Wall Street isn’t ready to manage crypto ETFs

2024 has been a year for the history books in the digital asset space. 

After a decade-long dance with the SEC, the US regulator approved the first batch of spot bitcoin ETFs in January, triggering billions of dollars in institutional inflows and setting the stage for the next bull run in the broader crypto markets. 

With institutional allocations expected to increase and a spot ether ETF recently approved, now’s the time to assess the preparedness of the digital asset and traditional financial industries. But current ETF issuers are not ready to grapple with multibillion-dollar inflows and the supreme complexities of managing a bearer asset tied to a cryptographic key. The underlying reasons are all related to one thing: security.

Large inflows call for stronger security solutions 

The flood of capital is surging at the gates, but large inflows require significantly stronger security solutions than those currently in place. 

ETF issuers and other institutions investing in digital assets must prepare accordingly. In the current ETF model, the majority of spot bitcoin ETF issuers rely on Coinbase for their custody solutions and most of the trading life cycle. Coinbase is the custodian for eight bitcoin ETF issuers in the US, including BlackRock’s (BLK) iShares Bitcoin Trust (IBIT), Bitwise Bitcoin ETF (BITB), the ARK 21Shares Bitcoin ETF (ARKB), and Grayscale (GBTC). While there are a couple other custodians in the mix, including BitGo, Gemini, and Fidelity’s self custody, this overreliance on one custodian raises concerns about centralization and counterparty risk.

Read more from our opinion section: Spot ETH ETFs without staking miss the mark

EY-Parthenon research suggests institutional allocations to digital assets and digital asset-related products are expected to increase, with this class of investors particularly focused on tokenizing real-world assets (RWAs). In a survey of over 250 institutions, 60% already allocate more than 1% of their portfolios to digital assets and overwhelmingly expect to increase their allocations in 2024 and 2025. 

Should this 1% allocation extend to global wealth managers across the board, an additional $1 trillion of inflows could soon enter the space. As Bitwise CIO Matt Hougan pointed out , “1% down, 99% to go.”

Large TradFi institutions must demonstrate to regulators that they are mitigating risk effectively. ETF issuers with rapidly increasing assets under management (AUM) would be wise to create a sturdier market structure that diversifies custody providers and introduces separate entities and technology providers to handle custody and trading. 

ETF issuers must prepare for a different asset class

Most people in crypto will remember the very first time that they interacted natively with cryptocurrency. And by natively, I don’t mean buying bitcoin on an exchange or in an ETF, but loading up a hardware or software wallet for the first time.

In almost all cases, you are quickly prompted with a series of words that you are told to write down and store in a particular way (you’re warned not to upload this list to the cloud or email it to yourself, for instance). But if you lose that passphrase and your hardware wallet or software wallet is ever lost, your crypto is gone forever.

With the great power of decentralized technology comes incredible responsibility.

ETF issuers, in many ways, have exactly the same problem. And while there may be some protection from litigation by the terms and conditions of an ETF, it is a responsibility they have to take very seriously. Others have written about the concentration risk that currently exists with ETF custody, which is a big part of the problem. Digging deeper, the real challenge is key security — Who holds the keys? Where are they held? Are they safe?

Unlike custody in TradFi, which largely involves record keeping for securities like stocks and bonds, digital assets are bearer assets — and asset security is a critical concern in an industry that witnessed more than $5 billion in hacks and scams between 2022 and 2023. Because blockchain transactions are irreversible, cyber-attacks leading to irreparable loss are significantly higher than traditional assets and require extended operational, technical and legal resources. Above all, cryptographic key management is critical.

Crypto ETF approvals are the tip of the iceberg

BTC and ETH ETFs will force Wall Street institutions to change how they treat the security of customer assets.

Looking ahead, we’re entering a world where crypto, stablecoins, fiat currencies, securities and other RWAs are tokenized to public blockchains — and the implications are massive. No longer will an asset be able to be “un-wound” with a phone call or email: Transactions will be final and immutable.

A landmark disruption in asset storage and the activity chain of transaction validation is coming, and it will mark a paradigm shift in how value is exchanged and stored worldwide. Increased financial security is paramount in this brave new world. And it starts with bitcoin and ether ETF approvals.

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