Has the appetite to hold digital assets across institutional investors increased in the past few years?
Loic Jeanjean: Institutional interest in digital assets is steadily increasing. The Harvard Management Company (the largest academic endowment in the world) put something between $5 and $10 million into cryptocurrency. In May, a Fidelity survey asked institutional investors including pensions, hedge funds and endowments what they thought about digital assets. Just under half, 47 percent of respondents, reported an “overwhelmingly favourable” opinion of digital assets while 72 percent of respondents said that they prefer to buy investment products that hold digital assets. The study indicated that “institutional investors are finding appeal in digital assets and many are looking to invest more in digital assets over the next five years”.
Jubair Patel: Yes, we’ve seen a change in attitude from institutions over the last two years towards digital assets, as the use cases have evolved from cryptocurrencies and non-securitised utility tokens to the more recognised security tokens that have now emerged. Institutions that were interested in holding traditional cryptocurrencies—such as Bitcoin and Ethereum tokens—were originally held back due to a lack of transparency around ownership, security concerns and a lack of institutional custody. As regulated, listed products such as Bitcoin futures emerged, this gave financial intuitions a low-risk entry point without direct ownership.
Over the last two years, the introduction of digital assets that replicate existing securities contracts, such as tokenised bonds, have demonstrated a legitimate use case exists in financial services, which has driven the largest investors to seriously consider their custody options for all potential digital asset applications.
We believe that this interest is still nascent and that a mature level of demand will only be achieved once regulatory guidance on taxonomy, investor protections and management of transactional risk have been issued.
Alexandre Kech: If you are referring to traditional institutional investors like investment or pension funds and their asset managers, the appetite is increasing but before it reaches mainstream interest, there is still a long way to go.
At Consensus, in New York this year, my co-panellists from Ledger, Kingdom Trust and Coinbase Custody, all agreed that there was not a traditional institutional interest in digital assets. It was noted that our customer base was predominately made of institutions and qualified investors who have been active in the crypto industry for many years.
I am referring to entities such as crypto exchanges who no longer want to manage the safekeeping of the assets they do not need for day-to-day trading, this includes specialised crypto or venture capital funds interested in ways to strengthen their operational and technological handling of private keys, projects and blockchain foundations who are looking at being able to focus on the growth of their community rather than on making sure their assets are safe. It also qualified investors in the high net worth individual (HNWI) sector of the market, who just want to invest and not have to worry.
Swen Werner: As a financial intermediary, we have to be client-centric in everything we do. We would not be investing time and effort into developing our digital asset capabilities if we did not believe it will become an important requirement to service clients in the future. In fact, we have positive feedback from alternatives as well as more traditional asset managers to look into the opportunities stemming from digital assets.
Broadly speaking, institutional investors recognise emerging technologies, such as blockchain, as a top opportunity for growth according to our latest Growth Survey, which shows a three-fold increase in appetite compared to the results of last year’s survey.
There is obviously a different trajectory whether the digital assets are or are not regulated, whether they fit into the investment guidelines of fund managers and whether the size and liquidity of those assets make them a good investment. So it will take some time before security tokens become mainstream.
What are the primary considerations with the buying/selling/holding and custody of digital assets?
Mark Profeti: The main considerations concern asset safety, and the legal and regulatory framework in which the custody provider operates. The investor must have full confidence that both technically and operationally the custodian can ensure the safety of the digital assets held on their behalf; and that local regulation and legal statutes recognise digital assets within their investor protection and rights frameworks to provide safeguards against counterparty default, theft, fraud, unauthorised use or misappropriation of assets (as would be the case for traditionally issued assets).
Kech: The first obvious consideration is cybersecurity. The technological architecture behind cryptocurrencies and other tokens is made exceptional by unique assets that cannot be forged thanks to cryptography and the blockchain consensus, but this also makes these assets more vulnerable to hacks.
This means users have the critical responsibility of ensuring their private keys are safe. They lose them, they lose their assets. This is where third-party custodians deliver the necessary focus, through reliable technology and processes, to ensure customers’ assets are safe.
