Crypto is trying to fix its custody problem as institutions pour in and regulatory uncertainty lingers

Published Thu, Jun 29 202310:39 AM EDTUpdated Thu, Jun 29 20235:34 PM EDT

Crypto has a custody issue that's hampering its ability to grow and mature. The crypto market is recovering well from a brutal 2022. Bitcoin is up more than 80% for the year, but companies still face some headwinds from here, regulation chief among them. And the highly regulated institutions wanting to give their clients access to bitcoin are still a little skeptical that the crypto industry has learned its lessons. On both sides, the next big focus for crypto is clear. "Every conversation that we have across the planet has first to do with: 'Where are my assets custodied? Are they safe by and large?'" Roger Bayston, Franklin Templeton's head of digital assets, said at the Coinbase State of Crypto Summit in New York City last week. "That's something that we will see continue to evolve: a number of different, high-quality, trusted custodians delivering what they have done for decades ... into this space," he added. "That's going to go a long way." In the past year, crypto has seen the failure of several major entities in the space including Three Arrows Capital, Terraform Labs, Celsius, FTX and Genesis. Now Binance, the largest exchange in the world, is in hot water after the Securities and Exchange Commission sued the company and its CEO earlier this month alleging they commingled investor funds with their own. BTC.CM= 1Y mountain Bitcoin is up almost 50% in the past year Events such as these are forcing businesses to mature to meet basic customer needs, such as being able to easily retrieve deposits or deploy assets as needed. The industry may ultimately borrow from traditional financial market structures, such as the separation of custody and trade, to improve crypto in a scalable way. The batch of recent institutional announcements last week — particularly that of the Schwab-, Fidelity- and Citadel-backed EDX Markets exchange — validates that demand. Concerns about where deposits are held aren't exclusive to crypto. For about two months this year, several traditional institutions, including Silvergate, Signature, Silicon Valley Bank, First Republic and PacWest, were under scrutiny as customers lost confidence in their stability and withdrew their funds in panic. "This whole storm has been a real opportunity for a lot of changes to happen that are going to leave crypto much more robust and reliable for investors," said Gustavo Schwenkler, associate professor at the Leavey School of Business at Santa Clara University. "Sentiment has improved significantly, and it has done so partially because we're starting to think about how crypto can become more mainstream." "It's started becoming clear that many times when people hold their crypto in some of these places it's not quite clear that that crypto is actually there," he added. "Now it's at the forefront of consumers' and investors' minds and getting an answer to this question is going to be important for how crypto's going to keep moving forward." The custody problem The problem that crypto exchanges have demonstrated time and again is they often play multiple roles in a way that doesn't exist in traditional markets. They match trades, as an exchange does, but also act as their own custodians of customer funds — simply because it's the easiest way to ensure settlement. Sometimes, exchanges also act as their own market makers. "There's a real conflict of interest there when you have one entity playing all of those roles, especially in the centralized exchange model, which is where most of the liquidity sits," said David Wells, CEO of crypto exchange Enclave Markets. "What we're seeing now is models where you decouple those things, which is more similar to other markets." Another issue is there aren't enough dedicated custodians in the crypto industry. Traditional players such as Fidelity , Nasdaq and Bank of New York Mellon have dipped their toes into custody of at least bitcoin, but they're nascent developments, according to Wells. "Some of them haven't launched yet in a meaningful way and they don't yet have integrations with exchanges, so it's hard to be able to trade your assets when they're in custody, especially if your assets are sitting in cold storage" — or offline storage — "which is this the most secure way to store your assets, but it's also the least liquid," he said. "If you need to trade them, you essentially have to do an OTC trade and then do a post-trade settlement," he added. "If you're trading multiple times per second like a high-frequency trading firm, there's no way to move those assets out of a cold storage custody solution that quickly to be able to do the settlement instantly." Rebuilding efforts The custody void has created an opportunity for companies from both traditional finance and crypto to jump in. This week blue-chip crypto custody firm BitGo told CNBC that it has gone live with its Go Network, which CEO Mike Belshe described as a first-of-its-kind "true settlement network where you can keep your assets in qualified custody all the time." "The thing that the investors are looking for is how do we de-risk these trading systems so we don't have to take it out of qualified custody in order to have access to liquidity," Belshe said on CNBC's "Crypto World." The Go Network acts as a platform on which partner firms can execute and settle trades between crypto assets and fiat currencies. BitGo handles custody of crypto assets while dollars are spread across a network of banks for safekeeping. Wells' Enclave Markets is an exchange partner. BitGo said it has upward of $1 billion being held and processed at its partner banks. While it first teased the development of the network publicly in October, it's been in the works for years. "Although we have had these concepts for five years, we haven't really been pushing and making it happen," Belshe said. "[The crypto industry] was operating on the edge, saying, it's risky, but we're making a lot of money. At this point, I think everybody's ready to come back with a more mature response. People were stung by FTX in a pretty significant way and that needs to be fixed." Last week, EDX Markets made headlines for its backing from finance heavyweights Fidelity, Schwab and Citadel when it announced that its new "non-custodial" exchange has been live for several weeks. Similarly, it has customer assets held at third-party banks and a crypto custodian. Both announcements came after BlackRock , the largest asset manager in the world, filed for a bitcoin ETF even amid the SEC's crackdown on crypto businesses, which many saw as a bullish signal for the future of crypto. In the near term, however, the industry still has the U.S. regulatory uncertainty to contend with. BlackRock's Joseph Chalom, head of strategic partnerships, spoke about that at the Coinbase event last week. "In the meantime, you can control what you can control, which is maturity ecosystem, working and partnering with good actors, maturing the infrastructure, and then ultimately that becomes very self-reinforcing," he said. "The money adoption will come ... We're in the long-term investing game. When it's ready, we will be there." "That custody piece is a huge question and leads everything else when we're offering advice," Franklin Templeton's Bayston said. "It is definitely the place where institutional conversations start."