Digital assets are unlikely to appeal to institutional investors until custody and asset servicing standards begin to mirror those for traditional assets, writes Bob Currie.
Cryptoassets have generated considerable excitement over the past 18 months as a mechanism for raising funds and as a means of exchange. They are issued via an ‘initial token offer’ (ITO), whereby investors transfer funds, either as cryptocurrencies or government-backed ‘fiat’ currencies, to the ITO organiser in exchange for electronic tokens held on a blockchain.
At its peak in early 2018, aggregate capitalisation of the digital asset market – including bitcoin – rocketed to around €700 billion before dropping back to €200 billion by the year end.
For investment in traditional securities, principles have grown up over decades that provide clear guidelines for safekeeping institutional assets. Standards have been refined, with input from the Association of Global Custodians and other bodies, to establish a set of guiding principles that are applied internationally when a global custodian or investment bank appoints a sub-custodian within its institutional agent bank network.
Standards have also been reinforced by a liability regime, growing out of the Alternative Investment Fund Manager and Ucits V directives in the EU, which make the fund custodian directly liable for any “avoidable loss” of any financial instrument held in custody on behalf of a fund client.
For digital assets, however, an equivalent liability regime and set of custody standards have not yet been established – and while this is so, digital assets are likely to remain off limits to many institutional investors.
Moreover, financial authorities are only in the early stages of evaluating how digital assets should be regulated. In the US, the Securities and Exchange Commission has taken the position that if an instrument feels and acts like a security, then it should be regulated as a security. In this respect, it is looking closely at a number of initial coin offerings (ICOs) and starting to apply this test.
For unregulated digital instruments, their legal and regulatory status is often unclear. According to Justin Chapman, global head of market advocacy and innovation research at Northern Trust, market authorities have debated whether to treat these instruments as a currency, a security, a utility token or a consumable token, but in many cases these do not fall cleanly into any of these categories.
While this is the case, some categories of institutional investor are not permitted under their investment rules to invest in these assets. A 401(k) pension fund investor in the US, for example, may invest only in regulated assets and is required to hold these assets in safekeeping with an eligible custodian.
One consequence of the rise of cryptoasset investment is that – at least at this early stage in the market’s development – it is resulting in a reallocation of functions along the transaction value chain. For institutional allocations to traditional securities, the custodian function is typically provided by an eligible third-party custodian, but this is often not the case for digital assets. Some cryptoasset investors may use a third-party custodian, others may be using a custody service provided by a digital exchange or another party (see box).
GMEX, for example, offers multi-asset exchange and post-trade solutions that embrace trading, clearing and central securities depository (CSD) solutions, along with custody provision via its Forum Custody digital vault and wallet that can be deployed by exchange or third-party custodians. Hirander Misra, chairman and chief executive of GMEX Group, explains that the company entered the digital asset market three years ago to support the supply chain for agri-products and gold.
Subsequently, it has extended its service offer to support trading, clearing and settlement for a range of digital assets.
It has recently collaborated with HYBSE Marketplace and MINDEX to list the world’s first multi-asset stable token (or MAST), which is issued in Mauritius. “These asset tokens are brought to market on a regulated exchange and stored in a regulated digital custodian, delivering a level of security and oversight that has not previously been available for digital asset launches,” says Misra. “This offers proper legal custody and escrow, with valuation overseen by Grant Thornton, an established international audit company.”
Misra notes that some traditional stock exchange groups have announced plans to establish digital exchange projects. But these create a model that largely mirrors the market infrastructure framework and chain of intermediation that exists for traditional assets. “These structures remain expensive and contain a significant level of embedded operational inefficiency,” he says.
Some are sceptical, however, whether exchange custody will provide the segregation of duties typically required by institutional investors and their regulators. “Digital asset exchanges have emerged that provide services across the digital asset value chain, including trade execution, brokerage, liquidity provision and custodial services,” says Northern Trust’s Chapman. “Although family office and high-net-worth clients may be comfortable with investing through these arrangements, currently these do not provide the separation of responsibilities required by many institutional investors.”
A number of leading global banks (including JPMorgan, Citi, Northern Trust and BNY Mellon) are investing in programmes to support trading, custody and asset servicing in digital assets. Several market infrastructure entities around the world are also adapting their operational structures to accommodate distributed ledger-based record-keeping and post-trade services. The Australian Securities Exchange, for example, has an ongoing project to replace its Chess post-trade settlement system with a new blockchain-based platform provided by Digital Asset.
SIX Digital Exchange (SDX), owned by the Swiss stock exchange group SIX, claims to be the first market infrastructure to offer a fully integrated end-to-end trading, settlement and custody service for digital assets. A SIX spokesperson told Funds Europe that it expects to pilot initial capabilities from SDX during the second half of 2019.
“When we first started looking at this, our organisation had already carried out a number of viable products using DLT [distributed ledger technology, or blockchain] experiments, including the creation of a trading facility for structured products, a corporate actions data-scrubbing tool and a bond-issuing platform,” he said.
“The reality is that taking an existing process and automating it with a new technology does not by itself give you much of a business case, particularly if the operational infrastructure is cheap, fast and reliable the way it is. Our approach is predicated on the hypothesis that the digitalisation of assets is coming no matter what”.
