Will users of Digital Assets need traditional custody providers?

Custodians by assets under custody 

Source: The Asian Banker 

Banks are increasingly coming under pressure to adopt new business practises and offer alternative products and services as financial markets evolve and further embrace technology, both at an institutional and retail level. With our lives becoming increasingly digitised, there is a growing dependency on IT and machine-based processing as opposed to  many of the paper-based analogue systems that historically have been the backbone of  banking systems and procedures. For example, there is a growing question as to the current need for custody services which have historically been provided by banks offering to hold 

assets (such as equities, bonds and commodities) on behalf clients in a safe and secure  manner.  

Custodian bankers don’t tend to offer what one would class as traditional banking services – mortgages, current accounts or lending services – but have focused on offering institutional  services particularly for fund managers. At one level it is rather strange that an investor in a  fund managed by Blackrock, the world’s largest fund manager with over $7.1 trillion of   assets undermanagement, needs to rely on a third party such as a custodian and not  Blackrock for the security of its funds. Financial services regulators, such as the SEC in the US  or the FCA in the UK, insist that Blackrock must use an external and independent custodian  to actually hold the assets e.g. the equities or bonds in a fund. This adds to the costs of the  fund for the investor as well as an added level of complexity and requirement for more  records to be checked and monitored, alongside the inevitable queries and time delays in  reconciling data. At the time, the requirement for such a system was developed when asset  managers were required to physically deal in paper-based assets, and it was extremely  difficult to be certain who actually had the physical possession of a share or bond certificate. 

Unsurprisingly today, there is the threat of redundancy for this rather archaic way of  managing money what with the existence of digitisation of information. The ability to hold  data in a very structured manner means that machines can easily track and trace who owns  what, and where the assets are held, in ‘real-time’. The application of Blockchain technology  and use of smart contracts ensures that many of the current manual checking and  monitoring can be carried out automatically. Therefore, it ought to be of no surprise that  organisations such as the Depositary Trust and Clearing Corporation (DTCC) has been  working with IBM to build a Blockchain-powered platform to handle the current $10 trillion of derivatives that the DTCC handles p.a. Recently, the Singapore financial regulator has  granted permission to allow the Asian bank, DBS, and cryptocurrency exchange,  Independent Reserve (based in Australia), to offer digital asset services to retail as well as to  institutional clients in Singapore. Adrian Prelozny, CEO of Independent Reserve, urged  Australians to take an example from the Singaporean “thorough approach to crypto industry  licensing”, reminding them that “there are no custodian requirements for the exchanges in  Australia”. 

Meanwhile, there is an argument that by using a multi-signature wallet there is no need to  have a separate firm to provide custody services, since the only way assets can be  transferred from a multi-signature wallet is if a number of the multi-signature parties are  involved. This sounds attractive as no one party is solely responsible for holding the digital  asset safe and therefore the custody costs can be less. However, multi signature wallets do  present challenges: 

• if something goes wrong, seeking legal address may prove to be a challenge since multi signature wallets are relatively new concepts. 

• transaction speed may be slow because multi signature wallets need more than one  party to execute a transaction.  

• the process of recovery of a multi-signature wallet requires importing each of the  recovery phrases on a different device, which is not a fast process.

For now, those institutions trading and holding cryptocurrencies are required to continue  using custody services which helps to explain why some of the largest traditional providers,  such as Bank of New York, State Street and more recently U.S. Bank, are now offering digital  asset custody services. Although the cryptocurrency market is still relatively small (approx.  $2trillion), as we start to see more organisations issuing digitised equity and debt  instruments the requirement to use traditional banks to provide custody services may well  be increasingly questioned. The potential ability to remove the need for a custodian is an  example of ‘disintermediation’, a term often used as a key reason why we are seeing  financial markets being disrupted by Blockchain-based platforms. Furthermore, such use of  Blockchain-powered platforms offers greater transparency, and therefore trust, which  ought to lead to lower professional indemnity insurance premiums and lower costs for the  end client. A smaller “Total Expense Ratio” for a fund ought to lead to better performance  for the funds held in your pension plans and savings. The use of Blockchain technology also  offers compliance departments and regulators, as well as senior management, greater  oversight (potentially on a real-time basis). These are powerful drivers helping to encourage  the huge potential offered by Blockchain technology. In turn, it raises a further question – will funds investing in Digital Assets in the future use, or even need, the traditional  custodians that are so extensively employed today?