DeFi Research Report - Institutional Asset of Choice & Barrier to Entry

Authored by Coinchange Research team: Jerome O., Pratik W.

Co-authored by: 

• 1291 Group: 

The 1291 Group Ltd is a global financial services group, offering tailor-made wealth protection plans to private individuals and investment professionals. Since 2000 they have been helping high-net-worth families protect their family assets and interests. They have licensed insurance brokers in over 36 countries and offer tax-compliant solutions for clients in over 50 countries. The 1291 Group counts on a high-performance team of experts with many years of experience in wealth protection, international tax, legal and compliance issues, as well as, the use of insurance, pension, and other investment vehicles. Learn more at https://www.1291group.com/ 

• SUN ZU Lab 

SUN ZU Lab is a leading crypto data provider on a mission to bring transparency to the global crypto ecosystem. They collect data from major trading venues, analyze it through algorithmic models and distribute the insights via quantitative reports, real-time dashboard & stream feed. 

Learn more at https://sunzulab.com 

Download our research paper as a PDF:

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Foreword

Coinchange and its Research department are happy to share their fourth Research Report titled ‘Institutional Asset Of Choice And Barriers To Entry’. Our first report was based on Permissioned DeFi where we discussed the emergence of regulated decentralized finance for the institutions. You can read the report here. Our second report was about the NFT landscape with insights on adoption and misconceptions about NFTs, which you can read here. Our third report focussed on NFT financialization and the potential yield-generating opportunities in the NFT sector (read it here). Through these research reports, we aim to shed light on sectors, protocols, and various aspects of the crypto space to allow a broad spectrum of new, and existing participants to easily understand the trends and the opportunities available. 

As part of our continuous improvement process, feel free to share via email any research subject you would like to have covered by our team. Also, we would gladly appreciate your feedback being sent to the following email address: [email protected]

Executive summary

• Two types of institutions have great interest in the crypto space. The corporate treasuries and the investment funds. Both seek exposure to it, but have many requirements to do so. The common requirements they have are custody and best execution of trades amongst others.
• Corporate treasuries have been working with fewer choices when it comes to generating revenue within a satisfactory risk threshold, explaining why crypto allocation for treasuries has become more approachable and mainstream. DAO treasuries are facing different issues than corporate ones, mainly lack of diversification and investment framework/strategies. 
• Investment funds are slowly but surely entering the space. They are showing an increased appetite for crypto exposure  with some of them up to 50% of AuM in crypto.
• Bitcoin as an asset of choice for corporate treasuries has shown the most adoption so far with Block, Tesla and MicroStrategy paving the way. This has been the case since it has the most investment thesis, from bitcoin as a store of value or hedge against inflation. Though, the most important factor is the number of bright and intelligent people working together to make Bitcoin a success.
• On the other hand Ethereum has seen increasing exposure as it is the leader in blockchain innovation with the ICOs, NFTs and more broadly DeFi. Ethereum could also be thought as the first digital bond in the world with an intrinsic yield, which will be of interest to investors familiar with discounted cash flow analysis. Ethereum is hence the open door to opportunities in crypto especially as DeFi matures and becomes more regulated.
• Traditional Finance companies have been accustomed to Best Execution as it is a policy set by the SEC and monitored by FINRA. Such services in crypto are not yet democratized as it caters to institutional money. However there are a few pioneers in the space and their quantitative data confirms that there is a clear gap between Bitcoin, Ethereum and the rest of the tokens.
• Investment funds and corporate treasuries must have a qualified custodian as it is a requirement by the SEC. Hence custody providers like direct custodians or technology service providers have increased their security standards by implementing best in class technology such as MPC or unique security features called HSM. 
• For high net worth individuals (“HNWIs”) behind these institutions, recent events have shown that it is increasingly vital for them to protect, preserve and pass on their wealth. Many forget these important stages in the wealth cycle as they go about actively creating value for their employer. Digital Asset Wealth Management service providers are hence becoming increasingly important since they allow HNWI to secure their legacy beyond just wealth creation.  

1. Who are the institutions? - Types of institutions

There are two main types of institutional players that are participating in the Digital Asset space: Corporate Treasuries and Investment Funds. 

Corporate Treasuries 

They are managed by treasurers who manage the balance sheet by matching assets and liabilities, monitoring, liquidity, and cash flows by hedging risks, and by generating a return from the cash sitting idle on their balance sheets. In the traditional finance world, generating returns is getting more and more difficult. Bank accounts, money market funds, overnight repo markets, etc. are currently generating yields close to zero. And if you take inflation into account, the returns are negative. As a result, a large number of treasurers are looking to include crypto strategies as a part of their balance sheet management strategies. Sparked by Block (previously Square) playbook then picked up by big online analytics firm Microstrategy and followed by the largest EV automaker Tesla, many public companies are looking to allocate some of their balance sheet cash to cryptocurrencies. In an article written in The Bitcoin Magazine, these businesses are also trying to put their crypto to use by adopting DeFi yield generation strategies. As of Sep 30, 2022 there are 38 public companies buying BTC as part of their corporate treasury.

