How do Bitcoin ETFs safely custody BTC?

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 underlying Bitcoin assets of the fund. This article will explore the role of custody in Bitcoin ETFs, outlining its functions, importance, and the mechanisms used to protect the BTC of the ETF.

Role of Bitcoin ETF Custodians

The primary responsibility of custodians is to securely store and protect these assets, ensuring they are safeguarded against theft, loss, or other security vulnerabilities. For most Bitcoin spot ETFs, custodians are one of two third-party entities specializing in digital asset security (among other things). They are Coinbase (responsible for 8 ETFs) and Gemini (responsible for one ETF from VanEck). They must comply with certain regulatory standards and adopt various security measures (such as cold storage and encryption protocols) to protect the assets.

Custodian Qualifications

To qualify, custodians must adhere to 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 sponsors.

For example, Ark describes its decision to choose Coinbase as a custodian:

"After due diligence, the sponsor [Ark] believes that the Bitcoin custodian [Coinbase] has policies, procedures, and controls for the custody, exclusive ownership, and control of the trust's Bitcoin assets that align with industry best practices to prevent the theft, loss, unauthorized, and accidental use of private keys." - Ark S1, Page 7

Similarly, BlackRock explicitly states:

"The sponsor may independently decide to add or terminate Bitcoin custodians. The sponsor may independently decide to change the custodian of the trust's Bitcoin assets…" - BlackRock S1, Page 136

How Custody Practically Works

Each sponsor (e.g., BlackRock, Ark, etc.) has its own agreement with the custodian. Therefore, while all parties use Coinbase's agreement, the agreements each party has with Coinbase may differ slightly.

However, almost all Bitcoin ETF custody mechanisms operate in the same way, employing the same principles and procedures. Here are some key points:

In and Out of Bitcoin

To understand the actual movement of the underlying asset (BTC), it is essential to understand its relationship with the ETF itself (and its shares).

Based on the demand for ETF shares from authorized participants (APs) like JPMorgan, the sponsor will create new shares or redeem shares in exchange for cash.

For example, when Ark creates new shares in this manner, it instructs its Bitcoin trading counterpart (in this case, Coinbase) to purchase BTC on its behalf.

Then, the BTC is transferred to the custodian (again, in this case, the custodian is also Coinbase). Conversely, BTC is moved out of the custodian and sold when shares are redeemed.

Cold and Hot Storage

Most custody agreements specifically mention "hot" storage and "cold" storage in some form. Cold storage refers to the offline storage of Bitcoin private keys (more secure), while hot storage refers to the online storage of private keys (less secure but faster access).

Bitwise describes this aspect of its custody arrangement with Coinbase as follows:

"The Bitcoin held by the Bitcoin custodian will be stored in a highly secure offline multi-signature cold storage. This means that the private keys (which allow users to access the Bitcoin's cryptographic components) are stored offline on hardware that has never been connected to the internet. Offline storage of private keys minimizes the risk of Bitcoin theft. The sponsor expects that all Bitcoin of the trust will remain stored in the cold storage of the Bitcoin custodian." - Bitwise S1 Page 17

Ark and others using Custody use similar or identical language.

VanEck (co-custodian with Gemini) describes their arrangement as follows:

"The custody agreement requires the Bitcoin custodian to store the trust's Bitcoin in cold storage, unless needed as a temporary measure to facilitate withdrawals." - VanEck S1 p.20

Fidelity will hold its Bitcoin in custody and outlines its intentions regarding cold and hot storage: "Most of the Bitcoin held by the custodian is stored in offline ('cold') storage, and the custodian is fully responsible for managing the allocation of Bitcoin between hot and cold storage, and will not publicly disclose the percentage of Bitcoin in cold storage." - Fidelity S1, Page 7

Account Segregation

Account segregation refers to keeping the ETF's Bitcoin accounts separate from any other Bitcoin accounts the custodian may hold. In other words, not mixing ETF BTC.

All ETFs mention segregation in some form. Here is a relevant excerpt from Franklin Templeton S1, which is consistent with other ETF sponsors custodied at Coinbase:

"The Bitcoin custodian will hold all of the fund's Bitcoin in a separate account of cold (i.e., non-networked) vault balances, except for the fund's Bitcoin temporarily held in the trading balance with the primary broker, as described below in 'primary broker.' The assets held in the vault balance are stored in a separate wallet and will not be mixed with the assets of the Bitcoin custodian or its affiliates or the assets of other clients of the Bitcoin custodian." - Franklin Templeton S1, Page 136

Why do all ETF sponsors ensure that BTC is not mixed? It is not that the mixed Bitcoin would be "lost." Rather, mixing Bitcoin (or any currency) introduces certain risks.

Specifically, ETFs want to mitigate the risk of custodians potentially incurring unknown liabilities, bankruptcy, or loss of solvency, or lending the Bitcoin "owned" by the ETF to other clients as part of their trading business.

Given everything that has happened in the "crypto" industry over the past few years (see: FTX, etc.), you might understand the reasoning.

These specific risks are explicitly addressed in multiple S1s, but Bitwise articulates them well:

Bitwise: "The trust, sponsor, or any other entity may not lend, pledge, mortgage, or re-mortgage any Bitcoin of the trust. The Bitcoin custodian also agrees in the Bitcoin custody agreement that it will not directly or indirectly lend, pledge, mortgage, or re-mortgage any Bitcoin of the trust, and the trust's Bitcoin assets are not considered general assets of the Bitcoin custodian, but rather are treated as custodial assets still belonging to the trust." - Bitwise S1, Page 69

Bitwise is also the first (and, at the time of writing, the only) ETF sponsor to publish its BTC wallet address as "proof of reserves."

Announcement: Today, Bitwise Bitcoin ETF (BITB) became the first U.S. Bitcoin ETF to publicly disclose its Bitcoin address holdings.

Now anyone can directly verify BITB's holdings and liquidity 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 key materials, security breaches or hacks, and fraudulent transfers. Coinbase's coverage is $320 million, while Gemini's coverage is $100 million.

On the other hand, Fidelity states the following regarding insurance: "Bitcoin is not protected or insured by the Federal Deposit Insurance Corporation or the Securities Investor Protection Corporation. Any insurance obtained by the custodian or for the custodian's benefit is solely for the custodian's benefit and does not in any way guarantee or insure the trust. There is no third-party insurance for Bitcoin accounts held." - Fidelity S1, Page 94

Custodians

Finally, the custodians. Most people are familiar with Coinbase and Gemini as major exchanges, but you can read comments from Apollo users and learn more about each platform (as an exchange) in the provided links.

Coinbase

As mentioned above, Coinbase is the custodian for most Bitcoin spot ETFs (ARK, Bitwise, BlackRock, Franklin, Grayscale, Invesco, Valkyrie, and WisdomTree). As Ark mentions in its S1, Coinbase is the largest exchange in the U.S. with a long track record.

Gemini

Gemini is a trading platform that allows users to buy, sell, and store cryptocurrencies. Gemini was founded by Cameron and Tyler Winklevoss in 2014 and provides a secure and user-friendly interface for trading various digital assets, including Bitcoin. Gemini is currently the sole ETF custodian for VanEck.

Fidelity (Self-Custody)

Fidelity is one of the largest financial institutions in the U.S., offering a variety of investment products and asset management services.