On-Chain Custody of Digital Assets

Part 3 of 4. In terms of safeguarding user financial assets, blockchain technology supports custody and transparency options that differ from traditional financial operations. Direct ownership of cryptocurrency is possible with digital assets and is commonly referred to as self-custody. Conversely, non-custody options come in various forms and with varying levels of transparency. This blog will explore various custody and non-custody options, while comparing them to options in the traditional finance system.

Traditional Finance

To build a common understanding of financial custody and how it works in practice, let’s briefly look at the SEC policy that governs custodianship of funds managed by the majority of Registered Investment Advisors (RIAs). According to SEC Rule 275.206(4)-2, “custody means holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” Instead of an investment advisor directly holding client funds, separate qualified custodians typically fulfill that role. The qualified custodians are held to certain operating requirements such as facilitating annual independent audits, providing quarterly reports to clients, and keeping client funds separate from each other.

Traditional RIA Custody Model
Source: Michael Kitces

It is worth taking a step back to ask whether the introduction of intermediaries that store investment deposits is net positive for the investor. Does this make sense in the era of the internet where assets are digitized and information can be directly accessed at all times and from any continent in the world? Are custodians safekeeping our assets, or building a wall to support an aging business model that allows custodians to profit from “net interest margin of cash deposits via an affiliated bank; securities lending and margin lending; trading commissions; order routing; and shareholder servicing” (Michael Kitces, 2018).

Let’s look at an alternative option for managing digital asset investments using blockchain technology.

On-Chain Investments

Since public blockchains are merely a global network of computers maintaining a single ledger, they are inherently accessible by everyone and viewable by all. These attributes lead to a permissionless and transparent ledger system that can operate without reliance of trust between intermediaries. An on-chain crypto fund investment means a digital asset is stored at a unique public address on a blockchain, which in turn acts as a wallet.

Crypto Self-Custody

Prior to blockchain technology and cryptocurrency, the only way to accumulate assets was to physically store dollars, gold bars, or some other physical legal tender, which could easily be at risk. Conversely, any amount of cryptocurrency can be stored using an on-chain wallet that allows investors direct self-custody, and in turn completely eliminates the need for intermediary custodians. Private keys are the most important security feature of self-custody crypto. They are typically represented as a 12-word seed phrase that should be kept in a safe place and never shared.

One-Way Crytpographically-Secure Private Key—Public Key Pair
Source: ledger.com

Private keys allow a user to generate their public key (wallet address) using a one-way cryptographic computation, and this is sometimes called a public key-private key pair. Additionally, private keys allow a user to send or receive funds, which is why it is extremely important to protect a private key wallet address.

Crytpographically-Secured On-Chain Transaction Flow
Source: ledger.com

Without private keys, the balance held in a wallet can be viewed, but not accessed.

Crypto Non-Transparent Custody

On the other end of the spectrum from self-custody are Centralized Exchanges (CEXs) such as Coinbase or Kraken, which offer full custody of crypto assets without providing on-chain wallet address(es) that allow for direct verification of funds. To read more about CEXs differentiated from DEXs, read the second in this 4-part series: Decentralized Exchange (DEX) vs. Centralized Exchange (CEX).

Storing crypto on an exchange requires the highest degree of trust—reliance that deposits are being custodied in a responsible and safe manner, and are not being used for investment purposes. In both traditional finance and in cryptoverse, retail deposits were commonly used to fund an exchange’s commercial investment pursuits, which exposed assets to additional risk ultimately transferred to the customer. Fortunately, a middle ground exists between self-custody and full, non-transparent custody.

Crypto On-Chain Transparent Custody

The purchasing of crypto-native assets means an account’s holdings (on-chain wallet) are stored on a digital ledger (blockchain) that is publicly viewable at any time. Therefore, a third option unique to crypto is to invest through a platform that provides the on-chain address of custodied funds. This provides an investor or fund manager with the ability to directly verify account holdings any time, since anyone can view public decentralized blockchains. This 24/7 real-time data availability leverages the power of the internet, and is a huge improvement over less-frequent quarterly or annual audits required under current SEC regulations (as of November 2022).

It is often said that transparency prevents corruption, and the extreme transparency offered by on-chain crypto fund investment platforms could have prevented various 2022 crypto disasters such as the fall of Three Arrows Capital and the FTX US exchange. Although those failures plagued the crypto industry, it is important to note that in both instances investor deposits were not on-chain so they could not be verified by the investor, auditors, or other public watchdogs. Instead, Three Arrows Capital and FTX utilized the same custody approach as traditional finance institutions by holding customer deposits on their private books in a non-transparent fashion. These funds were then commingled with high-risk investment activities. When transparency is lacking or intermediary custodianship is utilized, investor deposits can easily be exposed to a slew of activities that include fractional reserve banking, leveraged investing, and/or risky investments. A better alternative is the use of on-chain smart contracts which place an agreement between parties into immutable code that is automatically executed when certain inputs and/or conditions are met.

How Smart Contracts Work
Source: Elenabsl

Smart contracts live on the Ethereum blockchain and are enforced by the global Ethereum blockchain network. This method of investing on-chain using smart contracts allows investors to verify the deployment of their funds, measure performance at any time, and receive a disbursement of funds at the agreed-upon maturity date coded into the smart contract. These same services are baked into the business model of traditional RIA custodians, but can now be achieved on-chain without reliance on an intermediary, and subsequently at a lower cost and lower risk to the investor.

Evolution of Investing

Traditional investment firms provide limited transparency into investor deposits, and communicate via quarterly reports characterized by inherently stale data. Verification of funds is required only once a year by a third-party accounting firm, which requires yet another layer of trust from an investor. In contrast, blockchains provide permissionless access to all assets stored on-chain and allow 24/7, real-time fund verification by anyone, including investors themselves. This applies to all digital assets stored on a public blockchain, including cryptocurrencies such as Bitcoin and Ether, and ERC-721 NFTs stored on the Ethereum blockchain. Coupled with smart contracts, on-chain investments eliminate the need for several services supplied only by traditional intermediaries, challenging old business models that extract value from the investor relationship. On-chain investing provides a more efficient and deterministic digital asset investment approach.

Credits:

riainabox.com

investopedia.com

law.cornell.edu

investopedia.com

data.investmentnews.com/ria/

Kitces: Fee disruption is coming

coindesk.com

ledger.com

Our 4-part blog series on Why On-Chain Matters:

Why On-Chain Crypto Investments Are Superior to Traditional Crypto Investments

Diversifying Your Portfolio with Blockchain Assets