Custody, Return To The Spotlight
By Krypital Blockchain Institute | Author: Edison, Jay & Rena
1.Intro
The crypto prices keep staying within the bear market territory, which keeps dragging the market sentiment down. As there’s a high correlation between ETH’s price and the ICO market activity, we are seeing the evolvement of a downward spiral. Right now we are seeing pessimism even among traders, as the volatility in the crypto market is lower than that of the U.S. stock market. A moment like this makes more people start focusing on the movement of large institutions in the traditional market, hoping that the inflow of the “old money” will become the ultimate force to save this market.
“Custody,” an area most people only know from an intuitive level, seems to become major financial institutions’ most recent step to get in the blockchain industry. In this article, we want to provide a better understanding on Custody, starting from its history, then to services being provided by custodian banks, and finally its role in the financial industry. Then we will analyze the implications brought by the establishment of custody service in the crypto world. Finally, we will draw out the current competitive landscape in the industry.
2. What is Custody:
The definition derived from the traditional financial market, where custody services involve the holding and servicing of assets on behalf of others. The clients mainly include institutional investors, high-net-worth individuals, and individual or family trusts. However, as custodians do not exercise any discretion over the use of their client’s assets, their roles are very different from those of the asset managers.
a). The history of Custody: At first place, Custody referred to “the safekeeping by a bank in its vault of the paper certificates representing the individual shares or principal amounts owned by the banks’ clients.” The settlement of a transaction is obtained through the transfer of such certificates from seller’s custodian to buyers. With the evolvement of the entire financial industry and technology, the settlement has been segregated to other institutions, while securities nowadays are represented by either a single global certificate or an electronic book-entry.
b). Services provided by the Custodian in the traditional security market:
From an intuitive perspective, one of the basic functions provided by custodian doesn’t differ much from that historically provided by banks: to safeguard clients’ assets. Nevertheless, the role covers a much broader range of services:
Core Custody Service:
● Safekeeping and record-keeping services:
○ Properly recording the amount being deposited
○ Reconciling the securities holdings
○ Reports
● Asset servicing:
○ Income and tax processing services
○ Corporate action processing services
○ Securities Valuation services
● Transaction processing and settlement: typically a custodian takes instructions from an adviser, who executes a trade with a broker or dealer, to settle the trade through a central clearing facility
Ancillary Service:
● Agency Securities Lending Services: enable clients to lend their liquid assets to other market participants and thus improve their yields
● Foreign Exchange Services:make transactions in various currencies due to custodian’s global presence
● Other Administrative Services:include Fund Accounting, Transfer Agency, Collateral Processing, and Outsourcing Services
c). Custodian’s role in the traditional financial market:
Custodians not only safe keep clients’ investment assets, but more importantly, they also serve as a bridge between investors and financial institutions that clear and settles the transactions. As a result, custodians are usually members of Central Securities Depositories (“CSDs”) or International Central Securities Depositories (“ICSDs”), which in turn will track and record the changes of ownership through “book-entry settlement” rather than through the transfer of physical certificates.
In general, institutional investors seek for a custody service for the breadth of services provided, custodian’s access to the global network of CSDs/ICSDs, and sometimes for the traditional secure banking services
d). Custodian’s revenue model: primarily driven by fees collected upon its services, as shown in the following chart
3. What implications will the establishment of the Custody Service bring to the crypto world:
Besides applying Distributed Ledger Technology (DLT) technology to improve their internal processes, these days more traditional financial institutions constantly appear in the blockchain headline as they start getting into the Crypto Custody Service. It’s worth discussing what implications such moves will bring to the crypto market, considering the importance of Custody in the traditional financial market.
First of all, the development of Custody service serves as a necessity rather than a sufficient condition for traditional buy-side investors to get into the regime of cryptocurrency.
● Considering the programming and decentralization nature behind most tokens/currencies and service companies, for the majority of institutional investors, the first and foremost is to guarantee the safety of their assets.
● It is required by the SEC that certain institutional investors need to rely upon custodians to satisfy customer protection requirements. Under INVESTMENT COMPANY ACT OF 1940, every registered management company is required to “place and maintain its securities and similar investment” with a qualifying custodial entity. Considering the recent trend in STO and recent development in the regulation on cryptocurrency by various government institutions, Custody Services will become an irreplaceable part in this industry.
● Even within the traditional securities regime, custody only serves as parts of the entire trading, clearing, and the settlement process. The whole infrastructure for crypto-trading is yet to be completed even with a developed custody system. On the other hand, due to the low-risk tolerance of most of the institutional investors, they may need to see the proof showing that the entire system is mature enough before actually bringing in the capital to this “emerging market.”
Furthermore, the trading and settlement process in the security market is very different from that of the cryptocurrency. Generally, trading consists of the following steps:
● Execution: the advisers will go through broker-dealers to initiate the trade
● Clearance: to complete the trade, this step might be facilitated by the custodians, who will take instructions from advisors regarding the trade details, and clear the trade through central clearing facilities
● Settlement: the actual exchange between payment and securities.
As a result, it is essential for Custody Service providers to hold a relationship with CSDs or ICSDs to complete the job. However, in the case of crypto trading, the transfer of the cryptocurrency happens while trading, and there’s no later-on settlement process. Consequently, the current custody services provided are somewhat being limited to its basic features, but we might see changes coming in the near future.
