Interpretation of "Current Status of Digital Asset Custody": Opportunities and Challenges Facing Institutional Investors

01. Current status of digital asset custody

The development of digital asset custody has gone through three distinct stages, starting with self-custody solutions in the custody 1.0 stage, and then institutional-level solutions. The hosting 1.0 stage is mainly self-hosting, and self-hosting wallets include hardware wallets, software wallets, and paper wallets (physical printouts of public and private keys). At this stage, users keep their private keys and are responsible for managing their own digital assets. This approach is simple and decentralized, but lacks security and efficiency. And vulnerable to hacker attacks (for example, the earliest and most notorious third-party "asset custodian" incident was Tokyo's bitcoin exchange Mt. the exchange went bankrupt).

Since 2016, third-party custodians have begun to provide offline cold wallet solutions, marking the beginning of the 2.0 phase of institutional digital asset custody. However, its operational complexity fails to meet the convenience needs of institutions. In 2017, when the Chicago Mercantile Exchange launched Bitcoin futures, institutional investment demand for digital assets grew significantly, as did regulated digital asset custodians. In order to meet the demand, custodians have adopted technologies such as hardware security module (HSM), multi-party computation (MPC) and multi-signature to provide compliant and secure escrow solutions. In addition, institutional-level asset control models such as insurance, compliance tools, and customized trading strategies are provided. The diversification of hosting options, as well as the introduction of multi-party security and operation layers of third-party hosting are important features of the hosting 2.0 stage.

In the custody 3.0 stage, digital asset custody service providers help institutions participate more deeply in the growing Web 3 ecosystem. With the rise of the metaverse and gaming industry from the "Summer of DeFi" in 2020 to 2021, institutions have increased their demand for more flexible asset custody methods. The mission of institutional-level custody service providers is to provide one-stop services. At the same time, the demands of high-net-worth individuals and family offices are also increasing. What they need is not only the security of digital asset custody, but also appropriate governance levels and asset transfer. Flexibility (allowing assets to be transferred between multiple wallets, such as cold wallets, hot wallets, and spot trading accounts), these are key features of Custody 3.0.

Digital Asset Custody Layout and Differences from Traditional Custody Solutions

As of April 2023, there are more than 120 digital asset custody service providers, mainly divided into self-custody solutions and third-party service providers.

Third-party service providers, including digital asset custodians and exchange-hosted wallets, hold users’ private keys, but exchange-hosted wallets are more vulnerable to hackers. In contrast, digital asset custodians provide institutions with comprehensive services, including trading digital assets, and only charge a certain service fee. Self-custody solutions require users to protect their own assets, usually through passwords and seed phrases, but if lost, users may not be able to retrieve their digital assets. These characteristics show a clear difference between digital asset custody and traditional custody solutions.

Unlike traditional financial service custodians who adopt centralized clearing and settlement systems to host stocks, bonds, and commodities, most institutions choose third-party digital asset custody services, and custodians are responsible for managing customers’ private key information, so that they can control and access Client's Assets. Institutions also often prefer to choose licensed or regulated custodians to protect their assets.

02. Development of Institutional Investors

As more and more investors enter the market, especially institutional investors such as family offices and high-net-worth individuals, the form of digital asset custody needs to be changed to adapt to market changes.

Trend 1 | Ethereum merger sparks increased interest from institutional investors in staking

Ethereum’s Shanghai upgrade and shift from proof-of-work to proof-of-stake sparked interest from institutional investors in staking on ethereum. Since the merger of Ethereum in 2022, the total number of ETH deposited in its network has reached 22.9 million. Institutions usually choose centralized third-party providers such as decentralized staking pools, cryptocurrency exchanges, and digital asset custodians for staking. However, with the increasing variety of DeFi products, managing multiple private keys for different blockchain protocols becomes a challenge, especially for family offices and asset management institutions with limited energy and time, including selecting validators, Understand the possible risks of participating in decentralized staking, and awareness of risks such as smart contract security.

Trend 2 | Family offices favor digital asset pledge services provided by technology service providers

With the growing interest in digital asset staking, family offices and external asset managers are more inclined to choose technology service providers that can provide security, ease of use and diversified services. These providers not only provide digital asset staking, but also include one-stop services such as compliance, trading, fiat currency exchange, and tokenization. Compared with self-custodial solutions, the technology platform provides more security measures and provides an easy-to-use interface for implementing the pledge and income strategies of decentralized financial agreements. At the same time, built-in approval restrictions and multiple authorizations provide decentralized financial agreements. Extra security protection.

Trend 3 | Institutions focus on NFT and Metaverse fields

Institutional investors are paying close attention to the NFT and metaverse fields, seeking new commercial utility and investment opportunities. Well-known brands such as Starbucks and Nike have leveraged NFTs to increase customer engagement and develop new revenue streams. However, for new entrants, NFT's self-custody service may pose challenges. The COO of a family office in Hong Kong pointed out that self-custody solutions have issues with managing private keys. The NFT hosting solution provided by third-party service providers allows institutional customers to hold NFT without having to manage private keys themselves, and also allows institutions to visit multiple decentralized markets to directly buy and sell NFT, which is recognized by the industry. In addition, institutions are also looking for opportunities to invest in NFT collectibles and virtual land in the Metaverse. It is estimated that by 2030, the market value of Metaverse will exceed one trillion US dollars, and 82% of executives plan to incorporate Metaverse into their business within three years.

