A new era for digital custody

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An article by Archax

Bridging the worlds of Traditional and Digital

The Evolving Custodian - Backstage to Centre Stage

20 years ago in the world of traditional capital markets, the appointment of a custodian was often considered very late in the process of getting a transaction to market. Custody and the safekeeping of assets were very much considered part of the plumbing works for transactions, and this role sat alongside other unexciting but essential roles of registrar, transfer and paying agent. A choice of known, trusted incumbents of banks and financial institutions provided custody services for traditional assets and functions were often bundled together with relatively minimal cost. The business worked as a high-volume, low-cost model while the ask of the custodian was to keep assets safe and facilitate the settlement and transfer of those assets. How to achieve this was pretty well established for traditional assets and securities, and the custodian was at its core a trusted, regulated counterparty who could face off against other institutions to ensure the safekeeping of those assets.

Roll on 2023 and, while market players still use incumbent custodians today in much the same way for traditional assets as they have always done, digital assets have required and enabled an evolution of the role of the digital asset custodian. The appointment of such a custodian is now at the forefront of any proposed transaction involving digital assets as there are many challenges to navigate throughout the entire lifecycle of these assets and getting it wrong could be catastrophic for investors and asset managers.

The role for the digital asset custodian becomes so much more compelling given the growth projections of this market and the trajectory of all assets becoming digital. The size of global digital asset custody market is currently valued at over $0.45trn and while that’s a fraction of the size of the traditional markets today, (1) it is set to grow exponentially to over $1.6trn by 2028. (2)

What’s driving demand?

An increase in demand for digital asset custodians is coming from institutions, particularly global banks and asset managers now firmly in the space. (3) Their participation is seen as an inflection point in adoption of the underlying blockchain and distributed ledger technology. It evokes confidence in the benefits to be derived from this technology, including increased transparency and auditability, with an immutable record of all transactions, providing a clear audit trail for regulators and investors as well as opening access for investors and for global distribution. It also enables efficiencies in processes, particularly for settlement and post trade actions, and lays a pathway for new types of products in digital form.

If we look a bit deeper, we can see that the institutional demand for custody services is actually across the full spectrum of digital assets from crypto to securities tokens, as well as traditional securities. Institutional players are looking for a single trusted third-party partner who can bridge the traditional and digital worlds to provide institutional-grade digital asset custody for both types of assets, thus enabling institutions to focus on their own core offering and manage their own risk. (4)

Self-custody as an option has little appeal to institutions because unlike traditional assets, the custody of digital assets introduces unique operational challenges – typically anyone can view wallet balances and transactions on chain, but only private key holders can transfer assets. These institutions would rather outsource the complex and evolving activities of the digital custodian than maintain the service in-house which adds no value to their core business. Such outsourcing is necessary if the industry is to scale.

Also of interest to these institutions, is putting their assets under custody to work and generating yield through cross-collateralisation opportunities, institutional-grade staking and digital securities lending. This is achievable through tokenisation and access to yield-generating products such as tokenised money market funds of large global asset managers. Many also want to trade their digital assets on a secondary market, and to do so with the same trusted counterparty. A few players in the market are able to do this, most notably Archax.

The ask of digital custodian providers is therefore not only to provide enhanced security for the safekeeping of assets (including the use of advanced encryption algorithms and multi-signature wallets), but also to bridge the worlds of traditional and digital assets through seamless integration and to offer a comprehensive suite of services that cater to the needs of multiple asset classes.

It is no small task to build this ecosystem and huge strides are being made, but we are not quite there yet – which in part explains the slow burn towards adoption. In fact, institutions cite one of the biggest challenges to adoption of the underlying technology is the lack of digital asset market infrastructure to support issuance, trading and post-trade activities. (5)

How are current custody solutions addressing the demand from and needs of institutions?

It is true that few participants in the market provide custody across the full spectrum of digital assets and also provide services that enable yield and cross-collateralisation opportunities.

