Friday 12 Apr 2024
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This article first appeared in Wealth, The Edge Malaysia Weekly on February 27, 2023 - March 5, 2023

If there is a chart that matters the most to investors, it is the price chart — the higher, the better. But sometimes, they let their guard down when it comes to other equally important things, particularly when trading on cryptocurrency exchanges. Questions they should be asking themselves include: Are their assets and money safe with the service provider? Will they be able to withdraw their money when times are bad?

Investors learnt this the hard way last year when a slew of crypto-related hedge funds and start-ups collapsed, with the most notable being FTX Trading Ltd, the third-largest cryptocurrency exchange in the world as at November 2022. Its co-founder Sam Bankman-Fried had allegedly dipped into customer funds to prop up the business of its trading arm Alameda Research. The exchange collapsed when investors rushed to withdraw money amid falling crypto prices. 

The FTX saga has drawn local investors’ attention to custodian services. They are starting to ask questions like: Who is keeping our money and digital assets? Are they safe?

The local cryptocurrency industry continues to push on amid the negative sentiment. While many suffered losses from their crypto investments last year, the good news is that all three licensed digital asset exchanges (DAXs) in the country have assured investors that their assets and funds remain intact. In fact, several players are applying for a digital asset custodian licence with the Securities Commission Malaysia (SC). 

According to market sources, three new asset management firms could be launched this year, with at least one of them potentially looking to invest in digital assets. The soon-to-be launched initial exchange offering (IEO) service by licensed equity crowdfunding (ECF) platform pitchIN is another exciting event as start-ups and even public-listed companies will be able to raise funds by issuing digital tokens.

Keep your own crypto, beware of offshore entities 

Zhong Yang Chan, head of research at independent cryptocurrency ranking website CoinGecko, says investors have been too fixated on price movements in recent years and have forgotten simple but important questions such as how their money and digital assets are kept safe.

The mantra of the crypto community has always been: Not your key, not your crypto. Ideally, investors should keep their cryptocurrencies in their own digital wallet that comes with its own private key (or password). Delegating the task to a third-party custodian comes with higher risk as the industry is still nascent.

“Crypto investors should always keep in mind that putting their funds in third-party custody means having less control over their funds,” says Zhong. 

Kelvyn Chuah, founder and managing director of licensed DAX Sinegy, says many investors continue to seek exposure to cryptocurrencies through centralised exchanges as these allow them to easily trade and store their coins. But they should find out how the exchanges keep their funds and digital assets secure. They may also want to consider trading and investing in crypto through regulated exchanges that are scrutinised by local regulators, he advises.

For instance, the SC vets local DAXs before granting them a licence to commence operation. Investor protection measures, such as the appointment of a proper trustee and segregation of customer and company funds, must be in place. 

“The local regulator does not allow exchanges to commingle funds. Their funds do not sit in the same bank account. If the exchanges want to use customer funds to do something of their own, they can’t. The withdrawal right [of the customer funds] resides with the trustee,” says Chuah. 

The appointed trustee has the visibility to monitor transactions conducted by the exchange to ensure they are done properly and according to customers’ requests, he adds.

In the case of Sinegy, customer funds are kept in a separate bank account by Universal Trustee based in Kuala Lumpur. It is also the digital asset custodian of the exchange.

Chuah says the FTX saga reminds investors to rethink about trading cryptocurrencies with offshore entities, such as those registered in Malta, the British Virgin Islands, Bahamas and even Labuan. 

“It is unspoken of, but we all know it is easier to obtain a licence [to operate a crypto exchange] in offshore jurisdictions. Companies set up in these places are obviously avoiding stricter regulations elsewhere. As an investor, if you’re trading with them, you need to think about why they are registered there,” he adds.

The narrative surrounding the cryptocurrency industry has been rapidly changing recently, with regulations deemed necessary, as opposed to being a liability to investors, says Chuah. “Most people in the crypto community thought the SC was imposing too many rules and regulations on the DAX when it granted the first licence in 2019. But the regulator was right to be prudent.”

Chuah says Sinegy answered the SC’s queries recently and ensured its customers that their funds and digital assets were kept safe with the trustee. The exchange continues to be supported by family members and friends without accepting any money from external investors. 

“In terms of our finances such as cash flow, I would say we are doing okay. We have sufficient capital to continue our business. In fact, in 1Q this year, we will launch the third version of our website [interface]. We are looking forward to it,” he adds.

