How a Gold Standard for Custody Unlocks The Crypto Asset Market

An Institutional Investor’s View


by Dr. Karl-Michel Henneking, Simon Schaber

last updated August 12, 2020

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The interest of institutional investors in cryptocurrencies, in particular Bitcoin, as an alternative asset class is constantly increasing. Smaller investors are already active, whereas large institutions like banks, pension funds, mutual funds or insurance companies still see a couple of hurdles to overcome. Next to general regulatory issues surrounding cryptocurrencies, a safe and regulatory compliant storage and administration of crypto funds is a key concern.

Latest developments, though, indicate that barriers are gradually removed and the inflow of institutional money is increasing: The digital asset fund Greyscale with their Bitcoin and Ethereum trusts, for example, reported the largest quarterly raise in history with over $500m in Q1 2020. At the same time, the US state of Wyoming passed a law that will allow insurance companies to invest in cryptocurrencies. And a lot is happening on the crypto custody front: New players offer enhanced solutions and aim to provide institutional-grade investor protection. Plus, the regulatory landscape for custody is evolving. In particular Germany pushed the boundaries in 2020 with a new licensing regime for crypto custody, which defines a kind of gold standard for custodians safeguarding Bitcoin and co.

This article focuses on the strategic importance of custody for opening up the crypto asset class to large institutional investors. By taking Germany as a case we will outline who benefits from the new regulatory environment, who will likely lose, and what is essential to position successfully in the managed crypto custody market.

We start by briefly addressing a couple of foundational questions, namely why crypto custody is gaining traction, what so far prevented a wide-spread adoption by institutional investors, and how we see the custody market evolving in the future.

Why is crypto custody gaining traction?

Demand for safe custody of crypto assets is increasing due to several factors. They are closely linked to the attractiveness of and the investment thesis for the underlying asset class.

One factor is the performance of Bitcoin. With a 95% gain in 2019, the leading cryptocurrency outperformed all traditional asset classes including equities and gold, despite its still inherent short- to mid-term volatility. In addition, the recent coronavirus-induced government stimulus packages — so-called bazookas — raise inflation fears and might push investors to shift liquidity back in equities and inflation-resistant assets, such as gold and potentially also Bitcoins.

From a portfolio balancing perspective, Bitcoin and other cryptocurrencies, over the long-run, have been less correlated with traditional assets and thus might allow investors to hedge risk in their portfolios. Although during the recent crisis the correlation increased and Bitcoin couldn’t prove to be a safe haven so far, data for a couple of months ahead will tell whether the risk diversification thesis remains intact.

Another reason for increasing future demand for custody services becomes obvious with a view at the much broader class of digital assets. Bitcoin and other cryptocurrencies with a market cap of ca. $220bn (end of April 2020) form only a fraction of the overall market for new digital assets. Tokenized real estate, bonds and equities are estimated to reach $4tr in 2022 and surge up to $24 trillion in 2027. Should these projections materialize, it will become crucial for institutional investors to participate and invest in these markets in the future. But as already mentioned, there are certain hurdles to overcome.

What prevented wide-spread adoption of crypto assets among institutional investors so far?

Just to get it right: There already is institutional money in the Bitcoin and altcoin market. It comes from crypto hedge funds (more than 150+ according to a PWC/Elwood study from 2019), from crypto index funds, VCs, and progressive family offices which invested early. This might be one reason why Bitcoin temporarily dropped during the current coronavirus pandemic: investors had to fulfill their margin call requirement and serve other obligations. Consequently, they also converted alternative assets like gold and Bitcoin into cash.

However, the majority of institutional investors, in particular large institutions like endowment funds, mutual funds, commercial banks, pension funds and insurance companies, are still reluctant to allocate money to crypto assets. The reasons are obvious: institutional investors demand, amongst other things, regulatory compliant and secure custody services. Other critical factors include, for example, missing market liquidity for large investment volumes, slippage/time to settlement, a limited number of brokers and overall too many manual processes.

Regarding secure storage: Security concerns mainly originate from the fact that crypto exchanges and projects were hacked and at least $9.8bn was stolen since 2017. Cybersecurity is a risk inherent to digital assets in general. It requires banking-grade, some say military-grade, protection. Leading crypto custodians like Coinbase, bakkt and BitGo meanwhile (aim to) provide enhanced protection not only for their assets but also as managed third-party services.

Regarding compliance: There are still regulatory uncertainties around crypto as an asset class. Regulatory environments vary substantially from one jurisdiction to the next — at a national as well as international level. But the situation is improving: among others, Malta, Gibraltar, as well as the US states Wyoming and New York passed rules to regulate institutions that perform custody, exchange and other services for crypto assets. Liechtenstein introduced a comprehensive and progressive regulatory framework for digital assets in 2019, Switzerland recently licensed two crypto-banks, and Germany’s financial regulator BaFin established a special license regime for crypto custody at the beginning of this year.

How is the crypto custody market evolving?

