In the Wake of the FTX Collapse, What Is the Future of Custodians in Crypto?

It’s fair to say that the collapse of FTX sent shockwaves through the crypto industry. This was an exchange that, at its peak, was the third largest crypto exchange by volume with more than one million active users.

From what we know so far, this overnight implosion was apparently fuelled by years of irresponsible governance & shareholding structures, the intermingling of business interests across different companies in the group and, most notably, a complete disregard of proper risk management and risk controlling.

Put simply, crypto exchanges should not, in any circumstances, also be acting as crypto custodians and market makers at the same time. It is irresponsible and a conflict of interest to pursue your own interests using the assets from your customers as collateral. Instead these activities need to be run externally to any form of custodianship; properly risk-assessed, and regularly audited both internally and externally.

Exchanges aren’t banks, and therefore any lending or trading against customer assets should not happen. Yes, the exchanges are now rushing to show proof of reserves to quell any investor fears, but there is an underlying problem here in which exchanges such as FTX do not have clearly defined structures or roles. After all, what value is there on showing proof of reserves if there isn’t a similar level of transparency over proof of liabilities?

Finding safe custody solutions

The recklessness of a major market participant doesn’t change the fundamentals of the future of crypto. 2022 has been marred by a series of high-profile collapses, yet the medium to long-term thesis should remain the same for crypto investors. The challenge isn’t crypto, it’s ensuring that investors who take advantage of a lower entry price store their assets in safe custody solutions. Any return on investment hinges on actually getting your assets returned.

Self-custody is an option for retail and small investors, given they have sole power of disposal and only need to trust exchanges at the moment of a transaction, yet it is not the most ideal solution for more sophisticated or institutional investors. These investors often need shared access policies, and self-custody solutions typically offer single administrator privileges.

Also, while self-custody does offer more control over assets, it can be very complex to use. It also mitigates counterparty risk but, it should be noted, that it is still vulnerable to hardware or software failures. Often institutions have gone for a “halfway house” solution, trusting the custody solution of exchanges rather than looking for self-custody or appointing a custodian; an approach which, unfortunately, inherits the disadvantages of both solutions.

Typically it’s the more expensive solution, but appointing a regulated and properly audited custodian is often the best option for institutional investors to both safeguard their crypto assets and put them to work in staking or DeFi. Some custodians can offer better security; fully segregated wallets with a direct on-chain experience that allows activities such as transfers and staking, and all of which is verifiable on-chain (“Don’t trust, verify!”).

Reputable custodians will never blend their own assets and investor assets and, crucially, won’t trade or lend against any assets that don’t belong to them, preventing a liquidity crunch in the moment of a “bank-run” as seen in the case of FTX. Additionally, regulated custodians will keep customer assets off the balance sheet, ensuring no financial counterparty risk in case of financial distress of the provider.

For convenience and security, especially with institutional investors, custodians can also offer shared signature procedures across different tokens and protocols as well as secure succession in the event of personnel changes in the customer’s ownership structure. All of the above creates the perfect combination of CeFi reliability and DeFi verifiability and positions the custodian as nothing more but the guardian of the private keys, with everything else being an authentic, decentralised, on-chain experience.

The outlook for crypto

There are strong parallels between the development of the crypto industry and that of traditional finance. While some may see this as a threat to the decentralised nature of blockchain technology, the benefits of operating in a more transparent manner can’t be refuted. Crypto needs institutional involvement in order to continue to facilitate innovation and disruption, and these institutions need an element of trust in order to participate.

In addition to this, without uniform regulation and independent controls, investors who participate in the crypto industry are required to fully understand the protocol and processes, which could severely limit the number of active market participants in Web3 and hinder this innovation. If we are to truly see crypto adopted by a wider audience, then we do need to see a creation of standards that are implemented (and ultimately enforced) across the entire industry.

About the Author

Henrik Gebbing is co-founder of https://www.finoa.io/ , a FinTech focusing on Banking Services for Blockchain-based Digital Assets. Prior, Henrik worked as a Consultant at McKinsey & Company, serving financial institutions and high-tech companies across the globe. He started his career with a dual degree in the high-tech branch of Siemens AG.

Editorial Note: This sponsored article is made possible by MVPR. Opinions expressed are solely those of the sponsor and readers should conduct their own due diligence before taking any action based on information presented in this article.