**03、**Key challenges facing digital asset custody

【1】Security

Hacker attacks on cryptocurrency exchanges over the past few years have resulted in huge losses, sparking further demand for digital asset custody. At the same time, although the exchange wallet is convenient, its security depends on the reputation and infrastructure of the exchange. Take the example of the FTX exchange that will close in 2022, the lack of proper governance and risk management could lead to a significant impairment of customer assets. As a result, institutions are increasingly looking to use self-custody solutions or reputable digital asset custodians, rather than just co-holding assets with exchanges. A family office in Hong Kong has revealed it is considering switching from cold wallets to digital asset custody services to more easily manage its expanding digital portfolio. In addition, the digital asset custody service uses multi-party computing (MPC) technology to divide and disperse private keys to achieve a balance between security and availability. Even if some private keys are leaked, full failure can be avoided.

Graph: Digital Asset Hacking Losses (2022) | Source: Decrypt

【2**】 Decentralized supervision**

The report shows that the current main concerns of family offices are the security, operational framework, and usability of digital asset custody. After communicating with multiple custody service providers, it is found that these are obstacles that are currently difficult to solve. In addition, at the regulatory level, although the global legal environment has recently become more inclusive of digital assets, the regulation of digital asset custody is relatively scattered and requires clearer regulations. Many family offices and investment funds have businesses all over the world, so it is also difficult to choose digital asset custody services in jurisdictions with different regulatory policies.

【3】 Complete Insurance Policy

A comprehensive insurance policy is very important for customers who choose digital asset custody services, because it provides a safety net for unexpected events and helps build customers' trust in the security of assets. Although practitioners in the private wealth space have limited experience in managing digital assets, a well-established insurance policy can protect them from human error and oversight.

The report also pointed out that digital asset custody service providers and technology service providers offer a wide range of insurance policies. The following criteria may be considered in the assessment:

• *What is the cumulative limit for the hoster's policy? *
• *Are customer wallets separated? *
• *Which insurance company underwrites the policy? *
• *Does the insurance policy cover external theft of digital assets? *
• *Does the insurance cover insider theft? Executive internal theft? *
• *Does the insurance cover loss/destruction of private keys caused by natural disasters? *
• *Does the insurance cover losses due to software bugs? *
• *Is the insurance coverage cold wallet, hot wallet, both or neither? *
• *Which legal subjects are included in an insurance policy? Does it match the legal entity with which the customer signs the service agreement? *
• *Does the custodian or exchange allow you to purchase additional insurance? *

**04、**Choose hosting model

In the context of the accelerated development of the ecosystem and the widespread adoption of encrypted assets, custody, as the foundation of the digital asset ecosystem, has become a challenge to be solved today. Since the blockchain does not have a clearing mechanism and security prevention and control system like traditional finance, its transactions are irreversible, and investors need to track their own transactions and be responsible for them. We therefore recommend developing strategies and models that address the challenges of digital asset custody to strike a balance between operational efficiency and security.

The greatest risks to users and their private keys include confidentiality (ie, risk of unauthorized persons accessing private keys and backups), availability (risk of private keys and backups being unavailable), integrity (risk of private keys or backups being altered and cannot risk of reading). To combat this threat, managed security controls such as:

• Private key management throughout the period
• Appropriate technical infrastructure
• Segregation of Duties
• Restrict the number of accounts the key can access
• Transaction initiation/review process
• asset segregation
• Identity and willingness verification
• Set up strict transaction processing rules

Should institutions seek in-house or external crypto custody solutions?

Building an in-house hosted solution requires knowledge and team resources. If a third-party solution is used, hosting can be delegated to a qualified third-party service provider. But even so, users still need to bear the ultimate responsibility and related responsibilities, such as the selection and management of suppliers, asset security measures, and digital asset internal control systems.

Determine hosting model and provider strategy

Before selecting a specific hosting provider, an organization should formalize its target hosting model and provider strategy. As mentioned above, the outsourced custody model is the best option for institutional investors. But once you've chosen an outsourcing model, you still need to consider your vendor strategy. Institutions should evaluate which functions and operations need to be retained and compare this with third parties that would like to outsource.

What to consider when looking for a hoster:

When selecting a digital asset custodian, institutions should consider the following key factors:

• Reputation: Based on its history and background, evaluate the position and reputation of the hoster in the market
• Escrow and trade execution: Find out how a custodian operates and whether they offer additional security and transaction speed. For large exchanges that provide trading and custody services, it is necessary to ensure the safe storage of digital assets and to be able to quickly access these assets when transactions are required
• Compliance: Look for a custodian with built-in compliance operations to reduce reputational risk. Check whether the custodian is currently or has been affected by regulatory investigations, and whether the custodian has obtained relevant regulatory certification or license
• IT and network security: Learn about the custodian's network security measures, including the security of hot or cold wallets, as well as system compatibility and security features, such as multi-signature
• Service applicability: Evaluate whether the business model of the custodian meets its own needs, including the types of digital assets supported, the priority of cold wallet or hot wallet, and business continuity
• Commercial terms: understand the custodian's fee structure, including storage, deposit and withdrawal fees, and the rights and obligations in the commercial terms, especially legal rights in the event of disputes and non-payment
• Ownership and law: understand the legal structure and jurisdiction of the custodian and how these factors affect the way digital assets are managed
• Financial stability: Assessing the financial strength of the custodian and the viability of the business model, especially regarding access to assets should the custodian cease operations. A financially sound, well-capitalized, and viable business model custodian with minimal friction in service

Summarize

The digital asset industry is in a stage of rapid development and innovation, especially in Hong Kong. In the digital asset ecosystem, custody services occupy a pivotal position. Affected by bank bankruptcy and the impact of the market, more institutions have chosen to explore the field of digital assets. Institutional-level custody solutions have become a strong demand in the market, aiming to help investors seize the vast majority of assets in a safe and controllable manner. Investment Opportunities.

When designing the operating model, institutional investors should have a global vision and choose third-party providers to host digital assets. Only by implementing appropriate digital asset custody solutions can we seize market investment opportunities and prevent major asset losses.