For GMEX’s Misra, the future is not a simple choice between the established execution and asset servicing structures that exist for traditional assets and a less regulated environment that has emerged from the initial days of cryptocurrency trading. He believes that traditional custody fee structures remain expensive, whether applied to traditional or digital assets.
“For some asset token offerings, for example, asset owners are paying established custodians up to 30 basis points to deliver custody for those assets,” he says. “However, there is often limited legal certainty around this arrangement, with the asset owner required to bear significant liability [including liability on the authenticity of the asset, liability on the valuation, liability on whether there is a lien over it] under the custody contract.”
He also points to some issuance and tokenisation platforms that are charging sizeable fees to provide issuance and secondary trading, but are not addressing the inefficiencies that persist on the safekeeping and post-trade end of the transaction life-cycle.
‘Tokenised settlement’ on a blockchain makes it possible to execute transactions in an underlying security without the need to move that underlying security between the custody accounts of the participating counterparties. However, for this arrangement to be effective, it is important to have multiple participants active within this ecosystem in order to build scale and liquidity on the network.
Chapman says that Northern Trust identified such an opportunity with the launch of its private equity service on blockchain. This embraces the general partner, limited partners, along with the fund administrator and auditor, while also providing visibility to financial regulators of the transaction life-cycle. It was launched initially for a private equity fund with 15 investors, managed by Geneva-based Unigestion, providing a fully enclosed ecosystem that contains all the key participants.
“In building this ecosystem, we have been able to drive a range of efficiencies back into the operational area,” Chapman says. For example, Northern Trust has announced an arrangement with KPMG and PwC to deliver a robo-auditor service on the blockchain. Rather than requiring financial services clients to wait for periodic audits (for example, every 12 months), this facility enables audit services to be delivered on a near-to-real-time basis.”
SIX aims to provide a safe environment for issuing and trading digital assets, enabling tokenisation of existing securities and non-bankable assets. “The ability to tokenise existing assets promises a number of benefits,” says a SIX spokesperson.
“By tokenising a share, you could fractionalise [sub-divide] it. Today, if you want a fully diversified portfolio and you’re not going to buy ETFs or mutual funds, you need a substantial amount of money. In future, if shareholdings are tokenised, it opens up all kinds of do-it-yourself investment models.”
A later phase of the project will offer the tokenisation of non-bankable assets, providing new investment and funding possibilities – including, for example, art collections in museums.
Smart contracts have the potential to deliver significant efficiency gains to trade settlement and record-keeping. Under their current application, however, these potential gains are not being realised.
Typically, counterparties are waiting for transfer of ownership to be completed on the registry record to confirm settlement finality – and this slows up the process. When trading on a digital exchange, often the token settlement is taking place in close to real time, whereas in some jurisdictions, it may take two weeks to finalise transfer of ownership on the registry record. This is a large discrepancy. However, with a dynamic smart contract, the paper element will become obsolete because the ultimate legal record will be the electronic or ‘smart’ contract.
There are also major opportunities to deliver greater efficiencies around the asset servicing functions offered by the digital asset ecosystem. For counterparties that are holding fiat currencies and cryptocurrencies in trading accounts – potentially trading a fiat currency against a cryptocurrency, for example – the asset is typically collecting no interest while it is being held in a digital wallet.
There is an obvious opportunity to develop global payments and treasury services to interlink with this ecosystem, enabling asset owners to earn interest on their balances but also providing the foundation for a broader suite of treasury-type products that will bring additional value to investors.
It will take time for institutional investors and their asset managers to become comfortable with these digital asset custody structures. This will be an evolutionary process. Initial investment flow has come primarily from high-net-worth investors and family offices, but a number of large hedge funds are now making small allocations to digital assets.
Over time, a wider range of asset managers are expected to increase their investment in digital assets as they become attracted by the investment potential that these offer and they become comfortable with the custodial structures that sit around this.
THE KEY CONCEPTS
Public key cryptography
Public key authentication enables users to identify themselves to a server using a key pair, consisting of a private key (known only to the user) and a public key (shared with other parties to the transaction). The private key is used to generate a digital signature. Anybody holding the public key can verify that this unique signature is genuine.
In providing digital custody, the custodian will typically provide safekeeping for the asset owner’s private keys. However, in some cases the asset owner may hold its assets in a wallet and retain control over its private keys (‘self custody’).
To provide additional security, a custodian may use multi-signature authentication, where multiple signatories within the client firm hold private keys and multiple signatures are required to authenticate any transaction in the asset.
Key storage takes two main forms. In cold storage, private keys are stored offline in a wallet that is not connected to the internet. This reduces the risk that private keys are compromised through a network-based attack. In hot storage, private keys are stored in a wallet that is connected to a network. Custodian firms may transfer private keys between cold and hot storage (and perhaps into intermediate, or ‘warm’, storage behind a firewall) to process asset transactions and transfers.
Most digital assets are effectively cryptographic bearer instruments, meaning that if the private key is compromised, an unauthorised person may access and transfer the asset.
Similarly, if the private key is lost, the owner may be unable to recover the asset. This happened on two occasions recently at Canadian cryptoexchange QuadrigaCX. On the first occasion, the company was unable to access client assets worth €220 million held in a cold wallet following the death of CEO Gerald Cotten, who was the only person with knowledge of the private key. In the second case, the company “inadvertently” moved more than 100 bitcoins (value €310,000) into a cold storage wallet that it subsequently could not access.
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