A second consideration is independence and transparency. The crypto market is still very opaque: What is my crypto exchange or fund doing with my holdings? How can I be sure the assets are there and I will be able to withdraw them when needed? Are all coins co-mingled in one hot wallet exposed to hacks? Independent third-party custodians bring the neutrality and transparency that investors need and desire.
Yousaf Hafeez: This is the same as for any other established asset class. Entities trading crypto assets must be assured that the traded assets are recorded at the fair value when they are purchased and sold, and that appropriate and secure infrastructure exists for the safeguarding of such assets.
Alexandre Lemarchand: Proper custody of digital assets is not as easy as locking up gold or paper currency in a bank vault. Since cryptocurrencies like Bitcoin and Ethereum exist completely digitally on a blockchain and are by nature maintained in a decentralised environment, they present an enticing target for hackers. Further, institutions dealing with public and private keys on such a large scale isn’t easy. Secure storage of large digital asset funds is complex, and institutions need safe, comprehensive and integrated storage solutions.
Industry reports have shown that some $1.7 billion in cryptocurrency was stolen last year. The threat landscape faced by investors is similar to those facing security professionals in all tech spaces and will only become broader as the industry grows. From social engineering to traditional cyberattack methods like site clones, phishing and SMS hacks, to basic hardware tampering, there are many entry points in this new frontier.
Werner: On the asset servicing side of things, the biggest challenge at the moment is that there are no publicly traded unrestricted security tokens.
There are a number of factors driving this: traditional market infrastructures such as central securities depositories (CSDs) currently do not run blockchain-driven settlement systems, and where they are looking to do so, direct access to the blockchain is either not possible or not necessary. Issuing a security outside a traditional CSD and introducing them for trading to any investor without restrictions faces a number of regulatory barriers. Hence the market is not there yet. But things could obviously change going forward.
Asset safety and appropriate asset segregation across both custodians and market infrastructure have been a cornerstone of regulatory focus in recent years. What is being done in the custodian community to service these alternative and emerging asset classes?
Hafeez: Cryptocurrencies and other digital assets present unique challenges to custodians. What are these challenges? And, does this present the custodian community commercial opportunities as a result of evolving demand for these services.
The key challenge stems from the fact that crypto-assets are a nascent asset class. As such, firms are still developing models and processes required to manage cryptos. As the market matures, this will change particularly as post-trade crypto services start being offered by established providers.
Werner: Asset safety through asset segregation is probably the most important principle for how the custody industry operates today. However, whether this translates easily to digital assets has yet to be seen. Industry associations, such as the International Securities Services Association (ISSA) have started to explore the implications and published various background notes on the subject of how custody and securities settlement could change in light of digital assets. What is clear is that the introduction of blockchain and decentralised networks must not come at the expense of asset safety. This may explain why many banks are experimenting with permissioned networks that provide greater safety over open networks.
Kech: Specialised custody services like Onchain Custodian have emerged in recent years to provide exactly that; asset safety and segregation of assets.
All our resources, both financial and human, are focused on delivering a sound operational and technological environment that will ensure the safety and appropriate segregation required for institutional customers. Our goal is to deliver the peace of mind they need to focus 100 percent on their core business.
We are not only dedicated to delivering absolute safety for digital assets today but are also spending a lot of time and effort on evolving technology. We need to leverage the newest technologies and best practices to always be safer while becoming more and more agile in the way the assets can be transacted.
Profeti: A lot depends on the legal and regulatory frameworks of the jurisdiction where the custodian operates and the underlying legal basis for the custody agreement. There are very few custodians that have launched a custody offering for digital assets, and then only in a limited way. It is fair to say a number of custodians across all regions are analysing the market opportunity and are in various states of maturity with their product strategy, design and launch plans.
Cryptocurrencies and other digital assets present unique challenges to custodians. What are these challenges? And, does this present the custodian community with commercial opportunities?
