On January 10, 2024 the United States Securities and Exchange Commission (SEC) made history, approving eleven spot bitcoin ETF proposals from issuers including BlackRock, Fidelity and VanEck.
Fresh accessibility for both retail investors and institutional investors alike in the world’s largest economy is speeding up bitcoin’s advance into traditional financial markets.
What is a Spot Bitcoin ETF?
An exchange traded fund (ETF) is a security that tracks the underlying performance of a collection of assets or commodities. As such, a bitcoin ETF tracks the current bitcoin price.
Unlike previously available bitcoin futures ETFs, a spot bitcoin ETF directly owns bitcoin instead of relying on a derivative contract.
Spot bitcoin ETFs mark a turning point in the wider acceptance and integration of bitcoin into mainstream investment portfolios. These investment funds reduce barriers that traditionally deter institutions and non-tech savvy consumers from participating in crypto. For many, ETFs offer a better fit from a risk tolerance, investment, and regulatory expectation standpoint.
By facilitating the ease of entry and exit, spot bitcoin ETFs bridge traditional finance and the digital asset investment experience.
Custody for Bitcoin and Spot ETFs
The first gold ETF took over two years to reach $10 billion; BlackRock’s iShares Bitcoin Trust (IBIT) crossed this assets under management (AUM) threshold in a mere seven weeks. As inflows grow – and against the backdrop of prominent crypto exchange and lending platform collapses – asset custody questions surfaced again.
Main Street consumers, Wall Street investors, and market regulators want to know: who holds the coins and how secure are they? Additionally, how are traditional ETFs held in custody today, and why are digital assets not being custodied in the same way?
What is digital asset custody?
Digital assets refer to any form of value or direct ownership that exists in electronic form, represented and recorded on a blockchain or distributed ledger.
Assets may include cryptocurrencies like bitcoin or ethereum, as well as digital tokens and non-fungible tokens (NFTs).
A custodian is a regulated financial institution that holds customers’ securities and assets, providing protection against forms of loss or theft. In traditional finance, custody is primarily a record-keeping activity. However, digital asset custodians hold unique responsibilities to store and secure cryptocurrencies, while maintaining liquidity and accessibility.
Who custodies institutions’ bitcoins today?
Only a handful of qualified custodians exist in the United States, including Coinbase, BitGo, Fidelity, Anchorage Digital, and Gemini.
Currently, Coinbase serves as custodian for eight of the 11 recently launched Bitcoin spot ETFs. These include BlackRock’s IBIT, Ark Invest’s ARKB, Bitwise’s BITB, and Grayscale’s bitcoin trust GBTC, among others.
Traditional ETFs, on the other hand, are issued by asset managers such as Blackrock, and custody is managed by major custodian banks such as BNY Mellon, among others. Many of these same institutions are not currently able to provide scalable digital asset custody services for bitcoin ETFs due to limitations imposed by the Staff Accounting Bulletin (SAB) 121. This new rule issued by the SEC requires them to classify cryptocurrencies like Bitcoin as liabilities on their balance sheets - making it cost-intensive for traditional banks to offer crypto custody services.
That being said, banks are involved in other aspects of bitcoin ETFs, including as fund administrators for bitcoin ETF applications, among other roles and responsibilities.
Why is secure custody for spot ETFs important?
Digital assets featuring blockchain-based infrastructure like the bitcoin spot ETF require specialized storage solutions to maintain security, while also supporting liquidity and market activity for investors. In order to securely manage these types of digital assets, both the underlying asset as well as the ETF itself require custody. In this instance, that means both the spot ETF and the underlying bitcoins require secure custody.
Digital asset custody providers offer a blend of technological solutions, including cold storage (offline storage) and multi-signature wallets to protect assets from unauthorized access and cyber threats. Secure custody also involves asset segregation, ensuring investors’ bitcoins are not commingled with others’ investments.
Custody solutions for spot ETFs like the bitcoin trust must balance accessibility and security, especially as financial institutions target increasingly larger, commercial offerings. Offerings should include multi-vault custody setup and key management, multi-layered security architecture and encryption, cold storage solutions, hot/warm wallet usage, on- and off-chain accounting capabilities, and scalable compliance and governance policies.
Key Considerations for Spot ETF Custodians
Selecting a digital asset custody provider is crucial for ensuring the safety, security, and accessibility of bitcoin and other cryptocurrencies or tokenized assets.
For ETF issuers, several factors need considering:
Security measures
Secure infrastructure helps custodians detect and respond to potential security breaches in real-time. Key management, multi-signature wallets, cold storage, and encryption methods are among the security measures custodians employ to protect assets.
Qualified custodians also undergo regular security audits and comply with standards such as the ISO 27001 to demonstrate their commitment to asset safety. The key is striking a balance between adequately safeguarding assets and maintaining accessibility for investors.
Technological infrastructure
Effective bitcoin and digital asset custody relies on advanced technology to ensure functionality, scalability, accessibility, and resilience. Institutional solutions vary with respect to storage and key management techniques. Some include hardware security modules (HSMs) and multi-party computation models (MSPs), while applying specific cryptographic protocols. They also deploy various tools for interacting with blockchain protocols to support asset issuance, servicing, or transfer.
Each component of a solution – wallet type, key protection, and hosting – has strengths and weaknesses relative to speed and volume. In aggregate, these can affect the viability of an intended use case. Technology must be robust enough to handle high volumes, and flexible enough to adapt to the evolving digital asset landscape.
Regulatory compliance and governance
Custodians should follow the relevant laws and regulations, including Know Your Customer (KYC) and anti-money laundering (AML) rules. Beyond compliance adherence, capable custodians will build internal mechanisms for robust governance and policies around proper licensing and registration, detailed reporting and auditing procedures, and transaction verification processes. Further, strict access and authorization controls help foster an environment of trust.
Risk management
Sound governance and risk management practices ensure that both the custodian and its clients are aligned in their objectives and responsibilities. Standard practices include routine audits, governance frameworks that detail procedures and protocols, and contingency plans for risk scenarios not covered by insurance.
Risk managers will seek to counter cybersecurity risks, mitigate regulatory risk through ongoing monitoring, temper volatility-induced market risks, and identify operational risks (such as human errors or system failures) that may compromise business continuity. Custodians may also incorporate custom governance controls using specific roles and permissions to further reduce risks.
Beyond these, other factors to consider when assessing crypto custodians may include financial stability, insurance coverage and limits, transparent proof-of-reserves reporting, and industry tenure.
Conclusion
Spot bitcoin ETFs expand the investment territory for institutions and retail investors. With this, comes new unknowns. As inflows grow, digital asset custodians will play a central role in maintaining direct, regulated access to this asset class and other cryptocurrency ETFs.
For custody providers, tenets of security, compliance, advanced infrastructure, and comprehensive risk management make a difference – and will influence how the world interacts with bitcoin and other digital assets. And further adoption and inclusion of traditional finance in the digital asset economy is further evidenced by developments like BlackRock’s tokenized BUIDL Fund. Bitcoin ETF funds are undoubtedly bringing more interest to crypto and digital assets more broadly, and it's critical that banks understand how they can support and develop multiple business models using this new asset class. This is just the beginning.
Contact us today to learn more about institutional-grade digital asset custody.
