Coinbase Custody: Keep Your Crypto Safe and Use It Too - Ep.068

Transcript

Hi, everyone. Welcome to Unconfirmed, the podcast that reveals how the marquee names in crypto are reacting to the week's top headlines and gets the inside scoop on what they see on the horizon. I'm your host, Laura Shin. Unconfirmed is now on YouTube. You can find the most recent episodes there every week on the Unchained podcast channel and we'll soon be getting the full archive up. Also, if you're not yet subscribed to my weekly newsletter, go now to UnchainedPodcast.com to sign up. Are you ready for global cryptocurrency money laundering regulations? Cyphertrace secures the crypto economy with powerful AML tools for exchanges, crypto businesses and regulators. Today's guest is Sam McInvale, head of product at Coinbase Custody. Hi, Sam. Hey, Laura. Thanks for having me. Excited to be here. Tell us about Coinbase Custody's new offering with staking.

Sure. So let me set the stage by sort of talking to you through how we got here and why we got into staking, and then I'll dive into what the particular offering is itself. So just about everything at Coinbase Custody is gonna start with client demand. And so if we rewind the clock to Q4, early Q4 last year, we started hearing this steady drumbeat specifically from our clients, but also in the industry at large about large investors wanting to actively participate in the networks they've invested in. And usually this was staking and governance in particular, but occasionally it was some other mechanisms. And this really makes sense. I think from the institutional investor perspective, they have large states in these networks. They want to help support them. nourish them, they

want to see them appreciate, and staking and voting and sort of helping them mature is one way to help bootstrap and support them. So this all made a bunch of sense to us and we started hearing the drumbeat at large, but it really crystallized for us when a large client, I think mid Q4 said, hey, we really enjoy the partnership we have with y'all, we're big fans of the platform, but you're not getting this particular crypto unless you support staking. And so that caused us to really put our heads together to start thinking about what's going on and what we might need to do here. And as we started to dig in, we found Tezos and Cosmos. And what we realized was that we could actually engage with these networks.

We could support our clients in the way they were asking so they could actively stake and earn staking rewards by keeping their funds completely offline. So what that means is, I guess maybe the epiphany for us was that delegated proof of stake networks work really well with our current offline custody architecture. And that I think was the key, that was when the light bulb really went off, if you will, in that we sort of knew there was a lot of client demand and we knew that we could actually engage in these networks in a way that we were very comfortable with. And that's when we sort of realized we had to start building. And so how does it work exactly? Because if you were saying that it works well with your cold storage solution, which you know, essentially keeps these assets offline and yet staking is actively participating in these networks, then how do you do that? Yep, that's

a great question. We try to make this as simple as we can for our clients. So from their perspective, engaging in a proof of state network and Coinbase custody looks just like depositing, withdrawing any other crypto asset. So you deposit and withdraw Bitcoin into Coinbase custody. You can now deposit and withdraw Tezos to Coinbase custody. And as soon as you deposit your Tezos, what we're going to do is simultaneously delegate that Tezos that's deposited into a cold storage address to a baker that we're running. Now, your point about how do you actively participate? There's bonds for these networks. The way we're getting around that is Coinbase Custody is actually purchasing the bond on behalf of our clients. So we're the ones putting funds, you know, sort of quote, at risk.

We have hot funds. We have hot skin in the game. Our clients don't. So their crypto is never... at any more risk, their Tezos in particular, when they're participating in the Tezos network through delegated proof of stake is never at any more risk than say their Bitcoin or Ethereum, which would be similarly held in our cold storage. And so you guys are both keeping their funds in cold storage, but then also you are actually the validator that they are delegating to. Is that correct? Yeah, that's right. So Coinbase custody in this case is running the Baker that is actually actively participating in the blockchain, so baking blocks and endorsing other blocks. And our clients' funds and cold storage are delegated to our baker. So by doing that,

there's a couple of things we can control. One, we can control the bond for that baker. We can also control a lot of the infrastructure around it to make sure that it's highly secure, highly available, et cetera. We can also control the payouts from it. So as we earn baking rewards or staking rewards in future chains, we can just pay those out directly to our clients on-chain. But this way we get to own all of the infrastructure and sort of control everything there. And when you were saying that you built up the infrastructure around these nodes, like tell us about what it took to build these nodes to be able to participate in these networks for your clients. Yeah, happy to. There's really three things that whenever Coinbase Custody launches some new activity or some new product, there's three things that we're going to do. We obviously have engine product work, which I'll talk about right now. But

