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Custody of digital assets – 2023 a year for inflexion?

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Kam Patel, CEO of Custodiex, writes the 2023 will be the year of custody.

If you can imagine a counterbalance with four weights – North, South, East and West. On the North and South scales, you have Financial Institutions (Tradfi & DeFi) on one side balanced with the Regulator. And on the West and East scales, you have Security balanced with Speed – you will understand start to understand the elements driving custody in the world of digital assets.

Definition of digital asset custody

According to the Alternative Investment Management Association (AIMA), which provides leadership in industry initiatives such as advocacy, policy and regulatory engagement, educational programmes, and sound practice guides – the concept of digital asset custody revolves around the safekeeping of a private key. 

Their membership understands that as private keys are used to store, manage, and transfer digital assets by the owner and help with the decryption of messages and authentication of transactions, they represent a single point of failure in the system.

The trilemma for financial institutions adopting custody of digital assets has always been security, speed, and scalability. One of these is always had to be sacrificed in traditional Custody-enablement solutions. The market for Custody solutions is being driven in response to regulatory and technological changes, market infrastructure developments and enhanced risk awareness. 

The market requires a world-class technology for storing digital assets and a custody solution that solves all three issues of digital asset custody as the financial markets adopt blockchain technologies. The market for Custody solutions is being driven in response to regulatory and technological changes, market infrastructure developments and enhanced risk awareness

Transforming the financial services landscape

Several traditional financial institutions have publicly stated that digital assets are here to stay. One such organisation, BNY Mellon, are committed to supporting its clients as they adapt to this emerging asset class. And even with recent market volatility and discretions of 2022, it seems their level of conviction remains strong. They are keeping their sights on the long-term opportunities and transformative potential of the underlying technology. They like other banks and FI’s are on a journey towards a future where blockchain and related capabilities will transform the financial services landscape.

Michael Demissie, Head of Digital Assets Unit and Advanced Solutions at BNY Mellon commented: “Our research shows 70 per cent of respondents would increase their digital asset activity if services like custody and execution are available from recognised, trusted institutions.”

It is evident that the requirements of organisations vary greatly based on their position in the market. For example, small crypto funds that engage in active yield farming across a wide range of DeFi tokens have vastly different needs compared to multi-billion-dollar hedge funds that prioritize working with qualified custodians. Additionally, larger organizations often require specialized technology solutions for different funds, segments of their portfolio, or different regions.

Ideal attributes of Central Bank Digital Currency

The Digital Dollar Project – a non-profit organisation devoted to catalysing private sector research and exploration of the potential advantages and challenges of a U.S. central bank digital currency (CBDC), or “digital dollar.” – believes that an ideal digital dollar should be private, secure, accessible, and transparent:

·      Private: The CBDC should avoid subjecting users to undue corporate tracking or government surveillance and should allow users the ability to limit having their information shared with financial services providers. 

·      Secure: The CBDC should provide robust security against theft, hacking, illegal seizure, and fraud. As such, it should provide a new way for people to handle money individually, utilizing a system that is both secure against attacks and legally protected.

·      Accessible: The CBDC should improve global dollar users’ access to financial services by increasing efficiency and lowering the cost of transacting. Widespread CBDC usage should spur competition in financial services to produce better services at lower costs. Additionally, accessible, and low-cost digital vaults or wallets could serve as an on-ramp into the financial system for the un-and-under-banked.

·      Transparent: The CBDC system should have transparent operations to enable stakeholders to independently gain assurance about its technical functioning, security, and resistance to impermissible monitoring or other exploitation.

The story of 2022 – hack – innovate – protect – repeat 

According to web3 Studios and Blockstories, 2022 year in review in Crypto and Web3 – the crypto and web3 space has had a rough ride this year: significant declines in the market prices of major cryptocurrencies, a slowdown in the trading volume in many adjacent verticals (DeFi, NFTs), and bankruptcy for some of the space’s leading figures due to failed risk management and the misappropriation of consumer funds. The price of Bitcoin (BTC) reached a two-year low, and the rest of the market saw intense selling activity after the crypto exchange FTX collapsed.

It also showed that the “DeFi hacker” had a successful year in stealing over USD2 billion from multiple protocols (e.g., USD325 million from Wormhole, and USD625 million from Ronin), particularly through vulnerabilities in bridges which are essential for the ecosystem’s development but are still in the early stages of development.

It concluded that even though there has been a slowdown in capital and talent inflow, this in fact has brought the community back together, with people driven by conviction leading the way. The market may be down, but innovators are still working tirelessly on creating the tools and infrastructure to shape the future of crypto and web3.

Quantum computers threaten to break today’s cryptographic algorithms

Accenture Labs reported in their Cryptography in a post-quantum world, the importance of preparing intelligent enterprises for a secure future. This applies to the digital asset world as well as cryptocurrencies. Algorithms using traditional CPU computing have been engineered to be mathematically strong enough to support a 20-year service life requirement. However, recent technology developments have cut this service life expectation in half, causing the US National Institute of Standards and Technology (NIST) to rescind the current public key standard of RSA 2048 released in 2016 and aggressively seek more complex cryptographic algorithms to thwart attackers.

The advent of quantum processors that have the capability to break our current cryptographic primitives is a very real threat on the horizon. Accenture believes quantum processor capability will be able to compromise existing cryptography within the next eight years. Financial institutions have a complex task ahead to identify, evaluate and prioritize the business remediation to protect their data from cryptanalysis breaches and compromise.

