Challenges for Organizations Creating Digital Custody Propositions

Challenges for Organizations Creating Digital Custody Propositions

We discuss how to create a workable custody proposition for digitally tokenized assets and a blockchain-based trading environment.

July 2023

Swen Werner
Head of Custody, State Street DigitalSM

Dayle Scher
Research Principal, Celent

Despite recent market events and the collapse of a number of crypto platforms, there remains significant institutional interest in investing in digital assets as a means of achieving alpha, or of gaining experience interacting with these assets.

State Street and Celent’s recent research showed that many institutional investors are still planning to move ahead with preparations for digital assets and tokenization, despite the market downturn. While our research found high levels of interest in digital assets, we also found that in the short- to medium-term future, asset owners expect to take a hybrid approach, investing in both traditional and digital assets. Indeed, most of the top global custodians either already do – or have plans to support and service – digital asset holdings.

At its core, crypto custody shares the same basic objective as traditional custody services: the safekeeping and servicing of assets. However, due to vast differences in the underlying blockchain technology supporting digital assets, how they achieve this diverges significantly. In several areas, whereas traditional custodians exercise control over securities by maintaining accounts at various sub-custodians and central securities depositories (CSDs), crypto custody requires cryptographic processes (key management) instead to transfer digital assets recorded on cryptocurrencies’ respective blockchains.

Cryptocurrencies are not traditional financial instruments, and can present legal challenges around how to establish property rights. Although cryptocurrencies can be maintained without an intermediary (i.e., investors manage their own wallets and keys), many investors are choosing a specialized custodian as a preference or for regulatory compliance reasons, even though the regulatory status – under which a crypto-native custodian or a traditional custodian operates – will have material impacts on anything from services offered to investor protection.

Regulated banks are viewed as trusted institutions when it comes to custody, with some having been around for centuries. They have the expertise, processes and controls that people look for when it comes to their investments, and are generally subject to a comprehensive set of regulations covering behavior, capital requirements, reporting and safeguarding of assets.

The aforementioned Celent research identified that institutional investors are comfortable with traditional custodians, with nearly three-quarters preferring an integrated provider for their digital asset servicing.

The use of blockchain technology reveals a new set of risks that must be considered by investors and regulators alike, particularly since traditional process methods do not extend directly to servicing digital assets, while the overall control principles (e.g., segregation or dual controls) are independent of technology.

The following are some of the areas worth mentioning:

Segregation of client assets
The Securities and Exchange Commission (SEC) asserts that “segregation is a fundamental element of safeguarding client assets” and considered bringing cryptocurrencies within scope of its “custody rule” as seen in its proposed rule — Safeguarding Advisory Client Assets — currently out for comment. The SEC “continues to believe that segregation is a fundamental element of safeguarding client assets” by qualified custodians. The proposed requirement is meant to ensure that client assets are easily identifiable as client property.

According to the regulator, client assets must remain “available” to the client, despite custodian default, insolvency, or even if the custodian’s creditors assert a lien against its proprietary assets or liabilities. As was seen in the Celsius bankruptcy in July 2022, most of its customers will be last in line for repayment. In January 2023, a United States bankruptcy judge ruled that Celsius owns most of the cryptocurrency that customers held in its interest-bearing “earn” accounts (as opposed to its “custody” accounts that did not generate interest), impacting an estimated 600,000 accounts, with assets valued at US$4.2 billion.

Segregation of assets applies to custodian versus client assets as well as client assets versus client assets, and requires appropriate controls to ensure that segregation is achieved. Effective segregation requires controls such as consistent and frequent reconciliation, which is subject to supervision and audits. In traditional securities markets, the custody reconciliation process is in place to identify and resolve differences in holdings and transactions between its own records and those of the sub-custodian or central securities depository. Larger custodian banks employ teams of employees to complete this function.

The data model of blockchain requires new methodologies: There is no start of day/end of day. Ledger information is stored as transactions records, as opposed to account balances. This is information typically required to perform reconciliation. So where does that leave the digital custody industry?

In the Celsius example, neither client versus client segregation, nor custodian versus client segregation protocols were in place. Additionally, Celsius did not reconcile the number of coins reflected in the custody accounts with the number of coins actually held in the custody wallets. In fact, there were no documented reconciliation processes, policies and procedures in place. The aforementioned technical challenges, however, don’t resolve the issue that segregation without controls is insufficient, as the Celsius example shows.

When considering the differences between crypto and traditional custody, it is important to understand that it is not just about the technology; it is about the need to ensure the safety of clients’ assets. An investor’s due diligence process for custodian providers will need to evolve to reflect that the types of protection mechanisms and controls for digital assets can differ compared to traditional assets.

As digital assets become increasingly integrated into traditional investment portfolios, it is crucial that investors and regulators alike understand the differences between traditional and digital asset custody. While both aim to achieve the safekeeping and recording of assets, there are fundamental differences in how they are executed. Custodial services must develop new methods and controls to ensure that customer protections are in place, and the residual risk is understood when dealing with digital assets.

As the digital asset market continues to grow and evolve, it is critical for investors to be able to trust that their chosen custodian fully understands the complexities of digital asset custody, including how to implement the appropriate safeguards for the digital asset world that investors and regulators have come to rely on in the traditional asset world.



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