The Breakdown - Crypto Custody: The Frontlines of Operation Choke Point 2.0

Episode Date: July 23, 2023

A two-part Long Reads Sunday on crypto custody and the fallout of crypto's regulatory battles. Reading: Not All Crypto Custody Is Created Equal - Chen Fang Why Nasdaq Backing Out of Custody Is Bad, Bad News for Crypto - Daniel Kuhn Today's Episode Sponsored By: In Wolf's Clothing -- The first startup accelerator exclusively for Bitcoin and Lightning startups -- Applications for Cohort 3 open NOW -- https://wolfnyc.com/apply ** Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Sunday, July 23rd, and that means it's time for Long Read Sunday. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. All right, friends, welcome back to another Long Read Sunday. Today, we are talking about crypto custody. Now, there was a specific news item, NASDAQ, pulling its plans to custody

crypto that is the context for a lot of what we'll be talking about today. Many of the themes of this week have been this gradual transition and softening from where we were, maybe three months ago, to a very different vibe. But the NASDAQ story is a great reminder that regulatory insecurity can cast a very long shadow. So we're going to do a couple pieces and a thread in between and generally try to suss out what this all means. Now, before we get into that, I want to briefly shout out the sponsor of today's show. That, of course, is in Wolf's clothing.

Wolf is an eight-week accelerator program that helps companies that are focused on building on Bitcoin, Lightning. Yes, even Ordinals. The program happens in person in New York. It comes with a quarter million dollars of guaranteed seed funding, transportation and lodging are included. Companies get access to tons and tons of mentors. And right now, applications for their third cohort,

a program which will run between the end of October and the beginning of December, are officially open. Go to Wolf NYC to learn more and apply. Let's absolutely fill this program with breakers. Thanks again to Wolf for supporting the show. So, as I mentioned today, we are talking crypto custody, and we're going to start prod and general. The first piece is a coin desk op-ed called Not

all crypto custody is created equal, and it was written by Chen Fang. The piece begins, in the last year, the failure of crypto companies like FTX, Celsius, and BlockFi, as well as recent bank collapses, eroded belief in financial systems. A flight to safety has begun as investors of all sizes worldwide seek reliable and secure crypto storage. When investors approach custodians, their primary concerns are the safety of their funds and the ability to access them. Regulated custodians play a vital role in ensuring the security of assets. They offer service. such as segregated accounts, protection from financial instability, cold storage of keys, advanced security technology, and insurance against theft, loss, or misuse. Recently, several institutions

unveiled their plans for crypto, bringing new interest, capital, and participants. Notably, we saw BlackRock file for permission to create a Bitcoin ETF, which fired a bright signal flare to the rest of the financial world. As one of the world's largest financial entities, dipping their toe into the waters of Bitcoin is no small matter. It is the symbolic move that tells the rest of the market Bitcoin is here to stay. Institutions such as this will ultimately have a need for regulated custody to secure the assets for these new market instruments. However, it's not easy to gloss over what has happened in the past 18 months. What have crypto failures taught us? First, not all custody is the same. Just because someone is holding your assets doesn't mean they are a regulated

custodian. In traditional finance, custodians must meet specific regulatory standards to protect client assets. In the crypto space, custodial services range from software solutions to fully licensed and regulated cold storage solutions. The same controls that exist in other financial institutions are not yet global standards in crypto. Next, investors need the underlying systems to work together to protect their assets from misuse, theft, or fraud. Trading in custody should be done by separate entities. Traditional finance market infrastructure involves a carefully organized network of exchanges, broker dealers, clearinghouses, transfer agents, banks, and custodians. Each entity has a specific well-defined role and rules they must abide by.

Next, do you really know who your custodian is? Does your custodian have a long history of caretaking assets? What is their security model? Many sought to withdraw their assets in 2022 and were created by disappointment. If your custodian can't reconcile these points with your own personal risk analysis, you may need to look elsewhere. Over time, I believe the custodial practices will become much stronger out of necessity. No custodian wants to become the next news story about losing customer assets.

The lessons we've learned together as an industry over the last 18 months have only shown the need for strong safeguards to protect investor assets. The future is getting brighter for the custodial space, and we all must rise to meet the challenges. Digital assets continue to be the most novel asset class on the planet, and reliable infrastructure is crucial for the industry to grow. So where I want to pick up from here, back to NLW now, is this notion that BlackRock, specifically and other big financial institutions like them are going to need good custodians as they dig into the space. What one of the big exciting opportunities that they would have had in front of them was that NASDAQ had been planning to get in the crypto custody game. However, they have now

dropped those plans. The operator of the NASDAQ Stock Exchange had originally intended to roll out their custody product in the second quarter of this year. However, CEO Adana Friedman, said that those plans were being shelved during an earnings call this week. In September of last year, the firm said they were putting together the required infrastructure and regulatory approval. They said that they had applied to the New York Department of Financial Services for licensing to operate a limited-purpose trust company which would offer the custody service. On Wednesday, however, Friedman said that efforts to obtain this license were on hold, quote, considering the shifting business and regulatory environment in the U.S. NASDAQ will, quote, remain committed to

supporting the evolution of the digital asset ecosystem in a variety of ways, including partnering with BlackRock in an attempt to list to spot Bitcoin ETF. Notably, however, the BlackRock application lists Coinbase as their official custodian, which on the upside means that Nasdaq's decision to scuttle their product shouldn't affect the BlackRock ETF. Still, it's hard to read this announcement as anything but the direct result of continued regulatory uncertainty about institutional-grade crypto. Investor Adam Cochran said, so NASDAQ, an entity who is dealt with every type of regulation imaginable, does not feel it can confidently get the regulatory clarity to run a custody service in the U.S.? This tells you what a joke U.S. regulatory

