BRINGING CRYPTOCURRENCIES TO THE FRONT
Crypto Custody is Not Sexy
By Edward Wong on The Capital
Digital Asset Custody (DAC) could be the catalyst to take the crypto into hyper warp speed. The crypto planets are aligning for an even faster uptick in growth. With increasing global tensions escalating along with economic concerns, coinciding with the growing interests of big banks and institutions, and cautious regulatory oversight, Digital Asset Custody (DAC) is going to play a major role in giving the industry the confidence it needs for the next phase of growth.
Along the banks of the 1,520 miles long Ishim River lies the breath-taking capital city of Nur-Sultan, better known by its former name, Astana. The icy cold, winter air hovers the crystal clear blue skies like a majestic space dome giving you an invigorating shiver amidst its splendor. A perfect setting for a hot cup of tea when you settle back into the comfort and warmth of the cozy indoors.
Kazakhstan, an enigmatic country of friendly and hospitable people of mixed Turkish and Mongolian cultural ancestry, is aiming to restore its legacy in the annals of trade and commerce where it was once at the nexus of an ancient trade route - the legendary Silk Road. Marco Polo and caravans of Arab traders on camels crisscrossed it carrying silk, spices, gemstones, porcelain, perfume, tea, gunpowder, Persian rugs, and other goodies trekked through since 500 BCE. But even more important for human advancement, the Silk Road was the information superhighway of its day, disseminating knowledge, culture, information, and fiery gossip throughout the far-reaching places of the eastern hemisphere.
Ironically, it was the closure of the Silk Road in 1458 CE by the Ottomans that initiated the Age of Discovery [Exploration]. Europeans, by then accustomed to their eastern luxury goods, necessitated new routes to the Far East, propelling the likes of da Gama, Magellan, Hudson, Drake, Cook and Columbus into the uncharted territory. The exploration race triggered new innovations in ship design, map making, Horlogerie, and other technologies. But broader consequences would also follow such as the onset of colonialism. When one door closes, a new one is opened.
Kazakhstan established the Astana International Finance Centre (AIFC) in 2018 CE to position itself as a leading financial hub not only within Central Asia but also focusing on attracting global investment from beyond. There are many favorable factors helping AIFC, most notably that its applicable laws are based on principles, norms, and precedents of English Law. A company granted with an AIFC license, usually banks, financial services, investment firms, exchanges, including both traditional and crypto-asset based companies, after going through a stringent vetting and application process will then continue to be subject to thorough regulatory compliance and reporting. AIFC has created a regulatory “sandbox” placing newly licensed companies in a containment environment in order to allow it to test and vet out new innovations, particularly in the fintech and crypto space.
Digital Asset Custody (DAC)
Many in the crypto industry surmise that one of the most critical components hindering the growth and maturity of the crypto industry has not fully capitalized on the investment opportunities with institutional money sitting on the sidelines, especially if you consider that $17T² is vested in negative-yielding bonds (NYB’s). That’s a potential floodgate that both sides are trying to open. The unavailability of institution-grade crypto custodial services, irrespective of the highly publicized scams, has impeded more significant into the crypto markets. Coupled with the current lack of regulatory safeguards, cryptos are inherently more technologically complex in its nature than fiat, which exposes investors to many risks when using flawed storage solutions.
When I worked at the Fed, I was a Fed Ambassador — a fancy name for someone who volunteers to give public tours at the central bank on their lunch breaks. After a short presentation, the exciting part was when I took the visiting group down to the basement vault to see all the printed money. Contrary to popular belief, the Fed does NOT print money. That responsibility goes exclusively to the Treasury Department’s Bureau of Printing and Engraving, otherwise known as BEP, which readily obliges under the direction of the Fed. If you are ever in DC, the BEP is a popular tourist site but be aware of the long waiting queues.
On a visit to the NY Fed to initiate the processing of my top secret security clearance, I had a chance to tour their bank faults which is unique from the other Fed branches; it houses gold bullion on behalf of foreign institutions. In case you are wondering, most of the US government’s gold are in Fort Knox, TN. I noticed that the vault workers wore Fed-issued, cumbersome, magnesium boots to protect their feet from accidental gold droppings. As ridiculous as that may sound, did you know that dollar for dollar it costs about 17 times more to store digital assets like Bitcoin than it is store gold? Think about that for a minute — it costs more to store bits and bytes than a physical asset and no one even needs to wear mag boots. And not just a little more costly, but 17x more! Obviously this will come down as the industry matures.
An age-old consulting adage states that you can have it cheap, fast, or good… but you can pick only two of three. Likewise, with digital assets, the trade-offs are security, manageability, and convenience, except you can only pick one. The single-point-of-failure, access to one’s private keys, whereby losing it by fraud, mismanagement, negligence, or death is simply too great, resulting in funds getting lost, stolen or compromised with little or no possibility of recovery. Crypto exchanges, hardware security modules (HSM) and wallets, whether hot, cold, or paper, are not adequate solutions.
Managing cryptos in any significant amount is not easy. You are essentially acting as your own bank, often referred to as BYOB. There is no customer service, no bank manager, and no 1–800 number. If there is only one thing that you can get out this article, it is that you never, ever share or give your private key to anyone. The popular saying goes: If you don’t own your private key exclusively, then you don’t own your cryptos.
What happens if you die with crypto in your possession? Chainanalysis estimates that about 25% of Bitcoins, about $35B as of this writing, are lost forever. Most of it is due to loss without proper estate planning. The anonymous nature of cryptos and if the private keys are not provided to the heirs in some fashion would make recovery nearly impossible. This is a complex issue that regulators are tackling. Some exchanges, if the assets are under their management, will transfer it to the rightful heirs. This area is still murky. Ideally, proper planning and working with will and estate planners which specialize in digital assets, such as Octowill, can assure that all assets will be transferred as intended for when the time comes.
