In today’s environment of high-profile hacks and cyber security breaches, it’s not a huge surprise to me that the majority of my fund manager clients who trade digital-assets have a distrust of institutions that claim that they can safeguard their assets. In addition, despite the exponential growth of managers trading digital-assets over the past few years, there is still a dearth of service providers willing and able to service the industry (custodians included) which means the prices that institutional custodians currently charge are not yet at levels that can be tolerated by emerging managers. Finally, there’s the question of frequency of trading; by placing their digital-assets with a third party, many managers feel that this will slow down their ability to react to market volatility and take advantage of arbitrage opportunities between different exchanges.
The combination of these factors (perceived security risks, high costs and a reduced speed of trading) means that the majority of my fund manager clients trading digital-assets prefer to safeguard their own assets through the use of cold storage e.g. by sharding their private keys, putting them on individual thumb drives and, sometimes, even placing them in different safety deposit boxes in various locations. The number one question I get asked by my clients at the beginning of any engagement is can they self-custody their assets and, if so, should they do this? With this mind, I thought it would be helpful to set out the regulatory requirements (from a BVI and Cayman law perspective) together with what we see as current market practice.
Firstly, is there a regulatory requirement to use a third-party custodian when you establish either a BVI or a Cayman fund that invests in digital assets? For Cayman, the answer is “no”. For BVI, the answer is a little more nuanced and depends on the precise type of fund structure used. BVI “incubator” and “approved” funds do not require a custodian, whereas BVI “private” and “professional” funds do. However, even where a custodian is required for a BVI “private” or “professional” fund, there is always the possibility of an exemption being granted by the BVI Financial Services Commission (FSC). Indeed, I met with the FSC a few months’ ago to discuss this very question and they made it clear to me that they are well aware of the commercial realities involved and have, in principle, no objection to granting exemptions on a case-by-case basis.
When it comes to current market practice, it’s clear that there is no “one size fits all” policy for custody of digital assets. Instead, each manager must develop their own policy based on their specific fact set and designed to address the risks of ownership. As things currently stand, self-custody is the norm, particularly amongst emerging managers. However, as the industry matures and best practices are developed, the position is likely to change.
Part two of this mini-series will be authored by Doug Schwenk, co-founder of Digital Asset Custody Company which provides institutional quality crypto asset custody to professional investors. Doug works closely with a number of high-profile investors in the crypto asset space and has been integral to the evolution of the crypto asset custody industry. We’re very much looking forward to hearing Doug’s thoughts on the current state of the crypto asset custody industry and how he thinks things will develop in the future.
The author of this post is no longer with Harneys. For more information on this topic, please reach out to the key contact listed below.