Security driving Tokenisation

The Tokenise Europe 2025 initiative members indicated in a recent report that Tokenisation requires all its stakeholders to work together for its success. Legislators and regulators will be key to creating a simple and harmonised legal framework that facilitates innovation and incentivises corporates and citizens to further drive tokenisation while maintaining high standards of security and protection. Central banks and other financial institutions should prepare for the tokenisation of assets and put in place the infrastructure – again prioritising security. And finally, financial institutions will have to explore the possibility of introducing programmable money with a focus on overall benefits to the (token) economy.

Implications to regulation – prioritising Custody in 2023 

In November 2022, GDF convened their annual crypto and digital assets summit, involving a series of panels in which industry leaders exchanged insights on the regulatory landscape and emerging risks and opportunities related to digital assets and the financial services sector.

Some of the panellists contemplated how the “crypto winter” may in fact advance the digital assets agenda by focusing minds on the core capabilities of the technology and reducing the focus on the hype around cryptocurrencies.

Moreover, in the aftermath of such events, there is likely to be a push to implement new digital asset regulations — some of the issues that are likely to be addressed include custody, segregation of client assets, conflicts of interest regarding activities undertaken on behalf of firms versus activities undertaken on behalf of their clients, and insolvency situations.

Holy grail of balancing risk with innovation – real-time cold storage

The GDF annual report in 2022 reported that one of DeFi’s largest risks is around scams and hacks because users often self-manage custody and the value can be transferred automatically and approved only by software and attack vectors can be exploited by hackers. 

They also talk about opportunities presented by the technology as crypto and digital asset technology continues to evolve at an unprecedented rate. While the recent market correction has limited the potential for consumer harm or systemic risk, history has shown that prices may rise again at some point in the future.

Traditionally, the storage and custody of digital assets have been defined as hot wallets, warm wallets and cold storage with security concerns decreasing as you go down the value chain – but the counterbalance to being more secure is the time it takes to access the digital assets and trade with them. 

Hot wallets allow better control and interoperability but are still exposed to the risk of theft or fraud. Cold wallets are more secure, yet as hardware systems, they can malfunction, or users may lose access codes.

Newer innovations are hitting the market with redefinitions and contradictions like custody enablement organisations offering real-time cold storage over an airgap. Several large financial institutions are looking at such solutions to overcome the pitfalls of hot wallets with cold vaults. So, this type of storage is cold and allows for better control and interoperability and is not exposed to the risk of theft or fraud with high levels of security with mechanisms for counteract hardware systems that could malfunction, users, will never lose their access codes.

Custody technology to restore trust, transparency, and integrity

“Not your keys, not your coins” has never been more ubiquitous. We’ve experienced a dramatic blow-up in CeFi-institutions (e.g., 3AC, BlockFi, Voyager Digital, FTX etc.) caused by fraud, recklessness, and lack of transparency among these institutions. Meanwhile, DeFi stayed robust and performed as expected at any time. To restore trust, centralised exchanges are now adopting new standards such as Proof-of-Reserves. Despite these efforts, it is likely that the trend toward self-custody will continue, as people seek to take control of their own assets.  

Custody providers will also have to develop solutions to protect against bad actors

Whether it’s an individual (FTX founder Sam Bankman-Fried), a collusion (BSV Claims against Binance, Bittylicious, Kraken and Shapeshift in 2022), or a hacking cyber group (North Korea’s Lazarus Group masterminded USD100 million Harmony hack) – users need the ability to add policies and permissions to their account, technologically, limiting who can move funds, how frequently, how much per day, which addresses can receive them, etc. That kind of control can limit the amount of damage a bad actor – whether internal or external – could do to your balance sheet of digital assets. 

Another protection mechanism, which is required from a regulatory point of view is to segregate holdings of crypto-assets on the behalf of clients from their own holdings and to ensure that the means of access to crypto-assets of clients are clearly identified as such. They shall ensure that, on the DLT, clients’ crypto-assets are held at separate addresses from those on which their own crypto-assets are held.

Lastly, “Losing your keys, without losing your coins” for the end user means a more forgiving, low-burden, flexible recovery experience is required. The client can be the best crypto investor in the world, but if their crypto gets stolen or lost, they will lose every last bit. So, it’s important to safeguard their crypto, on their behalf, as best you can. 

Summary

2023 will be the year of Custody. The existing market perceptions of trust in digital assets, cryptocurrency and stablecoins can and will be restored with new rules of engagement like segregating trade execution and custody, use of institutional-grade custodial solutions, proof of reserves, auditing and so on. 

Technology – the sentiment in 2023 will be to take the time to build, innovate and sustainably create. Custody providers will partner with secure innovative companies and build an ecosystem for the safekeeping and execution of digital assets. There will also be improved cybersecurity and secure asset transfer to prevent hacks and fraud and much better risk management practices for people, finance, security, and operations. 

Regulation – Custody providers will not expect the regulators worldwide to regulate the blockchain or the technology around it – the emphasis will be more on regulating people.

Governance – There is an inevitable battle between decentralisation vs centralisation. Custody providers will ensure any solution they use in the custody space can cover use cases in both, and there will be potential hybrid solutions, which make the best of both worlds.

Markets – 2021 bull market was driven by mass adoption. Unfortunately, it started to become greedy, and in 2022, the focus switched to leverage, leading it to crash. 2023 will all revolve around protection and security – and stringer foundations for the future upswing

Investment – Over diversification will quickly become diluted. The focus will be on what companies are great at, and sticking to their core competencies, rather than trying to build the entire ecosystem.

These aspects alongside new education supported by innovative companies with something different for the market will make 2023 – the year of Custody.

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