Driven by increasing demand for crypto coins, bullish expectations towards the future of digital assets in general, and the opportunity to establish new financial ecosystems around custody, the market for managed custody services is gaining significant traction. Thus, players are not only positioning themselves for the crypto asset market alone but also see the potential for custody and respective value-added service offerings in the wider tokenized asset market. In 2019 alone, six new entrants came to the market in the US, and in Germany 55 companies expressed their intent to apply for the new crypto custody license following reports. The race is on!

The developments in Germany are of particular interest for many reasons: on one hand, the regulation in Germany provides a kind of gold standard for managed crypto custody by implementing a regime that is stricter than current EU regulation. On the other hand, the evolving landscape of competing custody providers and in particular their go-to-market, partnering and technology strategies in a large market like Germany might provide a blueprint for other markets — not only in Europe.

What are the building blocks of the German crypto custody license?

Germany positions as a hub for institutional crypto business with a regulatory framework that requires service providers to apply for a license expressly catering to crypto-asset custody. Key requirements of the license include:

▪ All crypto exchanges, but also all wallet operators that actively address the German market from January 1st, must have a license.

▪ The license requires an established entity in Germany, 125.000 € initial capital, an experienced management team and advanced risk management policies and procedures in place. The risk management has to consider BaFin’s MaRisk standards, BAIT banking-grade IT requirements and crypto-specific mechanisms that prevent theft and abuse of private keys. (For a more detailed report of these requirements see Bitkom’s info paper)

▪ All parties that want to apply for the license had to indicate their intent by March 31st, 2020 to BaFin, the German financial supervisory authority, and have to submit a complete application by 30 November 2020.

Grandfathering is in place for running crypto businesses: Service providers who already conducted crypto custody business on 1 January 2020 will be deemed to have been provisionally authorized if they follow the license application process and fulfill the requirement outlined above.

▪ Any firm, local or foreign, that hasn’t been custodying crypto for German customers before Jan. 1 cannot do so until they have received a license first.

▪ There is no EU passporting possible since crypto-custody services are not investment services according to the current European regulation (MiFID II).

With its strict regulatory regime, Germany provides a quality seal for any service provider that passes the application process. The licensing procedure ensures that custodians follow the high standards large institutional investors demand.

Who will benefit from Germany’s gold standard for crypto custody?

To understand the impact of the new licensing regime on existing and future providers in Germany we distinguish between different types of players:

The regulation sets a high bar for small and early-stage players, including smaller crypto exchanges and wallet providers, because the initial capital requirements, the hiring of experienced managers, and expenses for establishing a professional risk management all pose a significant cash burden. Although the grandfathering rule gives them some time to breathe, these players need to act quickly and potentially seek out partnership opportunities with established service providers or a progressive bank that comes as a new entrant. In any case, a market shakeout can be expected in the long term. On the positive side, this will eventually lead to a stronger, higher quality competitive landscape.

Established, larger, and well-funded fintechs will likely benefit from the new regulatory environment. They have technology advantages, are well-positioned and will face less competition from the long tail. They might use the opportunity and explore acqui-hiring options or at least will have better access to scarce talent from smaller start-ups. For the larger players, it will be easier to attract tech and digital talent than for traditional financial service providers because of cultural affinity.

Firms that were not operational in 2019, but intend to enter the German market will have to be patient. Since the application approval is a case-by-case decision by BaFin, a lot will depend on the number of seriously interested parties. In light of 55 expressions for interest, it is expected that the licensing procedure will take time considering that BaFin applies high-quality standards.

Traditional custodians and banks can leverage their established and loyal client base when entering the crypto custody market, which is an obvious opportunity. Most of them, though, miss the technological know-how to meet the specific requirements of safeguarding crypto assets and struggle with organizational inertia. If they don’t move, they face the risk of not only losing their client base for crypto-related services but their ‘fair share’ of the overall digital asset market (including tokenized equities) in the future. Traditional players, in particular banks, shouldn’t repeat the same mistake as in the payment market, in which they were marginalized in the last decade.

Which market players, including new entrants, can we expect in the German managed custody market in the coming years?

We expect a diverse landscape of service providers to emerge — from specialized crypto custody service providers to players from the traditional financial service industry. Based on their original and functional focus we grouped them in five clusters:

Innovative banks: Solaris, ING DiBa, TEN31 and Commerzbank Group (Main Incubator) position themselves in the crypto custody business. BNP Paribus expressed interest early this year. Munich based Bank von der Heydt and Frankfurt’s Hauck & Aufhäuser bank intend to enter the asset tokenization market including custody services as well. For innovative banks not only the pure-play custody market is important, but they also position to win the “war for the wallets”. Wallet providers have access to client data and can provide value-added services which traditionally are the domain of banks.

