Custodians are at a digital crossroads

Originally published: The Banker

This article is the first instalment of a series on the custody of crypto assets. Read the second article here, and third article here.

As their clients seek ways to add digital assets – including “native” assets such as bitcoin and ether – to their portfolios, executives at global custodians face a stark choice: invest in the capacity to support digital asset holdings, or adopt a “wait-and-see” policy but risk falling behind.

The novelty of digital assets based on distributed ledger technology (DLT), such as blockchain, has made the decision a challenging one. The volatility of crypto assets like bitcoin and ether can be attractive to traders and fund managers as part of a diversified portfolio, but the failure of significant “cryptocurrencies” (along with prominent market intermediaries like FTX and Celsius) has raised questions about their suitability for investment purposes.

In contrast, there is growing momentum for traditional financial instruments and bank deposits taking tokenised form to be issued and traded using DLT-based systems. Institutional investors are being given new choices for trading and settlement, and this changing environment puts traditional custodians under pressure to evolve.

Digital securities vs native crypto assets

From both the regulatory and commercial standpoints, a bright line is being drawn between the unregulated and tenuous world of “algorithmic stablecoins” and “meme coins” on one side, and digital assets representing established financial investments on the other. Rather than converging, “cryptocurrencies” and digital securities are being sent down two distinct tracks.

In the EU, the former are the subject of the new Markets in Crypto Assets regulation (MiCA), which is intended to bring tradeable crypto assets that are not financial instruments or deposits under the control of regulators and central banks for the first time. The latter remain the subject of the Markets in Financial Instruments Directive 2014, or MiFID II; the Undertakings for the Collective Investment in Transferable Securities Directive (UCITS); the Interchange Fee Regulation/Capital Requirements Regulation; and other seminal EU financial services legislation, subject to minor reforms to accommodate the use of innovative market infrastructure.

In the UK, the Financial Services and Markets Act 2000 characterises digital securities as “specified investments” under the Regulated Activities Order, while “other crypto assets” form part of a new Designated Activities Regime introduced under the auspices of the recently adopted Financial Services and Markets Act 2023.

The common feature for crypto assets on both sides of the regulatory boundary is that they involve deployment of some form of DLT (e.g. blockchain) and apply cryptographic methods to track changes in ownership or status. What separates them is their relationship to the real economy: digital securities represent proprietary rights or interests, or claims for the payment of money, against identifiable persons; while crypto assets exist independently of any person and do not constitute a claim on any one person.

This distinction is more than one of degree – it is a difference of kind. Native crypto assets represent a new asset class that is abstracted from the underlying economic activity of issuers/sponsors and which are constituted within a network of participants. Digital securities, while leveraging similar technology to achieve operational efficiencies and benefits such as immutability of transactions, retain the core legal and economic features of their physical and dematerialised counterparts.

It is not surprising, therefore, that institutional actors are investing in the infrastructure to support the transition to digital securities, rather than more speculative crypto assets.

In this article, which is the first part of a series, we develop some of the themes that are relevant to custodians supporting digital assets like shares, bonds and derivatives issued or recorded on DLT. In the second part, we will look at the ways that MiCA adapts custody services to deal with crypto assets like bitcoin and ether. In the third part, we will focus on MiCA’s requirements for custodians holding the reserve assets for stablecoins.

Custodians and digital assets

The custody infrastructure for book-entry holdings of securities and cash deposits has taken shape over a period of approximately 50 years. The growth of computing power during this term has enabled financial markets to accomplish the transition from certificated bonds and shares to notations in databases – achieving enormous gains in efficiency and eliminating the market interruptions that used to result from backlogs in physical deliveries.

Standardisation of messages in Swift, the use of international securities identification numbers to represent instruments, the commercialisation of the internet, and improvements in the underlying infrastructure – all of these have helped to make paper securities certificates (and, increasingly, physical banknotes) novelties. Clipping physical coupons and presenting cheques are now as out-of-time as the rotary-dial telephone. Global custodians – among the largest investors in technology, in order to manage the information that flows through their systems – are now confronting the next step in the evolution of financial markets.

"Clipping physical coupons and presenting cheques are now as out-of-time as the rotary-dial telephone"

The current digital transformation is changing the ways that information is held and transferred. DLT challenges the assumption that market actors should have different, proprietary databases that need to be reconciled against each other. The combination of digital securities and smart contracts calls into question cumbersome settlement procedures and the existing elaborate intermediation models. Always-on (24/7) systems overcome limitations imposed by time zones and market-day conventions. Deposit tokens transform cash deposits at banks into liquid assets.

The shift to DLT is weakening the technical barriers to efficient trading and settlement, while the pressure to remove politically and commercially inspired obstacles is mounting as well.

The emergence of digital securities is being driven by the search for efficiency, reduction and/or elimination of credit risk, and a quest to empower ultimate investors. The steps involved in issuing and during the lifecycle of a share or bond are burdensome and costly for issuers, which deters efficient capital formation. For market intermediaries, like custodians, there are significant costs involved in holding and servicing client assets in book-entry form; particularly when a chain of sub-custodians is involved.

