Today’s institutional investors are wise to custody their digital assets with a trusted third party — but can they reduce risk even further by spreading their assets across multiple custodians?

The value of custody diversification

Institutional investors entering the digital asset space today understand the importance of keeping their digital assets in the custody of a trusted third party (see previous blog article). Management of the assets’ private keys gets delegated to the custodian, requiring trust in the custodian and their underlying infrastructure. In this article, however, we will explore whether it is possible and practical to further reduce risk by spreading digital assets across multiple custodians.

Gold storage is similar to digital asset custody

Gold often serves as a good comparison to digital assets, since both can be owned directly or indirectly. Some gold investors physically own and store their gold, others store it at a bank, while still others go down the non-physical route and purchase exchange-traded funds (ETF’s) backed by physical gold. The cost of storage associated with these gold ETFs is low since they benefit from economies of scale, but these very same economic forces have consolidated most of the world’s ETF-gold in the same vaults, as shown in the table from HanETF below.




Location of gold stored by ETF providers
Examining the physical location of gold stored by leading ETF providers shows that owning several gold ETFs does not achieve custody diversification. (HanETF)

It is apparent that every major gold ETF stores its underlying assets with one of two banks, both in the city of London. This seems especially counterintuitive considering that the role of gold for many investors is an asset of last resort that holds its value across time and through any major disruptive events. It seems that buying gold through an ETF requires confidence that London’s infrastructure will continue to operate normally, should a disruptive event take place and investors wish to redeem their ETF shares for physical gold.

Thankfully, the major crypto custodians are not all consolidated in the same city: digital asset investors can choose from a number of institutional-grade custodians from around the world. It is still worth considering, however, whether or not a digital asset portfolio should remain with a single custodian or be spread out across several. No clear trend has yet emerged in the industry, and Finoa is also seeing a mix of investor attitudes on this issue. For more insight, we can look to emerging crypto-backed exchange-traded products (ETPs). These ETPs had over $6b in assets under management in May 2021, and are the preferred method for many institutional investors to achieve exposure to the crypto market.

The providers of these crypto ETPs partner with existing institutional-grade custodians in order to safeguard shareholders’ underlying assets. The ETP buyer, therefore, achieves exposure to crypto without having to manage a private key or even decide on a custodian. Many ETP providers partner with a single custodian, but a few enlist more than one custodian to store the underlying digital assets. As shown in the table, Wisdom Tree, Iconic Holding, and Evolve ETFs have each chosen two providers, with little overlap between their choices. Interestingly, the provider of the actively managed FiCAS ETP chose six custodians “for risk management reasons”.


ETP Providers

Are there benefits to spreading digital assets across multiple custodians? Are there risks to consider when using a single, well-regulated, institutional-grade custodian (see our previous article on cybercrime)? While risk is certainly very low, it is still worth considering reasons to seek out custody diversification.

Regulatory and tax diversification

Asset managers looking for a digital asset custodian are unfortunately still met with fragmented regulatory regimes across the globe and a general lack of regulatory guidance. In the US, both the federal Securities and Exchange Commission (SEC) as well as individual states are considering what constitutes a “qualified custodian” of digital assets. In the EU we see positive regulatory developments, and especially in Germany with progressive regulation such as the issuance of preliminary crypto custody licenses to companies like Finoa.

Laws and regulations surrounding digital asset banking are still evolving, with individual countries laying out regulatory guidelines for crypto service providers and businesses. In Europe, the lack of a common EU framework creates risk for both digital asset service providers and their customers, a situation the EC hopes to remedy with a new piece of regulation called Markets in Crypto-assets (MiCA). This MiCA regulation should come into play by 2024, ending EU member states’ national crypto policies and allowing EU crypto-asset service providers to operate across all EU markets, albeit under stricter rules. The EC’s proposal is a positive development but highlights the fact that service providers currently cannot enjoy the benefits of Europe’s internal market. There remains a lack of legal certainty about the regulatory treatment of crypto-assets, as well as an absence of a regulatory and supervisory regime at the EU level.

For asset managers, it may be advantageous to achieve relative independence from any single regulatory jurisdiction for the time being, by choosing to custody their digital assets with custodians domiciled in various countries. This may also be advantageous from a tax point of view — a common reason for institutions to seek footholds in diverse countries. In a crypto context, income from staking is an example of an especially unique tax situation that countries around the world have yet to solidify regulatory attitudes toward.

Fortunately, Finoa’s home country of Germany was one of the first countries in the world to define digital asset custody as a financial service, by incorporating custodians into the German Banking Act. It is evident that the German Supervisory Authority takes crypto seriously and is working to build a regulatory framework of high standard and set strict requirements for companies offering financial services in the country.

Getting exposure to digital assets in a compliant and regulated way is increasingly top of mind for institutional investors and corporations exploring custody options. As legal and regulatory requirements are taking shape, caution is advised when assessing unlicensed or unaudited providers in this space — institutional investors should only select partners who are strongly committed to compliance and security. At Finoa, we acknowledge that custody is an evolving and iterative service — if you are interested in learning more about our viewpoint on legal and regulatory compliance and how it may benefit you, feel free to reach out to our team here.