DAOs or Decentralized Autonomous Organizations (crypto native decentralized companies) also have their own treasuries and according to the research firm Messari, there is about $11 billion locked up in DAO treasuries as of Apr 26, 2022. This figure has changed since then and is now around $5.48 billions for the top 54 DAO treasuries according to openorgs.info. This large fluctuation in value come from market environment and on average over exposition of DAOs to their own gov token, which are volatile.  They use several strategies to maintain some stability in their reserves, including holding bluechip tokens, converting to stablecoins, depositing in yield-bearing assets, and mapping out risk in the treasury’s current form. However, governance tokens are the most common native assets held by DAOs and may include rights to fees, voting on protocol addendums (usually in a limited way), and future token/NFT airdrops from the DAO. The governance token serves a dual function because it represents both ownership rights and compensation in one medium. Also, these tokens can be viewed to be similar to public company stock where any shareholder of either is able to vote on matters and create proposals.

Looking at the overall treasury composition of the 15 largest DAOs, there are three distinct parts: the native asset, deposits in other protocols, and holding other assets (stablecoins, ETH, etc.). TradFi companies typically have a CFO who manages cash and asset movements. In the DAO world, treasury management is a bit more distributed and is typically left to the core team or dedicated sub-team, hence the community bear a greater responsibility in deploying its assets effectively.

Investment Funds 

These are the other institutional players that are thinking along the same lines. Around March 2022, Ray Dalio’s Bridgewater Associates announced that it was looking at investing in bitcoin through crypto funds as opposed to holding the asset themselves, probably due to custody challenges, which we will discuss later in this report. Others such as Brevan Howard Master Fund and Tudor Investment have sought exposure to bitcoin as well. Apart from these top TradFi funds, multiple crypto hedge funds are actively generating yield through various DeFi yield strategies. According to PwC’s 4th Annual Global Crypto Hedge Fund Report published on June 8, 2022, of the traditional hedge funds surveyed, 38% are currently investing in digital assets, compared to 21% a year ago.  Meanwhile, the number of specialist crypto hedge funds is estimated to now top 300 globally. According to the report, most traditional hedge funds getting into digital assets are still just dipping their toes – 57% have less than 1% of total AuM in digital assets.  But it is notable that for 20% of these funds, digital assets represent between 5% and 50% of AuM.  Further, two-thirds of funds (67%) currently investing in digital assets intend to deploy more capital into the asset class by the end of 2022. John Garvey, the Global Financial Services Leader, PwC United States, mentioned in the report that although the recent collapse of Terra has demonstrated the potential risks involved in digital assets, the market is maturing and with that is coming not just more crypto-focused hedge funds and higher AuM, but also more traditional funds entering the crypto space. 

Our team from Coinchange was present at the recent crypto conference Consensus 2022, held in Austin on June 9th, 2022. They noticed that the Tradfi presence was extremely strong.  Allocators from CIOs/executive directors of multiple pension funds to heads of sovereign wealth funds were speaking at the conference and the increased interest from these large capital allocators is very encouraging. 

However, there are some common key concerns among these institutional investors: custody of assets and private key management, best trade execution solutions over the counter, and regulations around digital assets. Custody raises several important questions. Will the company have custody of the asset itself, or will it rely on third-party vendors? Self-custody may provide easy access to the assets, but it also presents an additional risk in terms of accidental loss, who conducts transactions, and how transactions are monitored and recorded. Given the inherent complexity and risk associated with self-custody, more and more companies are resorting to third-party custodians. 

In TradFi, ‘Best Execution’ is a law that ensures that customers get the most advantageous order execution and that the brokers must consider other opportunities for a better price than quoted, faster speed of execution, and a higher likelihood of trade execution. We will be discussing more on the solutions to these concerns later in this report.

Another challenge arises when the executives behind the corporate treasuries and investment funds, typically High Net Worth (HNW) individuals, want to invest their personal capital into digital assets. In most cases, it becomes a conflict of interest for them to invest their own capital alongside the company’s funds they are in charge of managing. As a result, they need dedicated Digital Assets Wealth Managers, who can manage their capital in the most tax-efficient manner, while providing the best execution services and a highly secure custodian. 

