Investors look to custody banking to safeguard cryptocurrencies

Venture investors are eyeing custody banking for digital assets, both as an investment sector and as a resource firms may use as they grapple with how to hold digital tokens and cryptocurrencies in their funds.

Some blockchain companies have begun to offer custody for a limited number of tokens, but none have settled on a perfect solution. Meanwhile, large traditional custodian banks remain mum on whether they plan to expand their services to digital assets.

Without a custodian bank to store the full array of digital assets currently on the market, investors are on their own when trying to secure funds against the risk of hacking or complying with regulatory requirements.

“Venture investors invest to have capital appreciation, and what stops them from being able to invest in ICOs is the custody issue,” said Madding King III, a principal at Camp One Ventures. The firm in November announced it made a seed equity investment into blockchain startup Mobius Network, because the firm was unable to invest directly in the company’s ICO, or initial coin offering, due to a lack of custody, King said.

Traditional custody banks operate like safety deposit boxes for institutional firms with many large investments, holding assets like stocks, bonds, or currencies on behalf of clients. For added security, they safekeep assets with multiple signatories, audit trails and insurance, in addition to providing legal, compliance, administration and tax support.

But custody for assets like cryptocurrencies and digital tokens is less straightforward or secure. Unlike stock certificates, which can be re-issued, cryptocurrencies are secured by a private key, a string of alphanumeric characters that allows for secure access to the digital wallet where the assets are stored. If the key is stolen or lost, all of the digital assets it secures can be transferred irreversibly.

And as money pours into the emerging asset class, the need for a comprehensive cryptocurrency custody solution increases. In 2017, the number of hedge funds focused on cryptocurrencies grew to more than 120, according to a CNBC report. And last year, more than 200 blockchain companies raised nearly $4.3 billion through ICOs according to research group Autonomous Next, and the total market capitalization of all cryptocurrencies surpassed a half-trillion dollars according to coinmarketcap.com.

For institutional investors like Aberdeen Standard Investments, it’s critical to find a way to prevent private keys from being compromised before investing in digital assets.

“It’s something we’re focusing on because it’s different than investing in traditional equity,” said Kirsten Morin, a senior investment manager at Aberdeen Private Equity. “If you lose the private key, you lose the tokens, and that’s a key difference.”

Because of that risk, Morin said, institutional investors view investing directly into digital assets with varying levels of enthusiasm.

And many VC firms are unable or unwilling to participate in ICOs because of a lack of custody, effectively cutting them out of such deals, King said, even as the number of companies employing the fundraising mechanism rises.

With traditional custody banks, “you know your assets are safe with those places,” King said. “In the crypto world, it’s in its infancy and you don’t have the institutions that the regulators would look at as true custodians of assets.”

“We cannot put a bunch of bitcoin in our fund,” King said. “We’d like to, but it becomes a regulatory issue for us.”

But even if they never planned to invest directly into cryptocurrencies, some venture investors find themselves trying to figure out what to do with digital assets in their funds.

That’s because more venture firms are seeing existing portfolio companies hold ICOs to raise funds, and investors are often given tokens instead of cash. For venture firms, that raises a host of questions, such as how to securely hold the tokens, how to distribute dividends to LPs, and what regulatory structures may apply.

Without a satisfactory custody solution, venture firms that hold tokens are “super, super, super paranoid” about storing them securely, said Spencer Bogart, a partner at Blockchain Capital in San Francisco. Many firms use multi-signature wallets with a combination of physical and biometric security so that no one person can move the coins, he said.

“But it’s something we’d prefer not to do,” he said. “It’s a pain for everyone in the space, and hence the reason why there’s this activity to offer [custody] services.”

He added: “You’d never expect custody to become a sexy topic for Silicon Valley VCs, but it has become one.”

For the more than 120 hedge funds that have formed to invest in cryptocurrencies, a robust custody solution is often a matter of regulatory compliance, since the SEC requires investment vehicles with $150 million under management to comply with a battery of reporting requirements, including holding assets in a custody bank.

Several startups and international banks have begun offer digital asset custody. In November, Coinbase announced it would begin to roll out custody banking services for a limited number of cryptocurrencies to institutional investors in 2018.

The venture-backed company, which is valued at $1.6 billion and plans to go public, has raised more than $225 million from investors, including Tusk Ventures, IVP, Union Square Ventures, USAA and Andreessen Horowitz.

Coinbase CEO Brian Armstrong has cited estimates that there is $10 billion in institutional money waiting to invest in digital currency.

