Spot bitcoin exchange traded funds (ETFs) finally hit the market in January after the Securities and Exchange Commission on Jan. 10 approved their launch. Bitcoin on Feb. 12 cleared $50,000 for the first time since December 2021 as the new ranks of institutional investors began staking out their claims on the market.
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But the new territory also brings fresh challenges. Regulators, including SEC Chair Gary Gensler, remain concerned about illicit activity in the industry. One of the regulatory keys to avoiding such activity is through secured custody.
Custody is a vague concept even to many stock traders, who rely on custodial banks to facilitate their trades and holdings. It is a tightly controlled segment of the market, led by names such as Bank of New York Mellon (BK), State Street (STT) and JPMorgan (JPM).
Bitcoin custodians, because they deal with a currency that is new, fast moving and effectively invisible, face rules and oversight that are, in ways, even more strict.
Keys To Bitcoin Custody
In traditional finance, custody is primarily a record-keeping activity, said Diogo Monica, president and co-founder of Anchorage Digital. Anchorage helps institutions buy, store and manage digital assets.
Custodial banks in traditional finance settle trades and manage regulatory reporting, dividends, and other shareholder services. Custodians keep and manage client assets, such as stocks, which is why stock traders rarely see any of the actual shares they purchase.
Cryptocurrency custodians fulfill a similar role, but with some key differences that makes the process more complex.
Because Bitcoin is an actual currency, more like cash than stocks or bonds, "security is a top priority in addition to the traditional focus on record-keeping," Anchorage Digital's Monica said. "Crypto custodians must also balance the safety and accessibility of funds, since many digital assets are designed to incentivize active participation."
Anatomy Of Crypto Custodian
Cryptocurrency custody is divided into two camps — custody from a technology perspective and qualified custodians, according to Kyle DaCruz, Director of Digital Assets Products at VanEck. VanEck launched its spot bitcoin ETF, the VanEck Bitcoin Trust (HODL) on Jan. 11. VanEck recorded more than $95.7 million in inflows since launch and has $193,4 million in assets under management as of Feb. 21, according to BitMEX Research.
Bitcoin is a digital asset, so there are technical requirements for firms wanting to act as custodians. There are plenty of tech companies out there with such capabilities, DaCruz said. The spot bitcoin ETF issuers, however, have partnered with qualified custodians. These require additional safeguards and greater oversight from regulators.
Some of the added standards for qualified custodians include insurance minimum reserves that exceed assets. They must segregate their various bitcoin holding accounts. And regulators must review the company's crypto wallet structure.
Crypto wallets are software programs, apps, or devices that store and secure cryptocurrency. Hot wallets refer to those connected to the internet. Cold wallets are disconnected from the internet, adding an extra layer of security against potential breaches.
The cryptocurrency custodial banks are "held to standards that technology providers would not be," DaCruz said.
Another difference: Traditional banks are in most cases able to use cash from depositor accounts to lend as mortgages and other sorts of interest-earning loans. With qualified custody of bitcoin that's not the case, DaCruz says.
"That original bitcoin you put in there is still in that cold wallet, and it's not mixed up with everyone's money," he said.
Retail Custody vs. Qualified Custodians
There are only a handful of cryptocurrency qualified custodians in the U.S. Those include Coinbase (COIN), BitGo, Fidelity, Anchorage Digital and Gemini. The New York Department of Financial Services is the leading regulator, DaCruz said.
Custodians typically charge an assets under custody (AUC) fee, similar to the traditional finance world. The AUC charges are usually some basis point charges on the assets that they're contracted to custody.
The qualified custodians also generally operate as digital asset exchanges. The exchange aspect of the business operates similarly to traditional banks for retail traders.
When investors send cryptocurrency to exchanges, the funds aggregate those assets in an omnibus account with everyone and often utilize hot wallets.
The hot wallets provide greater speed to transfer funds because they are connected to the internet. They are also always open to risk from potential hacking threats, DaCruz said. "But when you're using a qualified custodian, it has to go through these very different checkpoints."
