Understand how custody impacts Bitcoin ETFs through account segregation, insurance nuances, and the practicalities of hot and cold storage
Custody in the context of Bitcoin Exchange-Traded Funds (ETFs) refers to the secure storage and protection of the fund's underlying Bitcoin assets. This post will explore the role of custody in Bitcoin ETFs, outlining its functions, importance, and the mechanisms employed to safeguard ETFs’ BTC.
A custodian's primary responsibility is to securely store and protect these assets, ensuring their safety from theft, loss, or other security breaches. For most of the Bitcoin spot ETFs, Custodians are one of two third-party entities who specializing in (among other things) digital asset security. These are Coinbase (for eight of the ETFs), and Gemini (for one - VanEck’s). They must adhere to certain regulatory standards and employ various security measures, such as cold storage and encryption protocols, to safeguard the assets.
To be eligible, Custodians must comply with various regulations, such as the New York Banking Law, and be a registered trust with the New York Department of Financial Services.
Despite these requirements, the ultimate responsibility for selecting a Custodian lies with the ETF’s Sponsor.
For example, this is how Ark describes its decision to choose Coinbase as its Custodian:
“After diligence investigation, the Sponsor [Ark] believes that the Bitcoin Custodian’s [Coinbase] policies, procedures, and controls for safekeeping, exclusively possessing, and controlling the Trust’s bitcoin holdings are consistent with industry best practices to protect against theft, loss, and unauthorized and accidental use of the private keys.” - Ark S1, p.7
Similarly, BlackRock makes it clear that:
“The Sponsor may, in its sole discretion, add or terminate bitcoin custodians. The Sponsor may, in its sole discretion, change the custodian for the Trust’s bitcoin holdings…” - BlackRock S1, p.136
Each Sponsor (i.e. BlackRock, Ark etc) has there own individual agreement with their Custodian. Therefore they might even be slight differences in the agreements that different parties have with Coinbase, despite all using them.
However, almost all Bitcoin ETF custody mechanisms work in the same way, with the same principles and procedures. Here are some of the main points:
In order to understand the actual movements of the underlying asset (BTC), you need to understand how this relates to the ETF itself (and its shares).
Depending on the demand for ETF Shares from Authorized Participants (APs) like JP Morgan, Sponsors will either create new shares, or redeem shares for cash.
When (for example) Ark creates new shares in this way, it then directs its Bitcoin Counterparty (in this case Coinbase) to buy BTC accordingly on its behalf.
The BTC is then transferred to the Custodian (again, in this case, this is also Coinbase). Conversely, BTC moves out from the Custodian and is sold when shares are redeemed.
For more detail on the mechanics of how the ETFs buy and sell Bitcoin, you can read our article here.
Most the Custody agreements make specific reference to ‘Hot’ and ‘Cold’ storage in some form. Cold storage being offline storage of Bitcoin private keys (which is more secure), and Hot storage being online storage of private keys (less secure, but faster access).
Bitwise describes this part of its custody arrangement with Coinbase as such:
“Bitcoin held under custodianship with theBitcoin Custodian will be kept in high-security, offline, multi-layer cold storage vaults. This means that the private keys, the cryptographic component that allows a user to access bitcoin, are stored offline on hardware that has never been connected to the internet. Storing the private key offline minimizes the risk of the bitcoin being stolen. The Sponsor expects that all of the Trust’s bitcoin will be held in cold storage of the Bitcoin Custodian on an ongoing basis.” - Bitwise S1 p.17
Ark and others using Custody use the same or similar language.
VanEck (who custodies with Gemini) describes their arrangement as:
“The Custody Agreement requires the Bitcoin Custodian to hold the Trust’s bitcoin in cold storage, unless required to facilitate withdrawals as a temporary measure.” - VanEck S1 p.20
Fidelity, which will hold custody of its own Bitcoin, outlines its intentions with Cold vs Hot storage as follows: ”A majority of the bitcoin held by the Custodian is held in offline (“cold”) storage, and the Custodian is solely responsible for managing the allocation of bitcoin in hot and cold storage and does not publicly disclose what percentage of bitcoin is held in cold storage.” - Fidelity S1, p.7
Account Segregation refers to keeping the ETFs’ Bitcoin accounts separate from any other Bitcoin accounts the Custodians may have. That is, not commingling ETF BTC.
