The Fenbushi Research Report series aims to share the in-depth insights and insights of Fenbushi Capital on many tracks in the industry. The first phase of the distributed research report is the research and analysis of the digital asset custody track by investment director Huang Bingjie Chloe.
1. The definition of digital currency custody
Simply put, digital currency custody is a third-party service that provides safe storage and management of digital currency. Broadly speaking, any digital currency “custodial” service can be called a custody service, including wallets, institutional custody, etc. In order to improve comparability and pertinence, the digital currency custody service studied in this article refers to centralized institutional custody.
2. Industry status
1. The front wave clings to the high ground, the back wave sprints violently
At present, several of the industry’s most well-known BitGo (2013), Coinbase (2012), ItBit (2012, later renamed Paxos) and Xapo (2013, later acquired by Coinbase), etc., all started around 2012. After BTC was first reported by the Wall Street Journal and received public attention, after so many years of development, these institutions have accumulated advantages in terms of customer channels, capital volume, and brand names. Although they have not yet formed an absolute dominance, the superiority of the head cannot be ignored.
Inspired by these relatively successful custodians from 12 to 13 years, the blockchain industry repeatedly set new highs in 17 and 18, and a lot of hot money poured in. When the entire industry once again became a hot spot for people to chat after dinner, the latest wave of a large number of new players also entered the digital currency custody industry. During this period, in addition to start-ups, there are also strong new players with strong backgrounds, such as Fidelity and Bakkt.
These new players are coming fiercely and challenging existing players. Therefore, the current industry is still too early to stabilize, and the industry structure is still likely to be adjusted.
2. Business from single to complex
The early custody business was relatively simple, mainly storing users’ assets statically in a safe way. The disadvantages of this are:
1. Low capital utilization rate;
2. The industry has high homogeneity and low value acquisition capabilities;
3. Single charging model.
The direct result of these disadvantages is that the profits of the custody business are too thin. In addition, some custody agencies bear very heavy compliance costs, and even make ends meet.
In recent years, in order to achieve long-term sustainable development (especially the early head projects), more and more hosting projects have begun to use their own brand recognition, the amount of hosting funds and the number of users to develop new services. For example, BitGo takes advantage of its large number of customers and large amount of funds to provide its users with large OTC (Block Trade) and inter-institutional clearing services; Coinbase Custody takes advantage of its own exchange cross-selling and project relationships to actively Jointly develop staking services with the project; Paxos uses its advantages in compliance and bank relations to launch a compliant stable currency service; Bakkt uses its traditional background and the advantages of its relationship with traditional institutions to provide more than 30 traditional companies Blockchain user points management service.
In addition to the aforementioned business expansion, the industry is actively discussing more feasible businesses. Among them, asset management and lending business based on custody assets are the most eye-catching expansion business . The reason why these two businesses have attracted much attention is that if asset management and lending can be realized, custodian institutions will basically achieve the leap from custody to bank. In the past, countless projects claiming to be digital currency banks emerged in the digital currency market. From the current point of view, custodian institutions that can carry out lending and asset management business are very close to this goal. Although the benefits are huge, the main reason why custodians have not made a big push into lending and custody is supervision: to carry out asset management and lending business, it is inevitable to use user assets, which is beyond the scope of rights granted to custodians by users at the beginning, and may Exceeding the scope of business permitted by the custody license. However, the exploration of custodian institutions in asset management and lending has not stopped, and the trend of custodian banking is still worthy of attention.
In general, custodians are relying on their brand, customer sources and capital advantages to develop more high-value services. The entire custody ecosystem is becoming more complicated. Therefore, although custodians have low profitability and mainly serve institutional customers in the past, the digital currency ecology dominated by retail accounts is at the edge of relatively unconcerned; but because of its great business scalability, it is expected to gradually become a transaction A very important strategic highland in the ecology.
3. Obvious advantages in compliance
At present, several well-known custodians around the world, including BitGo, Coinbase, Paxos, Bakkt, Anchorage, etc., are all compliance agencies. In addition, from the perspective of custody business, the development of custody in the US market that emphasizes financial supervision is earlier than that in other regions. This market structure reflects the importance of compliance to the custody business.