Werner: As a new class of assets, digital assets are expected to appeal to a broader audience, including those that may be less inclined to invest in traditional assets. However, for anybody working in the digital assets space, the question of how the custody industry can evolve to support digital assets is still unresolved. This includes questions regarding regulatory and market standards.
Tokenisation offers the opportunity for custodian banks to provide a digital solution to a market they do not presently service. This will necessitate a private key storage capability, whether that’s for Bitcoin, Ethereum or other blockchains/distributed ledger technologies (DLTs). As such, the question of how those private keys are controlled is a critical question for defining what is custody for digital assets.
Differences in technology between crypto and institutional DLT platforms, as well as the still-evolving regulatory framework, requires a nuanced answer when defining the custody opportunity, which may need to differ depending on the type of digital asset.
For example, cryptocurrencies have a unique set of regulatory challenges in terms of the obligations and liabilities they present to financial intermediaries. Security tokens on the other hand may have greater appeal given their ability to operate within the existing regulatory framework.
Kech: Beyond cybersecurity, that we already covered in the previous question, one challenge is the lack of standards out there.
There are so many players, blockchains and token protocols which means that integrating them safely and efficiently is a constant challenge. But we are doing it. It is our job to offer a single window access to all these protocols for our customers to be able to hold whatever assets they want.
This single window access to blockchains also applies to value-added service such as staking, lending services, and so on. This clearly constitutes the commercial opportunity custodians like Onchain Custodian is working towards.
Onchain Custodian also actively participates in industry initiatives looking at building standards and best practices for the digital asset industry.
As an active member of Global Digital Finance (GDF) and co-chair of its custody working group, we are working at defining a code of conduct for digital asset custodians.
As part of a GDF Custodian working group sub-committee comprising more than 20 institutions, with the support of SWIFT (the registration authority for the ISO 20022 financial data standard), we are also leading an application programming interface (API) standardisation initiative around withdrawal requests.
The aim is to build a standardised set of open APIs for all providers in the industry to implement for the benefit of their customers. Today, every service provider has its own proprietary set of APIs which does not contribute to interoperability between platforms.
As a representative of the Singapore market, I participate in the ISO TC68/SC8/WG3, an International Organization for Standardization working group looking at digital token identification.
As some tokens bear the same shortcode while representing different assets, and as different codes are used to identify the same cryptocurrency—for example, BTC also referred to as XBT—the group is looking at building a standard to issue unique identifiers for digital tokens to support automation and interoperability.
We are also involved in discussions around securities token classification and identification. We believe it is critical for the industry to collaborate in non-competitive areas for the sustainable growth of the digital asset space.
Lemarchand: Effective cryptocurrency custody solutions should ensure there are no single points of failure within an organisation. Think about the QuadrigaCX case in which $163 million disappeared. While that’s now developing into a matter of extreme fraudulence and one bad actor, it showed on a tremendous scale that the danger lies in trusting single points of failure.
For the cryptocurrency industry to truly mature, institutional investors are going to have to get involved. Exchanges, brokers, asset managers, over-the-counter (OTC) traders, custodians and others must enforce institutional-grade controls on all transactions. It’s the only way to bring about a new era of stability and trust in this new era of digital asset management.
Profeti: A custodian’s understanding of the legal and regulatory frameworks underpinning their service is critical to ensure they are not exposed to unnecessary risks that could result in regulatory breaches, loss of reputation, financial loss. Notwithstanding the technical challenges associated with integrating their existing IT infrastructure with the underlying DLT platforms, they must ensure their products and service withstand close scrutiny from potential clients seeking reassurance that they are not exposing their investments to unnecessary and unmitigated risks.
There is potentially a large commercial opportunity if the aforementioned regulatory challenges can be addressed and consumer and/or market confidence in the safety of digital assets grows.
What is meant by ‘hot storage’ and ‘cold storage’ and which is best suited to the institutional investors?
