The Inevitable Future of Digital Asset Custody and Hong Kong's Opportunities and Challenges

2023 is an excellent opportunity for Hong Kong to reclaim its position as a global digital asset leader and Web3.0 hub.

Written by: Lily Z. King, Cobo COO

To develop Hong Kong into a global Web3 hub, it is crucial to develop, support and strengthen Hong Kong's blockchain infrastructure. These include establishing a safe and secure blockchain network, developing a vibrant developer community, developing a favorable regulatory framework, providing safe and convenient asset custody solutions, and launching educational programs. Among them, digital asset custody plays a crucial role as the entrance for the upcoming institutional adoption of digital assets.

I. Asset Custody as Entry

Digital asset custody is critical in the safekeeping of clients' digital assets. It lays the foundation for the creation, management and exchange of digital assets, enabling services such as trading, banking services and prime brokerage. Custody solves two of the biggest concerns institutions face when it comes to safekeeping and adding value to digital assets: security and accessibility. By adopting new technologies and innovations such as private key management of multi-party computing (MPC), access to CeFi and DeFi hybrid solutions, exchange off-site custody and settlement services, and real-time transaction reserve monitoring, custodians continue to innovate and develop to satisfy investors and user needs.

Since the beginning of 2019, total assets under custody (AUC) have grown by a staggering 600% to over $200 billion. This has caught the attention of global investors, who have poured more than $4.5 billion into the field in 2021, up from just $850 million the previous year [1].

II. Trinity Model

To understand the evolving role of custody in the blockchain ecosystem, one can introduce the trinity model, where custody is at the center of the trinity of users, applications, and technology. In the past few years, these three factors have gradually become the main driving force for the development of the digital asset custody industry.

Holy Trinity of Digital Asset Custody

a. User Growth—Number and Diversity

Users with digital assets are currently estimated to exceed 420 million people [2]. As the number of users has increased, its composition has also undergone major changes. In the early days, it was mainly cyberpunks and geek programmers, but now there are DAO organizations, encryption funds, and more and more large companies and financial institutions. These institutional players have very different needs when it comes to accessing and interacting with blockchain applications compared to individual users.

b. Rapidly evolving blockchain technology

From Bitcoin in 2009 to the introduction of smart contracts on Ethereum in 2015, to layer-1 blockchains such as Avalanche and Cosmos, and emerging layer-2 blockchains such as Arbitrum and Optimism, the blockchain ecosystem continues to develop , new technologies emerge rapidly. Going forward, we will see more and more layer-1, application-specific chains, and even Rollups modular blockchains. This multi-chain, multi-layer environment will inevitably lead to the split of assets, users and applications.

c. Explosion of blockchain applications

Before 2020, mainstream blockchain applications are mainly cryptocurrency exchanges, wallets, and some payment services. Since then, smart contracts have fueled an explosion of new blockchain applications. In just one to three years, DeFi, NFTs, and DAOs have become massive multi-billion dollar industries. In addition, we also have application ecology such as GameFi and SocialFi. Now there are more than 4,000 on-chain applications (DApps) [3], and the concept of Web3.0 is undoubtedly becoming mainstream.

III. The inevitable future of digital asset custody

Given the rapid changes in users, applications and technology, custodians must go beyond simple safe functions. We have four key predictions for the inevitable future of digital asset custody.

a. Private key secure storage → full-stack solution

Blockchain applications are built on a four-layer stack consisting of blockchain, smart contract, protocol and application layers. The hosting party should understand how each layer works and integrate them seamlessly. They need to develop full-stack solutions that enable users to securely and efficiently connect to the underlying blockchain, access any smart contracts and protocols, and interact with various applications.

b. Fragmented user experience → unified user experience

It is clear that the future blockchain world will involve multiple chains and multiple layers. This means that users will have to access each blockchain and its applications through different entry/access points, resulting in poor user experience and inefficiency. Custodians must find a way to facilitate data and asset transfers while enabling interoperable and composable operations across currently siled blockchains. Most importantly, all of this must be enabled by a unified and simple user experience.

c. For Individual Users → Enterprise Programmability

As more and more professional teams enter the crypto space, the demand for customizable hosting solutions will continue to rise. Their participation in different protocols and applications will create more specialized needs.

d. Centralized infrastructure → distributed private key management

Centralized private key management has several advantages: first, it is easier to achieve compliance; moreover, it is considered a more institution-friendly solution because it is easily integrated with legacy systems and workflows. However, its fatal flaw is a single point of failure. This is evidenced by the many successful attacks against centralized custodians and exchanges throughout cryptocurrency history. Furthermore, without ongoing auditing, it lacks transparency. We believe that distributed private key management is the basis for more powerful blockchain applications, such as general-purpose private keyless wallets, social recovery wallets, on-chain trust, separation of duties, and even new types of blockchain applications that have never been considered before , there have been many attempts in this area, including but not limited to MPC-based escrow solutions, and hybrid private key management combining account abstraction and smart contract escrow.

