Custody in the Age of Digital Assets

The market for digital assets has evolved dramatically since the release of Satoshi Nakamoto’s Bitcoin white paper nearly ten years ago.

From Bitcoin’s origins as a peer-to-peer system of value transfer to the development of smart contracts and countless other blockchain applications, cryptography-based digital assets have become one of the most disruptive and revolutionary technologies since the advent of the internet.

Today there are at least 1,600 crypto coins and tokens, according to CoinMarketCap.com. Although it may be hard to think of another market that has developed as quickly, it is not difficult to see parallels between the development of digital assets and that of traditional asset classes such as stocks, bonds, and commodities.

Digital assets may soon become recognized as investable “stores of value,” tradable on global, licensed exchanges, and accessible to a broad swath of individuals and institutions across the globe.

And just as with stocks, bonds, or commodities, investors will want to keep these assets safe from theft or loss.

As the industry has evolved, solutions aimed at keeping digital assets safe have continued to develop. Enhancements to offline storage, multi-signature protocols, and other security measures are aimed at increasing investor confidence that their assets are secure. These developments are important, but for institutions holding digital assets on behalf of their clients, they may not go far enough.

For institutions, the most pressing unanswered question is how — if they choose to hold digital assets for their customers — these assets will be secured. The answer is that full-service institutional custody solutions are needed — solutions as equally robust as those provided for traditional assets. Most digital assets function as cryptographic bearer instruments, the keys to which, once lost or stolen, render the asset inaccessible and unrecoverable to its rightful owner, making secure custodianship of primary importance. Custody services for these types of assets are particularly technological, requiring new and different approaches, yet are based on sound financial principles.

In this white paper, we explain why custody services are of paramount importance to institutions and their clients, how financial custody services have evolved, and what all this means going forward for those holding digital assets. Additionally, we will cover:

• The history of financial assets custody
• An overview of the current landscape for digital asset custody
• Unique challenges associated with the custody of digital assets
• Key unanswered questions
• Our perspective

This primer is intended to be an educational tool for institutions seeking a better understanding of the custody issues surrounding this emerging asset class. For simplicity and consistency, the term “digital assets” is applied broadly throughout this white paper to describe bitcoin and other cryptocurrencies, cryptographically issued securities, and other digital tokens.

CUSTODY THROUGH TIME

In the simplest terms, custodians safekeep financial assets. Financial institutions acting as custodians do not have legal ownership of stocks, bonds, commodities, or other assets — those rights remain with the individual or institution that own the asset — but they are tasked with holding and securing these assets, as well as performing other functions such as settlement services, recordkeeping, and foreign exchange transactions.

United States financial markets have long benefited from investors having confidence that their money is secure, but this hasn’t always been the case. Before the Stock Market Crash of 1929, investors were responsible for securing the paper certificates that claimed rights to their investments. This form of self-custody, however, started to fade away rapidly after the crash, because investors recognized the inherent risks in this system.

It was around this time that trust companies and other financial intermediaries evolved to provide custody services for the holders of stock certificates. Given the lack of technology during this period, these services involved the cumbersome physical transfer of certificates from one financial institution to another. From the 1930s through the 1960s, the number of securities exchanged in the United States grew exponentially. From 1965 to 1968 alone, the trading volumes on the New York Stock Exchange jumped from five million shares a day to 12 million,(1) leading to a significant increase in the paperwork required to custody, clear, and settle these transactions. The trust companies and intermediaries were quickly becoming overwhelmed with these changing ownership records.

This paperwork burden and its inefficiencies, along with growth in the securities markets and the need for securities-related services, led to the 1973 creation of what would become The Depository Trust & Clearing Corporation (DTCC), which established the first set of centralized ledgers and certificates of clearing. Eventually, depository functions throughout the United States would be consolidated into the DTCC.

Shortly after the creation of the DTCC, the Employee Retirement Income Security Act of 1974 (ERISA) became law, making significant changes to how US pension funds invest and manage assets. Key to these changes was the requirement that plans separate investment management and custody of plan assets.

As mutual fund investing accelerated, “global custody” became a necessity as investors required custodians to secure their investments across an ever-increasing number of securities from around the world. Today four large banks (BNY Mellon, J.P. Morgan, State Street, Citigroup) provide the bulk of global custody services with approximately $114 trillion in assets under custody.(2) Recent trends suggest this highly concentrated model will continue, as ongoing barriers to entry have prevented other firms from challenging these incumbents.(3)