The Digital Financial Custody Revolution
Throughout history, storing physical assets has typically come with burdens inherent in a system dependent on human-to-human trust. This is why banking institutions and other financial intermediaries that secure, monitor and manage our assets were created. While the introduction of digital assets and cryptocurrencies eliminated many of these problems, the institutional infrastructure to take advantage of these benefits needed time to catch up. Thus, the focus of institutions in 2018 was primarily on developing custody solutions, enhancing offline storage and creating other security measures aimed at increasing investor confidence in the digital asset space.
Self-Custody Throughout History
For centuries, people sought to decentralize their wealth by distributing physical assets into silos and estates. However, the obvious setbacks of such efforts paved the way for qualified custodians becoming integral components of existing capital markets. While custodians do not have legal rights to their client’s assets, they have a fiduciary responsibility to mange, hold, secure and facilitate activity on their client’s behalf.
For many banking services, a paper based system seemed to function just fine for many years. However, the creation of stock markets made this infinitely more complicated. Prior to the Great Depression of 1929, investors would secure their own paper certificates for their investments. Yet due to the risks associated with such a method of self custody (theft, loss, paper decay), institutions began to provide custody solutions. While this was manageable for a number of years, the rapid growth of stock markets and trading volumes throughout the mid 1900’s overwhelmed the existing system.
Perhaps the biggest evolution of financial custody came through the creation of the Depository Trust & Clearing Corporation (DTCC) in 1973, which established the first set of centralized ledgers and certificates. This greatly reduced the vast amounts of paperwork that intermediaries and investors had to deal with. It also made way for the Employee Retirement Income Security Act of 1974 (ERISA) which changed how US pension funds invested and managed assets. Ultimately, as custody became easier and safer to facilitate the demand for it grew and as digital systems evolved so did the future of financial custody.
Jibrel and the Evolution of Self-Custody
One way of reducing conflicts of interest is to separate custodians and advisers and ensure operational independence. Yet a more ideal method is to utilize blockchain technology in order to eliminate conflicts altogether. Proof of ownership and identity in a distributed consensus system will revolutionize the nature of not only custody, but clearing and settlement as well.
Reducing friction and aiding self-custody have been major motivating factors behind Jibrel taking part in the DFSA Innovation Testing License Cohort and ADGM RegLab. While Jibrel initially took part in the Hilal Bank Smart Sukuk offering, we are planning to expand on this type of initiative by focusing on other financial asset classes as well.
Although cryptocurrency is one of the asset classes most associated with digital asset custody, the concept equally applies to any digital asset where users have full control over their private keys. By being able to secure assets on a distributed and immutable network, users are able to achieve a safe means of self-custody over their assets. While intermediaries will always play a role in our financial system, blockchain can make it more transparent, ethical, fair and accessible. Going forward, Jibrel expects the overall financial ecosystem to move an increasing number of assets toward a more decentralized type of model oriented towards self-custody — as regulators become more familiar with and accepting of this methodology. We look forward to helping further the self-custody model as regulatory support for it continues to develop.
Challenges Up Ahead
The move to the DTCC was a move away from bearer assets and toward a system of interconnected ledgers with costly reconciliation processes between those ledgers. Yet the proliferation of digital assets is a move back towards, a potentially error free, bearer asset system. The effort to place these assets on-chain presents certain challenges such as:
Private Key Security: These are used to verify the owner of as asset, and if lost, may render one’s assets completely inaccessible. If the owner surrenders such control to a third party, there needs to be a system in place for ease of access, recovery and a guarantee that the keys will be handled with care.
Self Custody: Most institutions and family offices have no interest in self custody solutions regardless of how secure they may be. This is not only due to regulatory and legal issues, but also peace of mind of not having to self manage logins for millions or even billions of dollars in assets.
Regulatory: Considering various questions around the application of current regulations digital assets on the one hand, and issues regarding the standardization of custody protocols on the other hand, many legal aspects will need to be developed and fully thought through.
Market & Security Challenges: These include not only understanding how volatility will impact the appetite of third parties to offer custody solutions for digital assets, but also coming to terms with the safety and insurance concerns involved in the protection of said assets.