Crypto Custody Gaining Momentum — Could Drive Billions of Inflows
Crypto Custody Gaining Momentum — Could Drive Billions of Inflows
Introduction:
The lack of mainstream custody solutions for crypto assets has been a major roadblock preventing institutions from entering the space. With exchanges continually the target of major hacks and self-custody introducing an array of human and technical issues, trusted third-party crypto custody solutions by a major bank is what the market needs to enable the formation of more crypto hedge funds and allow legacy managers and institutions exposure to crypto.
Major banks are now either testing or, in some cases, in the process of rolling out crypto custody solutions; Nomura and Intercontinental Exchange have announced definitive plans and sources state other major banks (J.P. Morgan, Goldman Sachs, Bank of New York Mellon) are exploring offerings.
We believe these major banks will roll our offerings within the next 12 months as there is a race to be a first mover, interest from funds, fees to be earned as a custodian and to fend off growing startups (Coinbase Custody, Gemini). This will drive massive capital inflows as legacy funds and asset managers can invest in crypto with the backing of major financial institutions.
Startups are leading the charge offering new crypto custody solutions that safeguard an ever-growing array of digital assets and it is logical to assume a major bank will purchase one of these entities to accelerate its entry.
The major reason for custody in the space is due to the regulation of hedge funds, which requires funds with over $150M in AUM to register with the SEC. All SEC registered funds require most adhere to the qualified custodian rule for all client funds. This is normally satisfied by a prime broker in the traditional asset management business, and there are some qualified custodians now in crypto but usually not covering all of the funds holdings, which is required and can not be a piecemeal coverage setup. As such having a major bank be a custodian is important, especially that it coverages a broad range of digital assets, not just the majors (Bitcoin and Ethereum).
Refresh on Custody
A custodian is a financial institution that holds securities or assets for another party to lower the risk of theft and to guarantee the assets exist. Custodians also allow institutions and funds to focus on their core business instead of having to worry about protecting their assets. Custodians are, in essence, a third party which provides investors a level of trust that a fund manager (for instance) hasn’t run off with their funds.
The Forms and Major Problems with Crypto Custody
Custody has many forms: “exchange custody” where the exchange holds the assets themselves; “self-custody” where funds are placed on an off-line cold wallet (Ledger, Trezor); and “third-party custody”.
Exchange custody is the most in-secure form of custody as exchanges are a honeypot that have been the subject of attack for years. Exchange hacks range from Mt. Gox in June, 2011 where hackers stole 844K Bitcoins (worth $5.7B today) to Coinrail in June, 2018 where various tokens were stolen (worth $8M today).
Self-custody is troublesome as it requires fund managers to have the technical skills to store all of their assets on a cold wallet which introduces numerous issues. Human error could lead to the funds being lost forever (i.e. if a private key is broken into three pieces and all three fund managers need to be present to interreact with the digital assets). This method also foregoes a fund having a trusted third party to audit that the assets actually exist. Granted, a third party, such as a law firm, could be introduced as a co-holder of a private key.
We note that Ledger does have a good solution for individuals, for instance the Ledger Nano S is secure and easy to use after set up. Although a fund using a ledger Nano S would not qualify meet the qualified custodian rule.
The space needs the third option — trusted third party self-custody. Especially since SEC regulated funds with AUM over $150M are required to use a qualified custodian.
Crypto Custody Interest Within Major Banks Is Heating Up
Third party custody options are gaining strong momentum and are progressing faster than the market currently assumes, in our opinion. The space is split between startups innovating and offering new solutions and major banks being the 800-pound gorilla in the room, testing the waters.
Intercontinental Exchange, the world largest exchange operator, just announced the formation of Bakkt, which intends to leverage Microsoft’s Cloud to offer the full package of a major CFTC regulated exchange with CFTC regulated clearing and custody. Bakkt’s ultimate goal is to allow money managers to offer crypto mutual funds and ETFs as regulated investments.
Beyond Bakkt’s confirmed crypto custody plans, the WSJ reported recently that Goldman Sachs, Bank of New York Mellon and JPMorgan Chase are all considering or exploring crypto custody offerings. Northern Trust, which has $10.7T in assets under custody or administration is offering accounting services to crypto funds but may launch a custody product within the next year, per sources. Last, Nomura, along with Ledger (who provides one of the most popular consumer hardware wallets) and Global Advisor Holdings announced Komainu in May, 2018 which is an entity that will provide institutional crypto custody solutions.
In our opinion, major institutions will begin to roll-out crypto custody solutions within the next 12 months and may partner or purchase crypto custody startups to accelerate the process.
Startups Are Enhancing Their Services and Safeguarding A Growing Number of Digital Assets:
Startups are leading the charge as they have been around the longest and are the most innovative in their offerings. Being able to support crypto assets beyond Bitcoin is vital for adoption in the space as investors and funds want exposure to protocols and platforms beyond Bitcoin. Crypto custody startups are aggressively expanding their services from historically only supporting Bitcoin to DACC now offering support for over 90 different digital assets and Coinbase Custody and Prime Trust stating they plan to support any ERC-20 token in the future (there are over 1,000 tokens built on the Ethereum blockchain).