Qualified custodians segregate the holdings to prevent commingling of funds, which contributed to the downfall of FTX in November 2022.
Security Nitty Gritty
The bitcoin ETF holdings are stored in hardware security modules (HSMs). The HSMs act as cold wallets distributed across the globe, DaCruz says.
"They've never been connected to the internet, meaning the hacking risk is effectively zero," DaCruz said. "The only way to get the bitcoin out of them is once the issuers like VanEck or others approve the transfer."
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Once an issuer approves a transaction, representatives from the custodian go to the devices, input the private keys into the HSM and sign the transaction. That permits the bitcoin to actually move.
"The benefit is it's much more secure, the downside is it's a little slower," DaCruz said.
There are also multiple redundancies to prevent fraud and accidental transfers. VanEck and Gemini approve only certain people to initiate transfers, and only certain people to approve transfers. Those persons can't approve or sign their own transfers.
Transfer Process
Bitcoin ETF issuers will typically only transfer funds during times of trading, when they need to either buy or sell bitcoin based on the creation redemption activity of the fund, DaCruz said, although he could only speak on VanEck's process specifically. Creation redemption activity refers to expanding or contracting the number of ETF shares to balance demand and keep the market price closely aligned with their underlying net asset value.
"Otherwise we're leaving all the assets in cold wallets 100% of the time," DaCruz said.
There's also the complexity of putting addresses in a wallet. These essentially act as routing numbers for crypto accounts, but often contain much longer, more complex strings of digits. One mistyped code could result in funds transferring to the wrong address.
To overcome the obstacle, issuers have white-listed, or preapproved, a rolodex of their cold wallet addresses so they don't have to be retyped.
"And to add or remove is a whole other process," DaCruz said. "It's pretty strenuous to approve, deny, or remove (addresses). So again, it protects from fraudulent actors, whether that's on the issuer side or the (exchange) side, trying to add in a new wallet address and send it to themselves or an associated party."
Coinbase Takes Center Stage
Issuers are very selective of their custodians due to of the complexity of the process and security requirements.
"It's a pretty significant undertaking because of the risks of the asset class," DaCruz said. "It's a bearer asset. So once it's sent to a wallet address, there's no recouping that. It's not like a bank sending the wrong money to a wrong account, they can grab that back. You can't unwind crypto transfers."
Coinbase is serving as the custodian for eight of the new bitcoin ETF entrants, including BlackRock's (BLK) iShares Bitcoin Trust (IBIT), the ARK 21Shares Bitcoin ETF (ARKB), Bitwise Bitcoin ETF (BITB), as well as Grayscale (GBTC), which converted its bitcoin trust to a spot bitcoin ETF. Valkyrie added BitGo as a secondary custodian, in addition to Coinbase. Hashdex selected BitGo for its ETF while Fidelity opted for self-custody of its Wise Origin Bitcoin Fund (FBTC). VanEck chose Gemini as its custodian and named Coinbase as their backup custodian in its prospectus, DaCruz said.
Gemini was among the first qualified custodians to handle bitcoin ETFs in North America. It had operated as the custodian for Canadian ETFs for the past several years, according to DaCruz. VanEck believes that Gemini built their platform to cater to bitcoin ETF products, offering plenty of synergy between the two, he said.
Multiple Custodians?
However, even with such extensive security measures, concentration into one custodian invites risk from bad actors, David Schwed, chief operating officer of Halborn and former global head of digital assets at BNY Mellon, argued in an opinion piece for CoinDesk.
"It's not Coinbase itself that worries me here. The firm has never been hit by a known hack, which explains why so many traditional institutions trust its know-how," Schwed wrote. "However, there is no such thing as an unhackable target — anything and anyone can be compromised, given enough time and resources."
The "extreme asset concentration" into a single custodian and the "cash-like nature of crypto assets" may be reasons for concern, Schwed wrote. He believes that qualified digital asset custodians should be subject to more oversight from regulators and more rigorous state and federal standards.
"The custody question is top-of-mind for ETF issuers," Monica, at Anchorage Digital, said. "Many ETF issuers are actively exploring the diversification of custody providers in order to mitigate against potential compliance, security, and operational risks."
