What’s been stopping institutions from allocating money to crypto-assets? Uncertainties. That might change soon. Last week a new bill was proposed in the state of Wyoming that may create the certainties institutions have been waiting for.
If this bill is passed into law, crypto-assets could have many legally-enforceable advantages over traditional assets like stocks, bonds, and even state-issued currencies such as the dollar.
As you continue to read on, keep in mind that “crypto-assets” include crypto versions of currencies, web technologies, and even securities themselves. That means the effects of this Wyoming law aren’t limited to the frontier of speculative bubble-prone assets. They also extend to the realm of tokenized securities that derive their value from the real world in the same way as stocks and bonds.
The 3 Roadblocks to Institutional Money Flows into Crypto-Assets
1 - Uncertainty Around Custody
Institutions are bound by the SEC “custody rule” to hold their assets at a “qualified custodian.” There are currently several qualified crypto custodians, but they are all relatively small and/or new compared to those with which large institutions are accustomed to doing business.
For example, Kingdom Trust is a qualified crypto custodian. It has $12 billion in assets under custody and has been registered as a trust company since 2010. In comparison, Northern Trust is a qualified custodian for traditional assets. It has $1.61 trillion in assets under custody and is on the list of oldest banks in continuous operation, since 1889. While Kingdom’s operations are impressive, some institutions are waiting for older and larger banks to get in the crypto-asset qualified custody game as a heuristic for trustworthiness.
2 - Uncertainty Around Forks & Airdrops
Crypto-assets have certain unique properties and functions beyond the traditional assets all are familiar with—namely forks and airdrops.
A fork occurs when a new version of a crypto-asset blockchain is created. A “hard fork” can result in one blockchain splitting into two blockchains independent of each other.
As an example, on October 25, 2016 a hard fork in the blockchain of Ethereum occurred which resulted in the original crypto-asset being known as Ethereum Classic (ETC) and the newly forked crypto-asset being known as Ether (ETH). Anyone holding Ethereum before the fork still owned ETC and additionally had the opportunity to claim an equal quantity of the new ETH for free.
An airdrop is a distribution of a crypto-asset, usually for free, to a large number of wallet addresses. Airdrops are primarily implemented as a way of gaining attention and new followers, resulting in a larger user-base and a wider disbursement of coins.
Airdrops and forks have two things in common: 1) The newly created crypto-asset that can be claimed could have significant value, and 2) While free, one usually needs to take actions to claim the crypto-asset that was sent to them.
The problem with forks and airdrops is that there are so many of them it leads to the question: Which forks and airdrops should I claim?
Currently, in the case of crypto-assets held at a custodian, that decision is ultimately the custodian’s. This leads to significant risks. For example, in the case of the 2016 Ethereum hard fork, the global market cap of the newly forked coin, ETH, hit an all-time high of $122 billion, while ETC’s reached only $4.5 billion. If an owner of the original Ethereum had its holdings at a custodian that chose not to claim the newly forked ETH, that decision would have created tremendous financial loss.
3 - Uncertainty Around Smart Contracts
Smart contracts are computer programs that can run themselves and control crypto-assets without requiring an intermediary to execute them.
The problem is that in the case of a legal dispute, it is unknown whether the judge will respect the smart contract or issue orders to the parties involved that go against the smart contract.
How Does Wyoming’s Proposed Law Solve These Problems?
1 - Certainty Around Custody
The proposed law strikes to the heart of the issue—trust and stability. Wyoming encourages crypto custodians to earn business not by being large and old, but by being better. Specifically, the law enables stronger property rights with Wyoming custodians by enabling direct ownership.
With traditional assets, custodians offer indirect ownership of assets—IOUs essentially. This leads to problems such as the Dole Foods court case where illegitimate stock share IOUs are issued beyond the supply of authorized stock shares. Alarmingly, indirect ownership—and its potential for illegitimate shares—is the standard model used with nearly all U.S. equities. The stocks you think you own are likely truly owned by Cede & Co, with layers of potentially insolvent intermediaries between you and your stock.
Wyoming’s new law would offer direct ownership of crypto-assets held at a custodian. This is superior to indirect ownership, which could result in a loss if the IOU cannot be exchanged for the full value of the underlying asset.
Additionally, Wyoming banks would have the option to opt into an enhanced regulatory regime for crypto-assets which meets SEC custody rule requirements. This is important because banks can do business in all 50 states, and the SEC has communicated a preference for qualified custody by banks which could lead to an earlier approval of crypto-asset ETFs.
2 - Certainty Around Forks & Airdrops
Under the new law, if you’re holding crypto-assets with a qualified custodian in Wyoming, all value belongs to you instead of the custodian. That means the value of forks and airdrops belongs to you unless you explicitly agreed otherwise in writing.
If this law had existed in 2016 during Ethereum’s hard fork and you owned Ethereum held at a WY custodian, the ownership of the newly forked ETH would clearly be yours. The same would hold true for any forked or airdropped crypto-asset.
3 - Certainty Around Smart Contracts
The new law would allow a smart contract to control a crypto-asset. This enables the peer-to-peer nature of crypto technology to be legally recognized which means that smart contracts can be legally binding. The promise of being able to reduce or remove multiple layers of intermediaries—and the risks of insolvency that comes with each intermediary—would be solidified by legal recognition of smart contracts.
How This Would Accelerate Mainstream Adoption of Crypto-Assets
New solutions won’t be adopted by becoming as good as the status quo. They must become better. If passed, this Wyoming law would give crypto-assets significant legally enforceable advantages over traditional assets.
While traditional securities are IOUs that might not be delivered on, crypto-assets in Wyoming use a bailment model in which you can retain ownership of an asset, even if it’s held at a custodian. This fully complies with the SEC’s custody rule without giving up direct ownership of the asset, making it possible for custody of crypto-assets to be more secure than that of traditional assets.
Less Fraud, More Stability and Trust
Rehypothecation occurs when an asset is pledged as collateral, then re-pledged as collateral for a new and different loan. Financial institutions that rehypothecate are technically insolvent which puts them at risk of a bank run.
This form of fraud is rampant in traditional assets because it is permitted in New York. In Wyoming, rehypothecation is a crime that leads to jail time. The new bill reiterates this common-sense position with respect to crypto-assets.
Many institutional due diligence policies and procedures are workarounds for problems in the infrastructure of the legacy financial system. The SEC custody rule inadvertently weakens property rights. Rehypothecation fraud causes systemic risk in the markets.
Wyoming already prohibits the fraud of rehypothecation, and this new bill stands to legalize direct ownership of crypto-assets for institutions and make smart contracts legally enforceable. If passed, this turns the cons of crypto-assets into pros virtually overnight. As for timing, the bill will be defeated or become law by the end of the legislative session in late February.