Law Firms and Technology: Financial Services Issues: Custody

Law firms that specialize in investment management will benefit from a clear understanding on the technology powering digital assets like Bitcoin and Ether. Firms that cater to investment institutions will be asked by a client how traditional legal frameworks are likely to be applied to digital assets. An investment firm with good council gains an edge through insight on the specific exchanges that may qualify as custodians and keep regulators satisfied.

One of the touchstones of asset protection law is the concept of custody. Strict rules govern which types of entities can hold financial assets in trust for investors. One example is an exchange. To trade on most large exchanges requires the user to hand over an asset (crypto in this case). The exchange becomes the legal owner of the assets with a fiduciary to the exchange customer. This potential agency problem prompted most regulators around the world to follow the lead of the SEC and restrict which institutions may act as custodians for large institutional investors.

What does it mean to have custody of digital assets? For Bitcoin it means having the ability to interact with the Bitcoin protocol and sign transactions. This is where things become complicated compared with a tangible asset like gold. A custodian for gold and other metals can verify it is the sole custodian by presenting evidence of metal sitting in a vault within its possession. This analogy fails when applied to Bitcoin. It is expensive to verify that one individual or firm retains sole ability to sign transactions for a given Bitcoin address. There could be several unknown copies of the private keys for any one public address. This is only one potential pitfall for codifying any rules or regulations while new technology is developing.

I expect the issues surrounding custody over digital assets to unravel themselves throughout 2018 if more institutions open the floodgates on cryptoassets and the general population.