IV. Hong Kong's Opportunities and Challenges

As an international financial center, Hong Kong has the potential to become a global digital asset center, but challenges and opportunities coexist. Hong Kong has a strong traditional financial industry and a deep capital market that can provide liquidity, expertise and infrastructure, providing a solid foundation for the development of digital assets. In addition, Hong Kong has a large number of investors and customers interested in digital assets, especially from the Asian market. Therefore, the development of digital assets in Hong Kong has been closely related to the financial industry since its establishment.

This environment allows Hong Kong to generate use cases connecting blockchain technology and the real economy with relative ease, giving Hong Kong a considerable advantage in pursuing the Web3 vision. For example, in February 2023, Hong Kong issued the world's first tokenized green bond issued by the government, issuing HK$800 million of tokenized green bonds under the Government Green Bond Program (GGBP) [4]. Custody is key to the institutional adoption of digital assets and ultimately the mainstream adoption of cryptocurrencies in the real world economy. For Hong Kong, it is imperative to stay at the forefront of the ever-evolving custody industry and keep pace with the times to maintain a competitive edge.

a. Regulatory Framework

Hong Kong has one of the most comprehensive financial market regulatory frameworks in the world. This framework can be used for digital asset regulation. The current Hong Kong regulatory approach to blockchain follows the same high standards as traditional finance. This is reflected in Hong Kong's cryptocurrency policy principle of "same business, same risk, same rules".

Hong Kong's regulatory framework is currently implemented through a top-down approach that favors established institutions. While this approach effectively facilitates collaboration between governments, financial institutions, large Web2 Internet companies, and blockchain-native enterprises, it also constrains opportunities for grassroots developers and entrepreneurs. To ensure that blockchain technology continues to thrive on bottom-up creativity and dynamism, a balance must be struck between top-down regulation and bottom-up innovation.

Traditional financial regulatory frameworks may not fully accommodate the unique changes in the blockchain industry. The digital asset ecosystem continues to evolve rapidly, and as such, regulators may need to work hard to keep pace with technological advancements and avoid over- or under-regulation that stifles growth or creates risks. Hong Kong can provide clear and consistent guidance and regulation for digital asset businesses, becoming a global leader and ensuring start-ups, institutions and investors have the confidence to operate safely within its jurisdiction.

b. Tech Ecology

For Hong Kong to build an innovation and entrepreneurship ecosystem, it needs to attract and support the technology of world-class infrastructure builders. The security, interoperability and evolution of digital assets can only be achieved with a strong and scalable infrastructure including cloud computing, blockchain, digital asset custody, cybersecurity and even artificial intelligence.

Hosting is a core component of this infrastructure. A strong custody industry can reduce the risks associated with digital asset ownership and boost investor confidence in digital assets, thereby driving mainstream adoption of digital assets. For Hong Kong, having a robust and trustworthy custody industry can be a competitive advantage in the global digital asset space. As digital asset custody is an emerging area of development, Hong Kong has a unique opportunity to shape and establish best practices and standards in the industry. This can be achieved by setting high standards for security and transparency and employing the latest technological solutions.

2023 is an excellent opportunity for Hong Kong to reclaim its position as a global digital asset leader and Web3.0 hub. Trust in the blockchain industry is currently at an all-time low and there is plenty of room for reshaping. Hong Kong can leverage its advantages in the traditional financial sector, embrace innovation and diverse talents, and develop a sound and reasonable regulatory framework to revive confidence and shape the industry narrative and development trajectory.

*Note: This article is excerpted from Deloitte's latest white paper "How Digital Asset Infrastructure Carries A City to Become a Web 3.0 Hub", authored by Cobo COO. *

References:

1. Blockdata, Crypto Custody: The gateway to institutional adoption, 27 January 2022

2. Triple-a, Cryptocurrency Ownership Data

3. 10 Clouds, Embarrassed by the Speed of Your DApp? Use DApp Scaling, Apr 7, 2022

4HKSAR Government's Inaugural Tokenized Green Bond Offering, February 16, 2023