It is tough for investors and asset managers to assess counterparty risk and perform complete due diligence on many new entrant custodians who have varying degrees of registration, regulatory approval and asset security. Most crypto custodians can only handle crypto and, whilst sometimes registered, most are not regulated. Only a few are doing both, including Archax and recently DZ Bank. (6)

Most mainstream custodians do not yet handle crypto, although a number of traditional incumbents are starting to look at providing digital asset custody services with limited scope, including the world’s largest custodian BNY Mellon, for certain US institutional clients, Citi and most recently HSBC for tokenised securities. (7) Even so, such incumbents cannot or will not yet provide the full suite of services to satisfy an ever-increasing demand and this in turn impacts progress for greater adoption of DLT and blockchain technology.

The failures of companies in crypto markets over the past 18 months have highlighted the consequence of lacking corporate governance, institutional-grade controls and processes, as well as insolvency-remote segregated structures. These failings have put assets at risk and the real losses have had significant impact on the market and suppressed the appetite for crypto and to some extent all digital assets. However, these were all human failings rather than issues with crypto instruments or technology. What remains robust is the underlying belief in DLT and leveraging blockchain technology. This period and the problems experienced also highlight the need for the use of best practice and standards, as well as regulation-shaping rules for those holding digital assets and how these assets are to be held.

Conclusion

Digital asset participation continues to increase among institutional investors. So too does the need to focus on market infrastructure, regulation and trading solutions. The role of a digital asset custodian to securely hold and store digital assets, is centre stage. A core pillar of that infrastructure and the function of that digital asset custodian includes the ability to handle crypto, regulated security tokens, other digital assets, traditional securities and other financial assets as well.

Investors and asset managers need to look at the regulated and registered status of a digital asset custodian as well as the level of corporate governance, controls and processes, which must be institutional-grade. The custodian’s ability to provide insolvency-remote segregated structures for multi-assets is crucial, whether regulated or unregulated, treating both equally and providing robust institutional-grade cryptography for secure key management.

Finally, investors want yield generation through cross-collateralisation opportunities, institutional-grade staking and digital securities lending. Few have this capability today. At Archax, as regulated custodian, broker and exchange, we address these needs as we forge a path forward for the industry, acting as a bridge across traditional and digital. For the industry to scale, incumbents and new players will need to coexist and evolve to be able to deliver as digital asset custodians on the opportunities presented through digital assets and the underlying technology. The journey is well underway and other challenges are also being worked through for implementing standards, (8) legal and regulatory certainty, (9) settlement and finality, (10) DLT governance and interoperability. (11)

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(1) As of June 2022, according to www.globalcustodian.com , the top four leading global custodians held US$136 trillion in AUC (BNY Mellon US$43 trillion, State Street US$38 trillion, JP Morgan Chase US$28 trillion and Citi US$27 trillion).

(2) Digital Asset Custody Report 2023

(3) Blackrock, abrdn, Fidelity, Goldman Sachs, Citi, BNYMellon - Big Financial Institutions Are Adopting Crypto And Blockchain - What Does The Technology Offer SMBs?, Forbes, 6 July, 2023

(4) BNY Mellon, Institutional Investing 2.0, Migration to Digital Assets Accelerates, Key Findings from Celent’s 2022 Survey of Global Institutional Asset Managers, Asset Owners, and Hedge Funds, October 2022, page 9. See also BNY Mellon gives institutional investors ‘crypto’ survey CoinGeek, 31 October 2022.

(5) A senior official at the European Investment Bank (EIB), the biggest digital bond issuer to date, is reported have said that a key constraint has been the lack of mainstream custodians to support digital assets. See Future of Finance, Digital Asset Custody: The Future looks like the past, page 4.

(6) Custody - Securities (archax.com); Germany’s DZ Bank Launches Crypto Custody Service, Embracing Blockchain Technology, Coinfeeds, 6 November 2023

(7) HSBC Plans Digital Assets Custody for Tokenized Securities, Bloomberg, 6 November 2023

(8) Gdf- https://www.gdf.io/working-group/custody/

(9) Including the EU Markets in Crypto-assets (MiCA) Regulation and the UK Financial Services and Markets Act 2023 (FSMA).

(10) Montis Digital https://montis.digital/

(11) Project Guardian: https://www.mas.gov.sg/schemes-and-initiatives/project-guardian; Ownera: https://ownera.io/