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Managing risk in digital asset custody partnerships

In January 2024, the US Securities and Exchange Commission (SEC) approved the listing and trading of several spot bitcoin exchange-traded funds (ETFs), which could signal a significant shift in the regulatory landscape for digital assets in the US, and potentially other geographies.

In January 2024, the US Securities and Exchange Commission (SEC) approved the listing and trading of several spot bitcoin exchange-traded funds (ETFs), which could signal a significant shift in the regulatory landscape for digital assets in the US, and potentially other geographies. Following the first two months of trading in the US, the UK Financial Conduct Authority softened its stance on digital assets, saying it would “not object” to the creation of bitcoin and Ethereum-backed exchange traded notes for professional investors.

Many believe this creates positive momentum and adds legitimacy to bitcoin, particularly given that the SEC rejected multiple ETF applications for nearly a decade on the grounds that they were susceptible to fraud and manipulation. The SEC approval statement, however, reminds investors to remain cautious.

What are bitcoin ETFs?

The new ETFs will make investing in bitcoin more accessible. Investors will be able to gain exposure to bitcoin without holding it directly. Instead, ETF investments are backed by bitcoin purchased by the fund; in most cases, the bitcoin is held by a third-party custodian on behalf of the fund. A spot bitcoin ETF invests directly in bitcoin rather than derivatives contracts that are based on the prices of bitcoin.

Four considerations for bitcoin ETFs

The respective roles of funds and custodians are worth exploring, particularly the risk and insurance-related considerations for each.

Consider insurance requirements and contractual risk transfer

As with other critical vendors, insurance requirements and contractual indemnities are key to the custodian due diligence process. While a variety of insurance solutions exist for digital asset custody, not all firms approach risk management or transfer uniformly, and not all insurance coverage is equal. Funds should understand the scope and type of the prospective custodian’s insurance, focusing on how it aligns with the custody architecture and technology rather than simply determining whether and how much insurance is in place.

Understand contingent risk

Even with robust technical controls and custodian insurance, some risks remain the responsibility of the fund sponsor. The fund may be responsible for certain aspects of securing digital assets, for example, through maintaining a key shard, multiparty computation node, signing devices, or determining allowable “whitelisted” addresses for withdrawals. Funds may seek to purchase coverage to protect them in the case of internal fraud, account take over, computer fraud, and other liabilities.

Generally, traditional forms of insurance can cover digital asset exposures, but policies may need to be tailored to address specific risks. Furthermore, some insurers are reluctant to cover digital asset risk, even on a contingent basis. This means that presentation of robust underwriting information can be critical to securing the insurance coverage desired. Engage with your broker or insurance advisor to align insurance policies with the specific risks that are prevalent and to determine potential limitations.

Determine the extent of uninsured or underinsured risk

Some risks remain uninsured or underinsured for various reasons, including limitations on insurance market appetite and capacity, and perceived aggregation risk. In addition to mapping risks to insurance, fund may wish to qualitatively and quantitatively examine select non-transferrable risks, enabling a broader enterprise view of risk tolerance and impact measurement.

Evaluate the benefits of multiple custodians

Less than a month after the new spot bitcoin ETFs started trading, it was reported that one provider added a second custodian in order to mitigate risk. Should others follow suit, financial and operational trade-offs can be evaluated by measuring how the magnitude and volatility of risk changes in different scenarios (for example, using one or more custodians and comparing different types of custody). This framework can be used for other strategic decisions and aligned to the fund’s growth over time to evaluate future risk, thereby connecting risk to strategy. 

Notably, this approach is not specific to ETF sponsors and may extend to any firm providing custody or partnering with a digital asset custodian, and this decision is not US specific. As highlighted the UK Financial Conduct Authority has already softened its stance on digital assets. Understanding risk through financial stress testing can help firms identify and quantify material risks in financial terms. Financial stress testing can also enable strategic decisions at the executive and board levels and help provide a measure of present and future risk scenarios, ultimately supporting growth opportunities for firms in the interconnected digital asset ecosystem.

As the regulatory landscape for digital assets continues to evolve, funds and other institutions partnering with digital asset custodians should carefully consider the potential risks and assess whether their existing insurance programs, risk management strategies, and approach to managing counterparty risk are designed to provide the desired protection.

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