Custody Protection, Regulation, Insurance Seen Paving Way for Shift to Cryptocurrencies

Hedge fund manager Kyle Samani embraces his job making multimillion-dollar bets on the wild market for cryptocurrencies, but he’s long contended with a headache: Ensuring his holdings aren’t stolen.

Samani, a managing partner at Multicoin Capital, hopes to offload that task soon. He’s among a small group of institutional investors who have been testing Coinbase Inc.’s new crypto custody service, one of scores of such offerings in development. Some services are now almost ready — with huge implications for the market’s future.

“There are a lot of investors where custodianship was the final barrier,” Samani said in a phone interview. “Over the next year, the market will come to recognize that custodianship is a solved problem. This will unlock a big wave of capital.”

Coinbase expects to win approval soon to serve clients requiring a so-called qualified custodian that meets tough U.S. standards for guarding assets, according to a spokesman. It’s among crypto startups including Circle and BitGo that have been talking with regulators. In May, investment bank Nomura Holdings Inc. joined crypto firms Ledger and Global Advisors to create a custody consortium called Komainu. And at least three giant Wall Street custodians — Bank of New York Mellon Corp., JPMorgan Chase & Co. and Northern Trust Corp. — are working on crypto-custody services or exploring it, people briefed on their efforts said.

Such projects would pave the way for vast tracts of investors to expand into crypto, potentially reviving prices in markets that have tumbled in recent weeks. Regulated crypto custody would allow more institutional buyers — such as hedge funds and pensions — to invest in Bitcoin, Ether and a multitude of other coins. Retail brokerages would have a safer way to let clients add crypto to portfolios stuffed with stocks and bonds.

And the services would provide peace of mind to Samani and other fund managers who’ve already waded into the market. Most investment advisers are required by the SEC to keep client funds with a qualified custodian. That’s left more than 250 crypto-focused funds — and especially the largest — facing the prospect that regulators could clamp down.

About $20 billion in crypto assets are poised to flow into custody services once they’re available, estimates Sam McIngvale, who’s leading Coinbase’s project. The figure has been ticking higher in recent months, despite Bitcoin’s downward trend, as startups hold initial coin offerings, pumping their own tokens into the market.

Institutional investors have long relied on global custodians such as BNY Mellon, JPMorgan, Northern Trust and State Street Corp. to guard their cash, securities and even gold bars and diamonds. But cryptocurrencies present a new challenge: Purely digital assets are vulnerable to hackers, and lost funds are hard to track, much less recover.

Coinbase has held discussions with established Wall Street custodians about partnering, McIngvale said. Another custody technology provider, Trustology, also has fielded inquiries from traditional custodians, Chief Executive Officer Alex Batlin said.

“We had quite a few folks pinging us,” he said, noting that such talks are in “early days.” Trustology aims to launch its institutional custody service in September, he said.

Komainu plans to start private testing around mid-summer, said Jean Marie Mognetti, who runs one of the partner firms behind it, Global Advisors.

“We hope to have a solution a bit more open to clients by the end of the year,” he said in a phone interview. The venture has lined up trial clients including hedge funds, a family office and an investment-management company.

Several startups said they’re already talking with the Securities and Exchange Commission or Financial Industry Regulatory Authority. BitGo, which acquired qualified custodian Kingdom Trust, is working to become a qualified custodian in its own right, and to get a state-chartered trust company approved in South Dakota, CEO Mike Belshe said by phone.

“We filed with them some time ago now. Hopefully it will be coming together soon,” Belshe said. “We are working with several hundred hedge funds and wealth managers” who are waiting for the approval.

Many custody ventures are working to obtain insurance to give customers a peace of mind. Some are also looking to expand into other Wall Street services, performing know-your-customer checks and directing funds to specific exchanges at customers’ requests.

BNY Mellon has been exploring a system for cold storage, keeping the keys to crypto holdings offline beyond the reach of hackers, according to a person with briefed on the matter, who like others asked not to be identified discussing confidential planning. That will be the norm for custody operations. Hot storage — linked to the internet — is faster but riskier.

JPMorgan and Northern Trust also are considering ways to offer custody, but haven’t made final decisions, according to people with knowledge of their deliberations. “Northern Trust takes an extremely cautious approach towards cryptocurrencies, and we look at crypto services as part of an enterprise innovation strategy to support our clients,” a spokesman said in an email.

Custody probably won’t come cheap. Coinbase has been charging a $100,000 setup fee, plus 10 basis points per month, and requires a minimum balance of $10 million. It may take up to 48 hours to take money out of cold storage — essentially the crypto equivalent of a vault. But as the number of options expands, prices would probably come down.

“The space is becoming increasingly competitive between the startup and the traditional players,” Lex Sokolin, global director of fintech strategy at Autonomous Research LLP, said in an email. “Regardless, the technology answer should be in the market toward end of year, and a traditional one will follow thereafter.”