There should be a segregation of duties between exchanges and custodians.
Nasdaq has halted the launch of Nasdaq Digital Assets, which aimed to start with providing custody, which highlights that institutions want custodians in the space who are independent from exchanges according to market participants.
Jack McDonald, chief executive of PolySign, which builds blockchain-enabled institutional grade infrastructure for digital assets, told Markets Media that his immediate reaction when Nasdaq announced the launch of a custody business was that this was the opposite of best practice.
Jack McDonald, PolySign
McDonald said: “One of the major lessons we learned through all the challenges in the crypto industry in 2022 was there is a lot of danger and conflict of interest in keeping your assets at an exchange.”
For example, collapsed crypto exchange FTX provided custody of customer assets, and it has emerged that they were not segregated and not protected in insolvency.
Nasdaq had announced the launch of the digital asset business in September 2022. Nasdaq Digital Assets aimed to initially develop custody which would bring together hot and cold crypto wallets through an innovative technology offering, subject to regulatory approval in applicable jurisdictions.
Adena Friedman, chair and chief executive of Nasdaq, said during the second quarter results call this month that the group made the decision to halt the launch of the US digital assets custodian business and related efforts to pursue a relevant licence.
PolySign owns Standard Custody & Trust Company, which was set up in New York in order to become a regulated qualified custodian under the New York State Department of Financial Services, and received authorisation in May 2021.
“Our premise for starting Standard Custody & Trust was that there should be a segregation of duties between exchanges and custodians from day one, as in traditional capital markets,” said McDonald. “It is also hard to build a digital custodian and get licenses, we have been doing it for the last five years.”
Regulation
Friedman also said the fundamental business opportunity for Nasdaq Digital Assets has changed over the last several months, and the regulatory overhang meant it was not the right time for us to enter that business.
McDonald believes that regulation is clear for service providers in the US. He said: “Gary Gensler, [chair of the SEC], has said several times that there should be a segregation of duties between exchanges and custodians.”
Gary Gensler, SEC
In February this year the SEC proposed rule changes to enhance protections of customer assets managed by registered investment advisers. Gensler said in a statement that if the expanded custody rule is adopted, investors working with advisers would receive the time-tested protections that they deserve for all of their assets, including crypto assets.
The proposed rule would entrust safekeeping of client assets to qualified custodians, including, for example, certain banks or broker-dealers and help ensure that qualified custodians provide certain standard custodial protections when maintaining an advisory client’s assets, including ensuring client assets are properly segregated and held in accounts to protect the assets in the event of a qualified custodian bankruptcy or other insolvency.
In January this year the New York DFS released regulatory guidance to better protect customers’ virtual assets in the event of an insolvency or similar proceeding and emphasised the paramount importance of the equitable and beneficial interest in the asset always remaining with the customer.
“I can’t imagine being successful in this industry serving institutions if you are not a regulated entity,” McDonald added. “If you want to be in the retail game that is a different story.”
Traditional banks and custodians have been entering the digital asset space.
For example, in July this year SG-FORGE, a subsidiary of Societe Generale dedicated to crypto asset activities, received the first license approval as a Digital Asset Service Provider from the Autorité des Marchés Financiers (AMF), the French financial regulator. The license is necessary to offer services such as the custody of digital assets, the buying or selling of digital assets for legal tender, and the exchange of digital assets against other digital assets.
Swen Werner, State Street
Swen Werner, head of custody at State Street Digital and Dayle Scher, research principal at consultancy Celent said in a blog that many institutional investors are still planning to move ahead with preparations for digital assets and tokenization, despite the market downturn.
“While our research found high levels of interest in digital assets, we also found that in the short- to medium-term future, asset owners expect to take a hybrid approach, investing in both traditional and digital assets,” they wrote. “Indeed, most of the top global custodians either already do – or have plans to support and service – digital asset holdings.”
The blog also highlighted that there are vast differences in how custody operates for digital assets. Traditional custodians exercise control over securities by maintaining accounts at various sub-custodians and central securities depositories. In contrast, crypto custody requires cryptographic processes (key management) to transfer digital assets recorded on cryptocurrencies’ respective blockchains. The use of blockchain technology also introduces new risks related to segregation of clients assets and reconciliation.
“As digital assets become increasingly integrated into traditional investment portfolios, it is crucial that investors and regulators alike understand the differences between traditional and digital asset custody,” said Werner and Scher. “Custodial services must develop new methods and controls to ensure that customer protections are in place, and the residual risk is understood when dealing with digital assets.”
Deutsche Bank Corporate Bank’s flow magazine reported on the discussions around digital asset custody at the Network Forum Annual Meeting 2023 in Athens in June which was attended by approximately 400 custody and post-trade professionals. Traditional custodians argued they are in a strong position as investors are likely hold a combination of traditional and digital securities, and they can also offer ancillary services such as processing dividends and taxes.
Stefan Teis, Deutsche Bank
The article said most custodians are avoiding cryptocurrencies but the industry is confident that tokenisation will grow over the next five to 10 years. Stefan Teis, head of DLT and digital asset service at Deutsche Bank, said on a panel that security tokens fall under existing securities legislation under MiFID and the clear layout of EU regulation provides security for implementing digital asset strategies.
“Under the rules, security tokens will fall under the Markets in Financial Instruments Directive (MiFID),” said Teis. “The majority of other digital assets will be subject to MiCA,”
In addition, once wholesale central bank digital currencies become available Teis said it will be possible for financial institutions to improve efficiency through atomic settlement, or instantaneous delivery versus payment. However, Teis warned that this reduction in settlement risk increases liquidity risk.
Ancillary services
One of the challenges in the digital asset ecosystem is that immediate atomic settlement introduces the need to pre-fund trades. However, under the proposed SEC regulation it will not be possible to move assets from custody to an intermediary such as an exchange or lending platform, even for a short time. As a result, Standard Custody is developing an escrow-like feature where the assets remain in custody, but could be pledged or delegated for other purposes.
McDonald said Standard Custody has two leading trade partners for the launch of this new feature which could lead to an increase in institutional volume.
“We are super excited about it, and think it’s going to have a meaningful impact,” he added. “We are unconflicted as we are not an exchange or liquidity provider so prime brokers and credit providers like working with us.”
Standard Custody has also partnered with with L1 Advisors, an on-chain wealth management platform, to offer integrated qualified custody and self-custody services. The firm said the partnership signifies an industry-first product offering for registered investment advisors, wealth managers, and family offices and combines the security and convenience of qualified custody with the portability and self-sovereignty of self-custody.
McDonald said in a statement: “L1 Advisors has solved an important challenge within the wealth management space, and we are proud to be partnering with them to help bring a more robust solution to the market via our next-generation digital asset regulated custodian.”
PolySign has also developed AtomicNet, a settlement layer that will be interoperable with other digital asset platforms, and is currently running proofs of concept.
“There is still a glaring need for a settlement layer that is interoperable between different liquidity venues and pools,” added McDonald. “What we are building is resonating with different members of the ecosystem by bringing greater liquidity and guaranteed settlement.”
