The Business of Bitcoin Cold Storage
Bitcoin is digital gold, and this continues to be its most appropriate and concise metaphor. I recently discussed some parallels between gold and bitcoin in an article about layered money and Lightning Network. In this writing I’d like to focus on the storage analogy. The capital market of gold relies upon protected, armored, and insured storage vaults around the world. Without a robust vault infrastructure, multi-generational savings held in physical gold would be impractical. Bitcoin, going forward, will be no different. Individuals keep gold secured in their homes, but countries and central banks build vaults. Individuals keep bitcoin private keys on laptops, hardware wallets, or pieces of paper in their homes, but countries and central banks will build vaults. Vaults storing bitcoin private keys have been around for years, but Fidelity recently set an asset management industry precedent that will redefine bitcoin’s custodial infrastructure landscape.
I have peppered this article with over a dozen articles, editorials, and media for anybody looking for a one-stop-shop of deep dive material for bitcoin’s investment case and financial system integration.
The Investment Case for Bitcoin
The investment thesis for bitcoin has reached an incredible level of clarity over the past couple years: bitcoin is officially money’s newest abstraction. Instead of reinventing the wheel, please refer to these particularly fantastic pieces by Vijay Boyapati and Iterative Capital outlining bitcoin’s investment case and an excellent piece by Pierre Rochard thoroughly covering bitcoin’s unique and decentralized governance. As we stand, the wealthiest university endowments are determined to allocate to bitcoin’s ecosystem, and Sovereign Wealth Funds will not be far behind. The legacy asset management industry has finally woken up to the truth: the business of bitcoin private key management has massive pent up demand, and the time to service that demand is now.
But I Just HODL
Many hodlers store their bitcoin themselves and never rely on trusted third parties for custody. These hodlers have financial sovereignty and are free of any counterparty risk. They also have a unique power: they can refuse to sell, limiting available supply at current prices. So why does any of this custodial infrastructure development matter to a hodler? Because the future clients of Fidelity are theoretically short bitcoin. Allow me to explain. I won’t predict a date, but one day major governments and corporations will need to pay for a good or service from a seller that only accepts bitcoin. These institutions will be forced to purchase bitcoin in the open market to make delivery of payment. Therefore, institutions are short a forward bitcoin obligation. The act of them purchasing bitcoin in the future may appear as just a purchase, but in theory it will be covering a short position they’ve had since bitcoin’s rise to global money status became evident. Therefore, hodlers have the power to exacerbate the mother of all short squeezes by not selling.
Private Key Management
How do you store your bitcoin? Is it on a Trezor, and is the Trezor in a safe deposit box at a bank? Where do you write down and keep your passphrase? Do you make your own paper wallets, on what computer did you generate them, and did you make sure the computer was never connected to the internet before and after key generation? Perhaps you employ the services of a company like Casa to help guide you through multi-signature cold storage while still maintaining both custody and full responsibility for your keys. Or perhaps you choose to keep your bitcoin on an exchange. Everybody knows by now that trusted third parties are security holes, and scammers are everywhere. Now, imagine you represent institutional money. You are the Chief Investment Officer for your alma mater’s endowment fund. How would this affect your decision on private key storage? Hopefully, you will be wary of your own ability to properly manage bitcoin private keys and equally wary of an exchange’s ability to do the same.
The Business of Private Key Management
I can comfortably answer many of these storage questions with two sweeping generalizations. Firstly, hodlers of bitcoin will never surrender their private keys and will continue to improve the science and practice of cold storage wallet infrastructure. Secondly, institutions buying real bitcoin (not bitcoin claims) will take delivery of their purchase into institutionalized cold storage solutions provided by well-established and insured asset managers and custodians. An endowment, central bank, or pension fund making its very first allocation to bitcoin will not self-custody due to lack of cold storage expertise. Unlike individuals with an ambition for financial sovereignty, these large institutions will trust third parties, diversify their risk, and buy insurance to protect their bitcoin. There is no company in the world currently better suited to provide this institutional solution than Fidelity.
Fidelity long ago started experimenting with the bitcoin software protocol by spinning up a full node and successfully mining bitcoin. With the release of a phenomenal whitepaper on institutional custody, Fidelity has not only positioned itself as a pioneer in the industry but also as an authority on the emerging bitcoin asset class. The literature released by the new Digital Assets subsidiary displayed an awe-inspiring grasp of the opportunities and challenges when building the custodial infrastructure for bitcoin. Fidelity’s position in the traditional asset management industry is one of modest dominance along with a handful of other firms. The warning shot sent to the rest of the industry with the release of this whitepaper and underlying physical vaulted custodial solution is one that will leave bitcoin’s financial system integration unrecognizable by today’s standards. I cannot stress enough the follow-on effects of Fidelity’s arrival. Bitcoin does not need Fidelity to become legitimate; rather Fidelity launched bitcoin custodial services because bitcoin has already achieved legitimacy.
I believe Northern Trust will be the next major industry player to announce a bitcoin physical vault infrastructure and custody solution for its clients sometime in 2019. Goldman Sachs, JP Morgan, State Street, and Bank of New York Mellon will follow, and within just a few years, the entire asset management industry will be involved in the bitcoin ecosystem to some extent. Robust custody infrastructure paves the way for the creation of more investment vehicles such as ETFs and Mutual Funds. Good actors in the industry will have the opportunity to disclose public keys to prove fully-reserved situations. ETFs are inevitable, and I hope to see the SEC specifically approve ETFs that will physically custody bitcoin such as the VanEck SolidX ETF. The SEC must approve bitcoin ETFs that will set lofty industry standards for investment structure, cold storage, cyber security, and insurance. Physically delivered bitcoin futures contracts offered by ICE, one of the world’s largest derivatives exchanges, will settle into ICE’s CFTC regulated Digital Asset Warehouse. ICE’s storage solution may serve as an interim custodian for investors that are actively trading in and out of positions. Not only are all the major industry players already arriving to the party, but also the premise that the US government will somehow ban bitcoin is becoming increasingly foolish.
Becoming a Major Asset Class
The price of bitcoin in the future will be a function of how much of the world’s wealth finds its way into the limited supply of 21 million bitcoin. With a total market capitalization today of just over $100 billion, bitcoin still appears only as a tiny grain of sand relative to the more than $100 trillion in financial assets held at the previously mentioned custodians. With new rails from the $100 trillion asset base to the nascent $100 billion bitcoin economy, bitcoin’s network effects, discussed eloquently by Trace Mayer, will strengthen drastically. As investors reallocate their current investment portfolios to include bitcoin, trillions of dollars in market capitalization appreciation becomes an inevitable result, a scenario beautifully laid out by both Tuur Demeester and Murad Mahmudov. Endowments and Sovereign Wealth Funds do not want to be late to this massive reallocation event, but neither will forward-thinking governments and central banks. Infrastructure for these investor types has arrived: let the digital land grab ensue.
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