The institutions are coming. The herd arrives. Institutional participation in the digital asset market is imminent.
In this case, it is worth considering how the entry of highly regulated financial firms will change the market infrastructure for crypto, which until now has been largely geared towards private investors. Institutions will have different and higher requirements throughout the transaction chain, especially when it comes to the safekeeping of digital assets.
Phil Mochan is co-founder and head of Strategy & Corporate Development at Koine, an international platform for the custody and settlement of digital assets.
Digital assets are bearer assets that have trading and security implications and are a consideration for institutional asset managers looking to allocate capital for a digital asset fund.
Ownership
In the case of owner assets, ownership is determined solely by possession. If I have a $ 10 bill, it’s mine. If I hold a $ 300 million bearer bond, it’s mine. If I have a private key for a 10 BTC Bitcoin wallet, it is (probably) mine.
We say “probably” because most carrier instruments are difficult to copy. Various counterfeiting measures have been built into them, such as serial numbers, holographic images, stamps, ultraviolet threads, etc. A private key for a Bitcoin wallet is simply a sequence of 32 alphanumeric characters that can be used to copy a pencil, an iPhone camera or a good memory. A $ 10 bill would have to be stolen in order to be used, while a private Bitcoin key can easily be copied.
Private keys are therefore the most vulnerable form of owner property and once exposed to a human, it is impossible to prove unique ownership. They may have been copied and no record is made that the copy was made.
A very large crypto fund showed me that it contains the private key on three pieces of paper that is held by three people.
Securing these private keys is therefore becoming a critical issue for digital assets. The original design for a blockchain record of assets is based on a wallet model. The use of the word wallet indicates the security issue. In practice, why would you want to store more value in a digital wallet when you would be comfortable in a physical wallet? Owners may feel like they have cryptographic security, but do they have physical security?
There are numerous examples of people being robbed of their digital assets under physical threat. It may come as a shock to learn that a very large crypto fund showed me that they are holding the private key on three pieces of paper held by three people. I advised them never to reveal their methodology to anyone else for their own safety. To illustrate how insecure it is, maybe suffice it to say that crypto exchanges in total lose all of the contents of their hot wallets roughly every six months.
Various technical solutions have been developed to make the wallet more secure, including MPC technology. But while the risks are (supposedly) reduced, they basically don’t take into account the nature of the risk. Losing $ 1 billion from a bank remains an expensive and risky proposition. Robbing a Bitcoin owner with $ 1 billion in a personal wallet is much easier and with much lower risk.
Effects on Industry
The first implication for protection is that the wallet model is not suitable for high value (> $ 1,000). Its design and architecture make it too fragile, and no technological improvements, however innovative they may be, will ever solve this challenge. “Better” will never be “sufficient”.
An alternative model is the account structure, in which a trusted third party takes control of the assets and separates the authorization processes from the management of the private key. This is how a bank works and it requires trust, regulation and governance, most of which are anathema to the ancestors of the cryptocurrency world.
See also: Crypto Custody – Unique Challenges and Opportunities
The second problem that arises with digital asset ownership is proving unique ownership. The only solution is to make sure (and prove) that no one is ever exposed to a private key. Given that cold stores (the most common form of long-term storage for digital assets) require people to move assets across the air gap (with the associated risk of collusion and poor scalability), such solutions seem unacceptable.
A third problem concerns the regulatory requirements for bearer instruments (which vary from country to country). In the United States, any fund over $ 150 million is required to “dematerialize” its owners’ assets and place them on a custodian-held property register. For this reason, almost all traded bearer assets are dematerialized into electronic registers normally kept by regulated custodians, the records of which are considered “truth” by law.
Given these rules and existing models, it is therefore likely that all digital assets will be dematerialized in a similar manner, in this case to a digital ledger (not for operational reasons, which is likely to be a blockchain) with ownership rights, to existing regulations to meet.
Just the beginning
The institutionalization of the digital asset trading environment is just beginning. The next few years will determine whether we have an efficient one-size-fits-all solution, such as for bond markets, or a more fragmented approach, such as for currency markets.
There will be a shift from crypto evangelism to capital market pragmatism.
DBS, Standard Chartered and Northern Trust have already implemented in-house custody solutions, with the larger banks still considering their options. Should a group of four or five people join forces around a core infrastructure in 2021, the market should develop faster and the high-frequency trading funds will increase the volume many times over.
For the existing primarily retail exchanges like Binance and Coinbase, institutional supply will require a significant redesign. The changes could quickly overwhelm some of them as, for the most part, their technologies are unsuitable for the behavior of high frequency traders.
With the cash-to-derivatives ratio low, cash-settled derivatives exchanges seem to gain the most if they can become institutionally compliant, accessible, and inexpensive.
There will be a shift from crypto evangelism to capital market pragmatism, and the anticipated mass adoption of blockchains will be more anchored in operational reality. The capital market infrastructure will lead to this realignment.