2. What are they buying?- Assets of choice

Once most institutions decide to dip their toes in the water that is the digital asset ecosystem, the hardest question is then which digital asset is best? Indeed, Bitcoin (BTC) is the most recognized, and first-ever digital asset, but there are thousands of other digital assets in the ecosystem with dozens of new projects coming to market each month. 

It may feel natural for investors when considering BTC as the first digital asset, to think it may be vulnerable to replacement or irrelevancy from technologically superior competitors, similar to what happened with MySpace and Facebook. Another common question when considering BTC from an investment perspective is whether it offers the same upside potential, with regards to returns, as all the newer digital assets.

Bitcoin

BTC has garnered most of the attention as the go-to corporate treasury asset of choice, with several corporations actively adding it to their balance sheets. Michael Saylor of Microstrategy, for example, started the trend by buying $3.97B USD of BTC. Later last year, Elon Musk and Tesla followed closely thereafter with a $1.5B bet of their own (which Tesla subsequently sold 75% of in Q2 2022) . The main investment thesis for Bitcoin is being the store of value asset in an increasingly digital world and has been seen with its recent adoption as legal tender in El Salvador as well as in the Central African countries. Bitcoin is different from every other digital asset, as the others are unlikely to improve upon Bitcoin’s security, decentralization, and sound digital money attributes without facing significant tradeoffs in both protocol incentives and consensus design. 

What sets Bitcoin investment thesis apart from any other token’s investment thesis is that there are multiple option depending on the type of investor and their time horizon for the investment - whether a fairer society, better financial inclusion, or simply better money. In essence, Bitcoin is attracting bright and intelligent people which are constantly pushing the boundary of bitcoin use cases. This information is relevant for investment funds managers and corporate treasurers because when investing, you are not only investing in a business model you are also investing in people.

Lastly, as DeFi took off on Ethereum, those holding Bitcoin were left wondering if there was a way to turn their idle holdings into income-generating assets by earning a yield similar to ETH. As a result, Wrapped Bitcoin (WBTC) was started as a project in January 2019 to facilitate the interaction between the two networks. Since then Bitcoin has been increasingly used in Decentralized Finance since its fundamental characteristics make it a pristine asset, allow it to be used in almost any Money Market Protocol for lending and as a collateral for borrowing (although lending bitcoin entails an entirely different risk profile to the investment because of the counterparty and complexity for legal and accounting) and for perpetual funding. Indeed WBTC supply has grown exponentially over time. There was only 563 wBTC in circulation as of August 19, 2019 (BTC price was ~ $10,250). Today, that figure has ballooned to over 244,856 wBTC in circulation (BTC price of ~ $20,120), which represents approximately 1.27% of all the Bitcoin currently in circulation (given BTC circulating supply of ~19,167,337).

Ethereum

However, several other corporations have decided to move out the risk-spectrum to invest in the second largest crypto asset, Ethereum (ETH). For example, Meitu, a Chinese software development firm, purchased $22M USD of ETH last year. Ethereum, originally published as a whitepaper in 2013 by Vitalik Buterin, innovated the space by taking the blockchain technology pioneered by Bitcoin and extending it to include more technical capabilities, the most important of which being more complex, data intensive transactions. As written in the Ethereum whitepaper: “What Ethereum intends to provide is a blockchain with a built-in fully fledged Turing-complete programming language that can be used to create “contracts” that can be used to encode arbitrary state transition functions.”

It is easy to be too zoomed in and not take in the progress that the entire blockchain industry has made due to Ethereum. For institutions looking to have crypto exposure, it can become quite risky to also not have exposure to ETH. Ethereum tends to be one of the leaders in innovation in the digital assets space (ICOs, DeFi, & NFTs all got started in their current iteration on Ethereum) and still has upside potential that most other digital assets don’t, while also having the second largest market capitalization in the industry.

What also sets these two assets apart for institutional investors is the liquidity of both derivatives and spot markets. As a result, asset managers can hedge their risk in a meaningful way using both options and futures-based trading strategies. It shouldn’t be surprising that meaningful amounts of institutional capital flowed into the market in 2020 following the arrival of a more regulated and liquid derivatives infrastructure for both BTC and ETH.

Aside from returns, another differentiating factor that makes ETH very attractive to institutions is the fact that ETH has undergone a network upgrade to Proof of Stake, which allows users to state their ETH tokens to validate the network, hence will offer yields significantly higher than most fixed income assets currently on the market. Staking yield can be compared to a digital bond with intrinsic yield since the yield does not come from any counterparty but from the consensus mechanism itself together with the value at stake. Note that the Proof of Stake taken for the comparison is Ethereum consensus as no other network has the same level of decentralization, security and number of developers working on the code (amongst other key criteria). 

