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Following Crypto’s “Great Deleveraging” and with a renewed focus from investors on ensuring that digital assets are kept safely, investors need to understand the various methods to hold their digital assets. Errol Bong, Managing Director & Head of North Asia at D2 Legal Technology, and Geoff McAlister, Managing Director & Head of Risk & Control at Hex Trust, explore the risks, costs and benefits of various methods of holding crypto assets.

Risk Exposure

The speed with which the crypto market unravelled in May and June is reminiscent of the 2007/2008 sub-prime crisis, the dot.com boom and 1987’s Black Monday. This crypto winter has unveiled a systemic lack of robust risk management practices and has forced retail and institutional investors to focus not just on trading risk but also on the credit risk of the persons holding their digital assets. With previous crypto downturns, investors faced the trading risks of falling crypto prices but this crypto winter has led to crypto lenders declaring bankruptcy. Retail investors who thought that their cryptos were kept safely with these lenders whilst enjoying high returns are now facing the grim reality that crypto deposits are exposed to much greater risk compared to bank deposits.

Bank depositors understand the risk of bank deposits; they know from history that banks can fail and, as a result, now enjoy the additional safeguards of high levels of banking regulation together with limited government guarantees over bank deposits. Crypto investors were attracted to crypto lenders with the promise of high returns for depositing their cryptos. When these crypto lenders fell into bankruptcy, crypto investors learnt the same lessons as bank depositors: a depositor takes the credit risk of the deposit-taker. The problem here is that crypto lenders are not regulated, nor do they have the benefit of deposit protection.

Widespread losses suffered by retail investors may give rise to increasing calls of regulation but we are yet to see a standard set of regulations throughout the globe. Investors may not be able to wait for regulations to catch up with industry developments, so where should depositors hold their digital assets?  Investors need to take responsibility for their risk exposure and perform their own due diligence – including the risks relating to how their digital assets are held.

Safe custody of digital assets with Robust Risk Management

Digital asset custodians provide an alternative method to hold digital assets. By ensuring the client’s digital assets are securely segregated from the custodian’s own assets and also the assets of other clients, the digital assets are held free from the risk of insolvency of the party holding the assets. Consequently, investors can have a refuge from the credit risk of entities in these nascent markets and can focus on trading risks and returns. While such custodians will not offer the high returns of crypto lenders and may in fact lead to a cost for investors in the form of custodian fees, investors have the peace of mind knowing that their investments are kept safely.

The custodian’s business is solely focused on holding client assets safely for a fee and therefore there is less risk of the custodian falling into bankruptcy. Nor can a custodian use the depositor’s assets to gain a return.  This is a different situation to crypto lenders who are taking their depositors’ assets and using them to get a return, e.g. by lending out such digital assets to Centralised Finance entities, deploying them to staking opportunities or into Decentralised Finance protocols / ‘yield farming’ strategies. While this principle has some similarities with banking, the key difference is that banks are highly regulated and have strict capital adequacy requirements, per the Basel Accord recommendations on Capital Adequacy adopted and implemented by almost every country and banking regulator in the world.

Even if a custodian goes bankrupt, such client assets are segregated from the custodian’s own assets. Consequently, client assets cannot be used to pay the creditors of the bankrupt custodian but must instead be returned to such clients. Additionally, custodians typically purchase insurance to cover risks of investor loss.

Enforcing Segregation

Segregation is the key principle in this model and can be reinforced by using distinct legal principles such as holding assets on trust. In any event, robust legal documentation must be established to ensure that such assets are legally segregated and protected from the custodian’s bankruptcy. To safeguard crypto investments it is vital that the segregation of assets is not merely a theoretical concept that can be established with legal agreements alone. It needs to be supported in practice to ensure that there is no commingling of client assets together with the custodian’s own assets.

Organisations need safeguards to ensure their investment assets can never disappear due to the failure of a crypto platform. With technically and properly secured segregation of assets, an investor’s assets cannot be repurposed or reused by the custodian and, in the event of bankruptcy, cannot be claimed by creditors.

Further, security and operational processes are required, supported by robust, external risk management to minimise the risk of hackers stealing digital assets. Institutional grade custody operations are additionally supported by audit and reporting to verify that such processes are robust and achieve the desired outcome. Digital custodians not only address credit risk but also focus on operational risks and IT security to help mitigate these external risks and this is where some of the custody fees are used. As regulation begins to catch up with the market, regulators may focus on the safe custody of digital assets to protect investors and crypto exchanges which partner with digital asset custodians may be well placed to address the new regulatory environment.

In the immediate term, digital asset custodians are using innovative technology to secure the safe custody model for crypto assets. Digital assets on a blockchain, of course, never leave the blockchain, it is a decentralised ledger, a record of account. A digital asset custodian employs special Institutional Grade architecture, including sharded keys and multi-sig authorisations, to enable the secure custody and management of a client’s assets, with bank grade processes & workflows for authorising transactions safely. As an added benefit of the transparency offered by the most popular blockchains, the client can always observe their digital assets, currencies, tokens, NFT’s, directly on the blockchain, taking comfort from the ultimate source of truth, that their cryptoverse assets are exactly where they left them.

Standardised Terms

In addition to the technology, such digital custodians must ensure that digital assets are legally protected from their insolvency. This includes using properly drafted customer agreements using standardised terms, which allows  investors to quickly determine how their digital assets are legally safeguarded. For example, custodians in English common law based jurisdictions (including Australia, Hong Kong, Singapore and New Zealand) would typically rely on holding assets on trust in order to protect assets. Well drafted, easy to understand client agreements greatly assist investors with performing due diligence. This applies not only for retail investors but also for institutional investors such as regulated asset managers which may be required by regulation to use enhanced due diligence including complex due diligence questionnaires and custody suitability requirements before selecting the custodian.

Regulated asset managers investing in digital assets will want clear, easy to understand customer agreements with their digital asset custodians to ensure that they can perform essential due diligence efficiently. With assurance in both asset ownership and security, that assets are ringfenced and insured, investors can have a safe port from credit risk in volatile markets, allowing them to focus on trading risk – and take refuge from the credit risk that has destabilised the market in recent months.

Standardisation of legal terms relating to investors’ rights and risks that investors are exposed to when depositing digital assets with crypto lenders would greatly assist investors with such due diligence and would facilitate making an educated comparison of the different risks created with different crypto lenders. Regulators would also expect clear legal terms and conditions to be presented to investors and when regulation eventually catches up with the market, digital asset platforms using well drafted legal agreements with their customers would be well placed to deal with the new regulatory environment. 

Conclusion

The demand for crypto assets and currencies such as Bitcoin will not diminish. Unlike bonds or shares, cryptocurrencies such as Bitcoin are not issued by a company or government and consequently its value is not linked to the fortunes of an individual company or government. Therefore, similar to gold, Bitcoin cannot default or be debased and it is Stateless, which offers huge appeal. After the events of the past six months, however, investors now recognise the need to be careful not only about how they trade but where they keep their assets.

This latest crypto winter has reinforced the urgent need for the industry to reconsider the role of crypto as an asset class. Just as collaboration and innovative leadership in creating terminology, definitions and operational clauses that have been embraced by the global market for OTC derivatives has played a key role in creating market stability and certainty, we need to develop and apply those same standards to crypto trading. In the meantime, digital custodians offer a viable way to mitigate credit and operational risk for crypto investors.

As a silver lining, it is worth noting that whilst many investors suffered real losses, there were no tax payer funded bailouts required to keep this industry going.