The Digital Opportunity For Custodians

The difference between digital assets and dematerialised securities is immaterial - except for custodians

Custodians are unlikely companions of the vanguard of history. But they now have the opportunity, as the philosopher of history G.W.F. Hegel might put it, to actualise the Digital Age, or be destroyed by it.

The power of digital computing stems from its ability to make perfect copies, at zero marginal cost. Which is why digitisation has inflicted such enormous damage on the music, film and publishing industries.

Their resistance of those industries to the loss of control of their assets was based on analogue technologies such as licensing, access and intellectual property rights. It proved largely futile.

Custodians now face a similar existential challenge. What has transformed digitisation from an ally of cost reduction – notably through the dematerialisation of physical securities - into a potential nemesis is the blockchain.

Digital assets are a potential replacement for securities

Whatever else Satoshi Nakamoto accomplished, his solution to the double-spending problem in cryptocurrencies has made possible the development of a rival digital financial instrument to dematerialised securities.

By making it close-to-impossible to replicate a digital asset (at least up to the point of a 51 per cent attack), Nakamoto inadvertently inflated the Initial Coin Offering (ICO) bubble of 2016-17.

That bubble was of course driven by investors attracted by the prospect of astronomical returns. But greed for gain is not the only aspect of digital assets which feels worryingly familiar.

Any asset can be placed on a blockchain, so digital assets can represent anything of value – but so can securities. In fact, most ICOs meet the famous Howey test for being a security: investors put money into common enterprises run by third parties in the expectation of making a profit.

Even the supposedly new features of a digital asset look less novel on closer inspection. Securities can also break real-world assets into smaller pieces for investors to own.

Likewise, the fact that investors who are also customers can increase the value of their investment by using its products is not unique to digital assets. It is true also of shareholders in old-fashioned public corporations.

No wonder lawyers and regulators are wondering if digital assets are just securities by another name.

The value of digital assets lies in their power to cut costs

It follows that the real value of digital assets must lie elsewhere. The obvious place to look is in the commercial economics. The promise of blockchain is the elimination of unnecessary costs, chiefly through the elimination of intermediaries.

When McLagan measured the impact of blockchain on intermediation in the global custody industry, for example, it predicted savings of $8.3 billion a year. (1).

This prospect helps to explain the lack of enthusiasm among custodian banks for developing digital asset custody services: those inefficiencies are their revenues. Yet it is a curious lack of enthusiasm, because their buyside clients - the institutional investors – would like to invest in digital assets.

A Fidelity survey of 400 institutional investors in the United States found seven out of ten enthusiastic about digital assets as an investment, a fifth invested already and half planning to do so. Yet they rarely invest directly. Most rely on proxies, like venture capital funds. (2).

It is not surprising. The investment infrastructure bequeathed by the ICO bubble is riddled with conflicts of interest so grave they make private banking look respectable. It is not unusual for the issuer, the broker, the exchange, and the custodian to be merely different parts of the same organisation.

Institutional investors want classic custody of digital assets

This is the opportunity waiting for custodians to seize it. Three out of four respondents told Fidelity the safety and security of their digital assets is their most important consideration. So it is puzzling that custodians seem content to let the exchanges take the lead in digital asset custody.

ICE owns digital assets platform Bakkt, to which it has just added the Digital Asset Custody Company (DACC). Nasdaq is extending its existing trading, clearing, settlement and custody technologies into digital assets. SIX is building the SIX Digital Exchange (SDX), through which digital assets can be cleared, settled and custodied.

True, BNY Mellon might provide custody services to Bakkt. Northern Trust says it is exploring a digital asset custody service for hedge fund clients. State Street has said much the same, adding that it is waiting for client interest to turn into activity.

Of course, there is a technical problem to address. Digital asset custody means keeping safe the private keys investor use to unlock ownership of the assets. To look after these alphanumeric strings, stored on silicon chips, custodians must revert to their roots as the guardians of physical vaults.

Reversion to analogue forms is not the only irony occasioned by digital asset custody. Institutional investors clearly want custodian banks to hold their private keys. In other words, they want a trusted intermediary to invest in assets issued on a technology whose original raisons d’etre were trustlessness and disintermediation.

The costs of digital custody must be lower than the cost of securities custody

It is worth asking whether there is any point in institutions investing in digital assets if they insist on reproducing the costs of investing in securities. There is only one sensible answer to this question. It is that the costs have to come down or switching from securities to digital assets makes no sense.

A purely digital infrastructure, without the multiple reconciliations and manual processing associated with legacy systems, will lower costs. So will direct connections between investors and issuers, which central securities depositaries (CSDs) which offer end-investor accounts are now exploring.

Costs will fall further as the volume of digital assets issued and traded increases. The question for custodians is whether they want to lead that revolution in costs or be undone by it.

Dominic Hobson Hobson Cardew