On the other hand, other revenue-generating processes like lending, Liquidity Provisioning, or Staking in DeFi protocol involve counterparties, essentially the Smart Contract interacted with. For example lending, BTC in Ethereum’s protocol like AAVE, entails the counterparty risk of the issuer of wBTC, (1:1 representation of bitcoin on Ethereum issued with bitcoin in reserve of a trusted custodian), together with AAVE’s counterparty risk (it’s smart contract essentially). 

This shows that interest bearing tokens (liquid representation of tokens lent on a Money Market Protocol i.e AAVE or Compound) are also digital bonds but they are not intrinsic yield instruments because of the counterparty. 

Following the same line of thought, all Proof of Stake (PoS) yield could be digital bonds, provided that the blockchain has sufficient network effect, whereas Proof of Work (PoW) yield will never be able to achieve the same risk profile that of PoS yield, since it require hardware to function to generate the yield, hence why the comparison of Bitcoin Proof of Work as a commodity. 

Other assets

After BTC and ETH, the top five altcoins traded by funds according PwC’s June 8, 2022 Crypto Hedge Fund Report, were Solana (SOL, 51%), Polkadot (DOT, 48%), Terra (LUNA, 45%), Avalanche (AVAX, 42%), and Uniswap (UNI, 39%). New L-1 blockchain tokens such as SOL, DOT, and AVAX have been quickly adopted by crypto hedge funds in the past year. This expansion in adoption seems to have occurred due to the faster transaction speeds and lower gas fees compared to Ethereum. A key thing to note is that since the collapse of LUNA, many other cryptocurrencies have lost significant value and because the Terra-Luna incident is a very recent one, its impact on the altcoins of choice remains to be seen. However the general trend is that Ethereum alternatives and scaling solutions have started to gain traction and widespread adoption. 

In terms of how these assets are being used by the institutions, many hedge funds today utilize DeFi platforms to enhance yield through farming, and/or borrowing and lending of assets. Traditional fund strategies have shifted from a passive buying and holding approach to an expansion across the spectrum of digital asset types with funds entering the NFT markets, Decentralized Exchange (DEX) listed tokens, and other tokens beyond BTC and ETH. 

This chart from the PwC report shows the Institutional Assets of choice over the past two years. With only a few of the previous year’s top 10 cryptocurrencies making it into next year’s, it is clear that institutions constantly seek for newer assets across the risk spectrum. 

Stablecoins

Lastly, stablecoins solve a crucial financial bottleneck in our current globalist regime - international monetary transfers. Both institutions and individuals need to transfer funds anywhere in the world, more by the day, and would prefer to use a protocol that is both low cost and that is accessible by all. This trilemma of the "mobility, instantaneity and minimal costs" of tokens is now part of the blockchain, a technology that makes these exchanges more efficient, transparent and secure.

Today, a major part of so-called "cross-border" payments — transactions involving individuals, companies or banks operating in at least two different countries — are made by companies to pay their suppliers, subsidiaries or employees. Nevertheless, these transfers are expensive and sometimes outrageous. The fees taken by the giants of the sector specializing in international transfers (remittances) are sometimes between 5% and 10% of each transfer. You might expect that with such high fees, the transfer would at least be convenient for both parties. But in reality, these transfers are painfully slow, sometimes taking up to two working days. 

Stablecoins also allow institutions to yield farm through various regulated DeFi protocols and earn eye-popping yields, with much lower risk than holding most other cryptocurrencies themselves. Dollar stablecoins can clear the way for corporate treasury management solutions by providing a frictionless and efficient means to process payments, manage cash, manage liquidity, gain cash visibility, and gain exposure to the yield-generation opportunities being afforded by crypto capital markets. The two largest stablecoins in terms of usage currently are Circle’s USD Coin (USDC) and Tether (USDT) with USDC being the first choice for US-based institutions although the market cap for USDT is higher. This could be due to the higher transparency of reserves backing the USDC as regulators get closer to regulating stablecoins.  

3. Best Crypto Execution Solutions for the Institutions

So far we have looked at the types of institutions participating in the digital asset space and the individual assets of their choice. However one of the most common challenges for institutions is choosing the right execution channel provider. In TradFi, ‘Best Execution’ is a law and not just an ethical guideline. The SEC requires broker-dealers to offer quarterly reports about customer order routing, as well as monthly reports on execution quality. The Financial Industry Regulatory Authority (FINRA) also conducts routine examinations where brokerage firms' best execution practices are audited. This Law ensures that customers get the most advantageous order execution and that the brokers must consider other opportunities for a better price than quoted, faster speed of execution, and a higher likelihood of trade execution. As a result of such laws in TradFi, many firms are offering Best Execution services, and the investment funds together with corporate treasuries are accustomed to such services. 

