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The Role of Digital Asset Custodians

Custodian is one of the most important market infrastructure in traditional finance. As the traditional giants stepping into the asset class, we see the growing influence of digital asset custodians. In this article we try to compare the digital asset custodians with their traditional counterparts. We start with the original functions of securities custodians, and then explore whether these functions are becoming more or less important in the digital world.

 

A decade after the introduction of Bitcoin, cryptocurrencies have proven two things:

  1. Bitcoin has failed at achieving its original goal as decentralized peer-to-peer electronic cash;
  2. Yet cryptocurrencies have shown alternative potential to the point that many governments now consider them an alternative asset class.

It is important when viewing financial instruments to not merely focus on the instrument itself. Instead, we must consider the ‘package’ as a whole, including any associated regulations.

The birth of cryptocurrency is mired in strong ideology and a will to achieve independence from existing institutions. However, the intervention of regulators is inevitable and will serve to foster investment confidence in the market and ensure investor protection. Regulators have recently been calling for digital asset custodians able to properly handle digital assets, yet the responsibilities of custodians may not be familiar to all. Understanding the role of custody services in traditional financial markets is critical if we wish to understand why digital asset markets need qualified digital asset custodians.

Custodians are first and foremost trusted business partners that assume fiduciary duties to their clients. As such, they must and will put their clients’ interests before their own, regardless of industry: traditional capital markets or digital asset markets.


I. THE ROLE OF TRADITIONAL CUSTODIANS

Traditional custodians play a crucial role in capital markets (click to view full diagram):

Digital Asset Custodians and Capital Markets
Potential Role of Digital Asset Custodians


I.I Safeguarding Assets

Your custodian is your vault. Modern banking has its roots with entrepreneurial goldsmiths. They offered to safeguard valuables for and assist in the settlement of financial obligations between merchants. Born out of that origin, modern custodian banks today still serve to safeguard their clients’ assets from theft or loss.

The ability to manage client assets and implement cyber-risk measures are both important requirements for a modern custodian bank.


I.II Improving the Operational Efficiencies of Markets

Your custodian is your agent. Custodian banks assume further responsibilities in modern capital markets beyond the safekeeping of assets. A core responsibility of a custodian bank is the offering of settlement services. Modern capital markets play host to thousands of participants, millions of trades, and trillions of dollars that are moved every day. Tracking the owner, amount, and type of every single transaction is a gargantuan task. And with more variables in the equation, the greater the likelihood of errors and inefficiencies in the output. The custodian simplifies this equation by netting and taking all transaction details under its own name on behalf of its clients. The custodian’s comprehensive operational duties, experience, and international networking power further serve to aid clients in accessing markets. The door of a custodian is typically the first door to knock on if you wish to enter the market.

The ability to effectively employ scalable on- and offline infrastructure and efficiently process huge volumes of transactions are essential characteristics of a custodian.


I.III Ensuring Client Compliance with Regulatory and Reporting Standards

Your custodian is your airbag. Transactions in the financial world are heavily regulated. The different roles and responsibilities of market participants are clearly mandated by the government. In the custody context, the segregation of investment management and the custody of underlying assets is required by law so as to promote objective business practices.

With custody service being the first step of every transaction, the custodian also serves as a central record-keeping house of past transactions for audit-trail purposes. The nature of this role transforms the custodian into the first line of defense against financial crime, such as money-laundering and terrorist-financing. Custodians are your regulatory partners that help you understand and mitigate legal risks by offering compliant transaction practices that are aligned with local jurisdictions.

Comprehensive knowledge of local regulations is a crucial characteristic for any custodian.


II. THE ROLE OF DIGITAL ASSET CUSTODIANS

In the previous section, we discussed the three major responsibilities of traditional custodians. All three responsibilities are also applicable to custodians of digital assets.