Based on the article published by Stephen Keen and Jesse Kanach, there are two potential solutions for institutional investors meeting the Custody requirements under SEC regulation within the crypto trading system:
● Having custodians give designated traders to access to the cryptocurrency that traders have authority to trade by applying cryptographic design
● Having custodians work as the dealer to facilitate customers completing the trades
The role of CSD, on the other hand, might also evolve over time. An Euroclear Report brought up an interesting idea, saying that as ‘custodians of the code, CSDs could exercise oversight of, and take responsibility for, the operation of the relevant blockchain protocol and any associated smart contracts. As for the future roles of custodians, it might be required for them to establish an extensive network with various token issuing projects/ protocol projects
4. Competitive Landscape
Currently, the major players include BitGo, Coinbase and Primetrust, while other players in the traditional custodian service firms (State Street, Northern Trust) were also working on delivering similar services.
Oct 15 2018，The 72-year-old Financial services giant Fidelity Investments, which administers more than $7.2 trillion in client assets, announced a new and separate company called Fidelity Digital Asset Services on Monday. The firm will handle custody for cryptocurrencies such as bitcoin and will execute trades on multiple exchanges for investors such as hedge funds and family offices. Fidelity is the first Wall Street incumbent to officially provide cryptocurrency solutions such as custody. Japanese bank Nomura also announced plans in May to offer crypto custody, and Goldman Sachs and Northern Trust are reportedly exploring custodial services. But until now, there’s been a noticeable lack of a big U.S.-based incumbent like Fidelity officially entering the space. The move by Fidelity may encourage more to do so.
In the traditional market, whether a Custodian is able to stand out depends on its network with CSDs and ICSDs, the breadth of services it provides, and its ability to secure the client’s fund. By addressing comparison to the crypto world, the current emphasis sits majorly on the security issue. With that being said, tech startups like BitGo might gain a competitive advantage based on its expertise in the cold wallet. However, with the development of the entire industry, which role each entity plays will become clearer. Traditional custodian banks, with experience in providing similar services along with massive resources, still have a great chance of gaining dominant market share.
5. OUTSTANDING QUESTIONS
The custody requirements for digital assets have steadily evolved with this maturing asset class. The key issues for institutional investors generally concern about fall into the following categories:
● Operational risk：Similar to one in the traditional finance industry, the operational risk may present to be the most prominent one in crypto custody. How will security processes and standards evolve? How will institutional clients and custodians implement the highest levels of protection for digital assets? Will there be industry insurance solutions that will give institutions and their clients more comfort?
● Regulatory risk: How will existing regulations be applied to digital assets, and how will regulators respond to the growth of this asset class with new rules and guidance? Will policymakers take a dim view of pension plans investing in digital assets? Is every custodian in a multi-sig protocol considered an equal-part custodian?
● Market/network challenges: For custodians, trading digital assets in a volatile environment with a third party carries its own challenges. How will custodians respond to token “airdrops” or bitcoin forks, for example? Will digital asset volatility limit the number of firms offering custody services?
5. Conclusion
● In the traditional Financial Market, Custodian banks may not glamorous, but they serve as an essential part in the entire process. There might be a similar structure in the cryptocurrency industry.
● With the further evolvement of regulation and Security Token Offering (STO), Custody will become an irreplaceable part in crypto-trading, but only as part of the entire infrastructure. It will take some time before other players become ready and only then we shall see a serious commitment by traditional buy-side firms.
● Currently, the services being provided by Custody firms are still at a very basic level. As a result, tech firms might stand out as they possess the competitive advantages to better meet clients’ demand. However, with the development of the entire industry, it’s hard to argue how the future competitive landscape might look like.
Sources:
https://www.davispolk.com/files/20160728_tch_white_paper_the_custody_services_of_banks.pdf
https://www.assetmanagementadvocate.com/2018/08/why-blockchain-custody-is-so-difficult-a-hard-part/
Appendix
What are the investors’ view on Crypto Custody?
Kyle Samani, a managing partner at Multicoin Capital, told Bloomberg in June that “there are a lot of investors where custodianship was the final barrier.”
“Over the next year, the market will come to recognize that custodianship is a solved problem. This will unlock a big wave of capital,” he added.
Coinbase launched its institutional-grade custody service in July. Sam McIngvale, who is leading the project, told Bloomberg that he estimates that $20 billion will make its way into crypto custod y services once they’re widely available.
Rana Yared, a Managing Director of Goldman Sachs’ Principal Strategic Investments group, stated: “Greater institutional participation in the digital asset markets requires secure and regulated custody solutions. We view our investment in BitGo as an exciting opportunity to contribute to the evolution of this critical market infrastructure.”
Big-name Wall Street firms and fintech companies may be the most well-known entities to enter the crypto custody race, but they certainly were not the first.
Greg Gilman, co-founder of incubator and investment firm Science Inc., told Wired that “people that were willing to take risks relatively early and stake out a little claim were able to grow significantly, while more established and larger, name-brand firms have been very quickly passed by in this area.”
Disclaimer
Please note that the information contained herein is not advice, and should not be treated as such.
You must not rely on the information contained herein as an alternative to legal, investment, financial, taxation, accountancy advice from an appropriately qualified professional. The information contained herein is also not an invitation to invest in shares or other securities, or any other products or services or otherwise deal in these or enter into a contract with us or any other company. If you have any specific questions about any matter you should seek professional advice.
To the maximum extent permitted by applicable law, we exclude all representations, warranties,andconditions relating this document.
For more information of Krypital Group, please visit:
Facebook：http://bit.ly/2FHP3ko
Twitter：http://bit.ly/2FRI984
Telegram：https://t.me/Krypital
Instagram：http://bit.ly/2FIN8vZ
LinkedIn：http://bit.ly/2HDZd1Z
Medium：http://bit.ly/2u1kUqU
weibo：http://bit.ly/2FTY7OY
Reddit: http://bit.ly/2IvlqAw
