Evolving Digital Asset Custody Solutions — Sepior

Cryptocurrencies such as Bitcoin represent the first phase of a digital asset revolution. While Bitcoin and other cryptocurrencies currently enjoy skyrocketing valuations, the global race to introduce Central Bank Digital Currencies (CBDCs) and a broader array of tokenized securities promises to exponentially expand the scope and scale of digital assets. Are custody solutions ready?

Digital assets, which is a term we’ll use to describe current and forward-looking derivatives of cryptocurrency technology, are recorded and stored on a distributed ledger or blockchain. What is actually in the possession of the owner or custodian of those assets is the private cryptographic key that is required to execute the transfer of ownership of digital assets from one party to another party.

Custody services provide regulated safekeeping and storage of digital assets. Most of today’s custody services were designed and implemented based on the technical limitations and market requirements for Bitcoin and other cryptocurrencies. As digital assets and associated services evolve the requirements around custody are also certain to evolve and drive material changes from historic cryptocurrency custody models.

OCC Greenlights Digital Asset Custody Services For US Banks

On July 22, 2020 the United States OCC (Office of the Comptroller of the Currency) published a letter clarifying national banks’ and federal savings associations’ authority to provide cryptocurrency custody services for customers. On January 4, 2021 the OCC issued another letter addressing the legal permissibility of certain payment-related activities that involve the use of new technologies, such as blockchain networks and related stablecoins, to engage in payment activities and other bank-permissible functions.

These clarifications open the door for US banks to expand their custody services of marketable securities and cash to include stablecoins at a minimum, and a broader array of digital assets over time. In light of this trend, we should ask if digital asset custody solutions that were designed for cryptocurrencies will satisfy the needs of these expanded services.

Tokenization of Conventional Assets and Securities

Tokenization is the concept of representing the ownership of more conventional assets in the form of security tokens that can be easily purchased, traded, or sold. Security tokens are created through a process known as a Security Token Offering (STO) for an associated asset.

Examples of potential tokenized assets include regulated financial instruments (equities, funds, bonds, loans, etc.) tangible assets (real estate, works of art, collectible items, gems, precious metals, etc.) or intellectual property (copyright to works of authorship, patents, etc.).

Tokenization offers many potential benefits such as operational efficiency, asset fractionality, transparency, and a single-source of truth across extended ecosystems. Regulation is a major consideration when tokenizing assets. Switzerland has long been one of the most advanced financial markets and was an early adopter of blockchain. It’s no surprise that Swiss regulators have made considerable progress in defining policies and regulations in this space. We anticipate escalating interest to accelerate regulatory guidance in broader markets, leading to broad industry adoption.

Central Bank Digital Currencies

A Central Bank Digital Currency (CBDC) uses a blockchain-based token to represent the digital form of the associated nation’s fiat currency. The Central Bank Of the Bahamas was the first Central Bank to rollout a CBDC on a nationwide basis. Following a successful pilot in 2019, the digital B$, known as the Sand Dollar, was formally launched on October 20, 2020.

While not on a national scale, the People’s Bank of China (PBC) is considered the most advanced and largest-scale CBDC initiative to date. In April 2020, the PBC began a proof of concept test of a Digital Currency Electronic Payment system in four Chinese cities, including Shenzhen, Suzhou, Xiong’an and Chengdu, representing a population of nearly 40 million. Testing has since been completed and the project has moved on to a pilot program.

While it is still early days for CBDCs, it appears likely that at least certain markets will make aggressive moves towards tokenizing fiat currencies for retail and/or wholesale payments.

Stablecoins

Stablecoins are cryptocurrencies that were designed to reduce the volatility of the price of the coin, relative to a generally stable asset, such as the U.S. Dollar (USD). In some ways they are similar to CBDC’s; however, they are not issued by, nor directly backed by any government.

Tether or USDT is one of the first and most popular stablecoins. It is pegged to the USD and for every USDT issued, a USD is placed in reserve to guarantee the value of each coin. Stablecoins are growing in popularity and were worth more than $33B as of January 2021. In general, they offer the efficiencies and borderless payment conveniences of traditional cryptocurrencies without the volatility.

