Commentary: What cryptocurrency can learn from traditional markets

Some 8,500 people attended Consensus 2018, the annual cryptocurrency and blockchain summit, in May.

Keynote speakers Fred Smith, chairman and CEO of FedEx, said he sees blockchain as a revolutionary change agent in the transportation and logistics, while Jack Dorsey, CEO of Twitter and Square, said that the internet needs its own native currency.

The crowd's enthusiasm was fantastic, but a major roadblock remains: The digital currency market structure has not yet been built. Worse, you can't just use the traditional market structure for non-digital assets as a model, because that old structure is fundamentally broken.

Look at any other asset class and you'll see the same model: an exchange in the middle surrounded by brokers, settlement and clearing houses, and banks. As a result, there are several participants in every transaction. This model provides some checks and balances, but with so many middlemen, it adds complexity and cost, reduces transparency, and increases risk for abuse and fraud. In many ways, the financial system is as broken as it ever was, but at least the market structure is familiar.

In the cryptocurrency world, many are drawn to the efficiency and simplicity that a structure-less market promises. In theory, you could eliminate some of the middlemen of the old analog market structure, because a digital exchange could also serve as the broker, the exchange and the custodian. But this approach would introduce catastrophic risks by eliminating transparency, removing the checks and balances, and inviting fraud and misconduct at shocking scale and speed.

If we continue to use a system without checks and balances, there will be other incidents on the scale like those this year of Coinrail and Coincheck, which resulted in virtual-currency losses of $40 million and $530 million, respectively, after being hacked.

In Coincheck's case, the Tokyo-based company lost half a billion dollars in NEM tokens because the entire amount was stored in a single-signature, hot wallet. If it had had a qualified custodian, the custodian would have moved the majority of those tokens to cold storage.

The lesson is simple: infrastructure matters. Security, storage and compliance are critical to any digital currency investment solution but the market structure is incomplete with a truly qualified custodian in place. And as we've learned — to the great personal cost of many— there are no shortcuts.

The irony is that the cryptocurrency industry is built around the tenets of decentralization and yet centralized exchanges have built the most centralized markets on the planet.

How did this happen?

Early participants in cryptocurrency weren't permitted to participate in the traditional markets, so they built their own infrastructure. In the early days of bitcoin — about 2010, these businesses weren't considering the long-term impacts of a feeble market infrastructure, they were just trying to build exchanges. The result was some major gaps, the most glaring of which is qualified custodianship.

In a 2003 amendment to the Investment Advisers Act of 1940, the Securities and Exchange Commission adopted a requirement that advisers with custody of client funds and securities must maintain them with qualified custodians. The qualified custodian acts as an agent or trustee for its clients and must be able to provide account information to its clients. This matters because institutional investors hold other people's money, which is very different from retail investors who manage only their own money.

Qualified custodians

What's needed is proper custodianship, which means custodians that are independent of the exchanges. The custodian's role goes beyond regulatory compliance. The custodian makes money safe because it separates "exchanging the asset" from "holding the asset" and distributes responsibility across different parties.

If you didn't have a bank to store your savings, what would you do? Put bars on the windows? Install a safe in a secret wall? Bury it in the backyard? No. You entrust it to people who know how to keep it safe, who know how to make sure you have access to it and who have all the safeguards in place to protect the assets you are managing for others.

Is qualified custodianship for digital currencies mandated by the SEC?

No, but it should be — and probably will be in the future.

However, regardless of regulatory requirements or not, qualified custodianship is an absolute must if we are to operate in a trusted, sustainable market for digital currencies. Along with security, storage and regulatory compliance, qualified custodianship is a non-negotiable necessity for institutional investors to fulfill their fiduciary duty to protect clients' assets. The infrastructure for institutional investing in digital currencies may not be there yet but the demand is.

And that means now is the time for the market structure to catch up.

Mike Belshe is CEO of BitGo, Palo Alto, Calif. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.