety, consumers refrain from maintaining the majority of their crypto assets in hot wallets. 

Cold Storage Options 

There are several different cold storage options that users can choose to control private keys. Potential options include USB and hard-drive-based storage. Other options include the storage of paper-based copies of private keys in physical storage facilities. Cold storage adds an additional layer of manual security but makes it challenging to manage assets. 

Alleviating Existing Risks in Wallet Management 

To improve digital asset accessibility, wallet providers and exchanges can offer users the ability to store their assets on the exchanges. This would allow users to have a higher degree of control over their assets. Wall owners would also have the ability to recover their accounts in case they lose access to passwords. This would be done through decentralized ID verification to recover access. 

Because of the requirement of shifting control to 3rd party platforms, it would be essential for custody providers to showcase security compliance and operational competence for consumers. Without these established security and operations mechanisms, digital assets could be at risk.  

Requirement For Institutional Solutions – DIF Insight  

Institutional clients represent a wide spectrum of financial organizations, including insurance companies, mutual funds, public and private retirement funds, and other corporations. As these companies serve as financial managers for their client’s assets, it is essential to have a track record of delivering exceptional safety mechanisms in client asset management. Asset managers need to have clarity over the storage of private keys. Self-custody is a key element for these companies due to fiduciary responsibilities and acting regulations. Self-managed wallets are not a compatible solution on the scale of institutional management. Advanced solutions will need to be implemented to ensure that institutional investors can confidently venture into the digital asset market and increase their stake in the market. 

DIF expects continued growth in the digital assets and crypto market segments with improvement in institutional investing. With the evolution of the asset class, professional custody solutions are central to increasing participation and improving security. We’re focused on meeting our clients’ requirements for digital asset products and services. The technology has transformational potential, but DIF is actively exploring solutions that provide a long-term directive to our partners.