One of the challenges investors and advisors face when looking at digital asset investing is the custody of these assets. The recent spot bitcoin ETF approvals provide exposure to bitcoin with custody taken care of as part of the package. However, many investors already hold or are interested in owning the assets directly and understanding where to store and secure those assets is new and often a technical challenge.
The Nuanced Spectrum of Crypto Custody
The landscape of crypto custody is ever-evolving, where the control and access of digital assets is determined by the custody setup chosen by the investor, or the custody method of the investment vehicle. As a financial advisor, it is crucial to understand that there is no one-size-fits-all approach to crypto custody. Instead, the most suitable solution depends on your client’s specific needs, goals and risk appetite.
In the world of crypto, whoever holds the private keys to a digital asset controls it. This control can be maintained by the investor themselves (self-custody or non-custodial solutions) or by a third party (custodial solutions) on behalf of the investor. Custody methods also determine the level of discretion advisors have over these assets.
Custodial solutions have come a long way. Over the years, advisors and their clients have gained more access to more compliant options to gain exposure. Some of the earliest solutions included publicly-traded vehicles with less than efficient pricing mechanisms, as well as private funds and hedge funds, some of which stored their assets on unregulated exchanges and custodians. Over time, qualified custodians have become the norm for these vehicles.
In 2020, the market saw the introduction of Separately Managed Account (SMA) solutions. SMAs provide a compliant way for advisors to gain direct exposure and discretion over their digital asset portfolios. Cryptocurrencies managed on SMA platforms are held in custody by qualified custodians which often act as liquidity providers for trades and other transactions of those platforms.
Fast forward to 2024, and on Jan. 10, the approval of 11 spot bitcoin ETF applications by the SEC opened the door to a new and efficient indirect ownership option. Although ETFs are not the purest form of “holding” digital assets, they are certainly seeing demand and addressing a need of a segment of the market, as seen in the average $300 million in daily new inflows for the first five days of trading and over $1 billion in net new inflows. This makes the spot bitcoin ETFs one of the most popular ETF launches in history.
Advisors can pick and choose
Boomer Saraga, founder and CEO of Khelp Financial, employs a diversified strategy in managing crypto custody. His approach includes integrating ETFs into various investment vehicles like 401Ks, brokerage accounts and holdings for large corporations and institutions. Saraga articulates his strategy, noting, “For high net worth individuals that are foreign to crypto and digital solutions but want differentiated exposure, Separately Managed Accounts (SMAs) offer an ideal solution.” He further adds that “digital natives,” adept in blockchain and DApps, are more likely to find self-custody solutions a better fit for their investment style.
The top chart is an oversimplified view of the crypto custody landscape, let alone the various investment vehicles or wrappers available to advisors and investors. This chart does not indicate performance, effectiveness or efficiency of the actual exposure or investment vehicles. It is a simple way to showcase two important inherent features of digital assets: access and control. Let’s define them.
Level of access: it refers to how closely an investor can interact with or from a digital asset in its purest form (on-chain). The more off-chain layers or wrappers around an asset, the less level of access. For example, the spot bitcoin ETF is a traditional (offchain) financial product backed 1:1 by bitcoins stored in a qualified custodian. Being cash-redeemable only, investors can’t redeem their shares for actual bitcoin, but they must liquidate them for cash. On the other end of the spectrum, self-custody is the purest, most direct access to the on-chain asset, with instant settlement and with the ability to do things with that asset directly – be it transferring, swapping, staking, lending, or borrowing against it – without the need for proxies or additional settlement layers.
Level of control: it is a measure of how much power an investor has to make decisions about their assets without external limitations or the need for permissions from third parties. For example, the newly approved spot bitcoin ETF does not give investors the ability to control the underlying bitcoins in custody that their shares represent (or the need to worry about private key management, for that matter), nor does it allow them to redeem, or withdraw bitcoin. On the other end of the spectrum, self-custodied assets can be used, moved, or traded at any time by whoever holds the private key, with the increased responsibility that entails.
Implications of custody and discretion (or the lack thereof)
The wealth and asset management industries have largely been built around asset discretion. This is why digital asset advisory solutions have focused on developing custodial, discretionary products that mirror the traditional advisory and investment management landscape. This has led to a growing segment of self-custodied, self-directed clients who’ve delved into digital assets on their own, seeking a wider range of tokenized products, yield, and other on-chain products, ultimately growing a portfolio outside of the advisory relationship.
The growth in the total addressable market of self-custodied clients will lead to the emergence of non-discretionary asset advisory as a relevant category. This trend, popular among younger, self-directed investors, reflects the findings of Fidelity’s new study, showing that younger investors want their financial advisor to be their financial and personal coach. This shift in client expectations represents an opportunity for advisors who recommend and coach their clients rather than dictate and control their investment and financial decisions.
Other considerations and what this means for your practice
Tax considerations play a significant role in the selection of a custody solution. For example, the cash-redemption nature of the spot bitcoin ETF will trigger a taxable event on every sale of shares. In contrast, an investor who owns the underlying digital asset can move their assets anywhere without triggering a taxable event.
Advisors may choose a combination of vehicles and custody solutions to provide exposure to digital assets, considering different investment horizons, tax strategy, risk appetite and liquidity requirements. A mix of digital assets in tax-advantaged accounts or retirement accounts in the form of an ETF, alongside direct ownership through a custodial or self-custodied solution, can accommodate different financial goals and needs.
From a fees perspective, Ironclad Financial founder Nick Rygiel sees increased competition starting a race across the industry to lower fees, “either through negotiation or acquiring their own custody solution, much like Fidelity has their own,” said Rygiel, whose firm caters to technology-savvy clients.
As a financial advisor, understanding the nuances of crypto custody will be essential to provide the best possible service to existing clients, and to hone in on your target market’s needs and expectations.
– Miguel Kudry, CEO, L1 Advisors
Q. How does one maintain custody off-exchange and trade on exchange?
A: There are numerous solutions to be able to trade on exchanges without keeping all your collateral or tokens on exchange. An example of the first to market was Copper Clearloop with MPC technology and delegating assets to exchange to trade. Fireblocks and other providers are following suit. More recently, there have been tri-party agreements between banks (a regulated financial institution) and exchanges, notably between Binance and a Swiss bank. The assets are held off exchange in escrow with the bank and “virtual margin” is created to allow hedge funds and individuals to trade on exchange without keeping collateral on exchange.
Q. Is buying a BTC spot ETF safer than self-custody of your own BTC (or other tokens)?
A. I would not argue one is safer than the other, but they are different models of getting exposure. With crypto natives, almost all would prefer to hold the keys and have the tokens in their possession and control at all times. When holding your own tokens you can leverage them, lend against and generally have more freedom. A risk with this is managing/losing keys or passwords which could lead to loss of assets. The BTC spot ETF approval has opened up the gates for a whole new class of investor. The U.S. retail market, RIA money managers, 401Ks and pension funds can all now easily get exposure to BTC via an instrument they are familiar with. There is no additional technical prowess required and is the simplest way to get exposure to the asset class. This is likely good for volumes over the long term.
— Todd Bendell, Co-Founder Amphibian Capital
The recently approved spot bitcoin ETFs reached $10B trading volume on day 3.
Last week saw crypto outflows as the bankruptcy trustees in charge of FTX liquidated $1B of assets held in GBTC.
Morningstar asks advisors to consider if they are ready to handle the fees and price volatility of crypto if the spot bitcoin ETFs get included in client portfolios.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.