Investing in digital assets is risky. Hosting shouldn't be one of them

2023-04-27 18:13:15
Customers who lose access to their digital assets in a 2022 cryptocurrency bankruptcy face serious hurdles in recovering them. This would not be the case if their assets were held by properly regulated custodians with fiduciary responsibilities.

Use a trustee to protect assets

A "fiduciary" is when an entity protects assets on behalf of a client, such as an exchange, hedge fund, or trading desk, and it has a legal duty to put the client's financial interests above its own. This requires internal and external controls, structured processes and governance. Regulators have clear processes for clients to recover all assets if an entity dissolves. All of these are essential to protect customer assets.

This requires the custodian to address various risks that may exist. For traditional assets like gold, this means storing it in highly secure vaults. Multiple key holders are required to gain access to the vault and there are fail safes for lost or stolen keys.

For digital assets, this means requiring multiple cryptographic keyholders to access the asset, cryptographically securing the keys and setting up failsafes for lost or stolen keys, storing the keys on secure hardware, and storing the hardware in a safe vault.

This also means implementing layers of isolation. The assets of each client must be kept separate from those of other clients. Custodians also cannot mix client assets with their own like FTX can. Custodians cannot take any risk on assets, so custody must be separated from all other functions (such as trading, hedging, lending, etc.).

The structure of the traditional financial system separates these functions. There is currently no such market structure for digital assets. This, combined with poor governance and a lack of internal controls, allows exchanges to risk client assets in their lending and hedging operations.