In the world of digital assets, however, there aren’t that many options and the choices are complex depending on the available liquidity (and the associated slippage costs), the variety of assets offered, efficiency in trading, availability of derivatives,  security risks, APIs/Ease of integration and even their reputation. Many institutions end up using more than one execution channel provider as a single provider is unable to satisfy all the requirements of the institutions.

On the other hand, the need for best execution has been increasing as reported by Genesis Trading Q1 2021 Report where hedge funds and passive funds were some of their largest clients on their OTC volume. Starting Q1 2021, when looking at their top 100 clients, “corporates” became 25% of their total activity for OTC trading, when it was under 1% before Q1 2021.

SUN ZU Lab is a leading independent provider of liquidity analysis for investors already active or crypto-curious. They provide quantitative research on the liquidity of all digital assets to help investors improve their execution strategies and source the highest level of liquidity at the lowest cost.

SUN ZU Lab data shows that crypto trading against stablecoins is much more concentrated in certain venues than trading against fiat. In fact, more than 75% of trading volumes against stablecoins happen on Binance-spot, for almost every pair analyzed, with the rest taking place majorly on OKX. Regarding fiat markets, Coinbase-Pro is leading on trading volumes for major pairs, but not as much as Binance-spot on stablecoin markets.

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Although trading against fiat displays higher market depth volumes in order books compared to stablecoin trading, we notice the opposite trend for global traded volumes, with stablecoin trading for major pairs showing higher volumes. 

Regarding fiat trading, whether we analyze liquidity through market depths or traded volumes, the five pairs BTC-USD, ETH-USD, BTC-EUR, ETH-EUR, and SOL-USD always come on top. For stablecoin pairs, trading against USDT shows higher liquidity figures than USDC for the same cryptocurrencies. We notice as well that BTC pairs are often more liquid than ETH pairs, except for ETH-USDC which has a higher market depth than BTC-USDC. 

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The global average 50 bps market depth graphics show on venues where both fiat and stablecoin pairs are traded that fiat order books have higher market depths. Nevertheless, this trend depends heavily on the chosen exchange; Coinbase-Pro, for example, displays order books with three times the market depth for USD pairs than for stablecoin equivalents. Binance-US on the other hand shows order book market depths two times higher, whereas this difference is negligible for FTX. 

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Moreover, for most stablecoin pairs available on Binance-spot and Binance-US, we notice lower bid-ask spreads on Binance-spot market. Bitstamp on the other hand still shows some of the highest bid-ask spreads in the market.

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To conclude, this previous analysis provides us once again with a confirmation that there still exists a clear segmentation between crypto market leaders BTC and ETH and other altcoins. We can also highlight that crypto trading has more volume on stable than fiat regardless of exchange with BTC and ETH dominating the total volume traded compared to altcoin. This could be explained by how regulation works in regards to trading in different countries with France for example where trading involves a taxable event only when the trader sells cryptocurrency to EUR. Thus incentivizing traders to stay in stablecoins rather than switching  back to EUR once they acquire crypto. 

4. Custody / Security Solutions for Institutions

Why do institutions need custody solutions?

As per Securities and Exchange Commission, under rule 206(4)-2, advisers, in most cases, must maintain client funds and securities with a “qualified custodian.” Qualified custodians under the rule include the types of financial institutions to which clients and advisers customarily turn for custodial services, including banks, registered broker-dealers, and registered futures commission merchants. These institutions’ custodial activities are subject to regulation and oversight.

Key Terminology 

Before diving further into the custody narrative, let’s take a minute to go over some basic terminology and key concepts that will enable us to best understand the differentiating factors between various custodians and the technologies they offer to make a sound decision for your firm. Digital assets use what is commonly known as public-key cryptography. The foundation of Bitcoin & Ethereum among other blockchains, use mathematical functions derived from this technology such as elliptic curve multiplication to create a pair of public and private keys that

control access to a user’s crypto holdings. These mathematical functions are easy to calculate in one direction (multiplication), but nearly impossible to calculate in reverse (division). Thanks to this one way relationship, owners of private keys are able to create unforgeable digital signatures that can be validated against the public keys without revealing the private key. 

Private keys are the cryptographic element that allow a user to transfer balances or interact with Decentralized Applications on the blockchain. Private keys are generated using cryptographically secure random number or word generators. These inputs are referred to as seeds. Key generation is completely independent of the blockchain and can be done without connection to the internet, in fact generating keys offline is considered a basic security measure. Secure private key generation and protection is so important that most of the advanced techniques employed by direct custodians and technology providers are dedicated to this matter. It is important because access to private keys means access through the blockchain to the asset the private key holds from anywhere in the world, due to blockchain’s decentralized nature. This power is among the main concerns with regards to entrusting a direct custodian with your digital assets, given that in a strict technological sense, the custodian is now the true owner of those assets, especially if they are the only party with access to the private keys. Thus, “not your keys, not your coins”.