Jeanjean: The distinction between the two of these is that hot wallets are connected to the internet while cold wallets are not. Leaving your crypto on an exchange is an example of hot wallet storage. Naturally, cold wallets are considered safer than hot wallets, as they spend little (or no) time connected to the internet. Hardware wallets of the cold variety are generally considered the best and safest option for storing cryptocurrency. These are typically in USB format and can be temporarily “hot” in that they can be connected to the internet to facilitate a crypto exchange, but primarily remain offline and disconnected with assets fully isolated and inaccessible to hackers.
While USB-based hardware wallets are undeniably the best way for individuals holding cryptocurrency to protect their investment, they are not practically viable for enterprises handling millions of dollars’ worth of crypto. In the early stages of institutional investing, asset managers would find themselves securing massive amounts of wealth on hardware wallets with no convenient and efficient way to implement meaningful segregation of duty. The financial industry needs custody solutions that are more holistic in their approach, combining both hot and cold approaches, and encompassing both hardware and software technology solutions.
How are regulators viewing the emergence of these alternative asset classes and how is the service community interacting and responding?
Lemarchand: The world of cryptocurrency is relatively new to regulators. In the US, this new class of digital assets falls under the jurisdiction of multiple regulatory agencies. The US Securities Exchange Commission (SEC) has taken the lead, but only time will tell how regulation in the US will shake out.
Kech: I would respond that the jury is still out. Some regulators are considered friendly by the community because they are open to learn and understand the nature and potential of these new assets.
Others refuse to see these assets from a different perspective than the existing assets classes they know of. It leads to a fragmentation of regulatory opinions across jurisdictions that impacts all players.
The Libra project might help change that. As controversial as Libra may be, regulators and governments cannot ignore blockchain and digital assets anymore. The Libra association gathers so many major global actors. If they stop focusing on Facebook’s privacy issues and look at the benefits this and other similar projects can bring, they will hopefully see what we all see in the industry—the potential to exponentially increase payment and liquid investment opportunities for billions and billions of people around the world.
Hafeez: Numerous regulators globally have programmes in place to look at the regulation required but this process is still in its infancy in most of the global jurisdictions. Those who have put initial regulatory frameworks in place are likely to have to significantly amended these as the market evolves.
Jubair Patel: In July, the Financial Conduct Authority outlined a taxonomy for digital assets that separates cryptocurrencies and utility tokens from regulated security tokens (which offer investors the same protection as the financial instruments they represent). The issuance of security tokens would be assessed on a case by case basis; though a precedent for issuance of tokenised bonds has been set by the World Bank, which has issued AUD 150 million worth of development bonds on behalf of the Commonwealth Bank of Australia since August last year.
Specific criteria for any regulatory assessment include scrutinising the features of the underlying DLT technology as well as the custody options available to owners of the digital asset. The Financial Stability Board also summarised a number of regulators’ viewpoints on additional criteria, including measuring exposure risk to digital assets, managing settlement risk and clearing of digital asset transactions, and valuation approaches for cryptocurrencies.
The taxonomy and treatment of digital assets varies by jurisdiction, but it is fair to say that regulators see themselves as playing an active role in overseeing trading activity in a DLT environment—especially given the cost-saving potential of regulatory roles being assigned directly in a permissioned blockchain.
Interaction between service providers and regulators is happening—but it is limited in comparison to other regulatory obligations such as the second Markets in Financial Instruments Directive, the Central Securities Depository Regulation and the Securities Financing Transactions Regulation, where industry collaboration is strong and there is also a collective engagement with regulatory authorities via trade associations. As the demand for digital assets grows, we are confident that industry collaboration will increase and collective standards will be defined for all areas of trade lifecycle processing.
What does the digital custody landscape look like in three years’ time?
Werner: This is very hard to predict. It is possible that in the future we may see the emergence of distributed financial infrastructures such as Fnality (Utility Settlement Coin), a permissioned cash tokenisation project as a centralised market infrastructure to facilitate securities settlement. This will naturally require connectivity from bank custodians that have to prepare the necessary technological and business solutions. We may also see more security token issuances with specialised providers working to resolve regulatory challenges.