- Crypto Exchanges — this is a very common practice whereby cryptos are stored on the exchange itself. Your private keys are kept separate from the exchange but your assets are transferred and stored on the exchange under your account. This pertains to centralized exchanges. While this provides direct access to markets with utmost liquidity because if the exchange gets hacked, as in the notorious Mt Gox incident, or in the case of QuadrigaCX the mysterious death of its CEO, who happened to be the sole possessor of the exchange key, it will be impossible to recover your cryptos. Some exchanges provide separate custodial service, a good thing, but it depends governance, regulatory oversight, and operational processes to ensure that the safety measures are adequate. It is not considered a good long-term practice to leave your cryptos on an exchange. Decentralized exchanges (DEXs) act as pure middleman, facilitating direct peer-to-peer (P2P) trading between buyer and sellers and are therefore not an issue with handling customer private keys.
- Self-Custody — this is basically the wallet route and while wallet developments are still progressing, there are inherent risks and trade-offs. First off, there are varying types of wallets:
- Paper Wallet — this is the simplest, you print your public address and private key on a piece of paper, the entries of which can also be in the form of QR codes for easy scanning and data inputting. While it works and many people use this method, the pitfalls are that if the sheet gets lost, stolen, burned, or eaten by your dog, then you’re out of luck. How about multiple copies with one in a safe deposit box? Well, if you change your private keys or manage multiple wallets, then this will be a headache. While I prefer simple solutions, the paper wallet is far from ideal.
- Cloud Wallet — these are web-based cloud services, which provides the convenience of internet access. But security is only as good as the wallet provider and non-compromise of your devices which access the service. Phishing scams can dupe someone into giving up their private keys by mimicking the actual cloud wallet site. In fact, some of these cloud providers were outright scams to begin with. Most are legitimate though although the landscape is fraught with treacherous elements.
- Phone/PC wallets — while there is safety in keeping private keys under your own control, as the saying goes, if they can get to the President, they can get to your phone or pc. Malicious apps, phishing, hacking, loss of device, malware, and frequent backups are the usual risks to this method of storage.
- Hardware Security Module (HSM) — these are dedicated hardware devices, with software designed to protect private keys. They can be kept offline, or in “cold storage“ mode to enhance security. The device range from a few hundred dollars and up. While this is the most secure of the self-custody options, it is still far from ideal. There is no easy way to configure it for multi-sig or quorum management. Also, maintenance upgrades, either the hardware and/or software, can be onerous. Even if the device is kept offline in “cold storage” mode, eventually connectivity and/or manual handling will be required whenever the private keys need to be accessed. The burden of security is therefore transferred to the proper handling, processing, and governance procedures of the device, limiting the window of opportunity for loss via direct hacking.
3. Custodial Services — When you have considerable digital assets which warrants peace of mind, then third-party custodial services are your safest bet. Mind you that nine times out of ten, the previously listed solutions will work fine. But can you risk being that one time out of ten? Custodial services are experts in storing, managing, processing and handling Digital Assets using the latest technologies, operational governance, authorization procedures, and regulatory frameworks to let you sleep well at night.
Institutional Investors and DACs
There isn’t a one size fits all solution for storing cryptos. Factors such as access speed and liquidity to markets, access frequency, risk tolerance, manageability, administration, and technical competence need to be carefully evaluated before deciding on the optimal solution. But the good news is that institutions investors are entering the industry, potentially bringing in trillions of dollars into the market which will necessitate improved DAC solutions. Managed investment from the institutional players will partner and offload the storage and management with the DAC’s. By “decoupling” the retail investor from the complexity of secure crypto management, the banks and institutions can work out the burdensome integration with the DAC’s. Can you imagine if a patient needing an MRI was responsible for conveying the results back to the doctor/surgeon?
Institutional investment houses along with DAC’s will invest in carefully constructed mechanisms, which will provide the much-needed custodial services in order to provide the optimal balance between security and market accessibility. DAC’s will be responsible for the storage and transfer of the assets. Meanwhile, the institutions, while responsible for the overall management, focuses on what it needs to do best — the where and how of capital allocation.
Institution front offices can also create UX friendly processes with the client using the latest technical schemes such as biometrics, multi-factor authentication, and token-based, etc. If you are only responsible for one thing, you better do it really well, and security in the form DAC’s will be that one thing.
Crypto payments still have not gained wide acceptance, but that is not surprising since the non-stable coins are still volatile. However, one only needs to look at China’s ubiquitous use of WeChat for payment to see its adoption as a use case. On the regulatory side, I mentioned earlier that Kazakhstan, amongst others, are enhancing the transparency of the industry and strengthening investors’ confidence. Cryptographic methods such as post-quantum cryptography (PQC) and multi-party computation (MPC) are not only making the handling of digital assets more secure but also in improving their usability. Companies like Facebook, Alibaba, JP Morgan, and not to mention China are introducing their coins soon. Next up will be the institutions and banks jumping into the fray. It’s an exciting time for the industry and it’s all coming together.
Edward Wong is a Co-Founder at QuantDART, a crypto custody, wallet, investment funds, advisory, and exchange. Edward is the Co-founder of the Shanghai Futures Exchange and was the former Treasury Architect at the Federal Reserve. Besides being a FEDophile he is a World Champion Spicy Eater, Stuyvesant alumni and a cat lady.