Infrastructure Risk

Infrastructure risk is the type of risk that custodians can control — indeed the primary mission of every custodian should be to design their digital asset infrastructure to eliminate the risk of financial loss. Today’s industry-leading custodians choose to manage clients’ private keys using either hardware security modules (HSM’s), multi-party computation (MPC), or cold storage “vaults”. Not all of these solutions, however, are flexible enough to meet the unique needs of institutional investors with large positions and varying levels of activity. Standards for underlying infrastructure are still forming, and each custody provider typically has a unique operational framework and infrastructure that should be considered in any service provider assessment.

See our FAQ page for more information, and request a demo if you are interested in learning how our HSM infrastructure can complement your digital asset strategy.

Unpredictable and human-made failures

Even beyond the choice of infrastructure type, there may be additional value in seeking geographic diversification of the custodian’s data-centers. Although unlikely, one can never rule out the possibility of extreme weather events, political and social unrest, or armed conflicts resulting in a failure of electricity or telecommunications networks, which would disrupt a custodian’s service through no fault of their own.

Perhaps the most unpredictable errors are those resulting from human beings, whether it be the Japanese stock trader who intended to sell a single share for 610,000 Yen but instead sold 610,000 shares for 1 Yen each, or more recently the BlockFi giveaway winners who won several hundred dollars but received several hundred bitcoin instead. Even if a piece of crypto infrastructure is completely secure, users can create irreversible errors if mistakenly sending blockchain transactions.

Finoa accounts can be configured to require multiple users’ authentication of transactions, preventing the withdrawal of funds by a bad actor or a well-intentioned person making an honest mistake.

Achieving broad asset coverage

Perhaps the most common reason to seek out custody diversification is to find support for a broader range of crypto assets. Especially for venture capital firms, crypto native funds, and hedge funds, it is critical to find a regulated custodian that supports every protocol of interest, with many of the leading custodians lacking the required agility to integrate with these new blockchains. Finoa has filled this niche in the market, offering support for many new tokens from day one, including MINA, NEAR, FLOW, SKALE, and ROSE. We pride ourselves on providing support for assets that our clients care for, and we also have demonstrated industry-leading integration times for emerging layer 2 projects built on already-supported infrastructure.




Number of tokens supported on Finoa

At Finoa we regularly hear from asset managers who initially invested in Bitcoin or Ethereum, picked a custodian offering competitive prices, and later became interested in newer digital assets not supported by the chosen custodian. We are proud to offer industry-leading token coverage, enabling institutional investors to support the development of emerging blockchain protocols without having to compromise on the security or usability of their assets.

The balance of cost and risk




Cost-risk analysis
The relationship between cost and risk depends not only on the number of custodians but also on whether staking, lending, or other (decentralized) financial activities are undertaken.

Everything comes at a price, and secure crypto custody is no exception. Custodians’ pricing models may discourage asset managers from opening accounts with many custodians and splitting their assets across them, although the possibility to earn income from offerings such as staking or lending may offset this price, and influence the custody setup selection process.

Custodians’ pricing models usually include a setup fee plus a percentage fee on assets held in custody, which decreases with larger amounts. Custodians, therefore, incentivize asset managers to put their entire portfolio with that one custodian, paying one setup fee and benefiting from the lowest possible percentage fee on the assets. This may be why we see crypto ETP providers diversifying their custody beyond a single custodian but not spreading their assets across more than two.

The relationship between cost and risk is not quite as straightforward as indicated in the graphic above, however. It should also be considered how much cost can be offset by participating in staking and lending, and how much accompanying risk those activities take on. While it’s possible to stake assets while in custody, lending involves removing the assets from custody and takes on more risk. Asset managers will have to consider the balance of risk and cost and decide for themselves how they wish to custody and manage their digital assets.

At Finoa, we aim to offer competitive pricing for our digital asset custody service, taking the full relationship into account when determining appropriate fee structures. Our goal is to build long-lasting relationships with our clients and grow with them by offering not only early access and continuous interaction with the protocols and projects they care for but also access to innovative decentralized products and services. All of this takes place within our highly secure, seamless, and regulated environment.

Conclusion

When seeking out a digital asset custodian, today’s investors are faced with a varied and inconsistent regulatory landscape, diverse custody solutions, and limitations on asset coverage. Asset managers must decide on their priorities when it comes to a custodian’s infrastructure type, the accessibility of assets, the ability to stake or lend, options for multi-governance accounts, and asset coverage. Many investors choose to enlist the services of multiple custodians — sometimes a necessity in order to gain access to a range of desired tokens. Understanding this challenge, Finoa strives to offer digital asset services that meet the needs of every institutional investor — we offer industry-leading token support all within the context of Germany’s strict crypto regulations.