Valkyrie chose dual custodianship. Meanwhile, VanEck opted for a different custodian than a majority of the new issuers, which the company feels helps diversify some of the risk of consolidation, according to DaCruz.
Still, too much diversification could create its own problems.
"It's sort of a sliding scale if you start diversifying the assets away," DaCruz said. "At some point, the risk actually goes up."
Essentially, too many custodians can actually multiply risk because there are additional points for something to go wrong.
Bitcoin Overtakes Silver
Coinbase stock dived 26% in January as bitcoin ETFs began to trade, then rebounded an equal amount in February. The price of bitcoin surged to its highest levels since late 2021.
"We've always said that ETFs would be a win-win for Coinbase and we're starting to see that play out on our platform," CEO Brian Armstrong said on the Feb. 15 earnings call, noting Coinbase custody accounted for 90% of the $36 billion in bitcoin ETF assets at the time. "We're earning revenue, not just on custody, but also on trading and financing. We've already seen great demand as bitcoin is now the second-largest ETF commodity in the U.S., surpassing silver."
A number of firms hoisted their price targets on shares after the report based on the performance and Q1 outlook. H.C. Wainwright on Feb. 16 raised its price target on Coinbase to $250 from $115 and maintained a buy rating on the stock.
The upcoming bitcoin halving event in April along with growing demand and incremental inflows from spot bitcoin ETFs will provide "significant positive catalysts" for the exchange going forward, the firm wrote.
JPMorgan on Feb. 15 ahead of results upgraded COIN stock to neutral from underweight. The launch of spot bitcoin ETFs translated into meaningful bitcoin price appreciation after initially being a "sell-the-news" event, the research note said.
JPMorgan expects cryptocurrency prices to improve Coinbase's activity levels and earnings power. But it remained cautious, maintaining its $80 price target on COIN stock — about 53% below where shares closed on Feb. 22.
Bitcoin ETF, Coinbase Performance
BlackRock iShares Bitcoin Trust has been the clear leader in fund inflows since the spot bitcoin ETFs launched Jan. 11 with roughly $5.62 billion in inflows as of end of day Feb. 21, according to BitMEX Research data. The Fidelity Wise Origin Bitcoin Fund ranks second at $3.78 billion in inflows. The ARK 21Shares Bitcoin ETF last week overtook Bitwise Bitcoin ETF in terms of inflows. ARKB has recorded $1.36 billion in total inflows as of Feb. 21 while BITB recorded $1.03 billion.
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Grayscale Bitcoin Trust (GBTC) recorded about $7.34 billion in outflows as of Feb. 21, which have steadily slowed. Still, Grayscale remains the leader in terms of assets, with $22.76 billion in assets under management, followed by iShares Bitcoin Trust at $6.36 billion.
Despite GBTC's outflows, the new ETFs have recorded $5.03 billion in inflows since launch, according to BitMEX Research.
Bitcoin Outlook
Bitcoin is trading around $51,600 as of Feb. 22 after peaking at $52,973 the morning of Feb. 20, its highest level since December 2021. Last week's gains put bitcoin's market capitalization back above the $1 trillion mark for the first time in more than two years. Bitcoin rallied about 23% so far in 2024, with a majority of the advance coming after the spot ETF launches.
"The biggest driver of bitcoin will come from mainstream adoption," said Joel Kruger, market strategist at LMAX Group. "Now that the bitcoin spot ETFs have been approved, more of an effort will be made from traditional institutions to promote bitcoin's value proposition. We also believe this sets the stage for the approval of an ether spot ETF later in the year, which should also drive additional interest that will benefit bitcoin."
But we still have yet to see the full force of institutional inflows, says DaCruz.
A majority of financial advisors don't have access to the ETFs yet because a lot of the platforms require due diligence and other parameters to be met, which can typically take months, DaCruz told IBD. "I think when that changes, then you're talking about the true unlock of that multitrillion dollar FA chattel," he said.
You can follow Harrison Miller for more stock news and updates on X/Twitter@IBD_Harrison
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