The promise of DLT-based digital securities is that these steps in issuance, trading, clearing, settlement and custody can be simplified and automated. This is a work-in-progress, as evidenced by the current EU DLT Pilot Regime, which allows participants to request that certain rules be adjusted to accommodate operating models aligned to the new technology. What is taking shape, however, is an ecosystem in which issuers like the European Investment Bank or Société Générale are able to benefit from new platforms operated by firms like Goldman Sachs, HSBC, Société Générale and JPMorgan.

The transformation of capital markets is being driven by institutions with significant legacy operations precisely because DLT has the potential to unlock the value tied up in redundant and manual processes.

A common question is whether and to what extent this process will lead to disintermediation, for example the elimination of roles performed by traditional global custodians. While a level of disintermediation is a possibility, it is not a certainty that the custody role will lose its importance. The use of custodians is mandated by both traditional finance (e.g. for Ucits funds) and crypto assets rules (e.g. stablecoins under MiCA) when there is a policy imperative to deliver operational independence and soundness for the benefit of investors.

The separation of asset holdings from investment mandates helps to avoid conflicts of interest and provides a degree of transparency and a safety net. It seems unlikely, therefore, that the role of an independent custodian will be eliminated entirely, only because it is possible to code around it.

It is sometimes overlooked that there is a distributed system of regulatory scrutiny and action, which is intermediated through private sector gatekeepers like trading venues, clearing houses, settlement systems and custodians. They all play a role in keeping markets safe and stable; and, even if the allocation of responsibilities needs to be adapted to new circumstances, there is no ready substitute for these functions that will meet the needs of the scaled financial markets.

"Sophisticated market participants need services for diverse portfolios, and focusing on only legacy or DLT systems could be a disadvantage"

A parallel question is whether custodians will take advantage of the opportunity to support both traditional and digital assets. As new entrants have found, there is limited demand for custody of exclusively digital securities. Sophisticated market participants need services for diverse portfolios, and focusing on only legacy or DLT systems could be a disadvantage.

Hedging arrangements, such as strategy trades, can involve multiple asset classes. Given that tokenisation of financial instruments is a work in progress, it seems likely that “one-stop shops” will be able to better achieve efficiencies than separate service providers working on different asset classes.

A parallel question is whether custodians will take advantage of the opportunity to support both traditional and digital assets. As new entrants have found, there is limited demand for custody of exclusively digital securities. Sophisticated market participants need services for diverse portfolios, and focusing on only legacy or DLT systems could be a disadvantage.

Hedging arrangements, such as strategy trades, can involve multiple asset classes. Given that tokenisation of financial instruments is a work in progress, it seems likely that “one-stop shops” will be able to better achieve efficiencies than separate service providers working on different asset classes.

Regulatory issues

In the UK, the government has signalled that “security tokens” (i.e. digital securities) that are considered to be “specified investments” under the Regulated Activities Order will continue to be treated as they are now. Therefore, custodians wishing to expand their services to include digital securities do not need to expand their licences to include them as a new asset class. There might well be a need to adjust risk management frameworks, resiliency policies, and transparency arrangements to recognise their specific features, but that represents a refresh of existing arrangements.

Custodians of digital securities cannot be complacent, however: the UK government has signalled that changes to the Financial Conduct Authority’s Client Assets Sourcebook are likely to follow for custody arrangements more generally, once it has determined the policy direction for custodians of crypto assets more broadly.

The recent Final Report on Digital Assets from the Law Commission made only limited recommendations for statutory changes under English law to accommodate DLT-linked assets. This was a positive sign that the existing legal framework is sufficiently flexible to support trading in a variety of assets. Further work was recommended by the Law Commission to address the use of digital assets as collateral, which will have an impact on custody arrangements – particularly for prime brokers and other service providers who offer custody as an ancillary service.

Additional development of insolvency and other areas of law will also be required to properly accommodate digital assets, which the government has mapped out in its phased approach to regulation of crypto assets. In any event, a great deal of the uncertainty surrounding the legal status of crypto assets has been put to bed by the commission’s work.

Conclusions

Custodians are coming under pressure from their clients to support a variety of digital assets. The growing momentum behind digital assets puts custodians at the crossroads of the digital transformation.

To invest in DLT or not invest in DLT – that is the question asked of their executive management. It is being answered, to a large extent, by clients who are looking to secure the advantages of the new systems and adding digital bonds and other digital assets to their portfolios. As the technology matures and achieves wider adoption, better efficiency gains can be expected. It is an open question whether incumbents or new entrants will steal the march.

The regulatory environment is going through changes that follow market and technical developments. Through the Financial Services and Markets Act 2003, for example, the Financial Conduct Authority is being given broad powers to determine the rules for the intermediated trading and holding of crypto asset services in the UK. They are also taking up the need to reform the rules for custodians of tokenised securities and other digital assets that represent traditional financial instruments.

These efforts should produce a stable regulatory platform for the growth and development of markets on both tracks – the question for custodians is whether they can afford to wait to make the investments needed to move in step with their clients.