Making the Move: Incorporating Digital Assets Into Custody Services

If you’re managing a custodian service, you may be feeling a new wave of change starting to impact your business. Long gone are the days of strictly physical asset protection, investment, and transfer; and with blockchain and cryptocurrency adoption on the rise, the latest advancement in the digitization of assets is here.

Digital assets hit the market first with exchanges, but other traditional services are also growing to accommodate these assets. According to a recent Fidelity survey, 47% of institutional investors view digital assets as having a place in their investment portfolios.

Custodians looking into accommodating digital assets into their service portfolio should be aware of the importance of tailoring that service to the unique needs of blockchain-based assets. In this article, we’ll cover what this means for your shifting roles and responsibilities in this space, the nuances of crypto asset security, and the regulatory forecast at the time of this writing (January 2020).

Custody Goes Digital

As a custodian, you’re well aware of the challenges in securing client assets. Access to high-security vaults, policy enforcement and careful monitoring of asset transfers, and orchestration of communication between brokers, agents, and trustees are the custodian’s day-to-day.

The evolution to dematerialized securities and electronic book-entry settlements has shifted custodians’ role from physical asset protection to secure management of digital records — and with blockchain-based digital assets it’s a whole new world. If your institution is exploring the digital asset space, you must become acquainted with associated IT infrastructure, cryptographic key management, and cybersecurity best practices.

And while security is always the name of the game for custodians, and will continue to be, it’s even more critical when it comes to blockchain-based assets. From a business perspective, according to the Fidelity survey mentioned above, 76% of institutions looking at digital asset custody services view security as the most important determining factor in choosing their custody provider. From a technical perspective, this is due to inherent technological quirks with the blockchain.

Blockchain: Fewer safety nets

Blockchain-based decentralized ledger technology has been hyped as ultra-secure as it removes the single point of failure when it comes to recording asset transactions, but there’s an inherent flaw. The primary challenge of blockchain-based assets is the lack of ability to “roll back” transactions between two addresses on the chain. In other words: once an asset has been transferred, the technology itself prevents “do-overs.”

The permanence of blockchain transactions is due to the technology’s immutability principle, i.e. that transactions are final and recorded on the decentralized ledger for all to see (in the event of a public blockchain).

More than just being a pain point for potential serious investors in the digital asset space, the lack of rollbacks presents considerable operational and serviceability issues for custodians:

• In the event of faulty fraud or AML checks, transactions completed cannot be undone.
• Operational or administrative errors cannot be reversed.
• Clients cannot cancel their own transactions.

Immutability also means that one misuse of a blockchain key is enough to lose the asset value; i.e. the malicious actor does not even need to have the key in his/her physical possession in order to gain ownership of the asset.

In addition, the key misuse quandary has led to a rise in insider attacks in the broader blockchain world — and it’s a nightmare for the institutional custodian with a high security prioritization.

Market: Developing ecosystem, regulations and processes

More importantly for custodians, there is no Society for Worldwide Interbank Financial Telecommunication (SWIFT) or equivalent in the world of digital assets. SWIFT’s efficiency issues aside, the network presents one unified, heavily regulated, mainstreamed institution for secure transfer of fiat assets and operates in cooperation with the world’s largest leading banks and financial powerhouses.

The digital asset custody world, by contrast, remains in the “Wild West” phase of unregulated, early-adoption, first-stage development.

Meanwhile, as digital assets are adapted to contemporary regulations and best practices surrounding fiat asset custody, several critical issues become apparent:

• Difficulties with fraud and AML protection, as aforementioned, due to the immutability principle
• Difficulties with the incorporation of Know Your Customer (KYC), compliance and other checks into the digital asset transaction verification process and workflow.
• Ambiguity surrounding regulations; for example, how to meet the definition of “qualified custodian,” due to the proliferation of different digital asset custody types (self-custody, partial custody, and full custody; based on key distribution and wallet types)

Looking ahead

The mainstreaming of digital asset custody is happening now, whether traditional custodians are ready or not. What the market will need for digital assets to succeed are an understanding of how to efficiently implement governance policies and accommodate AML/KYC/anti-fraud requirements through security and IT infrastructure, and a greater understanding of the developing wallet types.

Originally published at https://www.unboundtech.com on February 27, 2020.