The reputation of crypto markets as targets for hacks and fraud, as well as the potential anonymity of market counterparties, have to be addressed appropriately to manage operational, regulatory and reputational risk.
There is increasing demand in the market for a traditional, established custodian to provide custody of cryptocurrencies. This emerging asset class is of increasing interest to various client segments, such as alternative hedge fund managers who are keen to be at the leading edge, or endowment funds who have unexpectedly found themselves being gifted cryptocurrencies. Drivers for institutional clients to hold these assets include the potential for value appreciation and portfolio diversification.
Institutional clients may look to established custodians to secure these assets for a number of reasons. Practically, it may be preferable to go to a partner with whom they have an existing relationship, but often the main driver is the increased comfort found with the backing of a significant institution with a strong governance and control framework, as well as a sizeable balance sheet.
A number of specialist crypto firms have begun to launch services targeted to institutional clients, including safekeeping of crypto assets and trading services. Although many are moving to become regulated as financial institutions, only a few of these firms have the operational balance sheet or the deeply embedded control frameworks of an established custodian, and will take time to develop a full service custody model. For clients who may look to offer their own products into the market, for example fund managers, it is critically important to have high levels of asset protection, which may necessitate the engagement of a well-capitalized bank.
That said, there are some significant hurdles that must be overcome if traditional custody banks are to engage with this emerging asset class:
Cryptocurrencies stand apart from traditional asset classes in some important ways, and there are many variations of “coins” within that broad classification. Some have been assessed to be closer to a commodity than a currency, while others resemble securities. The features and characteristics of each coin need to be understood so they can be serviced appropriately. In addition, it is necessary to understand how clients want to interact with these assets. How should settlement risk be managed in a non-DvP (Delivery versus Payment) environment? What trading hours or settlement timeframes are anticipated? Norms and market practices are still under development.
Although financial institutions are no strangers to encryption or key pair management technologies, the importance of sophisticated and secure application of these tools when dealing with decentralized assets such as cryptocurrencies is paramount. Custodians need to implement the necessary technology and infrastructure to securely custodize cryptocurrencies, which, in effect, means to protect the private keys and develop secure mechanisms to support transactions in and out of custody. In addition to storage of the private keys, financial institutions also need to adapt their technology architecture to manage cybersecurity risks when interfacing with a public blockchain to facilitate transfers of these assets.
It should come as no surprise that cryptocurrencies raise significant risk and compliance issues for traditional custodians. Public cryptocurrency markets are unregulated, not jurisdiction specific, offer no contractual relationships or membership standards and provide no means to unwind trades. The reputation of crypto markets as targets for hacks and fraud, as well as the potential anonymity of market counterparties, have to be addressed appropriately to manage operational, regulatory and reputational risk. Any regulated financial institution operating in this space would be expected to apply rigorous controls to ensure the appropriateness of the counterparties and assets they are interfacing with, comparable to AML/KYC procedures in existence for other asset types. It is possible that, over time, a trusted ecosystem of institutional participants may evolve to facilitate trading and servicing of these public assets within a smaller, pre-validated network.
Finally, traditional custodians are highly regulated institutions, due to the nature of their role in the global financial system. Although very few global regulators have provided formal frameworks for servicing crypto assets, it can be expected that there would be significant scrutiny of any traditional institution looking to provide custody of crypto assets alongside traditional asset classes, and appropriate consideration of how this would impact their overall risk profile. The lack of clarity in terms of regulatory categorization of these assets and the potential for unforeseen regulatory action in relation to cryptocurrencies presents another challenge for custodians looking to develop a proposition in this market.
Given the market interest, custodians should be considering their capabilities in relation to cryptocurrency servicing; but in order to advance the industry will have to collectively overcome the issues and uncertainties which remain outstanding.
The views expressed herein are those of the authors only and may not reflect the views of BNY Mellon. This does not constitute Asset Servicing advice, or any other business or legal advice, and it should not be relied upon as such.
©2018 The Bank of New York Mellon Corporation.
Custody Product Manager, Asset Servicing
Kara Kennedy, Custody Product Manager in the Asset Servicing business, based in London. Kara is primarily responsible for strategic initiatives related to custody, including FinTech engagement and emerging technology.View Profile