Other companies to offer custody solutions for certain digital assets include Xapo, which holds digital assets offline in cold storage inside of Faraday cages within abandoned military bunkers in the Swiss Alps; ItBit, the first bitcoin exchange to obtain a New York State trust company charter in 2015; and Gemini, a bitcoin exchange founded by entrepreneur twins Cameron and Tyler Winklevoss, and which also obtained a New York state trust company charter later in 2015.  

Although Coinbase has received a virtual currency and a money transmitter license from the New York State Department of Financial Services, it has not yet obtained a trust company charter. The company declined to comment for this article.

Several banks have begun to offer custody services as well, including Lichtenstein-based Bank Frick, Zurich-based Falcon Bank, and South Dakota-based Kingdom Trust.

But none of the current providers offer custody for all digital assets. Current custodians offer safekeeping for only a limited number of digital currencies, mostly bitcoin and ether, a far cry from the more than 1,400 cryptocurrencies currently listed on coinmarketcap.com.

ItBit plans to expand its custody services to more currencies in the first half of 2018, focusing on the top 10 currencies in terms of market capitalization, said ItBit General Manager David Wells.  

Each cryptocurrency or token operates on a different protocol or consensus algorithm, he said, meaning that custody for each asset like bitcoin, ether, and XRP tokens operates differently.

To provide custody for each digital asset, “you have to set it up in a slightly different way and develop deep expertise,” he said.  

And insuring digital assets, which is required in certain cases, can be inexpensive and inefficient.

Further complicating matters, some tokens may be incompatible with the prevailing custody model. The most secure way to safekeep tokens is to put them in deep cold storage, which requires that both the assets and their private keys be stored offline.

But some tokens operate on an alternative consensus algorithm called “proof-of-stake,” which requires that they be online, making them potentially more complicated to store securely. 

“That’s one of the complexities in adding other currencies,” Wells said. “We’re still trying to figure it out.”

Multiple venture investors who spoke with VCJ said they are looking at companies working on offering a more comprehensive custody solution, although they declined to identify the companies by name.

Long-established custody providers have remained largely quiet on whether they plan to begin offering custody for digital assets.

Bank of New York Mellon, State Street, JP Morgan and Citigroup are the largest custodian banks, holding more than $103 trillion in assets under custody and administration as of Q1 ‘17, according to Trefis Research.

They declined to comment or did not respond to VCJ’s questions.

The reticence from the leading custodian banks may be due partially to the fact that there’s still much regulatory uncertainty. The SEC has refrained from declaring all cryptocurrencies to be securities, saying instead that whether or not a particular asset violates securities law depends on individual circumstances. Cryptocurrency exchange startups Cobinhood and CoinLion told VCJ they would only consider offering custody services once regulators release clearer guidelines.

But there are signs that State Street may be quietly moving into the sector. In 2016, when the Winklevoss brothers amended their application for a bitcoin exchange-traded fund (later denied by the SEC), they named their company Gemini as its custodian and State Street as its administrator.

“My take on things is that most of the financial institutions are at least researching and experimenting how they might [offer custody],” said Victor Pascucci III, who led USAA’s investment into Coinbase before joining Lightbank as a managing partner.

“Over the next six months or so, we’ll see large financial services industries starting to participate meaningfully within the cryptocurrency space,” he said.

But even without regulatory clarity and a universal custody solution, some venture firms have already invested directly into digital tokens. In early January, the Wall Street Journal reported that Peter Thiel’s venture firm Founders Fund invested in bitcoin across several of its funds. In May 2017 Boost VC, co-founded by Tim Draper’s son Adam Draper, announced it would begin to invest directly into tokens and cryptocurrencies.

And in the past six months, multiple venture funds have told VCJ they are modifying existing LP agreements to invest in digital assets or ensuring that all funds going forward can do so.

Despite the fact that digital currencies’ initial popularity stemmed partially from a distrust of established institutions like banks and centralized government, Pascucci sees digital asset custody as a boon for the emerging sector.

“Anything that provides security and validation to emerging technologies is a great thing,” he said. “You will always have the purists that come back and say it wasn’t supposed to be about that. But that’s the nature of technology and destruction and innovation. There’s always an alt to the alt.”

Disclosure: Kaitlyn Bartley and her husband own cryptocurrencies, including Ripple’s XRP.

Photo of cryptocurrency courtesy of iaremenko/iStock/Getty Images.