Public keys are the cryptographic element that allow a user to receive funds. Public keys are derived from private keys. A somewhat common misconception is that the public key is the public address, an understandable mistake since the public address is derived from the public key. Public addresses are the string of characters that we most commonly see when interacting with digital assets. Public addresses can be freely shared without risk of compromising a user’s private keys. Public addresses may also point to programs or tokens on a blockchain, for example the public address 0xdAC17F958D2ee523a2206206994597C13D831ec7 refers to the smart contract for the ERC-20 version of the Tether stablecoin.

The creation of the hardware wallet was another crucial innovation that helped lay the foundations of today’s modern digital asset custody industry. Hardware wallets led to paper wallets becoming obsolete due to their ideal mix of security and ease of use. Two of the leading hardware manufacturers, Ledger and Trezor, have come to develop services that enable their enterprise and institutional clients to secure their digital assets through a suite of specialized software and hardware offerings.

As both hardware and software manufacturers, Ledger and Trezor have created entire integrated software ecosystems designed to function seamlessly with their specialized hardware. Ledger, for example, built a Personal Secure Device, which links to a particular user within a company so they can authorize transactions themselves allowing segregation of duties. These technology service solutions are tailored around the increased demands and needs of enterprise users specifically, such as advanced reporting and recordkeeping and the need for multiple secure devices.

Custody option:

Self Custody:

Can be hot or cold storage refer to a spectrum of accessibility for digital wallets. The common understanding of hot and cold wallets comes from the retail user’s perspective, hot wallets are connected to the internet for quick access to funds, and cold wallets are typically specialized hardware devices that are kept offline and interact with the internet in an air-gapped manner. Those provide higher control over the asset in a relatively secure manner while burdening the user with greater responsibility over the asset, its management, and security management.  

Technology service providers refer to firms who provide both software and hardware solutions that enable their customers to reliably self-custody without transferring ownership of the private keys. Companies in this space look to differentiate themselves with the use of technology, a broader range of asset support, and unique features such as establishing a secure network of transactions among their customers so they do not feel a need to use direct custodians which tend to be very expensive. Direct custodians are sometimes themselves also customers of technology providers and their software. Typically technology providers operate by charging subscription and plan fees, as well as revenue from value-added services.

Technology providers are best suited to further crypto adoption and make crypto custody very easy to use, as evidenced by the recent partnership between NYDIG and Deloitte.

Third-party provider

Direct custodians refer to firms who themselves directly secure the digital assets of others by performing key management and assuming all the risks associated with asset safekeeping. They typically collect a percentage fee based on the total amount of assets under custody, other forms of revenue include trading fees and withdrawal fees, and revenue from other forms of value-added services they provide. Companies using direct custodians save on the upfront costs of creating an in-house solution for their digital asset storage. Exchanges evolved into direct custodians as most clients tend to leave their funds on cryptocurrency exchanges. Early Bitcoin users did not trust centralized service providers in the ethos of “not your keys, not your coins” due to frequent hacks, thefts, scams, and unreliability. This was further exacerbated by various exchanges undergoing large hacks including Mt Gox in 2014 & Bitfinex in 2016. As more and more people began to adopt Bitcoin and other digital assets, so too did the amount of funds exchanges held on behalf of their customers, and the liquidity necessary for daily operations. This is what led to many early exchanges becoming pioneers in the development of secure custody of digital assets.

For example, Coinbase & Gemini started as exchanges but now offer thorough custodial solutions for both retail and institutional clients. Both exchanges made key acquisitions in 2021 to improve user security, Coinbase acquired Unbound Security in December 2021 & Gemini acquired Shard X in June 2021 - both acquisitions resulted in enabling MPC technology & innovation for the companies,  which we will explain shortly. Such security enabled technology is the key reason for the recent partnership with BlackRock and Coinbase Prime.

Another notable acquisition in 2021 was PayPal’s purchase of Curv (MPC technology-enabled company) for an estimated $200M, which demonstrates large, non-crypto focused companies trying to enter the custody space. Another notable example is NASDAQ's recent announcement about a new custody service for institutions wanting to enter crypto. Custody is becoming a crucial foundational layer for businesses who invest and participate in the digital asset space, and wish to develop and offer increasingly sophisticated products. 

CeDeFi platforms like Coinchange rely on direct custody services and technology providers to safeguard customer funds. These platforms gather billions of dollars in user funds and are among the largest dollar value custody customers. 

How do institutions choose a custody provider?

