The Unsung Companions in the Bitcoin World: Crypto Custody and Caution
When it comes to the world of institutional custody: it's an ecosystem with high stakes, big risks, and even bigger rewards. But then what's the magical word for participants to bear in mind? Caution. It certainly pays in the long . run to be cautious.
While it's very easy for us, as individuals and often enthusiastic investors, to get swept up in all of the hype which came to epitomize the cryptocurrency market of 2018.
It had all the potential to subsume traders in a feeling of FOMO (Fear of Missing Out) while leaving those late-comers to scramble into a market that was already beginning to deflate. Leaving them with poor returns on digital currencies on a downward trend.
Or, at the very least, that's what we've seen in the aftermath of 2018.
In the cryptocurrency market, things are never as simple as we find from other marketplaces, often running contrary to broader trends. What is it that makes this area even riskier? Working in the realm of custody regarding crypto assets, which often acts as a necessary dampener to the constant drive by investors to seize upon trading volume.
Over the previous week, the President of Fidelity Digital Assets, Tom Jessop made it clear to investors that its platform would be rolling out a range of services which hinted towards its decision not to offer custody support for Ethereum. When pressed for a reason for this, Jessop stated that this was due to the level of uncertainty regarding Ethereum's recent Constantinople hard fork, as well as others being planned in the future.
So while there is a greater deal of caution being exercised by institutional finance and investors. This illustrates some of the very real difficulties that the cryptocurrency market has in obtaining the same scope as mainstream assets. And it goes a long way to demonstrating why institutional investment is taking longer than anticipated to get involved in the space.
Custody is a challenging field to get right for investments, and once you add in cryptocurrencies, it becomes far more risky and complex than any of us care to think.
Crypto Custody – What's The Problem?
First things first, it's worth looking back at what a hard fork is, and what it entails. When a blockchain instigates a hard fork, this means that its core developers intend on drastically changing the characteristics of the blockchain, effectively splitting the code between new and old chains.
So what does this mean for miners? They would have to switch over to the new fork, or the mined blocks will not be recognized by the old chain. Miners have a choice between entering the newly forked chain, or staying with the original code and continuing to mine.
So, with this in mind, let's go on to address the kinds of concerns that Fidelity had when it came to Ethereum and the problems that emerged when it came to hard forks in the underlying code, and what this means for custodians.
The most recent hard for that we saw with Ethereum was Constantinople. This hard fork was used in order to implement a number of EIPs (Ethereum Improvement Proposals) for scalability, data processing, and sharding. By all accounts, for core developers, miners, and users, of Ethereum for their dApps, the transition went really well.
But while this was an otherwise painless experience for the end-users, these hard forks bring a number of risks, however. Apart from having similar properties to the previous blockchain, albeit with a number of newly amended features, there's a certain amount of trust that has to be regained from those that were otherwise concerned about how robust this new fork is.
Along with this stability, the effect of having more hard forks in the near future, this is something that can negatively impact on confidence. For Ethereum, for example, there is another hard fork expected to take place, but with how long it took for Constantinople, the time-frame of the end of 2019 remains hard to ascertain.
The announcement from Fidelity regarding Ethereum and its hard fork has not gone down well with some. With a number of users criticizing them as being over-cautious, resulting in a loss of business as a large number of investors are seeking out reliable and stable custody solutions for the cryptocurrency world.
But, when we take the kind of risk that is placed on this company, not only from a standpoint of its reputation but also in terms of its capital, the decision comes off less as a foolish more, and more a rational one.
Is Operating As A Custody Safe?
Dissatisfaction often emerges from within the teams which make up the core development teams of various blockchain projects, and this results in a number deciding to stay on the old side of a hard fork, or simply split off on their own. We've seen this with the split of Bitcoin Cash, creating two warring forked variations – Bitcoin SV and ABC.
What makes this even more interesting is the fact that Bitcoin Cash itself was also a bitter split within the core development team in August 2017's Bitcoin community.
So is it safe for custodians with the hard forks taking place? On a general level, the holdings that were previously on the old chain are effectively replicated on the new chain that is created. While the only difference between these chains is that the new one carries on with new properties attached. Custodial services have the option to support the new chain variation of these various blockchains as well. But the kind of challenges and risks that come with supporting a new chain mean that some clients may not be so enthusiastic about adding these new forked chains.
