Advantages and disadvantages of centralized custodians in the crypto asset market

1 Feb 2023

Let's talk about containers-not the kind of large shipping containers, in the financial sector, this "container" is a custody service that stores assets. Good escrow services can reliably "storage" securities and bonds on behalf of customers, and often provide other services, but they never affect the value of the asset. The cryptocurrency market is different. A good cryptocurrency custody service may have a significant impact on the market price of an asset and even its underlying value.

This difference is more important than it once seemed. In the traditional financial field, although the custody institution is a key element, it will not affect the market. In the cryptocurrency space, individual or collective strategies can determine the success or failure of an asset. However, this influence is not monitored and regulated, and it will eventually give birth to a whole new authority. An example of

Changes in index standards

Cryptocurrency asset management company Bitwise established one of the first Cryptocurrency Index Funds in 2017 (Bitwise 10 Private Index Fund) and disclosed in a recent letter to investors that it Updated the calculation method of the index.

In the past, as long as an asset can be hosted in a cold wallet (off-chain wallet that is not accessible to hackers), it is eligible to be included in the Bitwise 10 Large Cap Crypto Index. Assets held by regulated custodians must now be eligible for inclusion in the index.

This sounds reasonable: custody is a complex and important aspect of investment management, not to mention that crypto assets are inherently anonymous. Due to the unique security risks in the cryptocurrency space, it seems best practice and better protection to pass crypto assets to a regulated custodian. Everything seems reasonable.

Let's take a closer look now. Changes in the above rules have also led to changes in the composition of the index. Because Monero (XMR) is not held by any regulated custodian, the privacy coin will be replaced by the decentralized oracle machine chainlink (LINK).

No matter how reasonable the changes to the index standards may seem, institutional interest in crypto assets is still determined by the escrow policy.

Of course, due to regulatory uncertainties, it is understandable that custodians avoid privacy coins. In addition, compared to the more cumbersome self-hosting, organizations tend to choose professional hosting services, which is understandable.

However, the inclusion or exclusion of major index funds may have a significant impact on asset price expectations. In addition, the decisions of market infrastructure players also have a significant impact on the market.

Ups and Downs

More and more escrow agencies are providing token-related services. For example, they can obtain benefits by participating in a governance mechanism called staking. Among them, token holders will use their own tokens to support network operations in order to obtain compensation. Many customers are attracted by the additional revenue, but they do not want to be exposed to complex processes, even if this will reduce revenue.

These customers are usually institutional investors. They may limit their investment scope to "convenient" pledge options, which only consider tokens backed by escrow services.

This shows once again that custodians influence the choice of investors, which in turn affects the market value of assets.

Banks do not provide interest on all types of currency deposits. However, due to the liquidity of the foreign exchange market and the wide range of interest-bearing investments, the strategic choice of a bank will not have a substantial impact.

However, given that the cryptocurrency market is still in its infancy and (currently) relatively few regulated custody institutions, institutional investors have different options. Assets are susceptible to institutional investor choices.

Summed up

In the traditional markets, large depositories will not participate in asset selection, but leave it to investors to decide. Traditional custodians do not need to decide which assets to support based on technical considerations. In addition to infrastructure considerations, market theory essentially believes that a level playing field can achieve fair asset pricing.

In the cryptocurrency market, the playing field is unfair.

A new type of power structure emerges when market infrastructure players such as custodians have a significant impact on current and potential market values.

In the future, as the market competition intensifies, the impact of the decision of a single hosting agency on the market will be weakened. There has been a lot of discussion about industry consolidation recently, but industry consolidation may have the opposite effect.

This highlights a fundamental shift in the spirit of the cryptocurrency market. Crypto assets are designed to eliminate the need for centralized hosting. However, we now have a centralized escrow agency that will play an increasing role in promoting the development of the cryptocurrency field.

I have no apology for this. I mean, we need to be aware of it and pay close attention to it. The complicated system will develop organically, and it will be easy to wake up one day, realizing that it has evolved into a structure with risks higher than efficiency.

We have seen this before: the decentralization promise of the early Internet has evolved into a centralized infrastructure with undesirable side effects, and most of us have chosen to accept it for convenience.

We may still make the same mistake, but it is not our information that is put at risk this time. This time, we are talking about a market that can shape wealth and transfer money-currently a relatively small market, but this market is affecting the mainstream asset portfolio and may have implications for the wider financial sector Significant influence.

Whether it's convenience or increasing market specialization and regulation in the cryptocurrency industry, both are good things. However, there is a saying: "Be careful what you wish for."

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