As Digital Assets Start to Gain Traction, Should We Reassess the Role of the Custodian?
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FOR DECADES, CUSTODIAL BANKS HAVE BEEN RESPONSIBLE FOR THE SAFEKEEPING OF THEIR CLIENTS’ ASSETS AND THE PROCESSING OF TRANSACTIONS.

The first market where custodial banks developed was in the United States. In the early days, when funds existed only in paper form, investors needed a safe place to store those certificates of value. At the beginning, investors practised so-called self-custody and personally secured the paper certificates that claimed rights to their investments. Then, in 1929, the stock market crashed, which led investors to realise the risk involved with this approach.

Around this time, financial institutions evolved to provide custody services. Banks, with their strong and protected vaults, were a natural choice for entrusting high-value assets. Due to the lack of technology at the time, the custody services involved the cumbersome physical transfer of certificates from one place to another.

Over the years, the technological developments emerged and the market matured. New asset classes surfaced. This forced custodians to transform their legacy systems and expand their service range to meet the growing demand for new types of assets, such as alternative investments, sustainable finance, and — recently — digital assets.

THE RISE OF DIGITAL ASSETS

The market for digital assets has evolved dramatically since the release of Bitcoin’s white paper twelve years ago. Digital assets have become one of the most disruptive and revolutionary technologies accessible to a broad range of individuals and institutions. At the start of 2020, CoinMarketCap listed over 5,100 cryptocurrencies with a total market capitalisation exceeding $250 billion. But cryptocurrencies are only a fraction of the overall digital assets market.

Tokenised real estates, equities and bonds are expected to reach $4trillion in 2022 and grow up to $24 trillion in 2027. Prominent banks around the world are announcing tokenisation projects. Austrian Raiffeisen Bank International (RBI) revealed that it will run a pilot project to digitise bank account cash as RBI Coin. Commerzbank recently announced that it has finished a test using distributed ledger technology for post-trade services and settled a securities transaction with blockchain-based tokens. Last year, the United States’ largest bank by total assets, JP Morgan, introduced the JPM Coin that enables enterprises to facilitate interbank payments and settle blockchain transactions instantly.

And we continue to see encouraging signs for further adoption.

CENTRAL BANKS ARE SLOWLY BUT SURELY JUMPING ON THE BANDWAGON

There is a clear trend towards digital currencies among governments and central banks. The People’s Bank of China has already started pilot trials of its digital currency in four cities across the country.

The government of Turkey has included a central bank-issued digital currency in its 2019–2023 economic roadmap and continues to work on implementing “blockchain-based digital central bank money.”

In Europe, countries such as the Netherlands, Switzerland, the United Kingdom, France and Sweden, as well as the European Central Bank, announced similar projects and initiatives.

REGULATORY ICE HAS BEEN BROKEN

Regulatory bodies worldwide are working to promulgate industry regulations. The European Union’s 5th Anti-Money Laundering Directive (AMLD5) that came into effect on January 10, 2020, extends the EU’s anti-money laundering and counter-terrorism financial rules to digital currencies and applies to entities that provide custody services related to these currencies.

On January 1, 2020, the Liechtenstein Blockchain Act came into force. The act, named the “Law on Tokens and Trusted Technology Service Providers,” allows straightforward of all kinds of assets and rights without legal workarounds.

But France was ahead of others. In April 2019, the country officially adopted a regulatory framework for digital assets while Finland started regulating its digital asset industry in May. In Turkey, Capital Markets Board (CMB), the country’s regulatory body, announced its plans to craft a regulatory framework for digital assets by the end of 2020.

Similar developments are occurring in Switzerland. In August 2019, two digital-asset-focused banks received a banking and securities dealer license from the Financial Market Supervisory Authority (FINMA). It’s also worth mentioning that FINMA continues to expand the regulatory framework for companies operating in this ecosystem.

Germany passed a law implementing the EU Money Laundering Directive into its Banking Act (KWG), which covers the custody of digital assets. According to the law, banks who want to extend their businesses to cover the custody of digital assets will now need an additional license. The business newspaper Handelsblatt recently reported that forty banks have already approached the German regulator BaFin to show their interest in obtaining the necessary license.

THE INCREASE OF INSTITUTIONAL INTEREST

Since the 2017 speculative bubble, we’ve been witnessing a constant rise of institutional investments in the digital asset ecosystem. Venture capitalists, hedge funds, family offices, established Fortune 500 stakeholders are becoming more and more interested in exploring this emerging space.

According to a recent Fidelity Investments survey of about 800 institutional investors in the United States and Europe, as many as 36 percent of institutional investors own some type of digital assets. Additionally, about 80 percent of institutions said they find digital assets appealing, and 60 percent believe that this new asset class has a place in their portfolios.

