Original title: How does Bitcoin ETF Custody of BTC work?
Author: Julian Fahrer , Apollo
Compiled by: ChainCatcher
Custody in an ETF refers to the secure storage and protection of the fund’s underlying Bitcoin assets. This article will explore the role of custody in a Bitcoin ETF, outlining its function, its importance, and the mechanisms used to protect the ETF’s BTC.
The Role of a Bitcoin ETF Custodian
The custodian's primary responsibility is to safely store and protect these assets from theft, loss, or other security breaches. For most Bitcoin spot ETFs, the custodian is one of two third-party entities that specialize in the security of digital assets (among other things). They are Coinbase (which is responsible for eight ETFs) and Gemini (which is responsible for one ETF from VanEck). They must comply with certain regulatory standards and employ various security measures (such as cold storage and encryption protocols) to protect the assets.
Custodian Qualifications
To qualify, the custodian 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 rests with the ETF’s sponsor.
For example, Ark described its decision to choose Coinbase as a custodian:
“After due diligence, Sponsor [Ark] believes that Bitcoin Custodian [Coinbase]’s policies, procedures and controls regarding custody, exclusive ownership and control of the Trust’s Bitcoin assets are consistent with industry best practices and protect against theft, loss, unauthorized and accidental use of private keys.” - Ark S1, p. 7
Likewise, BlackRock made it clear:
“The Sponsor may add or terminate Bitcoin custodians at its sole discretion. The Sponsor may change the custodian of the Trust’s Bitcoin assets at its sole discretion…” - BlackRock S1, p. 136
How Guardianship Works in Practice
Each sponsor (e.g. BlackRock, Ark, etc.) has its own agreement with the custodian. Therefore, each party’s agreement with Coinbase may be slightly different, even though they all use Coinbase’s agreement.
However, almost all Bitcoin ETF custody mechanisms operate in the same way, using the same principles and procedures. Here are some key points:
Bitcoin In and Out
In order to understand the actual movement of the underlying asset (BTC), one needs to understand how this relates to the ETF itself (and its shares).
Depending on the demand for ETF shares from authorized participants ( APs ) such as JPMorgan, the sponsor will either create new shares or redeem shares for cash.
For example, when Ark creates new shares in this way, it instructs its Bitcoin counterparty (in this case, Coinbase) to purchase BTC on its behalf.
The BTC is then transferred to a custodian (again, in this case, Coinbase). Conversely, the BTC is moved out of the custodian and sold when the shares are redeemed.
Hot and cold storage
Most custody agreements specifically mention “hot” and “cold” storage in some form. Cold storage is offline storage of your Bitcoin private keys (more secure), while hot storage is online storage of your private keys (less secure, but faster to access).
Bitwise described this part of its custody arrangement with Coinbase as follows:
“Bitcoins held by the Bitcoin Custodian will be stored in highly secure offline multi-layered cold storage. This means that private keys (the cryptographic components that allow users to access Bitcoin) are stored offline on hardware that is never connected to the internet. Storing private keys offline minimizes the risk of Bitcoin being stolen. The Sponsor expects that all of the Trust’s Bitcoin will be held in cold storage at the Bitcoin Custodian on an ongoing basis.” - Bitwise S1 p. 17
Ark and others using Custody use the same or similar language.
VanEck (who shares custody with Gemini) described their arrangement this way:
“The custody agreement requires the Bitcoin Custodian to hold the Trust’s Bitcoin in cold storage unless needed as a temporary measure to facilitate a withdrawal.” - VanEck S1 p.20
Fidelity will custody its own Bitcoin and outlines its intentions regarding cold storage vs. hot storage: “The majority of Bitcoin held by the Custodian is held in offline (“cold”) storage. The Custodian is solely responsible for managing the allocation of Bitcoin between hot and cold storage and will not publicly disclose the percentage of Bitcoin held in cold storage.” - Fidelity S1, p. 7
Account Isolation
Account segregation means keeping the ETF’s Bitcoin account separate from any other Bitcoin accounts the custodian may have. That is, no commingling of ETF BTC.
All ETFs mention segregation in some way. Here is the relevant portion of Franklin Templeton’s S1, which is consistent with other ETF sponsors hosted at Coinbase:
“The Bitcoin Custodian will maintain all of the Fund’s Bitcoin in segregated accounts in cold (i.e., non-connected) vault balances, with the exception of the Fund’s Bitcoin which is temporarily held in trading balances with its prime brokers, as described below under “Prime Brokers.” Fund assets held in vault balances are held in segregated wallets and are not commingled with the assets of the Bitcoin Custodian or its affiliates or with the assets of the Bitcoin Custodian’s other clients.” - Franklin Templeton S1, p. 136
Why do all ETF sponsors ensure that BTC is not mixed? It’s not that mixed Bitcoin is “lost.” On the contrary, mixing Bitcoin (or any currency) carries certain risks.
Specifically, the ETF wants to reduce the risk that the custodian might assume unknown liabilities, go bankrupt or become insolvent, or lend bitcoins “owned” by the ETF to other clients as part of its trading operations.
Considering everything that’s happened in the “crypto” industry over the past few years (see: FTX et al), you can probably understand why.
These specific risks are explicitly addressed in multiple S1s, but Bitwise lays them out nicely:
Bitwise: “Neither the Trust, the Sponsor, nor any other entity may loan, pledge, mortgage, or re-pledge any of the Trust’s Bitcoin. The Bitcoin Custodian also agrees in the Bitcoin Custody Agreement that it will not, directly or indirectly, loan, pledge, mortgage, or re-pledge any of the Trust’s Bitcoin, and that the Trust’s Bitcoin assets are not considered general assets of the Bitcoin Custodian but are instead considered custodial assets that remain part of the Trust’s estate.” - Bitwise S1, p. 69
Bitwise is also the first (at the time of writing) only ETF sponsor to publish its BTC wallet addresses as “proof of reserves.”
Announcement: Today, the Bitwise Bitcoin ETF (BITB) became the first U.S. Bitcoin ETF to disclose the addresses of its Bitcoin holdings.
Now anyone can verify BITB holdings and flows directly on the blockchain.
Insurance
Both Coinbase and Gemini have purchased a certain amount of insurance to cover various risks, such as employee collusion or fraud, physical loss (including theft), damage to critical materials, security breaches or hacks, and fraudulent transfers. Coinbase's coverage is $320 million, and Gemini's is $100 million.
Fidelity, on the other hand, has this to say about insurance: “Bitcoin is not protected or insured by the Federal Deposit Insurance Corporation or the Securities Investor Protection Corporation. Any insurance obtained by or for the custodian is solely for the benefit of the custodian and does not in any way guarantee or insure the trust. There is no third-party insurance held for Bitcoin accounts.” - Fidelity S1, p. 94
Custodian
Finally, custodians. Most people are familiar with Coinbase and Gemini as the main exchanges, but you can read reviews from Apollo users and learn more about each platform (as an exchange) in the links provided.
Coinbase
As mentioned above, Coinbase is the custodian of most Bitcoin spot ETFs (ARK, Bitwise, BlackRock, Franklin, Grayscale, Invesco, Valkyrie, and WisdomTree). As Ark mentioned in its S1, Coinbase is the largest exchange in the United States and has a longer track record.
my ship
Gemini is a trading 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 a variety of digital assets, including Bitcoin. Gemini is currently the sole ETF custodian for VanEck.
Fidelity
Fidelity is one of the largest financial institutions in the United States, with a wide range of investment products and asset management services.