If those changes on the supply side materialise, the demand side is likely to become more digital as well. We could see the launch of digital funds that may either distribute their services through tokenisation or focus their portfolio investments on assets that are structured as digital tokens, however, there are likely a number of issues to be resolved in relation to this possibility.
Jeanjean: As cryptocurrency awareness grows, the digital custody landscape will as well. In three years’ time there will be more institutional investors on the scene diversifying their portfolios with digital assets. More regulated custodians will be on the scene supporting serious long-term growth for individual investors, asset managers and family offices.
Hafeez: It is likely that many more institutional investors will be getting involved, driving advancement in post-trade services for cryptos. Indeed, it is possible that in three years’ time we will see a fully developed, or nearly fully developed, post-trade services offering. This will likely stem from much greater clarity on the regulatory environment.
Profeti: We will start to see the emergence of ecosystems that closely resemble the market infrastructure models for traditional assets. The traditional market infrastructures are looking to expand their capabilities to include digital assets and create environments that allow for the trading, settlement and custody of digital assets to function along similar lines to traditional markets.
The opportunity exists for custodians in their own right to offer their custody services exclusively to the emerging trading platforms on behalf of their trading participants. However, whether this is achievable over the next three years is largely dependent on how regulation evolves, and whether it creates arbitrage opportunities due to differences in treatment and behaviour across jurisdictions; or whether there is a concerted effort by regulators to standardise the treatment of digital assets through common set of principles.
Kech: It is very difficult to say. There are many players competing for the same market share with a couple of big ones trying to take it all.
I believe there will be room for dozens of custody services that will differentiate themselves by offering different visions of custody.
Our vision is one of personalised quality services, co-building of the right value-added solutions with customers, and industry collaboration to achieve standardisation for the benefit of all.
Are there any clouds on the near horizon for digital custody?
Kech: Regulatory uncertainty remains an area we are watching carefully. Though the situation is clearer in Singapore where we operate, it is not the case everywhere, and we will need to be able to adapt and comply quickly as the situation evolves.
Patel: There are two key risks that early entrants to digital asset custody need to consider: market participation and the underlying infrastructure risk of emerging technology. We expect the demand for digital asset custody to be driven by a mixture of buy-side and sell-side participation—institutional investors will look to digital assets to enable access to more markets, whereas issuers will look to attract larger markets. Custody providers will need to time their offerings and differentiate themselves to make the most of this market emergence while also ensuring regulatory adherence.
New entrants will also need to consider the risk of attack on an unproven underlying infrastructure. While there have been digital custody solutions available for a few years now, institutional entry will undoubtedly attract more sophisticated attacks—and no provider will want to be the first to face an unexpected event.
Overall, how safe is digital custody and how are service providers looking to protect holdings as we all move to a world of digitalisation?
Kech: As I hope my answers to the other questions proved, independent third-party digital asset custody is the safest environment for keeping digital assets, because we are 100 percent dedicated to our core business. Focus is the key, here. Working with specialised service providers like us and others is the only way for traditional institutional players to enter this space and for the industry to remain sustainable in the long run.
Lemarchand: There is no denying that the digital asset world is one that is constantly under attack. We spend significant time and effort to assess the security of our technology along with our industry’s. As hackers become more sophisticated, there is no question that our industry will be forced to adapt and create novel technology, which is exactly where our work leads us.
Researchers like us are consistently publishing findings to raise awareness about the security of our industry, and also to lay the groundwork for other security researchers. Our intention is that this work will lead to additional research and improve the overall security of the industry.
Designing security is serious, hard work. Those working in this field spend a lot of time and resources trying to create secure solutions.
Profeti: Regulators will need to explicitly consider current and emerging technologies used to exchange, transfer and store digital assets safely. To build client trust significant focus and effort will need to be placed on ensuring security is built into every layer of the technology solutions to protect against cyberattacks.
The balance will be to enable newer technology adoption and innovation, without putting clients’ digital assets at risk.
