Cryptocurrency custody gives commercial banks a foothold in the market

The crypto custody business blossomed in 2019, spearheaded by fintech firms, but now its center of gravity might be shifting.

Custody services aren’t the most compelling corner of the crypto ecosystem, but 21st-century solutions for storing and safekeeping digital assets are critical if cryptocurrencies are to achieve widespread adoption. 

For that reason, Cowen Inc.’s recent announcement that the 103-year old United States investment bank wants to hold crypto on behalf of asset managers and hedge funds is noteworthy, especially when coupled with similar statements from traditional bank giants such as Bank of New York Mellon and Deutsche Bank earlier this year.

Is it too early to speak of this as a movement? “This is absolutely a trend,” Raphael Polansky, managing director at Boerse Stuttgart Digital Ventures GmbH, told Cointelegraph.

Traditional bank giants like Wells Fargo — which also announced that it would begin offering crypto services to its wealthier investors — are being nudged into the business by their customers who are eager to increase their crypto and token activities. “Those customers are also not yet willing to trust those pioneering fintech firms with three-digit million amounts,” explained Polansky, adding: “They want a reliable and trusted partner that they have known for decades, and these are still the traditional banks.”

“Yes, more [traditional] banks will offer custody services,” predicted Michael Gofman, assistant professor of finance at the University of Rochester. It’s like building a house, where “custody is the foundation,” he told Cointelegraph. Most users are scarcely aware of the custody function, but it is critical if the house is to endure.

Matthias von Hauff, CEO of TEN31 fintech Bank, told Cointelegraph: “Those jurisdictions with a solid financial regulatory regime are in general beginning to appreciate the importance of providing a sound regulatory framework for crypto custody.” He, too, expects more traditional banks to enter the custody space.

A door opener?

Legacy banks’ interest in crypto custody might at first glance seem surprising. The fees aren’t lucrative, after all; Coinbase’s custody fees, for instance, are about 50 basis points on an annualized basis. “It won’t make them [i.e., the banks] much money,” observed Gofman. But banks may view it as a kind of loss leader, enabling institutions to sell new custody clients additional — and more profitable — services, like crypto trading.

Many providers until now have been offering services virtually free of charge, noted von Hauff, while crypto custody “is a perfectly logical ‘door opener’ for a wide range of cross-selling opportunities,” adding: “It is much like offering free checking accounts to banking clients. You lose money at first, but you have a client to whom you can offer all sorts of financial products.”

Also, banks have surely been keeping a watchful eye on Fidelity Investments, the mutual fund colossus that pioneered institutional crypto custody in 2019 and, in October, expanded its digital asset coverage to Asia. Its Bitcoin (BTC) custody business has been “incredibly successful,” Fidelity CEO Abigail Johnson told Barron’s in December, adding:

“If you had asked me in the beginning if we or anybody was going to be prioritizing custody of Bitcoin, I would have said, ‘no way, I mean, that’s kind of the opposite of what it’s all about,’ but the reality is that you do need it because if you’re an individual who engages an advisor and you want to make an estate plan, you actually need somebody to custody your Bitcoin.”

Will banks supplant fintechs?

With the exception of Fidelity, an outlier, the crypto custody business really began to blossom in 2019, spearheaded by fintech firms. But now, with more established banks entering the arena, its center of gravity could be shifting.

“I would not say that the first fintech interest to this sector will invariably be superseded by traditional financial institutions, but that by entering this space, the competition for clients will certainly increase,” Sean Stein Smith, assistant professor in economics and business at Lehman College, told Cointelegraph. It’s possible that certain demographics may actually prefer to deal with fintechs rather than traditional commercial banks, he added.

There should be room for partnerships between banks and fintechs, said Polansky. “We foresee a lot of strategic moves in the market where traditional banks will invest in crypto custodians instead of building up their own solutions.”

Banks typically aren’t at the forefront when it comes to embracing new technologies, noted von Hauff, so it is “not surprising to see that most banks left this playing field to fintech firms at first. Now it seems like they are beginning to catch up.”

The nature of crypto custody could change soon too, particularly as the crypto industry moves from proof-of-work to proof-of-stake transaction validation protocols and as staking becomes more commonplace, Gofman told Cointelegraph. If a user stakes a cryptocurrency, like Ether (ETH), which helps the network to validate blocks on its protocol, that staker could expect a return on investment — e.g., 6.7% over a 365-day period.

But who is going to track, secure and document all those additional funds? “In the future, everyone will have to provide staking,” predicted Gofman, but “not every custodian will be able to do that.” It might become the province of smaller crypto-custody specialty firms.

Meanwhile, events are moving fast, and Polansky expects to see the crypto custody business largely commoditized within the next three to four years. “The speed with which different companies are building up common infrastructure is amazing.” Besides all the new market entrants, regulations could also shape the future custody business, he told Cointelegraph, adding:

“Combine those effects and we will see a network of big players with similar pricing sharing the market and making it hard for new competitors to enter.”

This should be a plus for crypto users, who will get accessible, affordable services. In addition, Polansky foresees an “interoperability of custodians” allowing customers to “more easily move tokens and cryptocurrencies between ecosystems.”

What about custody services for everyday investors?

Recent announcements have focused on crypto custody solutions for institutions, not individual investors, but this isn’t so surprising, given that institutional players and private banking clients simply have more assets to deploy, said Stein Smith, adding: “From a business model perspective, it is logical to offer services to the most valuable clients first.”

“Retail clients don’t need it,” added Gofman. They can write their private key on a piece of paper and put it in a safe deposit box. It’s not even needed for tax filing. But it’s a different story for institutional investors. Indeed, in the U.S., qualified investors holding $150,000 or more in assets must keep them under the control of a “qualified custodian.”

This makes some sense, Gofman continued. You really don’t want a company’s CEO holding the private keys to the firm’s $1-billion BTC investment. Even though the CEO probably isn’t going to run off to the Cayman Islands with the private key, it’s better to place it for safekeeping with an established financial custodian.

Retail custody solutions are behind in terms of usage and functionality, stated Polansky, and he doesn’t expect that to change. “They will remain a valid option for those who want to use them but will not take over the market.”

Crypto in retirement funds?

All in all, the fact that financial heavyweights, such as Fidelity, BNY, Deutsche Bank, Northern Trust, DBS Bank and others, want to offer custody for digital assets could be a milestone event for the crypto world, and one might expect that even retirement funds could hold crypto assets soon.

“The inclusion of Bitcoin and crypto into retirement planning is actually already underway via the utilization of self-directed IRAs,” Stein Smith told Cointelegraph. “With the increased interest and integration of crypto into traditional custodial and other financial services, it makes logical sense that Bitcoin and other crypto will become an integral part of the retirement planning process.”

Related: Bitcoin on balance sheet attracts negative attention from anti-crypto banks

Custody is a big deal, said Gofman, the groundwork of the cryptocurrency edifice, and even if custody fees remain relatively low, “1% of $1 trillion is still a lot of money.” Meanwhile, nonprofit organizations, pension funds and other institutional investors must have secure and trustworthy custodial services if they are going to invest in cryptocurrencies.

“A big reason that institutional investors have steered clear of crypto until now is the custody issue,” Duke University’s Campbell Harvey told Cointelegraph in April, adding: “They had no mechanism to store private keys. They did not want to bear the custodial risk.” But now multiple solutions appear close at hand.