The digital asset custody model has performed very well … until now

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The original digital asset custody model has performed remarkably well over time and through the crypto winter …. But Prime Trust is a black eye

The cryptocurrency markets, in which the demand for digital asset custody first arose, have since November 2021 undergone substantial shrinkage.

The market capitalisation of the cryptocurrency market has declined from a peak of US$2.9 trillion in November 2021 to less than US$1.2 trillion in July 2023. This has greatly reduced the value of Assets under Custody (AuC) with the pioneering digital asset custodians.

The decline is well illustrated by the AuC recorded by the biggest of them, the Coinbase centralised cryptocurrency exchange (see Chart 1). 

Chart 1

Importantly, the series of failures which have accompanied and propelled the shrinkage in the value of the cryptocurrency markets, culminating in the collapse of the FTX cryptocurrency exchange in November 2022, have exposed the flaws in the existing model of digital asset custody. 

Most of the unregulated and opaque exchanges on which cryptocurrencies traded, and where investors custodies their assets, often failed to segregate customer assets adequately. In seeking to recover their assets from the failed FTX, investors found they ranked alongside ordinary creditors.

“Staking,” in which investors pledged cryptocurrency holdings to earn income from validating transactions on blockchain, turned out to expose holders to price volatility, liquidity and operational risks more commonly associated with venture capital investing.

Decentralised Autonomous Organisations (DAOs) turned out not to be owner democracies but oligarchic arrangements in which small groups of influential actors decided the direction of the code and the venture.

The unregulated, non-bank Stablecoins that fulfilled the role of payment device in the cryptocurrency markets turned out to be less than stable.

Even the USDC Stablecoin, whose management and transparency contrasted well with that of the larger Tether Stablecoin, would have failed if the United States government had not chosen to bail out the Silicon Valley Bank (SVB) where it held cash deposits. (1)

Throughout most of the unfolding crisis, independent digital asset custodians performed their primary duty well: customer assets were not lost.

However, this changed with the pattern of events that followed the news in June 2023 that the digital wallet provider BitGo would acquire the parent company of the Nevada-based retail trust company, Prime Trust.

When the acquisition was terminated two weeks later, it emerged that the Nevada Financial Institutions Division was placing Prime Trust into receivership and had ordered the firm to halt all deposits and withdrawals of assets in custody. (2) According to the court filing of the petition, Prime owed US$85,670,000 to its customers in fiat currency but possessed only US$2,904,000 – a gap of US$82,766,000 - and further that it owed customers US$69,509,000 in digital currency but possessed only $68,648,000. (3)

And Prime Trust was a regulated trust company, albeit based in Las Vegas. The irony is that Prime behaved as many mainstream banks have in the past – hiding a loss and trying to grow out of it. Though it had a crypto twist of inaccessible wallets as its origin.

Until this episode became public, no independent digital asset custodian had failed in its primary duty of protecting client assets. For example, despite wider troubles, Gemini, a trust company regulated by the New York Department of Financial Services (NYDFS) in the United States and the Financial Conduct Authority (FCA) in the United Kingdom, did not experience problems in its separate custody vehicle.

Nor did Genesis, which is also registered with the FCA and possesses a broker-dealer licence from the National Association of Securities Dealers Automated Quotations (NASDAQ).

However, it is significant that Genesis has agreed to outsource its institutional custody services to BitGo NY Trust Company LLC, a ten-year-old custody business which is licensed not only by the NYDFS but the Swiss Financial Market Supervisory Authority (FINMA) and the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) in Germany.

Behind such decisions lies an awareness of a worldwide push to regulate the cryptocurrency markets, most visibly in the United States.4 But its focus is mainly to protect retail investors. In the institutional markets for cryptocurrency investment, asset managers are choosing to protect themselves. They have intensified their search for solid digital asset custodians capable of reassuring their clients that their assets are safe.

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(1) See Stablecoins: Where They Came From, Where They Are Now, Where They Are Going Next, at https://futureoffinance.biz/

(2) See “Nevada Financial Institutions Division files court petition to place Prime Trust LLC in receivership”at https://business.nv.gov/News_Media/Press_Releases/2023/Financial_Institutions/Nevada_Financial_Institutions_Division_files_court_petition_to_place__Prime_Trust_LLC_in_receivership/

(3) See Petition For Appointment Of Receiver, Temporary Injunction, And Other Permanent Relief versus Prime Core Technologies, Inc., Prime Trust, LLC, Prime Ira, LLLC, Prime Digital, LLC, 26 June 2023, at https://www.docdroid.net/Q5WNMMS/prime-core-technologies-et-al-petition-pdf