Will centralized custody solutions save your coins or hurt bitcoin?
If cryptos were digital elements, Bitcoin (BTC) would be the first digitally scarce element.
Because it’s the first, many globally are slowly but surely using BTC as a way to save and store wealth while speculating on the tech.
As a result, storage facilities that hold BTC are becoming important human capital holdings.
Traditionally people would store wealth in old elements such as gold, antiques, collectible items, real estate, art, livestock, and shares in businesses. Most of these are physical assets that have large central custody systems built around them to improve efficiency, security, and access.
For example, buying shares in Real Estate Investment Trusts (REITs) is a highly profitable way to gain exposure to real estate, and all thanks to REITs centralization of custody.
Today, we have a new store of wealth asset called Bitcoin (BTC) which throws a wrench in the long tradition of centralized wealth storage. One reason for that is that BTC is the first digitally scarce asset that anyone can self-custody, meaning we no longer are reliant on central agents to verify that your assets are your assets.
Yet, crypto self-custody does come with risks and a heavy burden of responsibility, here are a few:
High chance for human error while securing keys (losing private keys)
Cyber attacks (exposing keys online)
Incompatibility with inheritance (difficulty to pass crypto on after death)
Difficulties for governments to tax their citizens
May disrupt lending practices
Crypto may encourage the hoarding of wealth which, in turn, may cause an economic slowdown due to poor wealth circulation
Difficulty for large institutions to self-custody due to the technical burden and strict regulations imposed on their investment practices
Bit of Old, a Bit of New
If managing and storing your own crypto is riddled with these problems, then it naturally explains why we are seeing a spike in custody services coming online.
However, many in the crypto realm would argue that custodians like Coinbase aren’t part of the original utopian P2P vision Satoshi Nakamoto had in mind.
But rarely do utopian visions come true. Including Satoshi’s. Reality tends to play out where the old and the new meet.
Borrowing from the old ways, current crypto exchanges like Coinbase have inadvertently become de facto crypto storage facilities of our time. Crypto exchanges broke the long traditional model that had custodian and trading mechanics separated and instead combined the two.
Having to juggle both the duties of a crypto custodian and that of a trading platform, exchanges have made many mistakes resulting in millions of dollars worth of stolen crypto.
The risks associated with crypto exchanges are now well known and the reaction to this has been on solutions that solely focus on crypto custody only.
The Secret Crypto Stash
Most of these custody-only solutions take the form of quasi-old school institutional solutions, one of which is Xapo. When Xapo first came on the scene many criticized the solution as overpriced.
On the Island of Gibraltar, Xapo bank, the first real crypto bank, is headquartered within an old army barrack.
Why store with Xapo when you can self-custody for free one would ask.
Quietly, Xapo has gained the lead, secretly managing the largest stash of Bitcoin in the world.
Grayscale Bitcoin Trust is one client of Xapos and Greyscale has been the only go-to investment vehicle for institutions to gain exposure to BTC.
Greyscale has reported managing over 1% of all global BTC where do they store their BTC? At least for a time, it was within Xapo, but recent news says they have moved to Coinbase Custody.
Titans Enter the Arena
Nearly half of institutional investors (47%) view digital assets as having a place in their investment portfolios.
— Fidelity Digital Assets, Crypto Division Research
When it comes to crypto custody, 2019 seems to be the year when the veterans come to play. With big names such as Fidelity and State Street just beginning to expand their offerings into crypto, we should also see others follow suit.
For example, computer giant IBM has just entered the crypto arena, and we at HollaEx in partnership with DACS have been working on secure and practical crypto custody solutions, combining IBM’s advanced HSM mainframes with our white-label exchange.
Slow Transition Period
Despite all the media hype and name-dropping, the truth is crypto assets such as Bitcoin are viewed by institutional investors like a diamond in the rough that has to be thoroughly polished before any consideration is put towards investing.
“Institutions […] aren’t ready to invest because they’re not yet comfortable with the available custody solutions.”
— Tuur Demeester, Founding Partner of Adamant Capital, Aug 3, 2018
Crypto custody providers are thus wrapping up crypto in a traditional financial framework to make them more palatable for institutional investors.
Though the process is slow, the writing is on the wall, custody solutions are in great demand and once the red tape has been cut, it will garner huge legitimacy for crypto assets and mean the green light for institutional investors.
If all goes well, there should be an influx of new crypto adopters piling into crypto custody providers, which begs the question, what would be the cons of more centralized crypto custody services? Are we coming around full circle?
Let's take a look at some of the possible issues that come with the normalization of crypto custodians:
Governments could easily seize wealth through the custody provider
Custodians can report on assets making it easier to overtax citizens
Big privacy concerns since custodians hold a load of sensitive data.
More friction when moving crypto if clients must ask permission from the custody provider (defeating the purpose of crypto)
With opaque central storage of cryptos, rehypothecation and fractional reserve crypto banking are much easier to pull off (we already saw this with FTX recently showing they in fact held no bitcoin!)
On top of these issues, custody providers have to grapple with a new reality… Once cryptos are lost they are really lost forever.
Crypto custody comes with its own challenges. If they are ever to attract customers, providers will have to come up with enticing benefits.
Besides strong security, custodians would have to offer other perks such as high interest on crypto deposits, attractive loans, and solid insurance which should make all the difference when attracting clients.
However, with the likes interest bearing accounts from Celsius, BlockFi, Gemini Earn and of course FTX, we all know how they went. Perhaps earning interest on your crypto is a red flag when coupled with a crypto custodians?
In order for the piggy bank to make a comeback, it might need some other special perks like better insurance funds to ease the weary hodler.
Bitcoin was invented as a reaction to these risky ploys and heavy centralization of our financial system, ironically much of the BTC is still stored in a handful of companies.
The takeaway, however, is that crypto is now giving everyone the opportunity to take full custody of their finances, which will hopefully help balance our delicate financial system should it ever go off-kilter again.
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