Furthermore, digital assets gained sizeable credibility among institutions. State Street’s recent industry outlook survey showed that 94 percent of the bank’s clients who participated in the survey already have or plan to have digital-asset-related investments within the coming year, while 69 percent of the largest companies plan to increase their investments to this asset class.

Hedge funds are also not falling behind. Crypto Hedge Fund Report 2020, published by PwC and digital asset investment company, Elwood, revealed that hedge fund investment in digital assets is notably growing. According to the report, the total AUM of crypto hedge funds doubled globally to over US$2 billion in 2019 from US$1 billion the previous year.

CUSTODIAN 3.0

The expansion of the digital asset market didn’t only bring new entrants to the ecosystem. It also brought a surging demand for reliable and secure custodians. Digital assets, just like traditional assets, require robust custody services. And banks, traditional custodians safeguarding their clients’ assets for decades, are once more, the natural trustees. By leveraging their already established and loyal client base, banks have a lucrative opportunity to capitalise on the emerging digital asset market.

The following quote from an opinion piece published on the website of BNY Mellon, one of the leading global custodians confirms this:

“There is increasing demand in the market for a traditional, established custodian to provide custody of digital assets… Institutional clients may look to established custodians to secure these assets for a number of reasons. Practically, it may be preferable to go to a partner with whom they have an existing relationship, but often the main driver is the increased comfort found with the backing of a significant institution with a strong governance and control framework, as well as a sizable balance sheet.”

The principle of delivering custody service is the same for both traditional and digital assets, but the methods are quite different given the decentralised nature of blockchain technology.

BRIDGING THE GAP BETWEEN THE TRADITIONAL FINANCIAL WORLD AND DIGITAL ASSETS

So, what do banks need to provide digital asset custody that is equally as robust, secure and compliant as the custody of traditional assets? For starters, the right infrastructure. Safeguarding digital assets requires a new kind of infrastructure, designed specifically for tokenised assets and distinct from the traditional paper-and-safe approach The infrastructure, that enables banks to overcome significant hurdles tied with digital asset custody such as:

SECURITY RISKS

Contrary to traditional assets, which are protected with keys and passwords, with digital assets, keys are equal to assets. A single misuse can lead to catastrophic consequences, and because of blockchain’s irreversible nature, any transaction that happens is definite. With cyber attacks growing in number and sophistication, it’s clear that traditional IT rules of protection are designed for the Web 2.0 era and are inefficient when it comes to blockchain-based tokens.

ACHIEVING AND MAINTAINING REGULATORY COMPLIANCE

As regulations continue to evolve, regulatory bodies are increasing demands and calling for assets to be managed in segregated accounts with transparent governance and audit trails. In addition, custodians must improve their surveillance practices and be able to detect possible fraud and market manipulation. Numerous compliance failures have left companies managing digital assets without a license to operate.

KEEPING THE PACE WITH THE EVER-EVOLVING INDUSTRY

The digital assets ecosystem is evolving at incredible speed with a constant stream of new assets emerging and entering the market. This means that any institution providing related services should develop technical and operational flexibility to quickly and easily embrace digital asset custody specific requirements as well as upcoming innovations. In addition, custody solutions have to be flexible enough to meet the unique needs of digital asset owners — especially at the institutional level.

RIDDLE&CODE’S INSTITUTIONAL-GRADE DIGITAL ASSET CUSTODY SOLUTION

At RIDDLE&CODE, we believe that institutional-grade digital asset custody should be backed with an institutional-grade wallet. With this in mind and as a response to the market’s growing needs, we developed a new breed of digital asset custody solution.

RIDDLE&CODE’s Digital Asset Custody combines hardware and software with a set of innovative features and functionalities to enable regulatory compliant and secure digital asset management.

Our solution deploys a decentralised architecture with several tamper-proof hardware components and ensures that the private key is not stored on a single device. Instead, by leveraging secure multiparty computation, it splits the key into shares and distributes it among several signees. Each signee gets a unique part, and transactions can only be signed if the predetermined number of signees contribute their secret shares. The final signing key for the transaction is generated out of signee shares from all participants in the transaction. In this way, a transaction must be authorized by a certain threshold of devices in order to be valid.

Digital Asset Custody has a set of built-in regulatory APIs that allow our clients to achieve and maintain regulatory compliance. Moreover, its architecture removes the hassle of managing hot and cold wallets separately and allows flexible signing schemes customised according to various roles and parameters.

Digital Asset Custody comes in two editions. First, the Essential edition is in a form of self-custody, deployed on-premises at a location of choice and allows the client to stay in full control of the solution and all related operations.

The second one, Key management as a service edition, is aimed at more demanding and sophisticated purposes. Using dedicated hardware devices several parties are required to authorise and execute transactions that comply with pre-defined approval workflows. Key management as a service edition can be run and deployed in RIDDLE&CODE’s distributed data centre or hosted in the clients’ data centre with the capability to integrate existing HSMs.

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