The world of digital is ever growing and shows no sign of waning. With the evolution and interest in digital assets increasing, custodians have everything to play for in this space
The world of digital assets is accelerating at a rapid pace. Digital assets cover a range of assets from smart contracts built on distributed ledger technology (DLT) to existing cryptocurrencies and future central bank digital currencies. According to Torstone’s CEO Brian Collings, many of these are nascent, giving a significant advantage to innovators who are developing new service offerings.
Traditional banks have an important role to play when it comes to the growth of digital assets. These banks can play on their strengths by bringing investment to bear on new ideas and use their client network to help innovators and fintechs add new digital asset services to existing securities services.
“The more traditional players getting in, the merrier. The increased interest of banks for digital assets further legitimises this asset class. It reassures investors and users that digital assets are here to stay and therefore adoption increases,” comments Alexandre Kech, CEO, Onchain Custodian, Singapore.
In line with the growth and interest in digital assets, the custody of digital assets is evolving to meet this demand. Custodians play a crucial role in legitimising this growing asset class. This was reinforced in June last year when Deloitte’s whitepaper suggested that custodians are “critical to the widespread adoption of digital assets”.
However, the methods of a traditional custodian may need to be updated in order to cater for the unique features of digital assets.
So, with the growing interest in digital assets coupled with the integral role of the custodian, there is everything to play for in this space.
Plenty of options
The phenomenon of crypto funds becoming an increasingly attractive option for fund managers looking to add crypto exposure to their clients’ portfolios is largely due to the regulatory certainty and the known reassuring operational and legal setup such products offer to fund managers or retail clients.
According to Kech, it is always easier at the beginning to invest in a product you have experienced for years than in an underlying asset you only start to learn about.
However, Kech suggests more and more investors will go direct and buy cryptocurrencies as the regulatory framework matures and as they understand that the institutional grade infrastructures, such as an insured, secured and compliant custodian like us, are in place to offer them the security, certainty and quality service they expect.
The attractiveness of this option can also be put down to more and more retail investors and high net worth individuals joining the crypto market. Experts say this has meant that fund managers have realised by expanding their offerings they will be able to capture additional market shares.
Meanwhile, younger generations are said to have taken investment preferences to cryptocurrencies such as bitcoin.
Delta Capita’s Karan Kapoor, head of regulatory change and regtech, notes that in order to align with future customer preferences fund managers have diversified their offerings by including digital assets/cryptocurrencies.
Challenges
With a spike in interest for this asset class, custodians have had to up their game and this has not come without its challenges.
For example, late last year, the SEC requested formal comment on the definition of ‘qualified custodian’ as it relates to digital assets.
San Francisco-based cryptocurrency custodian, Anchorage, offered a response, based on its expertise in handling digital assets and its experience as a once state-chartered-entity-turned-national-bank.
Anchorage notes that because digital assets are qualitatively different from legacy financial instruments from a technological perspective, the definition of qualified custody in the digital asset space should reflect that fact.
Some of the points in its response included the following:
Proof of exclusive control: A qualified custodian of digital assets needs to be able to prove exclusive control of private keys.
Proof of existence: Beyond proof of exclusive control, a qualified custodian should always be able to prove the existence of assets held under custody when requested as an essential consumer protection.
Blockchain monitoring: A qualified custodian should be able to regularly track and monitor the blockchain of any digital asset they custody.
Regulatory oversight and fiduciary requirements: Beyond technical capabilities, to determine whether an entity meets the definition of a qualified custodian in the digital asset space, it is also important to assess the level of oversight that entity receives.
In terms of further challenges facing digital asset custodians, Delta Capita’s Kapoor says: “Considering how crucial the role of digital custodians is in the digital asset environment, perhaps their greatest challenge is cybersecurity.”
“Given how blockchain technology works, if a malicious attack is to be performed successfully it would be very hard for the custodian to retrieve the funds and identify the attacker.”
This is exactly what happened to the Japanese crypto-exchange Mt.Gox, which saw 850,000 Bitcoin disappear from its account (now worth $51 billion) due to security breaches and has never been able to retrace them thus declaring bankruptcy.
“As it is easy to imagine, a breach of security that large would probably destabilise the market making it less safe for all the market participants as well as stifle its future development,” Kapoor explains.
Further challenges include issuance, settlement, and records are all understanding where the current asset servicing processes exist on a distributed ledger, and where the value will be offered in terms of servicing, according to Torstone’s Collings.
Collings affirms: “The rethink of back-office and post-trade processes will create a need for much more flexible technology to underpin both existing asset processing and the new model.”
The importance of partnerships
Partnerships and collaborations are great ways to overcome some of the challenges facing digital asset custodians today and have proved a popular solution to many in the industry.
An example of this is BNY Mellon recently invested in Fireblocks, a platform delivering a secure infrastructure for moving, storing, and issuing digital assets.
Caroline Butler, global head of custody, BNY Mellon, comments: “We made a Series C investment in them, and I hope that having a name like BNY Mellon attached to their funding would open the door for other institutional types who might not have considered investing or adopting their services otherwise.”
“But at the same time, we see it as a strategic investment on our part given our confidence in their platform and the proximity we have to them,” Butler adds.
This partnership is just one of several recent announcements about banks investing into fintech or collaborating with digital asset native solution providers.
Kech suggests this is a logical trend as some banks realise their lack of know-how in this space.
He says: “There will be more of these announcements in 2021 and 2022 as these worlds merge closer and closer. These collaborations will contribute to both, bringing technological and operational knowledge to the banks, while raising the profile and legitimacy of the fintechs, and for some of them, strengthening their compliance mindset.”
A digital future
The future of finance will see a bridge between digital and traditional assets. The role of the digital assets custodian is therefore only likely to grow in prevalence for the years to come.
Julie Veltman, head of finance, Anchorage, stipulates: “The future of finance will be digital assets and blockchain technology becoming ‘traditional’.”
“There is no doubt in my mind that the future of finance will be digital — as both a mechanism of delivery of traditional financial products, and also in financial products themselves being built in an entirely different way.”
“There will no longer be a distinction between traditional finance and crypto, because outdated and slow banking processes will improve by incorporating these technologies.”
In terms of moving this process forward, institutional adoption of digital assets will drive the process forward, and partnerships between custodians and prime brokers with their clients will enable that adoption.
“The lynchpin of success is that adaptability to asset servicing which will keep costs down for banks, support client adoption of these assets and enable greater profitability for both,” comments Collings.
Meanwhile, PARSIQ sees digital asset custody moving towards the hybrid model because the main of decentralisation in the cryptocurrency world is in conflict with the centralised power that many financial institutions have when providing custody of digital assets.
Collings explains: “Hybrid model means partially non-custodial. The owner of the assets has custody at most times. For example, in the case of exchanges, the owner of the assets holds custody at all times except when settling a trade.”
“We believe these hybrid models will become favourable with users and in time prevail over completely centralised models of custodianship.”
Experts also highlight that digital asset custody will become more and more important as more and more traditional players get into this space.
Kech muses: “Digital asset custodians, as they already are doing today, will strengthen the ancillary services they have developed at the request of their customers, becoming de facto prime brokers offering over the counter trading, lending/borrowing and other value-added services.”
“It will be difficult in the future to distinguish between a bank and a custodian as the tokenisation of money and assets will further blur the operational, technological and compliance differences, leading to a new type of banking and finance,” concludes Kech.