we also have a lot of legal and regulatory compliance work. So we're a New York limited purpose trust company. We need to make sure we're operating within our trust charter. And finally, we have insurance work. We need to make sure that we understand if there are any insurance implications at play for whatever new activity we might be undertaking. And let's say, for example, our current insurance policy doesn't cover some new activity. What are we going to do to mitigate that? I'll talk about the engine product and sort of infrastructure stuff first, and then we can get into the legal and insurance stuff, if interesting. When you run a blockchain node, you're not actually typically writing software yourself, right? So if you think about running a Bitcoin node, you're just running the Bitcoin core software. It's the same mechanism with Tezos. So Tezos is actually producing the software that we're running. What we've done is sort of stamp the

Coinbase effect on there, if you will. So Coinbase in the past seven years has built up a pretty large business serving tens of millions of folks around the world. And in doing so, we've had to run many, many, many blockchain nodes of different kinds. We've had to have them highly available. We push 100,000 transactions through these nodes each day and obviously highly secure as well. So we took all of that sort of learnings that we've built up over the past couple of years And we're basically doing the exact same thing with Tezos right now. So we sort of drop a Tezos node, if you will, into our infrastructure, into the way we know how to run these nodes at scale. We also decompose it a bit, and I can talk about that. So we actually took the private key out of it so that we

could hold that elsewhere. So it's a bit more secure in terms of baking blocks and controlling our bond. But for the most part, we really just put a lot of our expertise in terms of infrastructure and architecture around these things so that we can run as many nodes and bakers as we need to, to be highly available to support our clients, but simultaneously have sort of maximum security. So most of the work here was less about writing new software and more about sort of making the Tezos node work inside the Coinbase infrastructure. And when you were saying that you hold the private key elsewhere, what does that mean exactly? Yeah, so there's sort of an emerging best practice in Tezos and now Cosmos that's called remote signing, which means you can actually pull the private key out of the Baker on Cosmos or the

validator, I'm sorry, excuse me, the Baker on Tezos and the validator on Cosmos and hold that elsewhere. And the upside here is that if your Baker happens to get compromised, that attacker doesn't have access to your private key and can't actually move the funds in your bond somewhere else. So what we do is Coinbase has obviously built up It's proprietary hot wallet technology. Over the last seven years, we have what we call a secure key enclave. We call this Knox. We've actually blogged about it, so you can look it up and learn a bit about it. We hold the private key for our bond and for our baker in Knox. And the way this actually works sort of from the Internet into the internals of Coinbase is we're running what we call an edge node. This is just a very typical Tezos node that is

actually talking to the internet and it's gonna be talking to the Tezos blockchain. It will inject blocks that we bake back into the Tezos blockchain. Behind that edge node sits our baker. It's not actually directly talking to the internet. Our baker is really only responsible for assembling blocks that we get choose to bake or endorsing blocks when it gets chosen to endorse. It will take the header of a block it's about to bake and pass that off to Knox Knox will take the private key that's in there. It does a few checks. It checks to make sure this is only a baking or endorsing transaction. It also checks to make sure that it hasn't signed anything for this block height. We want to make sure we're not double baking. If it hasn't, it will sign that header, hand it back to the baker. The baker

will construct the rest of the block, hand it to the edge node, and that will broadcast it out onto the network. And so by decomposing a lot of these pieces, an attacker can get into a couple different places and we're okay. And obviously we've built up a lot of history and just comfort with the way Knox works. So it was helpful for us to be able to use that as sort of our quote hot wallet in this case. Wow, that's very interesting. And one other thing when I asked you kind of what you've had to build to offer this service is you mentioned the legal and insurance and other kinds of other features. So these assets are protected by Coinbase's insurance policy. So what does that protection offer and what happens if the bond is lost in some fashion, et cetera? Yeah, so the

bond is Coinbase Custodies. If that's lost, that's just our funds that are lost. Our clients are not gonna be impacted in any way. Although, depending on how that bond is lost, they might not be earning their baking rewards. So I'm sure we would have to spin up another bond or sort of figure out how we would get them baking again. But our insurance program, we've actually, our CISO, Philip Martin, put out a pretty lengthy blog post on how we think about insurance just last week, which dives into the details of how we secure our clients' funds. And there's sort of two ways we think about this, funds at rest and funds in transit or funds in flight. The long and short of it is we have a pretty comprehensive insurance policy that covers both of those, although primarily we aim to always make sure we're

covering funds in flight because that's where there's more risk. Right now, when our clients funds are in cold storage, again, whether it's Bitcoin, Ethereum, Tezos, Cosmos, whatever it might be, all those funds are covered by the same insurance policy. They're all held in the exact same cold storage architecture. It's the same one that underpins Coinbase. And so we really don't view the risk profile for our clients with regards to staking to be any different, whether that's from an insurance perspective or really any other perspective in this case. We're going to discuss governance in a moment. But first, a quick word from our fabulous sponsor. Ready or not, the Financial Action Task Force Anti-Money Laundering recommendations soon go into effect globally. If you handle cryptocurrencies, no matter where you do business, these new AML laws will apply to you. Cyphertrace helps exchanges,

