The Need for Regulating Crypto Custodians: Safeguarding Digital Assets and Building Trust

Cryptocurrency custodian regulation scene, Victorian-era steampunk style, warm low-light atmosphere, protective golden shield with multiple locks, secure vault in the background, diverse group of regulators meticulously drafting rules, optimistic and determined expressions, trust-building aura.

As the cryptocurrency industry evolves, the need for a regulatory framework specifically designed for custodians has become crucial. Very few jurisdictions mandate that digital assets be segregated from financial intermediaries through independent custodians, and addressing this issue has become essential.

Regulators in key jurisdictions must outline clear rules and guidelines on how crypto firms should operate. Historically, the exchange model for asset segregation has shown to be fundamentally flawed. Cryptocurrency exchanges often behave like banks, operating on a fractional reserve model without being regulated as banks. Many exchange platforms have ceased operations in recent years, leaving customers without deposit protection.

When an investor uses a crypto exchange to buy or trade cryptocurrencies, they entrust the exchange with holding those digital assets on their behalf. As such, they bear the risk of their assets being used for purposes they’re unaware of, as exemplified by the collapse of FTX. To mitigate this risk, an investor can use a custodian, a third-party service specializing in holding and safeguarding digital assets. This separation from the exchange helps protect customer assets from the reach of general creditors of a bankrupt firm.

However, simply having a regulatory framework is not enough. Regulators must build a “good” regulatory framework that provides clarity and protection for investors while setting clear expectations for service providers. Custodians focus on compliance, risk management, regulation, governance, security, and client servicing. These principles are tested across traditional finance and expected by clients.

Teams of risk management and security specialists analyze and assess both internal and external risks to help protect customer assets. Robust processes and contingency measures safeguard clients’ digital assets against external risks, natural disasters, power outages, and other force majeure incidents. Furthermore, insurance safety nets support these processes in the unlikely event of theft or loss.

Custodians are calling for regulators to mandate the use of independent, fully licensed custodians for safekeeping digital assets. Investors now need fit and proper due diligence to assess counterparty risk and manage perceived risk by using qualified custodians to segregate and protect their digital assets.

For governments to successfully regulate the crypto industry and effectively protect investors, their efforts must be directed toward establishing rules that enable custodians to operate transparently and legally. Focusing on punitive measures, excessive anti-money laundering, and know-your-customer user requirements or DeFi regulation will not yield the desired outcomes for the industry. By shifting the spotlight toward the proper regulation of custodians, governments can create a more secure and reliable ecosystem.

Source: Blockworks

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