What happens when your asset managers start to invest in assets your custodian knows nothing about?

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Why do digital asset custodians exist at all when blockchain was invented to eliminate the need for trusted intermediaries?

Issuers and investors, and intermediaries such as asset managers and brokers, are agreed that custodians are essential to secure mainstream adoption of digital assets. Such universal agreement reflects the fact that custodians reassure investors, asset managers and brokers that their assets are safe, and their privacy and confidentiality will be respected. Custodians also provide a crucial link with traditional asset markets, bringing digital assets within the scope of the regulations and the data standards that have enabled traditional markets to scale. Financial market infrastructures such as central securities depositories (CSDs) are also seen as providing convenient bridges between new and established asset types. Views differ on whether the need is best met by specialist digital asset custodians or by traditional custodian banks, which now have an opportunity to expand their product coverage.

How well are traditional custodians adapting to the digital asset opportunity?

Some traditional custodians are building digital asset custody services. The banks that are entering the market - and it is still a minority of the global custodian banks - are responding to rising institutional flows. They find the learning curve is steep, since they must integrate technological, operational and legal components. The custodians must understand and connect to multiple blockchain protocols, integrate off-chain assets while servicing on-chain representations of the same assets and adapt the fiduciary structure of traditional custody agreements to digital asset custodianship. They also find the settlement and safekeeping requirements of security and fund tokens are different from the settlement and safekeeping requirements of cryptocurrencies, so custodians are grappling with varying service requirements. In addition, they face the twin challenges of continuous changes in digital asset custody technology and digital asset custody technology vendors, whose ownership is subject to change through merger and acquisition. The cost and difficulty of integrating digital asset systems with traditional post-trade systems erects a further barrier to adaptation. But where custodians are really struggling is the settlement process for digital assets. They cannot interact with any counterpart without issuing a due diligence questionnaire and, even after the counterpart is approved, rely on bi-lateral test transfers, whitelists of counterparties and manual checks. A settlement system of this kind is impossible to scale, but custodian banks have no alternative vision of the type of settlement infrastructure that scale requires, and certainly no strategy to achieve it.

Why are so few established custodian banks taking an interest in digital assets?

The limited engagement by custodian banks is not for want of interest in blockchain technology. Virtually every custodian has experimented with the technology. The obstacle is the inability of the tokenisation enthusiasts at the banks to persuade risk committees to sanction investment. The principal explanation of this reluctance is the lack of legal certainty. After all, if a risk committee feels a legal contract will not be enforceable in the courts, they will lack the trust and confidence to authorise bankers to enter such contracts. Without the confidence that the law will support the ownership and transfer of digital assets, investment is bound to be limited. Conversely, once that confidence is in place, growth will accelerate because custodians can reassure their buy-side clients that a smart contract, for example, will be upheld by the courts. Once risk committees understand legal certainty is achievable, more custodians will enter the market. Which is why token enthusiasts at custodian banks should ensure their risk committees understand the legislative progress that is being made in the United Kingdom and the European Union (EU).

Custodians have always struggled to safekeep “out of network” assets that are not issued into a central securities depository (CSD). How are they reacting to the tokenisation of real-world assets (RWAs) outside CSDs?

Custodians asked to safekeep the RWAs currently being tokenised certainly do not enjoy the benefits of working with an established clearing and settlement infrastructure akin to that of the traditional securities markets. Issuers and exchanges have focused on the data “oracles” that govern the valuation of the tokens and have relied on digital asset custody technology vendors to provide custodians and their buy-side clients with the reassurance they need. In the absence of a CSD, custodians struggle to keep track of ownership and the transactions that govern ownership. But a CSD for digital assets is now being built. Montis, a subsidiary of the Archax digital asset exchange, has applied for a CSD licence in Luxembourg. Once it is secured, tokens can be issued into and settled in a digital CSD as well as traded on Archax. Montis has also applied for entry to the Digital Securities Sandbox (DSS) set up by the Bank of England and the Financial Conduct Authority (FCA) so it can provide issuance and settlement services for digital assets in the United Kingdom. It can be argued that what is missing from digital asset custody is not traditional custodian banks but the equivalent of traditional financial market infrastructures. Building these might require a greater degree of cooperation between market participants. 

Why do digital assets, which can be issued, traded, settled and safekept on a public blockchain, even need a CSD?

Primarily to make transactions in digital assets legally enforceable under the Settlement Finality Directive of the European Union (EU). Settlement in a CSD also simplifies the aggregation of transactions in digital assets with transactions in traditional assets, which are settled under the same laws. Luxembourg law has gone further and permitted the issuance and registration of both conventional and digital assets on any digital technology, including blockchain. By making assets technology-agnostic – in other words, operationally identical - in this way Luxembourg law makes it easy to aggregate assets and transactions in those assets across traditional and tokenised markets. The real value of a CSD in the future will be its ability to transfer and register ownership of both digital and conventional assets in the same way, with legal certainty. Business will gravitate to the jurisdictions that grasp the connection between legal certainty and increased scale in digital asset markets.

What do end-investors think about custody?

Investors are not yet convinced that digital assets offer superior returns to traditional assets and know that they are bound to be less liquid. What is visible to investors - albeit mostly through their asset managers and custodians - is the increased cost and complexity of investing in digital assets in terms of connectivity, on-boarding and account-opening, because of the lack of market infrastructure and data standards. Naturally, investors are concerned that rogue actors will steal their digital assets. They expect custodians to make them whole in the event of losses for which the custodian is responsible. They also expect custodians to operate on a regulated, fiduciary basis that ensures their assets are safe even if the custodian fails. But investors are not willing to engage independently with the technicalities of digital asset custody. They expect their traditional custodians to solve the problem of digital asset custody for them. An implication of this is that institutional investors are unlikely to appoint a non-bank digital asset custodian as a service provider. This argues for closer co-operation and even mergers between traditional custodian banks and non-bank digital asset custodians.

Does the custody industry have a responsibility to build the infrastructure to facilitate investment in digital assets?

They have an opportunity, not a responsibility.  Market developments indicate the buy-side demand for digital asset custody services in the near-term will come not from the tokenisation of the public equity and debt markets but from tokenised and tradeable private credit, carbon credits and money market funds.  In the longer term, custodians enjoy further opportunities in the transfer of wealth from Baby Boomers to Millennials and Generation Z. As the cryptocurrency market has proved, younger consumers want to trade, invest and safekeep their savings in digital form via apps. They also expect investment portfolios to be personalised to their wants, needs and values. In principle, tokenisation makes it easier to achieve these goals. Custodians will have to provide services that enable asset and wealth managers to deliver what younger consumers want, or they will not survive, so there is risk if custodians fail to rise to the opportunity. That said, the principal driver of growth in token investment will remain what has always driven investment: namely, the tax treatment of investments. Wealth will gravitate to the stable, legally reliable jurisdictions that offer the most generous tax treatment of investments, and custodians will have to be prepared to follow it. Ultimately, tax is more important than technology, or tokenisation.