Understanding Paper and Direct Ownership of Cryptocurrencies

Find out what the difference between paper and direct ownership of cryptocurrencies is, especially when it comes to bitcoin.

Custodial Service (paper) vs Direct ownership

Nowadays there are several alternative ways available to invest or gain exposure to bitcoin and other cryptocurrencies. The easiest way is to exchange from fiat to cryptocurrencies via third party services like a dedicated cryptocurrency exchanges and brokers, or via peer to peer platforms, where users can connect directly. 

The easiest options for storing cryptocurrencies are usually custodial services like exchanges, brokers or dedicated wallet providers, where private keys are controlled by a third party. In essence these are effective “paper” holdings for the users as user don’t have the controllability of their holdings. The mostly advocated way by the industry early adopters is to maintain the control of the private keys and use software or hardware wallets to store them under direct ownership. 

This relates to the old crypto wisdom “Not your keys, not your coins.” However in contrast to the wisdom, for many users it has been argued that it’s safer to hold your coins in a trusted exchange or broker, if you aren’t technically savvy to manage the self controlled storing options and steer clear of pitfalls that you might experience during the process. Industry leaders have pointed out why it might be safer to store in an exchange or broker and our founder Henry jas commented the matter as well. He recommends at least to start bitcoin investing with a broker or exchange.  

Managing counterparty risk with custodial services

The key risk assessment that each user needs to do is whether to take risk using a third party custodial or use a self managed wallet and to what extent (ie. allocating funds between these two options). One of the key risks of using third party custodian is of course the counterparty risk involved. Industry’s history is full of scams and hacks that have realised massive losses to users, so the scepticism towards third party service providers is more than justifiable.

Industry is still fairly scattered when it comes to transparency and standards of offering services. The regulatory pressures have made the situation even worse as some of the players have been forced to domice in jurisdictions where consumer protection is low and the transparency towards the company operating the service are even poorer. So users need to do their own research and due diligence of the service providers, if they are ok to store cryptocurrencies at their service and acknowledge that consumer protection might be close to nothing if some risks realise.

This relates to the fiat side as well, and the analogy there is the same. Are you comfortable to deposit and custody fiat money or some other financial assets at some offshore financial service provider and what are the counterparty risks involved. When trading fiat funds to crypto this is also a relevant risk to assess. If you want to repatriate your fiat funds, are you able to do it, and how long it takes. In some occasions some financial institutions have freezed or blocked the clients fiat custody accounts, usually for a reason related to the cryptocurrency service provider not complying with regulatory standards.

The argument that it’s safer to store cryptocurrencies in custodial service for most users is justifiable, but even that requires self activity and assessment of the counterparty risk involved.

Investment products (paper) vs Direct ownership

Here we take a look on emerging alternative ways to invest in cryptocurrencies from traditional financial industry like regulated futures, CFDs or different kind of exchange traded products (or “ETPs”) and the risk involved in these “paper” cryptocurrency investments. 

Paper exposure refers here to the ownership of financial product that is a derivative of direct cryptocurrency ownership. Currently the most popular way to invest is cryptocurrency linked exchange traded products in various formats. In Europe we have several Exchange Traded Notes (or ETNs) and certificates listed in regulated exchanges in Switzerland and Nasdaq Stockholm that trade fairly actively offering both long and short exposure. For a standard brokerage account the trading is fairly easy, as these are treadable in a similar way as other listed instruments. The investor is of course locked in to the opening hours of exchanges compared to 24/7/365 operating cryptocurrency markets.

Other more institutional focused way is to trade regulated futures like CME Bitcoin futures or Bakkt (ICE) listed future. These are available to retail clients also via their brokerage account, if the broker offers access to the future market. 

Third fairly used product in the foreign exchange market is Contracts For Difference (or CFDs) where service provider, an authorised investment company, offers exposure to the price variation of the underlying asset in cash settled manner. This is usually done with leverage as well. In Europe the leverage for cryptocurrency CFDs is limited to 2:1 according to the ESMA rules.

The key issues worth remembering when owning cryptocurrency via “paper” investment products are summarized below:

• ETNs and Certificates available are prone to counterparty risk. In this form, cryptocurrencies or assets are held by the issuing company or in a trustee, so you must rely on them to be able to get your payoff, if something happens. As these notes are usually debt instruments, investors end up being among creditors in a bankruptcy estate in case of issuer insolvency or bankruptcy.
  
• Investors need to evaluate the counterparty risk of the issuer, if the ETNs holdings are somehow segregated from the issuer balance sheet via Special Purpose Vehicle or similar arrangement. It’s also worth noting that the custody of the cryptocurrencies held by the issuer are not widely standardized, so the method of custoding the cryptocurrencies that act as collaterals for the ETN is important. The issuer is not usually liable for any loss, theft, damage or fraud when it comes to the collateralized assets, and for cryptocurrency custody, getting a comprehensive insurance is still challenging because of lack of standards.
  
• The current issuers are relatively new companies, so they might lack the track record and financial muscles to withstand troubles in their operations. Only few of the big ETP issuers have published products for cryptocurrencies, but the situation might changes as the Asset Under Management grow and the industry becomes more widespread. In the US the ETF debate has been ongoing already for years, so the situation can change quickly once first product is approved by the SEC.
• To sum up, owning these exchange traded products, futures, options, and Contracts for Difference you don’t actually own cryptocurrencies but rather a promise to receive the performance of the underlying asset.

Direct ownership of cryptocurrencies does not carry the same risks as paper investments. It is a direct holding that, once bought, is all yours. You can store it in your chosen method for as long as you like. Cryptocurrency markets are already very liquid compared to any other alternative asset class and the markets operate 24/7/365, so the position can be converted to fiat easily regardless of where you are in the world. What’s more, direct ownership guarantees the ownership also in the scenarios where financial or political crisis that may cause widespread malfunction of the financial markets and result in realisation of counterparty risks. Lehman Brothers bankruptcy is a fairly recent reminder where the counterparty risk realised for number of Lehman issued ETNs and other Structured Notes. Some of the proceedings lasted almost a decade and realised recovery values have been fractions of the invested amount.

What are the advantages of using Coinmotion service for trading and custody?

Coinmotion has been running cryptocurrency services since 2012, and the majority of our customer funds are kept in highly secure multisig cold storage, safe out of the reach of e-burglars.

We were granted a Virtual Currency Service Provider registration including right to operate a virtual currency exchange service and act as a wallet provider. We are among the few companies which have met the standards set under the new European regulation and we are transparent in the way we operate our services. We aim to provide user easy and accessible way to trade and store cryptocurrencies, but we also give the option to transfer cryptocurrencies to wallets elsewhere.

Additionally we support standard payment methods such us SEPA transfers, instant deposit schemes and card payments to easily deposit and withdraw fiat funds. As an authorized payment institution, we also allow fiat transfers between users and payment to third party bank accounts similar to your standard bank application.

If you are looking for more personalized service, please take a look at our Coinmotion Wealth service, which offers personalized service to explore cryptocurrency investments. Our OTC connections offer seamless execution for larger sums with selected international counterparties.