To Self-Custody Or Not to Self-Custody — Storing Your Security Tokens | The ORO Letter #4
You bought a stock. Now do you know where it actually is?
You bought a stock. Now do you know where it actually is?
Probably not. Because when you buy securities from a stock exchange, you may own them, but you don’t get to hold them. Instead, it’s your broker that has the pleasure of holding your securities. Custodianship helps with clearing and settlement, but introduces certain counterparty risks — just ask Robinhood users.
It is also a relatively recent arrangement. Before the 1970s, most securities were held by their owners. Now, cryptocurrencies, security tokens, and most importantly non-custodial wallets are taking us back to that time, yet straight into the future.
Custodianship Is a New Concept
For around 400 years, the owners of securities actually held on to their shares themselves. Stocks were issued as paper certificates, which owners kept safe, traded, and could even borrow money against with a bank. The German term “Wertpapier” (“paper of value”), an umbrella term for stocks, bonds, ETFs, and other financial instruments, is a reminder of that time. Back in the day, stocks were often beautifully designed: Disney stock certificates, for example, had Disney characters on them.
But during the 1960s, trading volumes went crazy, and the NYSE could no longer handle all the paper certificates moving up and down Wall Street. As a result, The Depository Trust Company (DTC) was established, and paper certificates were moved to brokers who recorded ownership of securities among their customers using book entries (“Street Name Registrations”). Later on, direct registration with issuers or their transfer agents was introduced as well (DRS). Under both systems, security owners lost custodianship of their securities, and paper certificates gave way to electronic records (“dematerialization”). Today, less than 1 percent of the DTC’s total inventory of stocks are paper certificates. Three things that are crucial for such a transition: regulatory, technical, and psychological. Remember that the introduction of mainframe computers in the securities industry back in 1960 really paved the way for the digitization of the stock market.
An almost striking similarity with the way our money has moved away from banknotes… But that’s a topic for another newsletter.
The Counterparty Risks of Custodianship
Electronic securities are obviously a boon to clearing and settlement, making the system more efficient and less risky. But custodianship comes with counterparty risks. Brokers or transfer agents can run into trouble, potentially leaving their clients stranded. With privately held paper stock certificates, you were fine so long as you didn’t lose the certificate, and even then you could get a replacement.
On January 28th, 2021, at the peak of the GameStop trading saga, Robinhood and many other retail brokers imposed restrictions on GameStop trades. Even if you already owned GameStop shares (GME), you could not sell them. Robinhood had run into operational issues. Its usual 7 a.m. collateral obligation with the National Securities Clearing House had ballooned to $3 billion, ten times its normal amount. Robinhood ended up raising only $1.4 billion but was allowed to proceed because it also promised to restrict trading in GameStop. Other retail brokers were similarly affected. At the same time, many institutional brokers continued allowing their clients to trade — and we all know how that ended.
Brokers are also prime targets for ransomware and hacking. With so many users and assets in one place, attacks become extremely attractive. If your account is hacked, your securities and money could be gone forever. Frequent reports claim that thousands of logins for online brokers can be routinely bought on the Dark Web.
Let’s not forget that brokerages are businesses, and businesses can go, well, out of business. In that event, most clients are forced to turn to government-provided insurance or line up with other creditors in the liquidation process. In 2008, industry giant Bear Stearns collapsed and was bought by JPMorgan Chase, while Lehman Brothers declared bankruptcy. Fortunately, most customers of Lehman’s broker-dealer arm did not lose their securities as they were transferred to liquid brokers during the liquidation process. But many clients, particularly institutional clients, experienced delays in accessing their securities, which meant they couldn’t trade their securities at the very point in time the market was going crazy — a large opportunity cost.
If you hold your securities at a reputable European bank, you might think you’re safe from any bad surprises like that. Well, not quite — for one, you can’t be sure your securities are actually held by that institution. And if whoever holds your securities for you goes bankrupt, your compensation may be limited. In Germany, for example, the maximum amount you can recover is €20,000.
