Why You Want to Hold Your Digital Assets with a Bank

Oct 8, 2019

Providers of digital asset custody must offer services on par with global custodial standards in order for digital asset adoption, especially amongst HNWIs and corporations, to grow.

Financial custodians have historically played a vital role in the financial and investment markets, ensuring safety and transparency in markets such as securities and commodities. A custodian safe-keeps and services an investor’s wealth, playing a central role in helping investors to preserve capital. If the investor decides to sell the assets or purchase a different asset, a custodian must process the transaction on the investor’s behalf in a simple and efficient manner. 

In short, custodians safekeep assets for owners. They do not have legal ownership of the assets they custody, which includes instruments such as stocks, bonds, commodities, digital assets or other assets. The owner of the assets retain those rights, while the custodian holds and secures the assets and perform settlement services, recordkeeping, and foreign-exchange transactions. 

Institutional Custody & Digital Assets

The four largest banks currently custody over 114 trillion dollars worth of assets. Meanwhile, the market cap of blockchain-based digital assets reached a meridian of $800 billion in December 2017. That number has yet to entice big banks to enter the digital asset custody space.

Meanwhile, most client and virtually all institutional investors require the safety and security of safekeeping their assets with a licensed third-party. Market research company PollRight showed in January 2019 that an expected 41% increase in institutional investment over the next five years. Cambridge Associates stated in February 2019 that digital assets are a sound investment for institutional investors. 

Research shows that 22% of institutional investors in the U.S. have some exposure to digital assets. Over the next five years, 40% of institutional investors are open to future investments in digital assets. These types of investors will want to store their digital assets in the securest possible manner.

In 2018, Reuters reported that the total amount of digital assets stolen from exchanges and users totaled over 1.7 billion USD. 

According to the University of Cambridge’s 2018 Global Cryptocurrency Benchmark Study, the amount of digital assets reported to be stored in hot wallets instead of cold storage increased between 2017 and 2018 due to demand for quick liquidation. Still, more than 80% of funds are kept in cold storage, according to the report. The report also found that 65% of storage services and 63% of exchange services hold their customers’ digital assets. 

But, two thirds of custodial exchanges do not have a refund procedure in the event customer funds are lost or stolen, while just 31% vault services provide sophisticated key management and custody solutions combining multiple layers of security

As blockchain technology matures, digital assets will need to be custodied with trusted third parties to provide that layer of protection associated with the veritable bank vault. Regulations will be implemented to ensure cryptocurrency financial services such as custody more closely mirror traditional markets. 

With many digital asset exchanges offering self-custody to users, regulations and permits will be developed. 


Japan Payment Services Act Regulates Custodial Service Providers 

Tack of sufficient custody solutions played a role in SEC’s decision to reject the Winklevoss twins Bitcoin ETF. Regulatory bodies globally, such as the U.S. Securities and Exchange Commission (SEC), the United Kingdom’s Financial Conduct Authority (FCA), and the Monetary Authority of Singapore (MAS) require institutional investors to keep customer funds with a regulated custodian, which includes banks, savings associations and registered broker-dealers. 

In Japan, the Payment Services Act, which was passed in 2019, makes custodial service providers accountable for hacks and money laundering/terrorism financing alongside other service providers, such as exchanges. Japan-based custodians must register with the Financial Services Agency (FSA) even if they don’t provide crypto exchange or trading services. 

From April 2020 onward, Japan-based digital asset exchanges must hold user money with third-party operators, such as a trust company or any other similar entity. Most jurisdictions require that the organizations which manage customer funds be independent from the entity that physically looks after the assets. In Japan, entities using hot wallet must hold the “same kind and the same quantities of crypto assets” as the user so the exchange or custodian can reimburse users if funds become compromised – a very high reserve requirement compared to traditional financial custody.

Wyoming Banking Commission Released Regulations for Banks Providing Custody of Digital Assets

In the U.S of Wyoming, the Wyoming Banking Commission (WBC) released in May 2019 its draft regulations for banks that seek to provide custody of digital assets there. 

