There are merely a handful of banks which currently dominate the global custody markets and, as we see an increase in the use of digital equities and bonds, there is a real possibility that being able to track and trace assets in real time and/or having the use of multi signature wallets could remove the need for the custody services as we know them.
Banks are increasingly coming under pressure to adopt new business practises and offer alternative products and services as financial markets evolve and further embrace technology, both at an institutional and retail level.
With our lives becoming increasingly digitised there is a growing dependency on IT and machine-based processing as opposed to many of the paper-based analogue systems that historically have been the backbone of banking systems and procedures.
For example, there is a growing question as to the current need for custody services which have historically been provided by banks offering to hold assets (such as equities, bonds and commodities) on behalf clients in a safe and secure manner.
Custodians by assets under custody…
Custodian bankers don’t tend to offer what one would class as traditional banking services – mortgages, current accounts or lending services, but have focused on offering institutional services particularly for fund managers.
At one level it is rather strange that an investor in a fund managed by Blackrock – the world’s largest fund manager with over $7.1 trillion of assets undermanagement – needs to rely on a third party such as a custodian and not Blackrock for the security of its funds.
Financial services regulators, such as the SEC in the US or the FCA in the UK, insist that Blackrock must use an external and independent custodian to actually hold the assets – the equities or bonds in a fund, for example. This adds to the costs of the fund for the investor as well as an added level of complexity and requirement for more records to be checked and monitored, alongside the inevitable queries and time delays in reconciling data.
At the time, the requirement for such a system was developed when asset managers were required to physically deal in paper-based assets and it was extremely difficult to be certain who actually had the physical possession of a share or bond certificate.
Unsurprisingly today, there is the threat of redundancy for this rather archaic way of managing money, what with the existence of digitisation of information.
The ability to hold data in a very structured manner means that machines can easily track and trace who owns what, and where the assets are held, in ‘real-time’.
The application of blockchain technology and use of smart contracts ensures that many of the current manual checking and monitoring can be carried out automatically. Therefore, it ought to be of no surprise that organisations such as the Depositary Trust and Clearing Corporation (DTCC) has been working with IBM to build a Blockchain-powered platform to handle the current $10 trillion of derivatives that the DTCC handles per annum.
Recently, the Singapore financial regulator has granted permission to allow the Asian bank, DBS, and cryptocurrency exchange, Independent Reserve (based in Australia), to offer digital asset services to retail as well as to institutional clients in Singapore. Adrian Prelozny, CEO of Independent Reserve, urged Australians to take an example from the Singaporean “thorough approach to crypto industry licensing”, reminding them that “there are no custodian requirements for the exchanges in Australia”.
Are multi-signature parties necessary?
Meanwhile, there is an argument that by using a multi-signature wallet there is no need to have a separate firm to provide custody services since the only way assets can be transferred from a multi-signature wallet is if a number of the multi-signature parties are involved.
Whilst this sounds attractive as no one party is solely responsible for holding the digital asset safe, and therefore the custody costs can be less. However, multi signature wallets do present challenges:
- if something goes wrong, seeking legal address may prove to be a challenge since multi signature wallets are relatively new concepts.
- transaction speed may be slow because multi signature wallets need more than one party to execute a transaction.
- the process of recovery of a multi-signature wallet requires importing each of the recovery phrases on a different device, which is not a fast process.
For now, institutions that are trading and holding cryptocurrencies are required to continue using custody services which helps to explain why some of the largest traditional providers, such as Bank of New York, State Street and more recently US Bank, are now offering digital asset custody services.
Although the cryptocurrency market is still relatively small (approx $2.5 trillion), as we start to see more organisations issuing digitised equity and debt instruments the requirement to use traditional banks to provide custody services may well be increasingly questioned.
The potential ability to remove the need for a custodian is an example of ‘disintermediation’ – a term often used as a key reason why we are seeing financial markets being disrupted by blockchain-based platforms. Furthermore, such use of blockchain-powered platforms offers greater transparency, and therefore trust, which ought to lead to lower professional indemnity insurance premiums and lower costs for the end client.
A smaller “Total Expense Ratio” for a fund ought to lead to better performance for the funds held in your pension plans and savings. The use of blockchain technology also offers compliance departments and regulators, as well as senior management, greater oversight (potentially on a real-time basis).
These are powerful drivers helping to encourage the huge potential offered by blockchain technology and in turn it raises the question will funds in the future that invest in digital asset use or even need the traditional custodians that are so extensively used today?