Musings on FTX and the traditional custody space

The recent goings-on in the crypto world could spur much-needed regulation in the space, while it’s important to remember the intentions of incumbent providers who have set up servicing around digital assets, a term which is much broader than your standard cryptocurrency.

The implosion of FTX over the past week has spurred conversations, opinions and revelations aplenty, once again thrusting the financial markets into the mainstream media spotlight in a similar fashion to the GameStop-Reddit saga of 2021.

Such a rapid ascendency in prominence and value meant that it was never going to be a smooth ride for cryptocurrencies, and that has been proved through immature market infrastructure and the incidents with FTX, Celsius and Voyager Digital – with BlockFi potentially next in the list of bankruptcies, according to the WSJ.

For an overview of what has happened, I can recommend this explainer from our sister publication The TRADE, which is free to read here. From Global Custodian’s viewpoint, it’s important to separate the takeaways and themes in the context of institutional investors and incumbent custodians versus retail investors and start-up exchanges/digital asset custodians.  

While few could have predicted the events of the last week, it’s undeniable – from an institutional investment point of view – that the model of exchanges acting as custodians is a flawed one which has carried over from the retail world.  

This is why the marketplace has been crying out for the involvement of incumbent asset servicers for so long, organisations which are among the most heavily regulated institutions in the world who have safety and soundness in their DNA. 

As securities services veteran Jason Nabi – now chief revenue officer of Bosonic – put it succinctly to me “for any fiduciary driven buy-side entity a regulated custodian is fundamental”.

To give you an idea of how institutional investors currently approach custody of cryptocurrencies, a recent piece of research from Coalition Greenwich found that half of buy-side institutions self-custody at least some digital assets while only 14% use a single, third-party custodian. Just over half 51% use a single or multiple third parties for custody (or a combination of third parties and self-custody). The report then noted: “Interestingly and surprisingly, an exchange-provided wallet/custody option (e.g., Coinbase, FTX) is equally popular among institutions, despite increased counterparty risk and potential technology risk that is hard to quantify. There is an inherent simplicity to this approach, with the exchange handling the entire process.” 

A number of hedge funds, family offices and asset owners entered this space in recent years – which was still very much in its infancy – and were faced with an unfamiliar setup. As the research paper put it “a bewildering array of technology infrastructure choices across digital wallets, crypto custodians, settlement networks, staking providers, fiat currency support, and the universe of digital asset securities”.

So the events of FTX will have impacted institutional investors as much as retail, and will undoubtedly scare off many of them from partaking in this market, regardless of the entrance of traditional custodians. The dangers of this space, bad actors and lack of regulation have never been as stark as they are at this moment in time. Because of this, institutional-grade cold storage will be the only play for many at this stage.

Regulators in the US now face a crossroads moment where they either accelerate efforts to regulate this asset class or go with the approach voiced by Senate Banking Chair Sherrod Brown who opined: “Digital assets pose risks to our financial system. There are many other risks we need to focus on.” 

If the former is true – and certainly in the EU we are seeing the progression of the proposed Markets in Cryptoassets (MiCA) – then a wave of regulation in major jurisdictions could bring much needed stability and clarity to cryptocurrencies. 

For the custodians which have announced their own digital asset servicing over the past couple of years – basically all of them – there will likely be little comment on FTX publicly as they rightly distance themselves from the whole saga. But those who I have spoken to believe this could be bad short-term, but potentially good long term for custodians, the industry and the end client, if the outcome is accelerated regulation. 

Meanwhile, the FTX incident validates why many of them use the term ‘digital assets’ rather than cryptocurrency when speaking about this sector, distancing themselves from the constant dramas of Bitcoin and the retail market, and instead drawing attention to the potential of tokenisation and opening illiquid assets, along with the use of the underlying technology. 

Surprisingly – or not, depending on your stance on cryptocurrencies – FTX is dominating conversations both privately and during industry conferences. Never has the importance of accurate news, transparency and regulatory clarity been so important as this nascent sector navigates yet another scandal, but the fallout in the coming months and years will determine whether cryptocurrencies have a future among institutional investors and the arrival of the ‘big kids’ (incumbent custodians) could provide safety and stability, or whether a decade from now in the securities services space we are uttering ‘remember crypto?’.

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