Building the Infrastructure for Institutional Digital Currency Investing - Chain of Thought Pt. 1
Mike Belshe
May 15th, 2018/8 minutes to read

Digital Currency Investing: Missing Pieces

Investing in digital currencies is rapidly moving into the mainstream, and as it does, the industry faces some significant growing pains.

For retail markets, the infrastructure for digital currency investing has evolved quickly, and the basic building blocks exist for aggressive early adopters who are ready to roll up their sleeves and take direct responsibility for assembling all the pieces of the infrastructure puzzle for their own investments.

What is not in place is the ability for individual investors to hire a manager to invest in digital currency on their behalf. Mutual funds, hedge funds, asset managers and wealth managers cannot fully participate today because the infrastructure required to deal with someone else’s money is not in place. Sure, the infrastructure to hold your own digital currency is there. But making it safe to hold other people’s money is still being built. And that’s where BitGo is leading.

The Market Structure Is Broken

As of this writing, the market structure for digital currency investing is broken — but that is completely understandable. The digital currency world arose out of nowhere, and the legacy infrastructure was simply not designed for it. Early participants to digital currency not only did not understand the legacy structure, but they weren’t allowed to participate anyway, so they created it themselves.

In every other asset class — from equities to bonds to derivatives and commodities — you see a much more evolved market structure of exchanges, brokers, clearing and settlement, and banks, with each playing their own role. The downside is that this structure has a number of middlemen, but they also create a system of checks and balances with the overall goal to provide safety in investing. It’s built to engender trust in the system.

And none of that exists for digital currency investing.

We Can Build a Better Mousetrap

While there are some benefits to the legacy financial world’s market structures, this article is not a recommendation that we copy them. We can do much better.

The change is what’s built into the heart of every digital currency and digital asset: the blockchain and cryptography.

What the blockchain provides is unprecedented transparency. Unlike every other asset class, digital assets are blessed with the ability to prove ownership and demonstrate transparency of holdings on a distributed, shareable ledger. No longer do individuals, investors, regulators, or money managers need to trust that their counterparties hold an asset — it can be proven.

Additionally, thanks to cryptography and advances such as multi-signature technology and smart contracts, individuals and investors can directly participate in every single transaction with a digital signature — even if that digital currency is managed by someone else. Imagine that, cryptographic proof that you approved of your money manager’s digital transaction.

Finally, some of the traditional roles, particularly clearing and settlement, can be radically improved with the use of smart contracts and digital escrow accounts. In addition to cost savings, these functions will dramatically speed up from days to near real-time.

The Missing Piece: Custodianship

Because the support infrastructure was not built at the time the first retail digital exchanges were built, all of them (Coinbase, Gemini, Kraken, etc) built a centralized order-book model. In this model, the exchange itself takes on all functions, from trade matching, to asset custody, to banking, and even clearing & settlement. The advantage of this model is that it is simple, and eliminates all market dependencies, which on the surface seems very efficient. But it also takes out all the checks and balances, and that’s what leads to failures.

Building the Infrastructure for Institutional Digital Currency Investing 1

The piece that is sorely missing is custodianship. Put simply, you don’t want the exchange to hold all the pieces. That goes against the decentralized philosophy behind all blockchain-based currencies. Besides, you always want to have checks and balances to make sure the asset is being held in a safe and manageable way.

Imagine if Mt. Gox had used a custodian. We could have known that the assets allegedly held were missing years before we did.

Imagine if CoinCheck had used a custodian. Instead of wondering how to build multi-sig cold storage while simultaneously signing up 100,000 retail users per day, the custodian could have unobtrusively and automatically balanced cold and hot storage on behalf of the exchange, all while digitally proving to CoinCheck’s users that the assets were safe.

Safe custodianship doesn’t just apply to digital currency — it applies to all asset classes. Bernie Madoff claimed to have assets he didn’t have, but there was no way to see that before it was too late.

Just like with every other asset class, digital currency needs custodianship. Custodians make institutional investing possible by providing a level of checks and balances to keep money safe. This requires a strong separation of duties between exchanging the asset and holding the asset. What’s more, for ETFs and hedge funds to work in digital, they are regulatorily required to separate these functions.

Lastly, hedge funds and asset managers, as opposed to exchanges, are not technical. They’ve never held assets of any kind. The only way they can participate in digital currency investing is if they have a custodian that’s institutional ready, continuity ready (that is, multiple people have access to assets), and can offer the required assurances they won’t lose the assets.

The Hidden Risks of DIY (do-it-yourself)

The infrastructure for institutional investing in digital currencies may not be there, but the demand is. So it may be tempting for some institutions to try to build out that infrastructure themselves. For institutions that have a deep technology bench, they might be able to get over some of the technology hurdles, but with all the different digital assets coming, this becomes a difficult, complex and costly challenge to tackle.

So for institutional investors considering a DIY approach to infrastructure, it’s critical to remember that you’re not just building out the support for just one coin, you have to build for all of them. And you have to be ready to build for the next wave of digital assets. And you have to do it in a secure way that’s compliant with local and global regulations. And beyond the technical challenges and compliance requirements, you have to do it in a way that builds trust in this new digital asset class.

It’s a huge task. It’s fraught with risk and complexity. It goes well beyond the core competencies of most institutional investors, hedge funds and wealth managers. Finally, the investment required to even attempt to build this infrastructure yourself ultimately provides no meaningful competitive advantage. That’s why so few are even attempting it.

It’s About Trust

Ultimately, the real problem to solve for here is trust. Unlike retail investing, where end users really can take ownership of their own assets trustlessly, institutional investors can’t. Institutional investors are required by their customers, their regulators, and the industry to provide a system of checks and balances that meets their fiduciary obligations.

That’s what BitGo is here to do. Our mission is to deliver trust in digital currency. And to do that, we need to give institutional investors the most secure, streamlined and trustworthy experience possible — one that integrates security, storage, compliance and custodianship.

In our next post, we’ll explore why this approach makes sense, go a little deeper into what this future digital currency investment infrastructure looks like, and where BitGo fits into the picture.

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May 24th, 2018
BitGo Building First Qualified Custodian Built Specifically for Digital Currencies
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