The draft regulations define sound banking practices in the context of digital asset custody, ensuring banks undergo annual testing for cybersecurity, penetration of security media, and adhere to anti-money laundering and know your customer (AML/KYC) procedures. If a bank outsources certain custodial services, it must demonstrate it has done due diligence on the provider of choice.

If a client banks with the same institution where they custody digital assets, the digital assets must be held in a segregated manner in the name of the client. When holding assets of a non-client,  the bank must be named as an agent or trustee of the digital assets. Custodians and clients, moreover, must agree on the protocols in the event of “forks” of digital assets. Custodians must inform clients of forks and their intent to provide custody of assets.

For a Wyoming-based bank using cold storage for customer funds, security protocol must entail two authorized key holders with security badges and at least two multifactor authentication methods – either personal knowledge via login or PIN, an access card or other program, and biometrics. Only authorized persons, verified through multifactor identity verification approved annually by an independent public accountant, may access the physical storage facility. Prospective employees must submit to background and security checks. 

Digital asset custody contrasts with the safekeeping of stocks and other types of assets. These distinctive features present a number of challenges, including private key security. 

Private keys are a unique, large number generated by a digital asset wallet and assigned mathematically to a transaction originating from the wallet. Private keys are specific to each holder and confirm that the owner of a digital asset is in fact the owner through cryptographic digital signature technology. The private key is like cash. These keys are never shared publicly.  Each user also has a public key used for the sending and receiving of digital assets. 

Storing private keys entails proper key management, which requires technical proficiency. Clients often outsource to third-party “custodial” service providers, which control access to users’ private keys. Since custodians can move user assets off-chain with their own internal recordkeeping systems, they could be prone to operating on a fractional-reserve basis. This makes it difficult for users to verify the solvency of certain custodians. Regulatory oversight will be key. 

Banks & Digital Asset Custody Are a Natural Fit

Banks and traditional financial institutions are held to an extremely high standard, and the same remains true when they custody digital assets. Demand for sophisticated custody solutions has driven some banks into the niche. That banks are developing digital asset custody services could have a major impact on the blockchain industry. 

But not just any old bank can custody. Kara Kennedy, custody product manager at Bank of New York (BNY) Mellon, stated in a research article that, although there is an increasing demand in the market for a traditional, established custodian to provide custody of cryptocurrencies, there are some significant hurdles that must be overcome if traditional custody banks are to engage with this emerging asset class. These hurdles include operating models, technology, risk, compliance, and legal and regulatory frameworks. 

“Given the market interest, custodians should be considering their capabilities in relation to cryptocurrency servicing; but in order to advance, the industry will have to collectively overcome the issues and uncertainties which remain outstanding,” according to Kennedy.

To date, despite a long history of hacks in the industry, most digital asset exchanges globally keep their own cryptocurrencies. By custodying digital assets, banks could lend more credibility to digital asset industry, but also secure customer funds better than exchanges.

The Global Digital Bank

Institutions will need third parties to secure their assets. Strict security protocols are needed to convince underwriters to provide coverage. Insurance is key as funds, family offices, and any reporting institutions need to be sure their assets are insured. At EQI we offer insured digital asset custody for any deposits up to $20M.

While 79% of custodial firms do not serve customers in particular jurisdictions, we service corporate and HNWI in 180 markets globally to be able to offer you fully insured digital asset management. Institutional investors want their digital assets custodied with a bank. 

For digital assets to be treated as traditional assets, the custody options and regulatory environment must resemble those of traditional financial instruments and models. But, the current breed of exchange that double as a custodian present a conflict of interest. 

With so many institutional investors seeking digital asset products and services, the resulting custody solutions – which combines the work of wallet providers, security firms, technology developers, and regulators – will only spur increased market participation in digital assets. Licensed and regulated financial institutions, such as banks, are uniquely qualified to provide access to various parts of traditional market infrastructure and to fulfill regulatory requirements. 

Learn more about digital asset custody with a bank today.


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