In an email reply to Wealth, Luno Malaysia Sdn Bhd — the first and largest DAX in the country — says the firm is “well capitalised and secure financially”. Its country manager Aaron Tang says the firm understands that investors are aware that its parent company has just slashed 35% of its global workforce. 

Its holding company, Digital Currency Group (DCG), is also facing a tough time as some of its renowned subsidiaries — such as the US-based crypto exchange, lending and custody firm Genesis, founded by the famed Winklevoss twins — filed for bankruptcy on Jan 20.

“Given all the sensitivity and misinformation with regard to the crypto market right now, it is important for us to reiterate that customers’ funds are safe and our operation continues as normal. Customers are able to deposit, withdraw, buy and sell in exactly the same way as before,” says Tang. 

When asked how much of Luno Malaysia’s operation and solvency depends on DCG and the parent company’s global operations, Tang reiterates that customer funds and digital assets are kept safe with its custodians and trustees. 

“Irrespective of how Luno as a business is funded or structured, customers’ funds are always segregated from corporate funds. All operations are continuing as normal,” he says.

Luno Malaysia’s digital asset custodians are US-based BitGo and Fireblocks, major players in the cryptocurrency security field. Its customers’ ringgit funds are stored in local bank accounts in the name of a licensed trustee, Petaling Jaya-based MTrustee Bhd.

To Tang, the key takeaway from last year is, again, the safety of customer funds and digital assets. “It is important for investors to do their own research and evaluate their risk appetite before investing in cryptocurrencies. Additionally, investors should take steps of their own to verify that they are dealing with a credible and regulated exchange.”

Another licensed DAX, Tokenize Xchange sent out emails to clients on Nov 14 last year to assure them that their funds and digital assets were secure. Among other points, it stated that customers have full control of their digital assets and that the firm does not lend or repurpose customers’ assets. 

The email also mentioned that beyond just trustee/custody standards, the platform is protected by top notch security protocols and backed by US$100 million in insurance, which is enough to provide investors with full coverage many times over.

New digital asset custodians and fund houses 

It is worth noting that the SC is looking at granting a digital asset custodian licence that would allow local entities to hold cryptocurrencies and digital assets on behalf of investors.

According to market sources, several entities are already in the process of applying for such a licence. They include Datuk Clifford Hii, CEO of blockchain solution provider GamBit Group and former group managing director of real estate company HCK Capital Group. He is the son of Tan Sri Clement Hii, founder and managing director of SEGi University & Colleges. 

When contacted, the GamBit Group CEO acknowledged that he is in the midst of applying for a digital asset custodian licence with the SC. After all, the solution provider has been operating for more than a year, offering clients blockchain-related services and helping them build blockchain platforms and applications. 

“Our existing clients ask us, why don’t we become their digital asset custodian as well? That’s why we are applying for the licence,” he says.

KL-based Pacific Trustees Group International is another applicant. When contacted, its non-independent director Paul Cheah confirmed that the firm was in the process of applying for the licence, but did not elaborate. 

It would be natural to assume that other trustees that are currently working with local DAXs, including Universal Trustee and MTrustee, are potential applicants of the digital custodian licence. 

In an interview with Wealth last year, Kenanga Investment Bank expressed its interest in applying for such a licence. But at press time, it had not replied to our query on the matter. 

Edmund Yong, a partner at blockchain consulting firm Celebrus Advisory, says it is an opportune time for the local digital custodian licence to be awarded as the FTX scandal has highlighted the importance of the custodian in keeping investor funds and assets secure. 

A benefit of doing so is that the SC can regulate the custodians more directly as the entities have local operations. The cold wallet, which is the hardware used to store customers’ digital assets offline, will also be located in Malaysia instead of overseas. “If an exchange appoints a custodian that is based overseas, the cold wallet is located in another country instead of Malaysia,” Yong points out. 

Another advantage of a local digital custodian licence is that when a crypto exchange or platform that appointed an overseas-based custodian goes bankrupt, the foreign country’s insolvency laws are applied to the custodied digital assets rather than local laws.

“If the custodian is based here, local insolvency laws and investor recourse apply. The custodian’s assets are in Malaysia and investors can claim against them,” he adds.

Sinegy’s Chuah says the cost of engaging a local digital asset custodian is also much cheaper than having a foreign one. “Engaging a foreign custodian, mainly the global ones with capacity to serve clients worldwide, are more costly as they all charge in US dollars. The cost of a local player engaging them is already four times more expensive than a local one due to the foreign exchange.” 