Security Tokens Fix This
But there is a solution, and that’s — you guessed it — security tokens! The advent of Bitcoin and security tokens has opened up opportunities we previously didn’t dare dream of: namely the benefits of electronic trading without the need for custodians.
As we’ve established in a previous issue of The ORO Letter, security tokens are essentially a uniquely identifiable set of code that is stored on a blockchain, a special type of database that records who owns each token or fraction of a token.
What that means in simple terms is this: you don’t need a broker to acquire and hold security tokens. Instead, ownership is recorded on the blockchain your tokens are issued on, and you have a lot more freedom when it comes to storing your funds.
Doesn’t That Mean You Can Easily Lose Your Security Tokens?
We’ve all heard the horror stories of early bitcoiners losing their private keys and missing out on millions or even billions of dollars in gains. Bitcoin’s decentralized nature is unforgiving in that the loss of your seed phrase means the loss of your coins.
Unlike Bitcoin, security tokens are not decentralized, but issued by a central authority. That means if you lose your wallet, the token issuer can always help you get your funds back. Phew!
That’s not to say you shouldn’t take care of your tokens at all. The process of recovering funds takes some time and effort; after all, the issuer has to make sure you’re the righteous owner of the funds. So as always, the freedom of holding your funds in your own wallet comes with great responsibility. Just like you’d (ideally) watch over your wallet of cash very carefully, you should watch over any non-custodial wallet you own.
Speaking of which...
Custodial or Non-Custodial: What Is the Best Way to Store Your Security Tokens?
While any bitcoiner — and likely many altcoiners, too — would disagree with us at this point, non-custodial isn’t always necessarily better — at least when it comes to security tokens. Luckily, you can choose between a number of options, and the one that’s best for you is usually best for your funds, too.
Security token wallets come in all shapes and forms and are available on desktop, mobile, or in hardware wallet form. You can even store your private key on a piece of paper. Securities have come full circle! From paper stock certificates to “paper wallets.” This is reminiscent of the transition we witnessed when the NASDAQ was presented as a high-tech trading alternative to the traditional paper-dependent, auction-based, specialist model associated with NYSE.
Custodial Wallets
We’re very used to custodial wallets. Our bank accounts are custodial wallets, as are our stock trading apps. If you hold funds on a centralized crypto exchange, they, too, are in a custodial wallet. And there’s nothing wrong with that if you’re looking to quickly move funds or take advantage of an exchange’s liquidity.
Notably, today’s security token exchanges often come with lower counterparty risks than traditional securities exchanges. This is because they’re available 24/7 and clearing and settlement are near-instant when security tokens are used, as opposed to cash. We wrote about this in more detail in our recent issue, “Can Coinbase replace NASDAQ?”
Yet if you want to reduce the number of intermediaries in your trading experience and minimize your counterparty risk, non-custodial is the way to go.
Non-Custodial Wallets
If your wallet provider doesn’t own your private keys, they can’t control your funds. In a worst case scenario such as the infamous GameStop saga, this can make the difference between you being able to trade or having to watch your stock value fall while your hands are tied. Even if centralized exchanges were to limit trading of a security token, as long as your funds are in your own wallet, you would always be able to trade them peer-to-peer with other traders. This is the crypto equivalent of exchanging paper stock certificates. It’s not exactly more convenient — you have to make do with lower liquidity and may have a harder time finding the other party for your trade. But alone the ability to move your funds to any exchange of your liking would have put you at a major advantage when Robinhood froze user funds, while other brokerage clients were unaffected.
Leading non-custodial wallet solution providers include Blockstream Green,MetaMask, and the Ledger Hardware Wallet.
Final Thoughts
There is no one right way to store your security tokens. As is often the case, more intermediaries may make your life more convenient, but not necessarily cheaper or more secure.
Bitcoin and security tokens have returned assets back to the hands of their owners. Brokers and transfer agents are no longer mandatory, so that the paper stock certificate has now truly been replaced by its true electronic heir: a private key in a non-custodial wallet.