ICOs, funds, brokerages, and regulators understand and manage crypto asset and compliance risks. Learn how to reduce your exposure and prepare now for tough new regulations. Cypher Trace is securing the crypto economy. Learn more at cyphertrace.com slash unconfirmed. Back to my conversation with Sam McInvale of Coinbase. And so just so I understand the problem that you guys were trying to solve when that institution came to you and said, hey, you guys aren't going to be able to, or I'm not going to, you know, or we're not going to let you hold this asset if we can't participate in staking. What are the risks associated with them for staking? Like, why wouldn't they just... try to take it on themselves? Yeah, that's a great question. There's a lot of risks involved for institutions. One, as we just sort

of talked through, a secure staking operation is technically complex, even though at the end of the day, you're really just running software someone else has already written for you. To sort of decompose it like we just talked through, to be able to manage the private key where the bond is going to be, to be highly available, you have to be available all the time to big blocks. And if you're not, you won't actually get slashed, but you'll miss opportunities for payout. So you could actually miss out on the whole point of this, which is earning rewards. So very technically complex. And most of our clients in particular are fiduciaries to their investors. So there's some type of investment manager. Up until now, frankly, as they've looked at the networks they could stake on, the risk and the complexity to get involved, so to

sort of spin up everything we just described themselves has dramatically outweighed the reward. So the reward being, right now, Tezos is paying about 7.5%. I think Cosmos is a little north of that because they just launched, but it's sort of inflation is rapidly decreasing as more delegates come online. So the risk-reward trade-off hasn't been there from a fiduciary perspective, and there hasn't been a staking provider that's really taken, I think the institutional approach we have, which was, hey, let's be regulated, let's be insured, let's make sure this is a solution only for these really large investors versus a more retail solution, which I think would look different in a bunch of ways. And so now we're hoping to help just change that calculus, that fiduciary calculus that our customers have been going through so that this actually can be

an opportunity for them to get engaged in these networks where they haven't been engaged previously. And what is the minimum amount necessary to participate? Well, the minimum amount for Tezos is just one roll is 10,000 Tezis, which at today's prices is roughly 10,000 bucks. We don't have minimums per se in Coinbase custody, but we tend to not see clients moving in denominations less than half a million. And what will Coinbase's fee be? So we're going to take somewhere around 20% of the network fee. sorry, of the staking rewards. So if, just to use round numbers, if staking rewards were exactly 10%, we would be taking 2% and our clients would be earning 8%.

We're justifying that 2%, one, because actually that 20% of the staking reward is actually pretty common across the industry right now. But we're taking a couple extra steps. One, we think our security and our infrastructure here is pretty special and sophisticated. We are posting the bond, which is not something that at least that I'm aware of any other staking providers are doing. We are fully regulated in this activity that we're undertaking. And finally, our insurance applies to all assets and our offline storage as well. And so now let's talk about governance, which is the next service I think you're going to be offering for Coinbase custody customers, both in Tezos and for MakerDAO. How will that work? Yeah, super excited about this as well. I think the

sort of clarifying moment for us with governance, someone said, hey, staking is great. I love earning 10%. Governance is how I earn 100 acts. So governance is really how I'm going to help make sure this network matures and appreciates appropriately. And so we've been thinking about governance likewise for a couple months now. How it's going to work is actually pretty simple. It is protocol specific in terms of how we're actually engaged with each protocol. And I can talk a bit about that for both Tezos and MakerDAO. But from an interface perspective, just like depositing Tezos, you drop it into Coinbase custody and we just delegate it under the hood and you start earning baking rewards. Kind of the same deal here. You drop in your Maker You do opt in to voting in this case because there is some smart

