Welcome to MondayMunday, this is my personal blog on all things fintech and DeFi. Over the coming weeks I want to take a look at the culmination of where fintech and DeFi / crypto meet. This signifies one of my biggest thesis on how fintech and financial markets evolve. Blockchains provide common infrastructure to build the next generation of financial services that is available to anyone! Now is the time to uncover the opportunities… Whilst this is abstract for now, the coming blogs shall unpick the key parts. So let’s dive deeper!
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The first building block is I want to discuss is custody, custody solutions always get the limelight for large fundraising rounds (e.g. Fireblocks raise $550M and $6Bn valuation, Anchorage raise 350M at a $3Bn valuation) and are discussed as key for institutional adoption of crypto. It feels natural to suggest this, but I wanted to take a deep look at what this means for industry and fintech builders wanting to leverage crypto.
I (😅) neatly summarise this as the AWS for digital assets… This is because custody underpins how any institution or individual can interact with crypto market infrastructure without becoming their own bank. This gives them ability to use blockchain products such as dApps and DeFi protocols without having to build infrastructure and undertake regulatory in order to build crypto products. Builders rejoice!
Todays post is about understanding this stack and the strategic importance for the industry and fintech builders leveraging crypto.
What we will cover today…
A primer on custody solutions and what powers them
Why custody is the foundation fintech builders in crypto
The convergence of fintech builders needing custody
The strategic importance for custody
A view to the future of custody
A primer on the basics custody
Due to the nature of decentralisation, how users interact with assets on a blockchain equates to ‘being your own bank’, your assets are protected in your wallet and secured through complex cryptography on the blockchain showcasing they belong to a certain public-private key pair. For simplicity, we can define protecting and owning your asset by meaning having sole access to private key, as this is the only way to prove ownership and control of a wallet and sign transactions. Custody providers exist because most users and institutions want protect and security over assets and a way to use people to use crypto technology without building their own infrastructure to hold and store assets.
What do custody providers do?
Custody of assets abstracts away this notion of holding your private key pair, they create the environment where you no longer worry about safekeeping of your assets through technological and operational methods. Custodians are the equivalent of a bank safe vs. cash under your mattress for digital assets. Custodians aim to protect your keys in a trustless manner by utilising a variety of security technologies such as, hardware security modules (HSMs), multiparty computations (MPC) or multi signature transaction signing to verify your keys such that no-one knows the full private key when signing a transaction (perhaps this is a deep dive on this is for another post…).
The short of it is custodian technology abstract away the complexity of storing these assets private keys in a trustless manner
Not all custodians are built the same…
Whilst custodians get brandished under the same banner, providers differ in what they offer to users of their platform. Below we dive into different types and their use-cases.
Technology providers - Technology providers provide the infrastructure to custody digital assets. They allow builders to plug into their products to build secure custody solutions.
Use-case: Provide common infrastructure for builders to give their clients or build secure access to crypto assets.
Examples: The primary example for this is Fireblocks, whose technology is leveraged by regulated institutions and other custodians to build digital asset custody infrastructure.Direct custodian - These are custodians who hold you keys and manage you keys whilst giving you access to services such as their own trading, settlement, execution and regulatory services. There are two model used for this building your own infrastructure or partnering with technology providers to offer this service.
Use-case: abstract away complexities with holding and using by building regulatory, operational or product elements around custody technology.
Examples:Removing regulatory barriers - Anchorage Digital are case in point, they are a chartered US bank who provide the regulatory requirements to custody digital assets for clients
Abstracting away operational elements - Komainu are an example of this, they allow users to bring their own custody technology if required and manage the process of holding and controlling the operations of them for clients.
Abstracting away product elements - Prime Trust provide this by simplifying the way you access crypto accounts for your clients and their ability to interact with fiat through a Banking-as-a-Service APIs, and on-ramping through providing fiat / crypto liquidity.
These differing models are our first signal that their usage is key for builders wanting to create products. These differing models provide flexibility for how companies can build services to onboard users to DeFi / crypto without worrying about security of keys or building complex infrastructure.
Why is custody important for adoption of Crypto for fintech builders
Crypto markets are fundamental difference to traditional financial markets make custody a key problem to solve for fintech builders wanting to leverage DeFi and crypto.
Traditional assets traded on exchanges are not bearer instruments, when electronically traded and cleared, ownership can be resolved through a court of law to determine who the underlying asset belongs to. Crypto tokens are bearer instruments, whoever holds the keys to the wallet with associated tokens is the de-facto owner.