Announcing support for ERC-20 tokens is positive for Ethereum (2nd largest crypto, a platform for building decentralized applications) as it shows interest in professionals gaining exposure to utility tokens. This is great for the Ethereum ecosystem as it validates the model of building on-top of the platform and could support ETH’s price since to acquire utility tokens an entity generally purchase Ether first.
Coinbase is the most aggressive startup in the space (stores $20B in crypto and has 20M accounts, operating in 32 countries) and is one of the most well-known and established players which has entered the institutional custody space. Coinbase Custody started accepting deposits on July 2, 2018 and we believe this service will continue to gain traction and adoption.
While startup custody entities are innovative and moving forward, we believe a major legacy financial institution announcing an offering is what the space needs.
Crypto Custody Costs Aren’t A Deal breaker, But Must Come Down
While the space is nascent, crypto custody costs are well above traditional custody costs. We note traditional custody costs are hard to find and could even be lower depending on whether the fund used an affiliate of the custodian for other services and many funds do not use a custodian since their AUM is low. Shown in the below exhibit, high pricing is still an inhibiting factor for funds to use these services especially since in the early days of a fund it is a major performance drag as every 100bps counts.
While we do not believe higher custody fees are the breaking point for adoption, we believe the holdback is a major player offering a solution, crypto custodian costs still need to come down in order to lower the barriers to entry for the formation of crypto funds. Annual percentage fees on AUM at Ledger Vault and Coinbase Custody are 30x and 76x our estimate of what traditional custody providers charge.
Beyond the higher percentage fees on AUM, Coinbase Custody and Ledger Vault each charge setup fees of $100K/$60K, respectively. Gemini also requires minimum annual fees of $100K (although no setup fee) and Ledger Vault has minimum annual fees of $48K.
Solving Crypto Custody Would Unlock A Large Amount of Capital
Mainstream crypto custody offerings would unlock a large amount of capital. Whether it be a major legacy bank that leads to inflows (what will happen in our opinion) or the continued uptake of solutions offered by startups, either has the potential to lead to large institutional inflows.
Coinbase’s CEO Brian Armstrong stated in the release of Coinbase custody that there is $10B of institutional money waiting on the sidelines today and the number one item preventing them from getting involved is the lack of secure custodian services. Further, Cryptoslate reported on August 16, 2018 that Coinbase Custody’s Head Sam McIngvale stated the company is aiming to store $5B in institutionally owned cryptocurrencies before the start of 2019, which is ambitious but outlines the potential. We note Coinbase already provides custody for $20B on the retail side.
Hedge Fund Research Inc. found total global hedge fund capital stands at $3.2T. To put this into perspective, if 7% of global hedge fund assets were invested into the crypto space, that would correspond to the entire current market cap of all cryptocurrencies and projects. The positive price appreciation of such an event is unknown and would be accomplished over a long period of time. This thought experiment is conservative and excludes other investment vehicles such as pension funds ($41T in assets per Reuters).
Kyle Samani, a Partner at crypto fund Multicoin Capital told Bloomberg this past June, 2018 that there are a lot of investors where custodianship was the final barrier. In our opinion a large financial institution offering a custody solution would unlock billions of capital and lead to large inflows into the crypto space which would be positive for crypto prices.
The Future Argument: Security Tokens
Custody of security tokens, or tokens that represent ownership in an entity or of an asset instead of utility tokens which can be used to power a network or protocol, is the next frontier which is likely further away as many security token providers are in the early stages of rolling out their offerings. For example, Polymath, one of the leading security token platforms, has not received SEC approval for any security token listing as of this report. Other startups in the space include Templum, Vaultbank and Harbor but are beyond the scope of this report.
We will save this discussion for a future article, but we expect major banks and startup players to begin discussing or exploring the custody of security tokens over the next 12 to 24 months. Security tokens represent a major opportunity through tokenizing existing assets: global equities are a $100T market and derivatives are a $1.2 quadrillion market.
Conclusion: Crypto custody is accelerating on two fronts: major banks and startups. While we believe a major bank offering a crypto custody solution is imminent and could drive large capital inflows, the use of startups for crypto custody can still drive capital but will just take longer.
Today, the conversation for most portfolio managers on whether or not to invest in crypto is a hard stop since custody solutions by major players don’t exist. Once a major bank enters the space the conversations and inflows begin. While valuation is difficult to ascertain for crypto projects, we believe PM’s may be able to make an argument to invest based upon crypto being a good fit for a portfolio as an uncorrelated asset.
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About The Founder:
Tom has a passion for finding the most relentless founders and disruptive protocols. Prior to 51percent, Tom was an equity research associate at Oppenheimer & Co Inc, covering cloud and communications where he researched and wrote an extensive blockchain white paper in addition to researching wireless and cloud spanning from 5G to OTT video and cloud technologies. Tom previously founded SecretCaps, a technology MicroCap research company and received his B.S. in Finance from Rutgers Business School
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Disclosures: The author owns Ethereum and Polymath. By reading this post you agree to 51percent Crypto Research’s Terms and Conditions. This report is solely informational and is not investment advice.
