There are many outstanding or unanswered regulatory questions, after the recent guidelines provided by the Hong Kong Securities and Futures Commission. They require virtual asset fund managers to work with licensed custodians as they are tasked with controlling or managing assets both on-chain, and on digital currency exchanges.
Virtual asset fund managers need custodians to make purchasing and selling crypto assets as convenient as possible. Crypto custody solution providers are responsible for taking care of the underlying private keys associated with digital assets.
Alex Batlin, founder and CEO at Trustology, and co-founder and Board Member of Enterprise Ethereum Alliance, recently shared his views and insights with Crowdfund Insider.
Batlin, who’s also the former Blockchain Lead at BNY Mellon. brings his experience in banking to the crypto space. He has established Trustology in order to promote the mass adoption of digital assets, and believes that the secure management of private keys is a vital step towards making that future a reality.
Alex discussed how regulated cryptocurrency trading involves custody, and how custody relies on technology, to offer financial services such as the ability to purchase, hold and sell crypto assets. Proper custody solutions are built using advanced underlying infrastructure, Alex explained.
Crowdfund Insider: What do Hong Kong’s new regulations mean for virtual asset fund managers?
Alex Batlin: “In October 2019, Asia came out with rules that asset managers and funds have to abide by to basically protect investors. Despite there being a number of outstanding regulatory questions, the guidelines issued by the SFC essentially gives the nod to virtual asset fund managers needing to appoint a custodian as they are expected to control assets both on-chain, as well as on-exchange.
Very specifically, the Virtual Asset Guidelines issued by the Hong Kong Securities and Futures Commission states that Virtual Asset Managers require an independent custodian.
The necessity to introduce an independent custodian does raise additional issues for fund managers. In theory, segregated accounts can provide extra security. However, in order to comply with the rules, fund managers are often at the mercy of the exchange’s protocols. Most exchanges only allow you to have one username and password to manage an entire portfolio. One inadvisable workaround is through credential sharing. This, of course, raises significant security issues. Another is to create several accounts. Although, then you have to fund each account separately, which can present liquidity issues.
An exchange credentials wallet can provide advanced controls across API and TOTP secret keys to build trust with investors, evidence compliance, reduce operating risks and conveniently manage asset transfers across exchange and custody accounts.”
Crowdfund Insider: What is your take on the potential implications coming out of the guidelines?
Alex Batlin: “I think that since virtual assets are a regulated asset class, it’s essential to evidence two things: segregation of duties and audit. It will become much more important to be able to provide a full paper trail of what you’ve done – regardless of whether we’re talking on-exchange assets, DeFi assets on a decentralised exchange, or straightforward custody of a private key.
This will take a lot of work and it is where custodians can provide value to funds. It is now being acknowledged that you not only need to protect assets on the blockchain but also on exchanges.
Some funds will have 80%+ on-exchange rather than off-exchange. Segregated accounts will allow for clearer audit purposes and help make sure that in case of liquidation, it is clear whose funds are whose. It’s now required that you have adequate safeguards in place, ideally with an independent custodian.
These safeguards include: creating new accounts on trading platforms, whitelisting IP addresses on trading venues to make sure you talk to the right venues, whitelisting wallet addresses at the trading platforms. Walled gardens are a new safeguard that is starting to be introduced. This is where the fund manager can only move funds between approved exchanges and approved custodial wallet accounts.
As for the broader implications, if these rules become standardised around the world, it could further catalyse the widespread adoption of cryptocurrencies – especially from institutions. For the most part, institutional investors are the ones most in need of custodians due to their extensive portfolios.
Cryptocurrencies, in general, can present significant risks and complications, especially to more traditional financiers. These can be mitigated by custodians who can ease the entry of institutional capital by providing the same standards expected within the traditional financial system. In the U.S, the Security and Exchange Commission has already instilled this safeguard in place for institutional entities under the Dodd-Frank Act.”
Crowdfund Insider: Why do virtual asset fund managers need custodians?
Alex Batlin: “Virtual asset fund managers need custodians to make buying and selling digital assets as easy and painless as possible, and handling the underlying private keys is the cornerstone in facilitating this. So anyone looking to deal with Hong Kong exchanges can use a custodian to fulfil their regulatory compliance obligations.
It also comes down to the simple act of private key protection. If the keys are at risk, then so are your assets. Custodians provide that protection. Their sole purpose is to ensure the safekeeping of client’s assets and as such, they act as a fail-safe and are liable for any losses. This extends peace of mind, as well as added security for both the fund manager and the client. Existing crypto custody solutions are relatively lacklustre.
Hot storage – wallets connected via the internet – offer instant liquidity but have blatant attack vectors. Cold wallets allow greater security but hinder liquidity. Luckily there are other methods available. These include hot storage that leverages secure hardware security modules, and several levels of encryption to reduce risk while harnessing API integrations to lessen transaction delays caused by third party operators.”
Crowdfund Insider: What should custodians do to help?
Alex Batlin: “Now that there are additional requirements, I think new custodian services will have to be introduced to keep up with them. More advanced custodians can secure the fund’s exchange account credentials on behalf of the fund. So if you’re a crypto fund and have opened an account with an exchange, it’s highly likely that you’ll only be able to have one username and password to manage your whole organisation’s accounts.
From a security point of view, this isn’t very sophisticated. There may be times, for instance, when a number of people want to do something with the exchange but they have to share the username and password. There is the option of creating multiple accounts, but this requires funding each one separately, which is a liquidity nightmare. Custodians should ideally be able to secure the exchange account, keep the credentials and create API keys. They’ll hold an API key that is commissioned to withdraw assets.
The fund admin will hold an API key that has read-only access, and the fund manager will hold one that permits them to trade open and closed possessions. Essentially any time anyone wants to move assets off the exchange and feed it to another exchange or an off-exchange self-custody wallet address then they can do it through the custodian.”
Crowdfund Insider: How can regulators incentivize exchanges and virtual asset funds to apply for licenses and comply with the Hong Kong regulations?
Alex Batlin: “They should be incentivised by the fact that complying with regulations will drive business. People simply won’t place money with them unless they have enough trust. They seek regulation as a form of assurance, and people are a lot more comfortable to entrust a small amount of their funds with a regulated entity.
This also harks back to institutional involvement, i.e. the cryptocurrency industry’s holy grail. Boasting additional compliance will inevitably draw in accredited players. At the end of the day, it’s a matter of competition. Non-compliance will reflect poorly on those who choose to ignore the directives. The market will decide whether those entities can continue to exist.”
Crowdfund Insider: What should regulators be prepared to think about next?
Alex Batlin: “Similar guidelines should be expected to be dotted around the world, as the Hong Kong Monetary Authority and SFC closely follow what the FCA does and vice versa. In this sense, we can anticipate a global standard emerging. This, in turn, will produce a cohesive approach to crypto custody, allowing for greater confidence from investors, both retail and institutional.
Also, I think the question of decentralised exchanges will become an interesting one. If the whole movement of DeFi picks up, regulators will have to figure out how to deal with DeFi protocols. They will have to think about how to wall garden, audit and segregate duty on decentralised exchanges, as well as centralized exchanges.”