However, CoinGecko’s Zhong, who comes from a regulatory background, says the appointment of an overseas-based digital asset custodian shouldn’t pose much risk to investors. It is akin to trading stocks in foreign markets as their shares are custodied overseas as well. “Instead of prioritising whether they are local or foreign, the competency [of the custodian] should come first,” he points out.

New fund houses investing in crypto and IEO projects

Market sources say three new firms have obtained conditional approval from the SC to operate as asset management firms. One of the firms is said to be exploring opportunities in the cryptocurrency space. 

Having conditional approval means the three firms would have to meet the necessary requirements of the SC within a given time frame before being granted a licence to officially start offering their services. 

An industry player says some existing small and mid-sized fund houses are also exploring ways to gain exposure to crypto. One of the small firms is exploring a structured product while a mid-sized one intends to offer investors cryptocurrency-related research reports. 

“There is definitely more interest coming from institutional investors despite last year’s dismal performance [of cryptocurrencies]. Asset management firms are also looking to get a foothold in the crypto space,” says the industry player. 

In fact, Khazanah Nasional Bhd has just ventured into digital assets by investing in pitchIN via its subsidiary, Malaysian Technology Development Corporation (MTDC), according to a Feb 2 announcement. Its co-investor is venture capital firm Gobi Partners.

According to pitchIN’s press release, MTDC and Gobi Partners have invested RM5 million in the firm to help it expand its ECF offering and to launch its IEO platform, among others. 

pitchIN, the country’s largest ECF platform by market share, received conditional approval from the SC last year to operate an IEO platform that allows businesses to raise funds via the issuance of digital tokens. Its co-founder and chief investment officer Kashminder Singh says the firm expects to meet all of the SC’s requirements and launch its IEO offerings in the first quarter of this year. 

pitchIN is taking a little more time in its preparations as IEO is something new in the local market, with the regulator and other market players keeping an eye on it. 

Deal flow isn’t a problem for now, says Kashminder. “We have a pipeline of deals [waiting to be launched] and we are working on some of them. There are issuers, but we can’t release the details yet until we are cleared [by the SC] and it is good to go.”

Among other things, pitchIN needs to ensure companies that raise funds through IEO utilise blockchain technology and “provide an innovative solution or a meaningful digital value proposition for the country”, in line with the SC’s guidelines.

“We need to articulate the innovation part better. There must be good use cases from issuers to raise funds through an IEO. If it is just to expand the business, why not do it through ECF?” says Kashminder. 

An IEO is somewhat similar to an initial public offering. Kashminder says the firm is focusing on building the ecosystem through partnerships with industry players, including investment banks. It wants to raise funds through the issuance of digital tokens for not only start-ups, but also larger companies.

“We are exploring partnerships with various parties for IEO. Just throwing it out there, we could be working with investment banks to actually build the pipeline. We are working on a wide range of deals,” he adds. 


What is a digital asset custodian? 

To have an idea of what a digital asset custodian is, imagine a company that manages a gold vault, says Zhong Yang Chan, head of research at independent cryptocurrency ranking website CoinGecko.

“Like a gold vault service provider, you need to know how to run the vault and what security measures are in the vault. Do you have people to safely take things out of the vault and put them back when needed? You would also have to check from time to time that things are kept safely. You may also want to place your vault in a remote and hidden place where others can’t find it easily,” he adds. 

“Analogically, this is the same for a digital asset custodian. Now, you have a digital vault holding cryptocurrencies for people, how do you protect it well?”

Digital asset custodians have a role to play when investors trade crypto with exchanges. But some investors prefer to hold their assets in their own wallet, which means they are their own vault keepers.

These wallets could be a cold wallet, which is a piece of hardware that looks like a thumb drive, or a digital wallet generated by a third-party service provider such as the likes of MetaMask. Some use both.

After the unravelling of the FTX saga, Zhong says investors who store their cryptocurrencies with third-party digital wallets have started to question how safe these wallets are.

The safest way to store digital assets is to keep them in a cold wallet, he points out. “But given how careless people are with their passwords, private keys and stuff, industry players realise this is probably impractical [for everyone to use a cold wallet]. There are projects that are working on better solutions for wallet holders to more easily recover their lost keys, but that is only coming in a year or two.”

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