In terms of compliance, custody and exchanges show completely different preferences: custody relies on compliance, while exchange compliance is mixed. This divergence of compliance preferences is not difficult to understand; on the one hand, the clients of custody are mainly institutions, and the main incremental expectations come from traditional institutions, which have rigid requirements for compliance; on the other hand, custody Important suppliers, such as insurance institutions, also have a certain preference for compliance.
Currently, digital currency custodians mainly comply with traditional trust licenses or Bitlicense in New York State, USA. In the future, countries may also have more licenses for digital currency custody business. For example, the German regulator Bafin is considering expanding the business scope of its bank licenses to digital currencies.
4. The beginning of vertical integration
In 2019, Coinbase completed the acquisition of Xapo’s custody business. This acquisition allows Coinbase to expand its trading business, such as attracting more traditional institutions like Greyscale that carefully configure cryptocurrencies.
In addition to Coinbase, Bakkt, Gemini and other exchanges have also expanded their business by adding custody services. Although Bakkt, Gemini, etc. do not implement “vertical integration” according to strict M&A terms, they all hope to create stronger overall value through the linkage of custody business and other businesses.
As mentioned above, due to the low value acquisition ability of a single custody business, the custody business has very strong scalability and synergy with other businesses, so it has a very high “integration value”.
3. Future Outlook
As mentioned above, no matter what the purpose is: to seize the opportunity of traditional institutions to enter the market, or to expand the existing business, etc., the custody business has a very important strategic position. Therefore, we will also foresee more and more players entering the hosting market.
However, although many blockchain entrepreneurs ridicule themselves that blockchain entrepreneurship is a “grass-rooted” entrepreneurship, the hosting track is a very “grass-to-father” track. It is not for the “grass-rooted” or “scratch” entrepreneurs. Unfriendly. This speculation is based on several characteristics of the hosting industry:
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1. High sales barriers. Since hosting mainly faces institutional users, institutional sales have the characteristics of high trust barriers and long sales cycles. This is a huge challenge for start-ups without strong resources and relatively low cash flow.
2. Rely on compliance. As mentioned above, compliance is likely to become a necessary condition for winning the “custodial war”, but the high cost of compliance may overwhelm entrepreneurs. In developed regions such as Europe and the United States, entrepreneurs seeking compliance have to bear high compliance costs in the early stages. Generally speaking, compliance costs include: preliminary legal preparations, time costs in the process of applying for compliance, reserves to be prepared after the application is completed, and subsequent additional operating costs to meet compliance requirements. Usually, entrepreneurs need to pay the first three parts of compliance costs before they can actually start a business, which brings great financing difficulties and challenges to entrepreneurs.
3. The profitability of the custody business itself is poor. If we only look at the hosting business alone, its ability to obtain value is very limited.
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Only by charging a certain percentage of the custodial amount of handling fees, in the current situation of limited industry scale and slow growth, it is even difficult to cover its high compliance and operating costs. The real value of the custody business lies in its collaboration with other businesses. For new and smaller grassroots start-up projects, it is difficult to achieve a competitive level of business collaboration.
Therefore, although the possibility of the success of a new “pure grassroots” managed entrepreneurial team cannot be completely ruled out, such projects often need to be outside the current major competitive dimensions (licenses, customer channels, user experience, etc.). New breakthrough.
There are currently three main types of hosting new entrants who have “background advantages”:
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1) The first category is to rely on strong capital and investor background to build high-rise buildings on the ground to realize the whole ecology from zero to one. Representatives of this type of project include organizations such as Bakkt;
2) The second category is to rely on other businesses related to existing digital currencies to achieve ecological expansion and collaboration through custody. Representatives of such projects include Coinbase Custody, Gemini Custody;
3) The third category is to rely on the existing legal currency custody and management business to enter the digital currency business by developing digital currency custody business. Representatives of such projects include Fidelity, Japanese banking giant Nomura, Dutch banking giant ING, South Korea’s largest bank KB Financial Group, etc., which want to carry out digital currency custody business online.
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It is expected that such projects will give play to their respective advantages, the Eight Immortals will cross the sea, and each will show its magical powers. In addition, because it is still uncertain about the entry method of certain projects (for example, it can be self-built or looking for white-label cooperation, etc.), the project and the project can compete or cooperate. At present, it is difficult to foresee the end result of this competition, but there are two not too bold conjectures: 1. The market will not develop into an oligopoly, but will achieve a balance of multi-party coexistence; 2. The market will show regionalization , That is, hosting companies with local advantages will appear in different regions.