contracts involved that we have to deploy. But once you've engaged in that, we will surface all the upcoming votes to you in the app. We'll also send you email notifications and things like that so you can be aware whenever a new executive poll comes up. We'll actually also send you a quick digest. So what is the relevant info on this vote? What do you need to know to make an informed decision? How many people are voting, potentially things like that. And from there, you can just navigate directly in the app and see the see the available votes and participate in the polls right there. Well, it sounds super, super interesting. So, so far Coinbase has been known as the safest, easiest place to buy cryptocurrency. And this offering enables people not just to hold or huddle the asset, but also participate in the network. Why is Coinbase going to is Coinbase generally going to be moving in

this direction? Like, are you going to offer this on Coinbase.com as well? Yeah, absolutely. So I think Coinbase's goal is to build an open financial system for the world. And the way we've always thought about that is it's going to come about in two phases. First is the investment phase. And second is the utility phase, where people really start to engage with crypto in crypto-native ways. It's funny because we launched Coinbase Custody thinking this was much more of an investment phase product. But what we've realized is that the vast majority of our clients are really at the efficient frontier of, let's call it, activist and activist investing in crypto. And what that really means is that they're actively engaging in crypto networks, mostly through staking and governance, but through other ways, maybe they're participating in auger dispute markets, for example. And so what we

found is that the custody client basis is a bit of the tip of the spear here and helping to lead us to the utility phase. So we're thinking that Coinbase custody might be where a lot of these new actions come into the Coinbase ecosystem. And then from there, you'll see them make their way into other Coinbase products. Okay. And so you also, or we're also seeing that a whole bunch of chains are offering all kinds of different ways to participate in the network. So what other chains do you think you might offer this feature on in the future? Yeah. So great question. There's actually a ton more for us to explore in the MakerDAO ecosystem.

So right now we're supporting governance, but you can imagine that a lot of our clients might have large ETH positions that they want to use to deploy CDPs in. or maybe they want to use some ethers and die that they're holding to run keepers and actually keep a watch across CDPs that are out there. Um, to figure out which ones look like they're going to soon become under collateralized and. Exactly. And potentially liquidate them. Yep. Um, in auger, uh, we've now seen a couple of markets go through dispute resolution. And so we've, we've definitely had clients come and ask us and say, Hey, I'm holding rep with you. I want to stake my rep, uh, on this, this sort of market dispute. Cause I think it's going to come out on this side. Um, so that's another action that we want to enable, but thinking about blockchains more generally, It seems like the trend with regards

to most newer blockchains is delegated proof of stake. So we expect, or we see that most of the big name ones coming out later this year will support delegated proof of stake staking and will be engaging similar to Tezos and Cosmos. And then they'll be supporting governance in some form or fashion. And that's still evolving, which is really fun. But it looks like there'll be just a lot of opportunity for us to engage across all of those chains. And actually just what you've described So it only works with delegated proof of stake. And what about proof of stake? Well, it's interesting. So Ethereum is maybe the one chain that's still considering a sort of a non delegated proof of stake model, although that model is not something I'm fully up to date on. And I know that they're the architecture that Ethereum itself is considering

is changing pretty rapidly. So if we get to a world where it's You know, funds need to be hot to be staked. We'll sort of cross that bridge when we get there. Luckily, like I said, we've built up a lot of expertise with technology such as Knox that we manage in-house. We'll be able to bridge that gap when we need to. And you talked about how this all started because you had demand from institutional customers at Coinbase Custody. Do you have demand from retail customers on Coinbase.com to offer these types of services? You know, I'm not the best to comment on that. My hunch is not yet, but I suspect as we see, you know, specifically with the success of Tezos recently with its first on-chain amendment with Cosmos launching, I suspect this is where we're going to trend. And the opportunity to earn rewards

to sort of, you know, engage with your crypto, I think is just a trend that has started and it's going to pick up steam throughout 2019. Yeah, well, we will see. Maybe I'll have somebody from Coinbase.com on in the future if you guys go in that direction. I can think of a few folks who would love to be on, Laura. All right, great. Well, I guess I'll have my people talk to your people. All right, well, it's been great having you on the show. Thanks for coming on Unconfirmed. Thanks so much, Laura. I enjoyed it. Thanks so much for joining us today. To learn more about the topics we discussed, be sure to check out the links in the show notes of your podcast player. If you haven't yet signed up for my weekly newsletter, be sure to do so at UnchangedPodcast.com. And be sure

to check out our new channel on YouTube as well. Unconfirmed is produced by me, Laura Shin, with help from Raylan Gallipali, Fractal Recording, Jenny Josephson, and Daniel Ness. Thanks for listening.