clarity has been and the chilling effect it's causing. And that, I think, will bring us over to our second opinion piece today, why NASDAQ backing out of custody is bad, bad news for crypto. It's by Daniel Kuhn, and the subheader is if a financial giant can't navigate the red tape, who can? Daniel writes, yesterday Nasdaq, the prominent tech forward U.S. Stock Exchange announced it as calling off plans to launch a cryptocurrency custody service. The new business line, which would have been regulated as a special purpose trust in New York was slated to launch in the second quarter of this year. The news is a significant blow amid emerging signs of life in the crypto industry. Last month, an unexpected proposal from the world's largest asset manager BlackRock for a spot Bitcoin ETF rekindled optimism for an

asset class that was pummeled by regulators and bad news for at least the past 16 months. BlackRock signaled that despite the recent apparently coordinated crypto clampdown by U.S. authorities, there is still deep institutional interest in Bitcoin and crypto. A flurry of other spot Bitcoin ETF filings quickly followed, and the white-collar side of crypto scored a win after the U.S. SEC missed its window to deny a different but similarly exciting type of Bitcoin ETF to start trading. Markets sprang back. On top of all that, a major concession to ripple last week in a long simmering legal dispute with the SEC, masked the Silicon Valley blockchain pioneer's expensive technical defeat. After a district judge found over $700 million of ripple sales of XRP direct

to hedge funds constitute illicit securities offerings, also buoyed sentiment. XRP's short-seller were liquidated as a number of U.S. and international crypto exchanges announced plans to restart XRP trading, reversing a wave of de-listings from 2020. Now, Nasdaq's decision to exit the crypto custody business before it fully entered is likely not enough to derail the increasingly positive sentiment in crypto. But it is nonetheless a blow and one that portends that much of the industry might be on its way to nowhere if the current regulatory regime stays in place. In a quarterly earnings call, NASDAQ CEO Adina Friedman, said that the firm pulled out because of the shifting business and regulatory environment in the United States, a line that crypto has heard

often over the past year. The company initially announced its custody plans in September alongside the formation of a new unit NASDAQ digital assets, to which the firm remains committed. Friedman adds that the firm still plans to build and deliver crypto software, including other custody solutions, and list BlackRock spot Bitcoin ETF if that is approved. It's still unclear why exactly NASDAQ is backing out, whether there's proximate cause, or this is just an example of a corporation reading the tea leaves. The firm was reported in dialogue with the NYDFS for months, and it's unknown if its proposed limited-purpose trust company got the official green light. Notably, in February, the SEC voted to expand its

existing regulations over all trading and lending firms by requiring them to keep customer assets with qualified custodians, meaning chartered bank or trust companies, SEC-registered broker dealers, or CFTC derivatives merchants. Crypto speaks about the proposal as the custody rule. The rule, which needs approval to go in effect, implicates more asset classes than just crypto, but seems designed to curtail full-stack crypto companies like Coinbase that offer both trading and custody services. Coinbase is famously or infamously not registered with the SEC, aside from having its IPO approved by the same regulator, and it disapproves the proposed requirements to become qualified as a custodian. In traditional finance, legalized gambling on

securities is typically split into three distinct services. There are exchanges that handle trading, custodians to safe keep the assets being exchanged, and clearing houses that make sure trades settle, aside of the business that is handled automatically by the blockchain in the case of crypto assets. It's worth mentioning a number of financial incumbents like JPMorgan and the Small Business Association also came out hard against the SEC's sweeping changes, even though they might stand a benefit if crypto companies had to go outside the crypto industry to find approved custodians. You might think a firm like NASDAQ would be fit to navigate the red tape, which is why its decision to back out of crypto custody is so telling. If they cannot

do it? Who can? Although the SEC's stricter custody requirements are not yet in play, it seems increasingly likely that there will be regulation that separates custody services from trading. A number of bipartisan bills going through the U.S. Congress suggests the same. In some form or another, crypto custody is going to come under greater scrutiny, a situation that would likely impact any business that does not offer non-custodial crypto services. And good. Such changes would have prevented Sam Bankman-Fried from allegedly dipping into FTC's customer accounts had they been in effect, assuming for the hypothetical that the overseas exchange was subject to U.S. law. Such rules would likely, at least in near-term, benefit established financial companies in crypto-incumbent Bickgo, which dominates

crypto-custody most. But even that might be preferable to the current situation, considering how many crypto-native custody firms keep dropping the bag. But the fact that NASDAQ can't quite hack the laws or grok what's going down the pike does not bode well. Crypto custody is a cornerstone of the industry. Even if you can hold your own keys, there has to be a workable solution for everyone else. So this is what I mean when I said at the beginning of this show that lack of regulatory clarity casts a long shadow. Right now, it doesn't matter that things seem to be trending in the right direction, that judges are ruling in large part in favor of us and against the SEC, that real legislation is coming down the pipeline. Right now, all these big institutions see is chaos

and insecurity, and they don't want any part of it. Hopefully at this time next year, things will look much different, and we won't have these sort of stories of people pulling out anymore. For now, that's going to do it for today's Long Read Sunday. A big thanks again to Wolf for sponsoring the show. And if you are thinking about building a Bitcoin or Lightning startup, or you've already started, do yourself a favor. Go to Wolf NYC, check it out, and consider applying. Until next time, guys, be safe and take care of each other. Peace.