Among the reasons why custodians may not be so quick to provide services to these new chains can be down to the fact that they involve a higher level of technical complexity, as well as further concerns regarding matters of broader security.
So when Ethereum underwent its hard fork back in 2016, creating ETH and ETC, one of the things that did give credence to custodian services is the fact that a glitch was discovered within its underlying code.
This allowed for transactions which took place on one chain to be reflected onto the other, even if there was no corresponding transaction on the new or old chain. While a part of this can be chalked up to the relatively ‘new' act of committing to a hard fork, imagine if you're part of a custodial service, and you're charged with keeping track of holdings within this kind of glitch.
Upon Consideration – Is It Worth It?
One of the other reasons why businesses would be reluctant in working with a blockchain which had undergone a hard fork. And that is straightforward business reasoning.
But for those that are versed enough in the blockchain world, it would be a pretty simple thing to just add support for these new digital assets as and when they emerge on a blockchain that is already on and in operation. Now, on a broad level, adding another chain requires a greater degree of work. And the sort of time that this involves work from the custody's side. So with this in mind, will the coins that these custody's place within their service have enough in the way of market volume and liquidity? Is there really enough demand from the community to substantiate delegating time and resources to include it?
It's these questions that demonstrate just why companies and custody providers are rather averse to simply throwing together support for newly hard forked digital assets / ERC20 tokens. It's also one of the main things that divide these crypto custodies from ‘conventional' electronic securities. The latter, for example, is not wholly defined by the underlying technology, while the former often is.
This is exemplified by BitGo, which operates as one of these crypto custodians. It is continually working on adding to its already expansive list of digital assets. But when it. comes to the matter of hard forked assets, BitGo made the decision to support them “based on a number of criteria, including technical stability, market capitalization, and liquidity.”
For the likes of Kingdom Trust, on the other hand, it stated that “if there appears to be little or no value or no trading interest in the new fork…, Kingdom will not support the fork.”
Along with Kingdom Trust, we have the digital custodian and institutional dealer, Gemini, which has explicitly “does not support hard forks.” As a result, we can see that there are a number of strong opinions when it comes to the approach businesses should have to hard forked assets.
Is It Truly Mine?
One of the other issues that crops up is the fact of ‘Settlement finality,' and it is a continuous issues that complicates the crypto custody world. On its own, settlement finality is a legal construct which defines the time when a transaction of money and an asset is conducted, thus transferring ownership from one user to another.
Where crypto custody's face problems is the specifics of this settlement finality, which can often differ significantly depending on who and were. While this is a construct that can often be in flux, it is an important principle, and it's one that has drawn in a large number of custodians who are in dire need of knowing where they stand on a legal standpoint.
Settlement finality, specifically with digital assets on blockchain, is an exceptionally blurry area from a legalistic standpoint. Within a decentralized ecosystem, there needs to be a consensus when it comes to any transfer of digital assets. Meaning that the network needs to agree on whether a transaction has officially taken place.
There are those in the industry that contend that blockchain technology renders legal aspects like settlement finality increasingly irrelevant and that the ecosystem is able to take on the responsibility of delegating ownership among its various users in a fair way. For traditional systems, they are used to a system of Settlement finality, and if crypto is to enter this institutional space, the latter will require a clearer concept from the blockchain space.
With the increasing pace of evolution coming from the blockchain space, there will be an increasing number of ways in which other industries will work to compensate for limitations, as well as to keep up with it. While industries, people and technology can reliably do this, legalese and broader definitions are not as fast as other areas, and they take a much longer time to adjust to the new state of play.
We see this even more so now, with a higher number of regulators across the world struggling to provide a clear definition of what cryptocurrency is and what kind of position it should have legally. Speed seems to be both blockchain's strength, and weakness when it comes to people's ability to perceive it.
It is because of this that providers and custody services prove reluctant to just dive into space and provide services to institutional investors seeking to delve into the cryptocurrency marketplace, leaving them desperately seeking out these custodial services. while custody service providers have taken a great deal of flak for its cautious approach, it's a method of approach that is needed, especially from the bigger names on the international stage.
There is certainly a great deal of interest in these kinds of services out there, and that is a very good sign for the future. But while there are many institutional investors that are willing to dive headlong into this space, it is foolish to assume that every single one of these companies will jump in too without assessing the kinds of risks that can come with it.
Businesses, after all, regardless of their scale, have entire departments dedicated to assessing and mitigating risk.