Functions Traditional Custodians Digital Asset Custodians
Safeguarding assets As participants in central clearance and settlement systems, custodians maintain records and custody ownership on behalf of clients The responsibility of safekeeping assets becomes more important with custodians now being responsible for the private keys to client assets
Improving the operational efficiencies of markets Providing fund managers with access to various market entities and infrastructure, e.g. settlement systems and global custodians Providing access to various parts of market infrastructure, e.g.  consortiums or distributed ledger networks for settlement
Ensuring client compliance with regulatory and reporting standards Fulfilling regulatory requirements such as KYC/ AML policies Fulfilling regulatory requirements such as KYC/ AML policies


II.I Safeguarding Assets

Your digital asset custodian is your vault. Cryptocurrencies and crypto-assets are alternative asset classes that reside on distributed ledgers (e.g. blockchains). The systems for how these instruments are stored and traded are susceptible to significant cybersecurity threats, and it is estimated that over 1.2M units of Bitcoin (~USD 4.1B today) have been stolen to date through various wallet hacks (BTC = $3400, article written: 7 Dec 2018).

Digital asset custodians must safeguard client assets through their own unique operating procedures in order to sufficiently protect client funds from cyberattacks. One of the potential ways to ensure this sufficient security is through the use of air-gapped cold wallets that store deposits offline, safely out of reach from any malicious attacker. The aforementioned cases of stolen cryptocurrencies were all stolen out of hot wallets, in other words deposits being stored in online environments. The use of a cold wallet system eliminates this external threat, but internal threats still remain a concern to clients.

The track-record and integrity of staff are two key metrics for clients when assessing internal control risks.


II.II Improving the Operational Efficiencies of Markets

Your digital asset custodian is your agent. The cryptocurrency industry is an emerging industry operating under immature market practices. A lack of business practice standards and regulations that mandate market objectivity and transparency (in other words informational efficiency) currently frighten potential investors and contribute to heightened entry barriers.

  • Potential investors: There is a lack of standard practice, and countless platforms to choose from, not sure how and where to begin?
  • Service providers: Can potentially take advantage of the lack of market scrutiny, experience, and expertise.

Only with market experience will digital asset custodians be able to provide clients with improved efficiency through balanced and informed guidance. This guidance is crucial, as it serves to help clients fully leverage market potential and protect them from malicious settlement practices from informational inefficiencies. In addition, the extensive network power of experienced custodians may provide clients with trusted transaction execution channels to shorten unnecessary delays.

Experience and technical expertise are cornerstone pre-requisites of any digital asset custodian.


II.III Ensuring Client Compliance with Regulatory and Reporting Standards

Your digital asset custodian is your airbag. The digital asset industry has attracted the attention of regulators after proving its market potential. Although cryptocurrency has its roots in the complete separation from government, the intervention of regulators is inevitable and unquestionable. Citing the potential misuse of transactions (financial products and services) for purposes of financial crime, and the lack of structured monitoring as major concerns, official regulatory bodies such as the U.S. Securities and Exchange Commission and the Hong Kong Securities and Futures Commission recently made a series of official regulatory announcements. However, these regulatory bodies are also new to this market, and strong regulatory statements are as such still avoided.

Digital asset custodians must under these unclear conditions be ready to address the questions and needs of regulators, should they be called for. There are regulatory requirements and mandates that must be properly fulfilled for an entity to be considered a legitimate custodian. Many of these requirements relate to anti-money laundering and anti-terrorist financing measures, which require robust Know Your Client (KYC) practices and procedures. Digital asset custody services will as such enhance the credit of the participant and the transparency of transactions being made. At the same time, when regulatory changes are introduced, the custodian must be sufficiently agile to implement and reflect respective changes. This is crucial to protect its clients from breaching local jurisdiction.

Agility is going to be a key determinant for the success of a digital asset custodian.


Closing Remarks:

There are still ‘many elephants in the room’ with regards to the custody of digital assets. Regulators’ cautious first steps into the digital asset market make it difficult to determine the degree and nature of future regulations. There is currently little in the form of standard market practices. Digital asset custodians can at best ensure they are compliant with the regulations of traditional markets, and at worst completely ignore regulations. The custody of digital assets also introduces several new challenges, such as ensuring sufficient cybersecurity protection of assets, and there is little regulatory precedence from traditional markets to follow.

New markets tend to attract the brightest and most ambitious of minds with promises of new business models and opportunities. Sometimes this experimental nature of the ‘financial wild west’ straddles the law and pushes technology usage in the direction of malicious and fraudulent activities. Custodians are a natural first ‘sheriff’ to enter this environment. They extend the reach of official regulations, introduce standard business practices, introduce added transparency, and improve market efficiency. Just ensure that your trusted digital asset custodian has the financial as well as technical expertise. They not only protect your assets against 21st century threats, but also unlock new market opportunities for you as your trusted agent.