Why Regulated Custody is the Next Step for DeFi

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Why Regulated Custody is the Next Step for DeFi

The events of 2022 have been sobering for the digital asset industry. Billions of dollars worth of assets have vanished due to excessive risk-taking, financial mismanagement and malfeasance, and the result was a massive decline in digital asset values.

What’s harder to measure is the crisis of confidence. Investors and crypto users are wary of what protocols they can trust with their assets. That has led to a revival of a rallying cry from the early days of crypto: “Not your keys, not your coins.”

Essentially, this is a call for the return of self-custody.

Viable Option

That’s understandable. Self-custody is one of the foundational principles of crypto. For an individual retail investor, self-custody can be a viable option. But it’s not a feasible way forward for the industry as a whole for three reasons: it’s risky, it’s not scalable and it limits the utility of digital assets — particularly for institutions.

Licensed, regulated custodians with financial fiduciary duty play a critical role in reducing systemic risk and securing digital assets, which is essential for broader adoption from traditional finance firms to Fortune 500 corporations.

Custody 1.0: Secure Custody

Back in 2013, the big issues in custody were around technology. Digital assets were completely novel because they were bearer instruments built on code. That led to security issues. If you lose your digital key, you lose your assets.

Imagine if your bank went out of business and left your assets trapped in a vault. That was a big risk in those days, even with federally guaranteed deposit insurance. Wallets and exchanges also suffered from hacks and mismanagement and investors lost all their assets. The industry was in its infancy, so the value lost was relatively small, but it was a bad experience.

Custody 2.0: Regulated Custody

As the ecosystem grew, the value of digital assets increased, and businesses began to participate. The idea of “not your keys, not your coins” started to break down.

For fiduciaries (people who act on behalf of another person or institution) to participate in the market, you can’t have just one person holding the keys, or risk losing the key. You wouldn’t give your safety deposit box key to the IT person and say, “Here, don’t take anything.” You need a separation of duties, internal and external controls, operations security, and business continuity if someone leaves the company.

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To meet these needs, the industry evolved and added regulated, qualified custody. Simply put, custody is safekeeping. The No. 1 job for a custodian is to protect clients assets and eliminate any single points of failure in the way those assets are managed.

Assets should be insured and held in segregated accounts with regulated custodians. In crypto, this means all your keys are protected and managed by a licensed and audited fiduciary. Customer funds are separated from the custodian’s funds and from other customers’ funds.

This enables customers, such as institutions, corporations, and high-net-worth individuals, to participate in the market with confidence.

Custody 3.0: Separation of Custody

The traditional financial system has a market structure that has evolved over time. There is a fabric of regulated broker dealers, exchanges, clearinghouses, transfer agents, etc.. Each operates according to certain rules and is accountable to their regulator for following the rules. This provides a system of checks and balances as counterparties transact.

Crypto was born without a market structure. As the ecosystem grew beyond just trading to include staking, lending, market making, hedging and other functions, we saw the rise of centralized exchanges that did all of those things, including custody — most commonly unregulated custody — under one roof.

This model where you have to store your funds with the exchange to participate is fundamentally flawed. There are no checks and balances. You can’t possibly measure your counterparty risk because it’s the sum of the exchange plus whatever markets they’re participating in. Are they lending? Hedging? What are they doing off chain? There’s no way to know.

Since 2013, the crypto industry has made progress on the market structure component. There are now products that allow institutions to participate in the greater crypto economy with assets protected in qualified custody.

Moving Forward to Build Trust

People talk about crypto as trustless, but there’s actually a good deal of trust because it turns out that when it comes to money, humans aren’t reliable.

When you’re holding your own keys, it’s fantastic because you’re empowered. You participate on equal footing with banks, traditional financial services providers and everybody else in the ecosystem.

You don’t have to go through any intermediaries to use your assets. But we can’t build the next global financial system if we can only trust ourselves. We need qualified custodians that are regulated to protect client assets. However no one firm can build market structure alone.

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Custody for digital assets continues to evolve in large part because the infrastructure is still emerging. There’s a lot of work for us to do and I think every individual and institution getting into crypto needs to be looking at every counterparty risk that they have—in trading, lending, borrowing, or custody.

There will always be a place for self custody, but to get Custody 3.0 right, we need regulated custody as well.

Mike Belshe is the CEO and Co-Founder of BitGo

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