Assessing Digital Asset Custody Solutions
Assessing Digital Asset Custody Solutions
Understanding Custody of Digital Assets in the Blockchain Industry
Introduction
The world of digital assets and cryptocurrencies has gained significant traction over the past decade. Investors have been drawn to the potential financial rewards offered by these digital currencies, but they also face the challenge of safely storing and recovering their investments. Understanding the complexities of digital asset custody is crucial for both investors and financial advisors in order to navigate this evolving landscape. In this article, we will explore the concept of digital asset custody and discuss various solutions and considerations for managing and protecting these assets.
The Tenuous Nature of Digital Records
To highlight the importance of custody in the blockchain industry, let’s consider the story of James, a Welsh IT worker who discarded a hard drive containing a digital wallet with 7,500 bitcoin. Today, this lost fortune would be worth approximately USD 217 million. James’ unfortunate experience serves as a reminder of the delicate and irreversible nature of digital records.
In the realm of digital currencies, the need for secure storage and retrieval is paramount. Investors must recognize the significance of custodial solutions that provide the necessary safeguards for their digital assets. Regulatory frameworks exist in various jurisdictions, outlining the rules and requirements for crypto custody, which align with the standards for holding traditional investments.
The Role of Custody in Digital Asset Management
As advisors, it is essential to support clients in making informed investment and custody decisions. To do so, a comprehensive understanding of custodial solutions is of utmost importance. In a recent discussion by Jason Hall and Jason McNiff from Methodic Capital Management, they introduced various crypto custody solutions, ranging from self-custody to “custody as a service.” They emphasized how the transparency of the blockchain can aid in making informed custody considerations and navigating the available services.
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Over the next few months, we will delve deeper into topics like custody to empower advisors with knowledge about this ever-changing space. We will explore how technology and regulatory aspects come together to benefit clients in managing and safeguarding their digital assets.
Categorizing Digital Asset Custody Solutions
Digital asset custody can generally be categorized into two types: self-custody and custody services.
Self-custody
Self-custody allows individuals to independently manage their digital assets. While third-party providers may offer wallet services and hardware solutions to facilitate the process, the primary responsibility and risks are borne by the individual.
Custody Services
Custody services, on the other hand, resemble traditional asset custodianship. These services are more commonly preferred by asset managers and advisors due to regulatory interpretations, risk management capabilities, technical expertise, and best practices. Custody service providers ensure the secure movement of assets, settlement times, and overall security. However, the lack of standardized regulations poses challenges for advisors in choosing suitable custodial solutions.
A Framework for Choosing the Right Custody Solution
To assess custodial solutions effectively, a robust framework is necessary. While the following framework is not exhaustive, it provides a high-level overview of the factors to consider:
Regulatory Considerations
Digital asset custody carries specific legal obligations. For example, in the United States, registered investment advisors are required to use “qualified custodians.” While the exact parameters of this designation for digital assets are not yet clearly defined, choosing regulated entities is advisable. Licensing and regulatory mandates vary globally, with some countries not requiring licensing at all. Working with custodians that adhere to clear regulatory requirements and possess robust internal frameworks helps protect against fraud and ensures business integrity.
Transparency Measures
Custodial solutions should exhibit a certain level of transparency. Comprehensive audits of financials, IT infrastructure, risk management procedures, and information security practices are essential. Blockchain-based custody solutions can offer high transparency through technologies like proof of reserves. This technology demonstrates to all participants that customer-pledged assets are securely held. However, off-chain commitments require additional scrutiny to prevent unauthorized actions.
Compatibility with Investment Strategy
Before selecting a custodial solution, it is crucial to ensure compatibility with the investment strategy. Some custodians may have limitations on the types of assets they can custody. Certain strategies, such as high-velocity trading and permissionless DeFi, may not be supported by more regulated custodians. It is necessary to find custodians that align with the execution of the advisor’s strategy, including market access, custody, and associated reporting.
Deliberate Due Diligence
Digital asset custody is a complex matter that demands serious consideration. Alongside the framework outlined above, technical considerations, such as structure and private key management, require meticulous analysis. Ultimately, the right custodian should align with regulatory rules, security measures, and transparency requirements. With appropriate diligence and resources, digital asset custody can offer enhanced safety, transparency, and cost efficiency compared to traditional custody models.
Q&A – Ask an Advisor
Q: Can my client move their existing crypto to an IRA?
A: According to IRS rules, contributions to Individual Retirement Accounts (IRAs) can only be made in fiat currency. Digital assets must be sold for cash before they can be placed into an IRA.
Q: What types of retirement accounts can my client hold crypto in?
A: Various retirement accounts can be used to hold cryptocurrencies, such as Traditional, Roth, SIMPLE, and SEP IRAs, as well as Individual 401(k)s and Profit Sharing Plans (PSP). If an individual has an old 401(k) from a previous employer, they can roll it into a Digital Asset IRA. However, it’s important to note that an in-service withdrawal from an active 401(k) to invest in an IRA may not be allowed by most plans. In such cases, services like DAIM can assist. DAIM currently functions as a 3(38) fiduciary for employer-sponsored 401(k) plans, providing direct exposure to bitcoin.
Conclusion
Custody of digital assets is a critical component of crypto investment management. The unique operational challenges and opportunities presented by digital assets demand a thorough understanding of custody solutions. By following a comprehensive framework and conducting extensive due diligence, advisors can assist their clients in making informed decisions. The blockchain industry presents a promising future, where custody solutions offer enhanced safety, transparency, and cost efficiency for managing digital assets.
References
Edited by Pete Pachal.