Secondly, crypto markets fundamentally differ in structure from traditional markets. Traditional markets are systems of record, marketplaces and products are all separate. In practise, this means you can build products utilising assets as long as they are recorded in a central repository in a compliant way. For example you can build a securities lending business as long as the settlement is done in a complaint way with a Central Security Depository (CSD) who handle the record for ownership and settlement of securities. Blockchains provide all three-in-one with inbuilt ledgers, network effects and workflow creation via smart contracts.
Given these first two factors, ownership and direct ability to hold assets on the blockchain are essential to own, transfer, record and interact with products built on this new infrastructure. For example, in a crypto market you need to OWN a token in order to trade it in a DeFi protocol (even if this token is a derivative of another asset).
Thirdly, direct custodians act as a regulatory barrier to speed up the process for fintechs to build crypto products. They can hold cryptocurrency in a compliant way and allow you to provide access to your customers. They act like ‘Crypto-as-a-Service’ providers, lending you their licences to hold crypto in a compliant way.
We can see this being played out in real time with a a rush to bring custody in-house through partnerships and acquisitions. We have seen exchanges such as Coinbase and Bitpanda acquire custodians; Infrastructure players like Prime Trust partner with custody tech providers to offer crypto and BaaS services and Fintechs and Banks partner (e.g. Revolut partnering with Fireblocks), buy (e.g. PayPal acquiring Curv) or build (e.g. Fidelity building Fidelity Digital asset) custody solutions to offer crypto services to their clients.
Broadening the crypto-custody definition?
Given the breadth of companies providing various flavours of custody, a unified definition of ‘safe keeping of digital assets’ no longer applies. Custody comes in flavours and choosing the correct based on the services you need to build your desired crypto project for users, this can include:
Building infrastructure to hold digital assets
Building end solutions to hold crypto on behalf of clients
Regulated access to crypto
End points to build crypto solutions
This is to say custody provides a building block for providers to offer you needed infrastructure services or for you to build the products you need directly. The mix-and-match approach that custody provides allows new crypto services to be built with ease.
For example, we can remix different custody providers and layers to build primitives for fintechs to build crypto solutions.
Custodian technology = Fireblocks = Qredo = etc…
Regulated crypto access = Anchorage = Ledger + Komainu
Crypto trading products = Fireblocks + Revolut = Coinbase
Crypto custody APIs = DFNS = Fireblocks + PrimeTrust
The formula can be simplified to...
New fintech x crypto product = Custody + Operational + Regulatory + Product elements.
As you can see custody no longer represents the securing of assets, but the gateway for builders to use crypto assets in DeFi and Fintech models without having users to hold assets directly. This turns custodians into the AWS-like infrastructure for digital asset workflows. The result of this is a base layer for fintech firms to build crypto products which reduces the number of steps to get to market.
Custody is key to building product which will allows the fintech builders to leverage these new rails in unique ways whilst still maintain interaction with the traditional financial system as custody takes away complex operational, product and regulatory risk which would have been a significant barrier to adopting crypto.
The strategic importance of custody?
Custodian technology providers are the the key block into allowing builders to create compelling value propositions for institutions and users by abstracting away security and access to assets and ability to use tokens on a blockchains.
Acquisition or partnership of custody required to succeed for fintech builders using crypto. We will see a rise in players building solution on top or partnered with custody providers to service specific niches to solve various operational problems, regulatory risks and product demands from certain clients. This will allow fintech builders to partner with solution providers
Here we can see how custody forms a foundational element for all fintech x crypto products. With custody providers building solutions directly or through partnerships with custody technology providers to solve key infrastructure and product pain points for customers.
A view to the future…
Custody providers will move ‘up the stack’, The nature of custody means it abstracts away a lot of the complexity of building digital asset solutions, therefore we will see custody providers start providing end solutions to clients such as access to protocols. We are already seeing this with Fireblocks, who have build tokenization engines, Web3 engines and staking services on-top of the foundation of being able to securely hold assets for clients.
Custody becomes a ubiquitous part of the fintech product stack as more player utilise DeFi and crypto rails. We will see a niching down of custodial services to target specific customer segments. To mirror our AWS example, we have seen large players dominate the space of cloud computing e.g. Google, Microsoft but specific niche products have arisen e.g. DigitalOcean which focuses on cloud computing for start-up. We may see the same in custody solutions.
We have our first custody winners with regards to technology to secure assets, but the next decade will shape who will build user friendly niches and empower builders to build the the crossover products which take advantage of DeFi to combine with traditional finance.
As a key building block for the future of building with crypto, I look for to seeing verticalised custody solutions and the fintech x crypto product custody will help create.
If you are fintech builder or investor feel free to reach me by replying to this email or DM on Twitter or LinkedIn, I’d love to chat! 🙏