According to a keynote given by Mike Belshe, co-founder and CEO of BitGo, at the 2019 Pantera Annual Summit, typically his clients ask him the following questions about custody providers: 

1. Who is the management team? 
2. How long have they operated?
3. What is the balance sheet/financial standing?
4. What insurance policies are available?
5. What operation audits exist? SOC2 type audits
6. Who is your regulator?
7. Do you have business continuity plans?
8. What is the technology used?

With that in mind, let’s take a look at the different technologies used by custodians. Institutional custodians manage funds in a much more sophisticated manner than the majority of individual users; nonetheless, the exact mechanisms of how this is achieved are not often understood even by their large clients. There are several advanced techniques used to both securely generate and store the private keys which ultimately have control over digital assets. While every custodian optimizes for security and client needs in their own way, there are many areas of overlap. The following are the leading technologies utilized by custodians to help secure and manage access to digital assets.

Hardware Security Model

A hardware security module is a special piece of hardware that protects and stores digital keys, and performs encryption, decryption, authentication, and other cryptographic functions. These modules are specially designed to be tamper-proof and isolated from external systems and the internet. HSMs are used across all industries where digital security is crucial, from securing medical hardware to protecting against piracy in online streaming, as well as in the traditional financial industry.

Hardware wallets fit this description but when speaking of HSMs in the institutional custody space, this term refers to robust and highly specialized hardware, often custom-built and running a custom-built software and operating systems. These more robust HSMs can serve multiple purposes for the custody of digital assets. They can generate and store private keys as well as generate and sign transactions at high throughput. 

HSM technologies are quite capital intensive - they have high variable costs and require constant upgrading of hardware to stay on the cutting edge of security, which is much more expensive than software-based solutions. 

Multi-Signature

Multi-Signature, often referred to as multisig, is a system in which multiple keys are required to sign a digital asset transaction. For example, 3 of 5 or 5 of 5 users need to sign a transaction for it to go through. These signatures can be from different devices, e.g. one person signing from their mobile device and a hardware wallet, or they can be multiple keys held by multiple parties.

Multisig takes a modified form when used in the institutional custodian space as it is often implemented more as a policy and asset management feature than a strictly technical and security solution. For example, given the irreversible nature of most blockchain transactions, institutional investors in digital assets often implement multisig policies to ensure that no single individual in a company could conduct transactions. An additional benefit of implementing multisig technology from an institutional policy perspective is that it can be applied to any digital asset supported by the custodian rather than utilizing a different multisig solution for every blockchain of interest as is the case with a traditional technological implementation.

Multi-Party Computation

MPC allows inputs to be taken from multiple sources to create the desired output, without the individual inputs being revealed to other participants. The data of each participant is scrambled before being randomly distributed. As a result, increasing the number of participants as an MPC solution scales up, makes it almost impossible for anyone to know the details of others in the system. 

MPC technology is used by custodians and technology providers for a secure key generation - it allows for private key shards to be generated, distributed, and used to produce signatures without the private key ever having existed as a whole. This is in contrast to other methods of sharding keys where the private key is generated first, then divided and distributed. This crucial difference has led to a growing number of institutional custodians adopting MPC technology, as it tends to be a much superior form of multi-signature technology. 

The largest benefit to generating private keys using MPC is that there is never a single point of failure during the lifespan of that private key. These key shards can then be utilized under a similar institutional governance policy as previously described, where all the generated key shards, or a predetermined number of them (eg. 3 of 5), must sign to approve a transaction.

In conclusion, it can be said that the MPC technology is the most secure form of custodial technology that exists today and institutions should be aware of these key differences when choosing the right type of Custody Provider. In the next section, let’s look at the top three custodians. 

What are some of the top custody providers?

There are several Digital Assets Custody Providers such as Coinbase Trust, Fidelity, Bakkt, Paxos, Bitgo, Gemini Trust, Prime Trust, Kingdom Trust, etc. Of these, the three most widely used are:  

1. Coinbase Custody, launched in 2018, offers clients access to the secure, institutional-grade offline storage solution that has been used by Coinbase’s exchange business since 2012. Coinbase Custody is regulated by the New York Department of Financial Services (NYDFS) and operates as an independently capitalized entity, Coinbase Trust Company, LLC. Currently, they offer custody for over 100 crypto assets. Coinbase Custody has designed a proprietary, best-in-class key generation protocol to generate cold storage addresses for Custody wallets thanks to their acquisition of MPC technology through Unbound Security. Some features you can set up are M of N signatory consensus, address whitelisting, duress protocol setup, and many more.

