Digital assets custody: too big to ignore

Securities services providers feel their way into the world of digital assets

 Stock markets around the world have continued to surge into 2021. And more glaringly, bitcoin prices soared to all-time high of over US$40,000 on January 8, with a market cap of over $740 billion. Similarly, prices of ethereum, the second most popular cryptocurrency, jumped to a record high of more than $1,250. The total value of the cryptocurrency market exceeds $1 trillion, according to data from cryptocurrency website CoinGecko.

The explosive growth underscores how cryptocurrencies have come a long way from the days where many considered them a scam.

Massive stimulus measures introduced by global central banks, especially the US Federal Reserve, to deal with economic fallout of the coronavirus crisis have created enormous amounts of liquidity in the market looking for investable assets.

The infrastructure built around cryptocurrencies over recent years has made it easier and safer to invest in them than before. This has attracted more and more private wealth and institutional money to adopt them as a viable investment in their portfolios. It’s no longer a purely retail play. Some investment advisers are even proposing to institutional clients a rotational allocation between bitcoin and gold as store-of-value assets.

Digital asset manager CoinShares estimates that institutional investors had allocated over $15 billion into cryptocurrencies as of December 2020.

Regulations around crypto assets are developing. A growing number of regulators around the world, including those in Asia such as Japan, Hong Kong, Singapore and Korea, have begun licensing the players and exchanges to put them under oversight and greater transparency. However, China is completely banning cryptocurrencies.

Wall Street joins in

The mainstream acceptance of cryptocurrencies has lured many seasoned Wall Street bankers to join the crypto market. Goldman Sachs has announced opening a bitcoin trading section with plans to offer bitcoin futures.

A 2020 survey of 774 US and European institutional investors by Boston-based money manager Fidelity found that one in six view digital assets as having a place in their investment portfolios, and 36% have already invested in digital assets.

The majority of investment products in the market were offered by crypto firms and lesser-known hedge funds or private equity funds. But in August, Fidelity launched its first crypto fund for subscription by qualified investors. Fidelity Digital Assets, a subsidiary specially created to provide a full-service enterprise-grade platform for storing, trading, and supporting eligible digital assets, will be the custodian of the fund.

In November, New York-based asset manager Guggenheim Partners entered the bitcoin space with a 10% investment exposure in Grayscale Bitcoin Trust. It’s also been reported that the US Securities and Exchange Commission is actively working on regulations that might permit crypto exchange-traded funds.

Potential game changer

The entry by marquee names into the fast-growing crypto space could be a game changer. Lack of trusted managers and third-party custodians for digital assets has often been cited by institutional investors as significant barriers preventing them from joining the crypto market in greater numbers. The participation of traditional players will boost institutional investors’ confidence in digital assets.

Cryptocurrencies, which are not backed by any physical items or the real economy, are considered ‘natively-issued digital assets’. While they attract much of investors’ focus with their potential for huge returns, tokenised assets are also on the rise.

A tokenised asset is a traditionally issued asset that is converted into a token using distributed ledger technology or DLT. The token could represent a share in a company, a unit in a bond or a fund, or a share of ownership of something more esoteric like an art piece.

Tokenising an asset changes how that asset is held and transferred in terms of value and workflow. This can expand its access to a wider group of investors, which might not have been feasible otherwise. Asset tokenisation is a key step in furthering the digitalisation of financial marketplaces.

In a recent interview on CNBC, Mathew McDermott, head of digital assets at Goldman Sachs, predicted that in the next five to ten years, all of the world’s financial assets will reside on electronic ledgers, and activities like initial public offerings and debt issuances that now require squadrons of bankers and lawyers could be largely automated.

This brave new world is driving changes to traditional financial players. Besides brand-name money managers and trading brokers, third-party custodian banks with strong reputations will also play a vital role in the market infrastructure of this digital evolution. The crypto custody players today are largely financial technology firms, and few have the trust of institutional investors.

Partnership with fintechs

Global securities services players have formed a variety of partnerships with fintech providers to develop capabilities for supporting digital assets in recent years.

To meet sell-side needs, BNP Paribas Securities Services participated in the DLT-based trading and settlement projects of the Australian Securities Exchange and the Hong Kong bourse right from the start.

Recently, the company announced a partnership with Digital Asset, a digital developer, to design a number of real-time and settlement apps using digital asset modelling language, or DMAL, smart contracts to provide market participants with real-time access to the two exchanges’ platforms. In addition, it’s partnering with Curv, a cloud-based digital asset security infrastructure for financial institutions, and has successfully completed a proof of concept to transfer security tokens securely between market participants.

HSBC has collaborated with the Singapore Exchange and Temasek Holdings to establish a DLT-enabled bond issuance platform. In September, the partnership successfully completed the first digital bond issuance in Singapore – a S$500 million ($375 million) public bond offering by Olam International.

On the buy-side, BNY Mellon made its foray into the crypto world in April 2019 by collaborating with cryptocurrency exchange Bakkt to help it launch a custody service.

Eight months later, State Street launched a digital asset pilot programme in collaboration with cryptocurrency exchange and custodian Gemini Trust. The programme aims to combine Gemini’s digital assets custody solution with State Street’s investment reporting.

Most recently, Northern Trust and SC Ventures, a subsidiary of Standard Chartered, entered into an agreement in December to launch Zodia Custody, an institutional-grade custody solution for cryptocurrencies.

Challenges

But custody and servicing of digital assets come with new challenges. At the core of the service is the storage of private keys, whether that is for bitcoin, securities tokens or asset tokens. Custodians will take a node in the blockchain and manage the private keys for the wallets on the blockchain as well as perform asset servicing.

As digital assets are a form of bearer instrument, the private key controls the ability to use an asset. Once an asset has been transferred on the blockchain, the transaction is irreversible and permanent. Consequently, misuse or loss of the private key would result in the loss of the asset.

Concerns around cybersecurity of private keys and transaction addresses are real, as is how to allow third parties such as regulators and fund administrators to receive pertinent information without compromising the safety of assets.

Instances of outsider and insider hacking or losses due to software malfunction are not unheard of. There have also been several cases of cryptocurrency trading exchange scams.

While institutional investors are hoping to entrust protection of their digital assets to reputed traditional custodians, the latter at this point do not necessarily have all the right tools and technology to do the job effectively.

Regulators are taking cautious steps into this space. It’s still early to determine the degree and nature of the ultimate regulations that will be put in place. There is currently little in the form of standard market practices or regulatory precedent from traditional markets to manage and service digital assets. Legal rights and liabilities specifically for these assets need to be further defined.

There are still many elephants in the room today with regards to custody and servicing of digital assets. However, institutional investment in these assets is becoming a reality. The market is developing fast and can no longer be ignored. Securities services providers have to find solutions to meet clients’ needs, albeit by ‘crossing the river by feeling the stones’. 

The industry has to proactively engage the players and regulators to work together to support orderly growth of digital assets for mainstream investing.

*This article was published in Asia Asset Management’s February 2021 magazine titled “A potential game changer”.