Where Finance Finds Its Future


Is the digital asset custody industry ready to grow up?

Season 1, Ep. 111

Safe custody is the crucial service for crypto-currency investors. The theft, loss or destruction of the unique private keys to the digital wallets in which cryptocurrencies are held is irreversible and – unlike conventional cash deposits - they are not insured by any commercial provider or guaranteed by any government or government agency. Data analytics firm Chainalysis estimates that a fifth of all Bitcoins ever mined (or somewhere between 2.78 and 3.79 million of them, worth over US$200 billion) are now lost. Losses to hacks (such as the US$97 million stolen from Liquid Exchange in October 2021, the US$200 million stolen from Bitmart in December 2021, the US$320 million lost via the Wormhole bridge in February 2022 and the record US$624 million taken from the Ronin Network in March 2022) remain disturbingly frequent. Although some retail investors have ignored these risks, institutional investors cannot. These facts alone explain the two distinct surges in the foundation of digital asset custodians. The first was at the height of the Initial Coin Offering (ICO) boom and early crypto-currency exchange hacks in 2017-18, when no less than 65 specialist custodians were founded, including well-recognised brands such as Copper, Fidelity Digital Assets, HEX Trust, Komainu and Propine and leading custody technology vendors such as Fireblocks. The second boom occurred in 2021, as the first institutional investors such as Ruffer and MassMutual invested in crypto-currency. The two biggest global custodians in the world, BNY Mellon and State Street, found themselves pressed by watching buy-side clients to provide a crypto-currency custody service. A further impetus to invest was imparted by the leading crypto-currency exchanges, which launched independent, institutional grade and (most importantly) regulated custody services. Coinbase, for example, has established an independently capitalised institutional custody business (Coinbase Trust Company) that is regulated by the New York Department of Financial Services (NYDFS). A third threat to the established custodians has come from specialist, independent, regulated, institutional grade custodians such as HEX Trust, Komainu, Standard Custody & Trust and Anchorage Digital. According to Blockdata, another US$1 billion of venture capital money was invested in digital asset custody businesses in 2021, taking the total raised since 2017 to US$4.6 billion. In its most recent fund-raising, technology vendor Fireblocks was valued at US$8 billion. In its last fund-raising, Copper was valued at US$3 billion. In a low margin business, these valuations indicate high growth expectations, and global custodian banks and central securities depositories (CSDs) are right to be concerned that they might be disrupted or even bypassed. That concern ought to become acute if the crypto-currency boom is followed by an equivalent boom in security tokens, though there are at present plenty of bystanders. London-based token exchange Archax is building its own CSD because no existing CSD can meet the needs of its customers.

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Data provides the prices that drive activity in tokenised asset markets

Season 1, Ep. 119
Liquidity in privately managed assets is hampered by a lack of reliable and timely data about asset values. If value is hard to discern, privately managed assets are more difficult to buy and sell, harder to use as collateral and suffer from a less favourable accounting treatment. It is also difficult to develop secondary markets in which the assets can be traded. A distributed technology such as blockchain is well-adjusted to capturing, validating and then distributing data scattered across multiple databases, within as well as between institutions. It enables Inveniam to deliver the data needed to value private managed assets regularly, frequently and reliably without the need to centralise it in a single data warehouse.The data garnered by Inveniam is used by orthodox valuation agents such as Cushman & Wakefield, CBRE, Houlihan Lokey, Mercer and others to mark privately managed assets to market on behalf of their buy-side clients. The data enables the valuation agents to provide a faster, more frequent and more reliable valuation service to their clients. Where privately managed assets such as real estate, infrastructure and private equity can be marked to market daily, weekly, monthly or quarterly, by an independent third party and at low cost through the use of technology to retrieve and process data from widely distributed and highly variegated systems, two-sided markets can develop to facilitate price discovery.Accessible, reliable data improves valuations and makes two-sided markets possible, but liquidity ultimately depends on the engagement of market-makers with tokenised asset classes. They have already engaged with the cryptocurrency markets and can be expected to engage with the security token markets once issuance volumes gain sufficient momentum.The emergence of two-sided markets on blockchain-based networks will attract issuers of privately managed assets and funds invested in privately managed assets in tokenised form, because better functioning markets will lower the cost of raising and servicing capital (for example, paying dividends). Estimates indicate savings of between 20 and 50 basis points.Real estate will pioneer the tokenisation of privately managed assets in the United States because the impact of more accurate, frequent and independent valuations in reducing the capital financial institutions must allocate to the asset class is so dramatic. Similar benefits will accrue to holders of infrastructure and private equity investments as well.Reliable valuation data also cuts the cost of fund accounting or calculating the Net Asset Value (NAV) of a fund. If the cost of the NAV is borne by the fund, it lifts returns. If it is borne by the management company, it widens margins for general partners (GPs). With independent valuations, it also becomes easier to post fund units as collateral for margin loans.In the United States, the Decentralised Autonomous Organisations (DAOs) that issue tokens to raise funds and use smart contracts to service the tokens are now obtaining formal legal recognition. Three states have granted DAOs legal status and the leading jurisdiction for publicly traded corporations (Delaware) is expected to follow suit.