All ETFs make reference to Segregation in one way or another. Here is the relevant part of Franklin Templeton’s S1, which is consistent with the other ETF sponsors who custody with Coinbase:
“The Bitcoin Custodian will keep custody of all of the Fund’s bitcoin in segregated accounts in the cold (i.e. non-networked) Vault Balance other than the Fund’s bitcoin, which is temporarily maintained in the Trading Balance with the Prime Broker as described below in “The Prime Broker”. Fund assets held in the Vault Balance are held in segregated wallets, and are not commingled with the Bitcoin Custodian’s or its affiliates’ assets, or the assets of the Bitcoin Custodian’s other customers.” - Franklin Templeton S1, p.136
Why do all the ETF Sponsors ensure that there is no commingling of BTC? It’s not like Bitcoin can get ‘lost’ when mixed up together. Rather, there are certain risks that come from commingling Bitcoin (or any money, really).
Specifically, ETFs want to mitigate the risk that the Custodians might have unknown liabilities, be or become insolvent, or otherwise lend out Bitcoin that is ‘owned’ by the ETFs to other customers as part of their exchange businesses.
Given everything that’s happened in the ‘crypto’ industry over the last couple of years (see: FTX and others), you can perhaps understand why.
These specific risks are addressed explicitly in several S1s, but Bitwise lays them out nicely:
Bitwise: “Neither the Trust, the Sponsor, nor any other entity is permitted to lend, pledge, hypothecate or rehypothecate any of the Trust’s bitcoin. The Bitcoin Custodian has also agreed in the Bitcoin Custody Agreement that it will not, directly or indirectly, lend, pledge, hypothecate or rehypothecate any of the Trust’s bitcoin, and that the Trust’s bitcoin assets are not treated as general assets of the Bitcoin Custodian but are instead considered custodial assets that remain the Trust’s property.” - Bitwise S1, p.69
Bitwise are also the first and (at the time of writing) only ETF Sponsor to publish the address of their BTC wallet, as ‘proof of reserves’.
Coinbase and Gemini have both secured some insurance coverage, for various risks such as employee collusion or fraud, physical loss including theft, damage of key material, security breach or hack, and fraudulent transfer. Coinbase is insured to $320m, and Gemini to $100m.
On the other hand Fidelity says this about insurance: ”Bitcoin is not subject to the protections or insurance provided by the Federal Deposit Insurance Corporation or the Securities Investor Protection Corporation. Any insurance coverage obtained by or for the Custodian is solely for the benefit of the Custodian and does not guarantee or insure the Trust in any way. There is no third-party insurance held on behalf of the bitcoin accounts.” - Fidelity S1, p.94
Finally, the custodians. Most are familiar with Coinbase and Gemini as major exchanges, but you can read reviews from Apollo users and learn more about each platform (as an exchange) in the links provided.
As mentioned, Coinbase is the Custodian for the majority of the Bitcoin spot ETFs (ARK, Bitwise, BlackRock, Franklin, Grayscale, Invesco, Valkyrie, and WisdomTree). As Ark mentions in their S1, Coinbase is the largest US-based exchange with the longer track record.
Gemini is an exchange platform that allows users to buy, sell, and store cryptocurrencies. Founded in 2014 by Cameron and Tyler Winklevoss, Gemini offers a secure and user-friendly interface for trading various digital assets, including Bitcoin. Gemini is currently the ETF Custodian only for VanEck.
Fidelity is one of the United States’ largest financial institutions, with a variety of investment products and asset management services. You can learn more about their Bitcoin spot etf, FBTC, here.