Crypto custodians — Already operational German players like Börse Stuttgart backed Blocknox as well as start-ups like Tangany, Finoa, Upvest and Plutoneo benefit from the grandfathering regulation. The start-ups might form partnerships with more established players. In addition, international crypto custody providers from Europe and further abroad, i.e. Crypto Storage AG from Switzerland and BitGo from the US will be part of the play. Both have formed German entities already. Asian digital asset specialists with an interest in the European market are also exploring options.

Fintechs expanding their business scope: i.e. the KYC/AML specialist Fractal, the crowd-lending provider Kapilendo, as well as tech enablers like Riddle & Code, that decide to move up the value chain.

Crypto exchanges and wallet providers have to apply for a license if they want to continue serving their German client base. These include, Bitwala, Coinbase, Gemini, Kraken, Bitpanda, Bitstamp, just to name a few.

▪ And sooner or later: more risk-averse big European banks that are currently studying the market and selected US players with a strong traditional custody business like BNY Mellon, State Street, JP Morgan, and Citigroup, … might join to ensure regional service coverage for their client base.

A non-exhaustive and partially illustrative outlook is provided in the graph below.

How to position within the Crypto Custody Market?

In our opinion, there are a couple of general positioning options and levers to be considered by existing players and new entrants in the managed custody market.

Since custody is a rather low margin business, scale and respective cost advantages are key — in particular, if custody is a stand-alone offer. As the US market shows, acquisitions such as Coinbase/Xapo, bakkt/Digital Asset Custody Company, BitGo/Harbo, and recently Genesis/Vo1t, are a lever to acqui-hire talents and gain scale, even in an early stage of market development.

Furthermore and strategically, crypto custody can be seen as a starting point to develop a broader digital fintech service offering — replacing some of the intermediaries in the current process such as brokers, traditional custodians, clearing & settlement houses, paying agents, transfer agents, banks, fund administrators, etc. In this case, custody is a door opener, a market to invest in to subsequently serve customers with higher-margin products.

A key strength to play within the positioning game originates from customer access. Any player with an established and loyal institutional customer base is a formidable gatekeeper. Irrespective of technical capabilities and understanding of the crypto-asset market, such players can use this asset to build substantial partnerships. Tech/solution partnerships, in general, are a central strategic lever for traditional players in the financial service arena. The partnership between State Street and Gemini hints at further movements in this strategic direction. And not only the big players join forces. The same applies to smaller ones. Munich’s Bank von der Heydt, for example, partners with the German fintech Bitbond for the tokenization of assets.

For an optimal go-to-market for crypto custody service providers, next to understanding general positioning options and levers, it is important to tailor the approach to the respective regulatory and market environment.

What’s essential for a successful Go-to-Market in the managed crypto custody market?

There are several key questions that any managed crypto custody provider has to answer, either when entering a new market or as part of a regular audit of the go-to-market approach. For an initial orientation we have compiled a checklist of central decision items that a strategy and execution plan needs to cover:

▪ Which geographies and client segments do we want to target?

▪ How does the existing competitive landscape look like in the target market? What are the strengths and weaknesses of the active competitors? What future competitors might enter the market?

▪ Which new regulatory developments can be expected in my target market? How would they affect my offering and the other market players?

▪ Can we benefit from partners — on the solution or the market-facing side? Which potential partners should we approach?

▪ Which crypto-assets to support first, which later?

▪ Do we offer a full-fledged solution right from the beginning? Which technical features, e.g. security, account and client management, are priority 1, which can be provided later?

▪ Do we triple jump the current service offerings and differentiate with next-gen security, comprehensive compliance, 3rd party trust and value-added custody?

▪ Do we need financial, legal and security compliance certifications and attestations? Which to choose and implement?

▪ How do we position price-wise? What’s our overall pricing level? Which types of fees, price points per SLA, minimum holdings amount, … do we set?

▪ What is best-in-class when it comes to communication of the custody value proposition?

In our opinion, new entrants and established players facing increasing competition must be clear about institutional investors’ requirements regarding a secure, regulatory compliant and still flexible custody solution. Custodians need to be prepared for an in-depth due diligence of their service offering from customers. They should expect that most institutional actors will preface their supplier selection with a more thorough analysis than anything they might be used to from high net-worth individuals or smaller crypto hedge funds.

At UIE, we use a 360Custody Framework to assess crypto custodians. The tool builds on more than 200 criteria mirroring institutional investor requirements holistically.

Reach out to us, if you are interested in more details: and

Special thanks to our Untitled INC colleagues Thomas Euler and Dr. Oliver Krause for their critical review of this publication.

About UIE and the authors:

Dr. Karl-Michael Henneking and Simon Schaber are co-founders of Untitled Investment Expertise (UIE) - a venture of the Untitled INC distributed economy think tank and venture launchpad.

UIE helps professional investors to identify value in blockchain technology & the distributed economy. We apply advanced assessment frameworks - our holistic ‘360’ methodologies - for analyzing blockchain investment opportunities and for assessing cryptocurrencies as well as crypto custody businesses. We also support institutional investors in getting familiar with the specifics of this alternative asset class via our dedicated crypto on-ramp program.