2. Copper: Copper Connect provides institutional investors, like crypto funds, with a highly secure way to connect digital assets stored in Copper’s multi-party computation (MPC) wallets with decentralized applications (dApps). Their infrastructure enabled by dual offline and online technologies enhances the security of assets throughout the DeFi lifecycle, ensuring that assets are secure when under custody, during transfer, and when locked into a smart contract to be transferred into a DeFi Pool. They support more than 150 digital assets and are audited, certified & insured. In fact, the HFM European Hedge Fund Services Awards named  Copper as the Best Digital Asset Custodian 2019-2021. 

3. Bakkt Warehouse: Bakkt was founded and is majority-owned by American Fortune 500 company Intercontinental Exchange, Inc. (ICE), the parent organization of the New York Stock Exchange. In April 2019, Bakkt announced that it had acquired Digital Asset Custody Company (DACC) and launched The Bakkt Warehouse (their Bitcoin custody division) is composed of both online (“warm”) and offline, air-gapped (“cold”) digital assets storage. Bakkt rebalances between warm and cold storage tiers to minimize risks associated with warm storage. To further protect their customers, their warm and cold wallets are covered by a $125,000,000 insurance policy. They offer Multi-zone physical security, including bank-grade vaults, IP address and withdrawal address whitelisting, Multi-signature wallet policies, Shamir's Secret Sharing for key sharding (MPC), and Hardware security modules (HSMs), and offline storage of private key material. 

5. Digital Asset Wealth Management

So far we discussed the types of institutions that are allocating large amounts of capital to the Digital Assets ecosystem, the custody and execution challenges that they face, and the solutions to those challenges offered by some of the largest names in this space. But for the high net worth individuals (“HNWIs”) behind these institutions, recent events have shown that it is increasingly vital for them to protect, preserve and pass on their wealth. Many of these HNWIs forget these important stages in the wealth cycle as they go about actively creating value. Many are only focused on managing their employer's capital, while not being able to get the best execution rates for large transactions, maintaining privacy, securing their digital assets with a custodian, and doing so in the most tax-efficient way possible. The 1291 Group can help HNWIs secure their legacies for future generations by looking beyond just wealth creation. 

The 1291 Group is a global financial services group, offering tailor-made wealth protection solutions to private individuals and investment professionals. Founded more than 20 years ago, it counts on a high-performance team of experts with many years of experience in wealth protection, international tax, legal, and compliance issues. 1291 Group is licensed to operate in 36 countries (and counting) and is the leader in private placement life insurance (“PPLI”).

Using PPLI, 1291 Group helps clients achieve the PATEC principles:

• Privacy and confidentiality
• Asset protection from hostile parties
• Tax savings and optimization
• Estate and legacy planning
• Cash and liquidity access

PPLI is a unit-linked, single premium payment insurance policy. The premium can be paid in cash or with a portfolio of bankable assets, but it is also possible to pay with non-traditional assets such as art, precious metals, real estate, or digital assets. Once the client pays over the assets as a premium, the insurer becomes both legal and beneficial owner of the assets. This results in the PATEC benefits. As the client is no longer the owner of the assets, his name is no longer linked to them.

As digital assets can enjoy tremendous upside, the PPLI solution can help HNWIs eliminate or minimize income and capital gains taxes. And all the while potentially protecting assets from creditors. With a bank/custodian account embedded into the PPLI structure, it also becomes an effective off-ramp connecting crypto to fiat. 

PPLI is legal and compliant. It works perfectly with wills, trusts, fund structures, and family office set-ups. The world’s leading private banks endorse PPLI as a flexible and versatile solution for wealth planning.

Additionally, 1291 Group can assist HNWIs with:

• Securing non-recourse fiat loans against their digital and other assets;
• Emigration and foreign residency;
• General wealth planning.

Conclusion

The two types of institutions that we’ve focused on in this report have great interest in the crypto space and are actively seeking more exposure to it. This is partly due to a decreasing panel of investment options while crypto exposure has been more mainstream.

The three barriers to entry for them are known by crypto market participants and we can see that companies and technologies are helping bridge the gap between crypto, corporate treasuries and investment funds. Pioneers in the space are key facilitators for the onboarding of such institutions.

The asset that they will choose to have exposure to will depend on a multitude of factors like liquidity, previous example of successful exposure from peers, investment thesis, breadth of services and regulated product for the asset. The clear leaders are bitcoin and Ethereum with the former promising to be a store of value which can be easily transferred across the world for pennies; whereas the latter could become the first digital bond with intrinsic yield in the world on top of exposure to crypto innovation through it. 

Custodians have pushed the security standard to their maximum and regulated custodians comply with the highest security standards that exist in the world to ensure safe and secure onboarding of those institutions. Making sure that they can use services and products that meet their standards and requirements is crucial, especially when it comes to liquidity analysis or wealth preservation.

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