What does bank custody of crypto look like today?

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The global cryptocurrency market today is approximately $ 2.6 trillion. As of June, there were around 200 million crypto holders worldwide – a figure that could reach 300 million by the end of 2021, thanks to the rise in popularity of NFTs, according to Eric Anziani, COO in Hong Kong. Crypto.com.

No wonder traditional banks are scrambling to provide custody, trading and other services to this market. The most basic of services, asset custody, has been at the center of attention of banking providers for several years. DigFin occasionally overhears people in the area declaring the custody “resolved”.

But a conversation at the Network Forum, a conference on securities services, suggests that the safekeeping of cryptocurrencies remains largely a work in progress.

From fintech to TradFi

“Complexity is inevitable,” said Seamus Donoghue, vice president of strategic alliances at Metaco, a crypto-native custody, trading and DeFi platform for crypto. “You need an agile and scalable framework. “

Many companies have emerged from the cryptocurrency world to provide custody and related services.

Metaco, in addition to selling its own services, also served as a technology partner for SC Ventures and Northern Trust to launch Zodia, their own crypto-native custody company.

Crypto.com, a retail-focused digital asset exchange, offers custody to its own users, in the form of a cold wallet operated by Ledger, i.e. the assets are stored on devices that are not connected to the Internet.

However, these fintechs are not the only ones in the custody game: so are traditional securities services players such as Deutsche Bank and Standard Chartered, which are trying to integrate blockchain-based services into their existing infrastructure. .

Banks in the “TradFi” world, or traditional finance, provide several advantages. They have a long track record in asset custody and, as a result, close relationships with institutional investors. They comply with know your customer and anti-money laundering rules in many countries. They are authorized to operate as custodians and provide the full range of services in addition.

Waking up Wall Street

Although a few banks have dabbled in crypto for several years, Coinbase’s IPO on the Nasdaq in April rocked the industry. Although crypto purists don’t care about Coinbase listing on an old-school public exchange – centralized! – this IPO valued the company at 85 billion dollars. After a roller coaster ride, its stock has returned to April levels and is currently valued at $ 71.6 billion.

“Coinbase’s IPO was a big wake-up call for financial institutions that were on the sidelines,” Donoghue said. “Almost overnight, banks began to change their risk policies to accommodate crypto.”

Ryan Cuthbertson, managing director of Standard Chartered Bank, said banks’ balance sheets and their ability to protect their assets will be critical in helping regulated entities ranging from pension funds to EU-domiciled Ucits funds enter the space. “We are spending time developing how we can provide an integrated solution between traditional analog assets and crypto assets,” he said, “as well as providing a native digital solution.”

Insurance gap

The only hurdle that fintechs and banks all face is the lack of insurance coverage for digital assets. Crypto.com has received the largest coverage to date, at $ 750 million, but it falls short of its needs.

Banks face the same problem. “The gap between insurance coverage and assets in custody is large and growing,” Cuthbertson said. However, large banks have the option of self-insuring using their own balance sheets – a potentially expensive tool to enter the market.

What is digital custody?

For banks, the next conundrum to be solved is what kind of child care to offer. These can range from cold storage like the one used by Crypto.com to Secure Multipart Computing (MPC) – a service some crypto-native exchanges prefer for its flexibility.

Under MPC, a client or exchange does not hold the key to the assets. Instead, the key is split among many independent nodes, and the owner or custodian of the asset “turns the key” but makes those nodes calculate their share without knowing the details of the other shards. This sort of thing may appeal to fast-trading hedge funds, but it is unlikely to pass due diligence among approved institutions.

Practical questions also arise, such as how the custodian can help clients access their assets. Cold storage is safe as long as the storage device is offline. But at some point, the client has to bring in and out of assets.

Airgapping is one solution: use a hardware wallet without plugging it into a computer or phone, so data can fill the “air gap” via a USB stick or QR code scan. But airgapping assumes that the data is not malicious or corrupted during the transfer, or that a dedicated desktop used for the airgap is not hacked by insiders.

Due diligence goes in depth

Custodians need to develop all of these capabilities, but more importantly, they also need to manage a network of sub-custodians. A bank is only allowed to operate in a limited number of markets, but its investor or commercial counterpart may be located elsewhere. Banks must rely on a network partner to provide the same level of protection, security and compliance.

This means controlling how tokens are managed end-to-end, including configuring users, granting permissions, and managing transactions. “It’s not just about modeling a guard layer, it’s about managing the entire stack,” Donoghue said. “This is where we see the need. “

Banks are seeing their due diligence requirements extend even deeper into the cryptosphere.

Boon-Hiong Chan, head of securities market and technology defense at Deutsche Bank, says banks need to look at a range of market integrity factors, such as how to deal with “confidentiality pieces” such as than Monero, which may be a regulatory minefield.

The stakes for banks are even more existential. “The crypto industry is now $ 2.6 trillion, but who is protecting the unauthorized public blockchains that support this?” Chan wondered. No organization has such power in a decentralized market: it is the community of developers and miners who are responsible for it. “How do you do due diligence on them? “

He described a pyramid of responsibilities that custodians must take on.

A very long checklist

The advice is the license. As regulated institutions dive into crypto, there is now more regulation and banks operate with uncertainty as to what will be allowed and what will not.

For example, banks are now confident in cases where distributed ledger technology is bolted to existing processes, such as trade finance consortia. These are club-like environments involving group authorization to participants, and regulators support these initiatives. The authorities have not yet made a decision on whether banks can participate in DeFi markets or treat new entities such as automated market makers as counterparties.

Second, regulations regarding transactions, such as the travel rule, in which anyone facilitating a crypto transaction must verify the identity of the originator and the beneficial owner of the assets.

This is not a simple exercise in data management. Custodians should exercise due diligence on institutions and networks. They need to understand data privacy rules and develop policies on how to handle the transfer of data with counterparties, including when a bank communicates sensitive data with a virtual exchange, and how those exchanges also handle information.

Finally, Chan says custodians need to investigate a base layer of data residency, which is beyond their capabilities. “Our IT department cannot develop cryptographic key storage in-house,” Chan said. “So how do we see where the data flows and how it is stored? The solution is to outsource this to fintechs like Metaco, forcing the custodian to deepen their due diligence knowledge.

Is it all worth it?

If this all sounds like a lot of hard work and risk for what is a relatively small market, it is. While the retail market and investor demand to trade cryptos is pushing banks into the space, they are keeping an eye on the big picture, the image that is supposed to ultimately justify all the problems: the tokenization and digital currencies of the central bank.

Tokenization of securities would allow banks to make efficient use of blockchain, as they could eliminate much of the reconciliation and other costs in their processes. They could free up capital through more efficient collateral management.

However, tokenization remains embryonic at best. Real estate developers are not rushing to turn their skyscrapers into liquid, marketable assets. For now, traditional banks are limited to crypto custody and trading, putting them in competition with crypto-native fintechs who are better positioned to capture the current NFT boom.

And while everyone welcomes regulatory clarity, the rules can also split markets, and therefore liquidity.

Banks are building expensive and difficult technology stacks for what is a small market, and in which banks are unable to capitalize on their strengths. They need to see crypto mature and institutionalize, quickly – or they will face an upheaval.

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