Cryptocurrencies Expand, But Bitcoin Still Dominates

Approximately 7,800 different cryptocurrencies exist today. Per coinmarketcap.com, Bitcoin alone represented 70% of this sector’s market cap as of January 8, 2021. While Bitcoin is technically considered a payment-focused digital asset, an estimated 61% of all Bitcoin in circulation are held in wallets where more than 75% of the bitcoins have not been sold or traded for multiple years, per Chainalysis. So, in practice, Bitcoin is more of a store-of-value, which is predominantly bought and held versus actively traded. As a result, the vast majority of Bitcoin under custody are held in cold storage, often using air-gapped, offline mechanisms.

Staking, Lending and Other Cryptocurrency Services

Ethereum and other blockchains which form the basis of most tokens have evolved to use Proof of Stake (PoS) algorithms. For PoS to work, nodes seeking to be chosen to forge the next block must make a deposit in the form of a stake, similar to a security deposit. The larger the stake the higher the probability the node will be chosen and financially rewarded. As a result, exchanges and custodians will increasingly offer clients interest on their digital assets if they make them available for staking.

Given the predominantly buy -and-hold model of most investors, some service providers will also offer loans against the client’s digital assets. When the loan is paid off, the client receives the same number of digital assets back at the then current valuation. This allows the client to continue to enjoy the potential upside for valuation increases in their digital asset holdings while paying a presumably lower interest fee.

Providing such services for assets under custody is another area of interest for custodians, exchanges, and clients. These and other services may introduce new requirements with implications for custody models.

Evolving Regulatory and Compliance

As digital assets evolve to include more mainstream financial instruments we should anticipate that regulatory and compliance requirements of digital asset custody will similarly evolve. Many of those requirements will be transparent to the custody model and operations, but some may require changes in processes or even implementation models.

Expanding Diversity Mandates More Uniform Approaches and Interoperability

Most custody solutions implement multiparty approval schemes to prevent any single party from executing large transactions without multiple approvals. For cryptocurrencies, many custodians use an on-chain signing scheme known as MultiSig. While MultiSig increases approval security, it is not natively supported by most tokens. As a result, it also requires a new smart contract for nearly every different token, which often introduces considerable implementation delays, added costs, and increased security risks.

Exponentially Greater Scale Requires Automation

While Bitcoin is one of the highest trading cryptocurrencies, its global daily volume of 300–400 thousand transactions is low relative to the NASDAQ volume of about 30 million trades. As tokenized securities, stablecoins, micropayments and CBDCs become available this transaction volume must increase dramatically. The historic model of cryptocurrency custody providers held upwards of 95% of all assets in off-line, cold storage. Recent surveys indicate that custody providers today store just 80% of assets in cold storage. Historic models of storing the majority of digital assets under custody in manual, offline, cold storage, will not satisfy emerging market requirements.

Irreversibility Mandates Resilient Security

With very few (coin specific) exceptions, cryptocurrency transactions are irreversible, meaning they cannot be undone or canceled when done in error or fraudulently by malicious actors. While this attribute can be a downside, it also eliminates common sources of fraud such as double payment scams.

Irreversibility means that extra steps must be taken to ensure that compromised or malicious insiders, as well as external hackers, cannot realistically gain control of the private keys that are used to sign for and execute transactions.

Sepior is a trusted partner in digital asset custody solutions. Our world-renowned cryptographers, such as Ivan Damgård, Jesper Nielsen, Jakob Pagter and others are well known and widely respected experts in multiparty computation and its application in threshold cryptography.

Headquartered in Denmark, Sepior currently works with some of the world’s largest and most innovative financial institutions, startups, and fortune 500 companies. Our fully developed, third-party validated, proven, and performance optimized secure MPC technologies are available for custom integration into your existing or new security frameworks. If you prefer a turn-key custody wallet or other turn-key solution, one of our existing customers/partners may offer a solution to fit your needs.

We invite you to contact us to learn more, and to download our white paper on Securing Digital Assets Under Custody for a more technology centric review.

Originally published at https://sepior.com on January 21, 2021.