Diving into digital
27 May 2021
As attitudes towards digital assets become more positive, the next few years will see the digital asset industry become more mature, with clearer regulations around digital assets and the establishment of a vibrant digital ecosystem
Image: goinyk/stock.adobe.com
The growth of the digital assets market has been indisputable with the industry’s estimated value reaching $239 billion, as measured by total cryptocurrency market capitalisation.
Research from Deloitte last year showed that digital assets are already disrupting traditional financial services, and they have a key role to play in the future growth of the sector.
The growth around digital assets has also sparked a change in attitudes within the industry.
Although there is scepticism towards pure crypto assets such as bitcoin, it is starting to shift as institutions like Fidelity and Nomura start to provide custody for those assets.
The scepticism around crypto stems from the 2018 cryptocurrency crash, which occurred after an unprecedented boom in 2017, when the price of Bitcoin fell by approximately 65 per cent during the month from 6 January to 6 February 2018.
However, the industry is starting to show a better understanding of the benefits blockchain can bring, especially towards automating workflows and more use cases are becoming apparent.
Simon Ong, director of product innovation, securities services at Standard Chartered, notes that digital assets have gained “much credibility among institutional and market infrastructure providers”, with the recent announcements on successful proof-of-concept and collaborations among banks, fintechs and market exchanges in building up the new digital asset ecosystem.
If you discussed digital assets a few years ago, the conversation would solely focus on crypto assets. However, now with a flurry of new regulation around the globe, Benjamin Duve, head of digital assets and custody at Commerzbank, says digital assets can soon be a traditional security in a modern wrapping.
According to Deloitte’s report, 50 per cent of asset managers expect to introduce cryptocurrencies to their funds over the next three years.
With this in mind, Justin Chapman, global head of market advocacy and innovation research at Northern Trust, says custodians will need to offer new, innovative digital solutions.
In the digital asset space, custodians operate in a similar fashion to traditional financial markets in that their primary role remains the responsibility for, and the safekeeping of customer’s digital assets. The Deloitte research paper explains that this is achieved through safe key management, which allows the assets to be cryptographically secured.
However, it explains that unlike for traditional assets, an entity has custody of a digital asset simply by holding the private key on behalf of the asset holder, ensuring that it cannot be accessed by any other party.
“As custodians adapt to this transformation, the focus will be on better access to data for clients with actionable insights that help them make better investment decisions,” Chapman explains.
As part of its efforts to meet the evolving requirements of clients, Northern Trust recently launched Zodia, an institutional-grade cryptocurrency custody solution, in partnership with Standard Chartered.
BNY Mellon also recently launched a digital assets unit announcing plans to build a new multi asset digital custody and administration platform, while Deutsche Bank has revealed it is exploring options around crypto custody after collaborating with Singapore fintech Hashstacs to explore a proof of concept related to the technological and practical feasibility of digital assets interoperability.
Trends
There are many types of digital assets that require adequate custody such as cryptocurrencies and stablecoins, tokenised assets, and now central bank digital currencies.
Historically in the custody space, there were few available secure custody solutions, and early investors were mostly comprised of the tech/start-up community, some retail investors, as well as some wealthy individuals and family offices. But Samar Sen, head of digital products and data at Deutsche Bank Securities Services, suggests that has changed a lot now.
One of the bigger developments Sen explains is that regulators in many countries are now offering clear guidelines and licensing paths on how to offer digital asset custody in a responsible and regulated manner with investor protection in mind.
For example, in the US last July, the Office of the Comptroller of the Currency (OCC) declared that national banks and federal savings associations have the authority to provide cryptocurrency custody services to their clients. The OCC said it acknowledged the need for banks and other service providers to leverage new technology in order to meet clients’ needs.
Traditional banks supporting digital assets are also on the rise. Banks like Northern Trust, BNY Mellon, Standard Chartered are offering digital custody services for clients, either through partnering with a digital asset infrastructure provider or developing these new capabilities in-house and offering them as a new custody model.
Standard Chartered’s Ong says: “This is a result of increasing demand from institutional investors and asset managers who seek to diversify their portfolios for their clients.”
He suggests the interest in cryptocurrency was also further propelled by the recent surge in bitcoin prices, which he says has spurred even greater client demand for access and exposure to crypto and digital assets.
With many new start-ups focusing on digital custody as well as more traditional firms starting to show interest, Chapman says: “Tokenisation of mainstream assets is something that might change the industry — it has the potential to allow a wider group of investors access to investments which were historically only available to larger institutions.”
From a landscape made by several small players with basic offerings, Daniele Savarè, director of innovation and business solutions at SIA, has also observed the growth that has taken place of a few big players with many value-added services.
Savarè explains: “They invested a lot to be able to offer more complete and secure solutions to satisfy institutional clients’ strict requirements and to manage a large number of retail customers.”
Most players are currently based in the US, some of them in Asia and very few in Europe, including the UK and Switzerland.
There is also a trend that solutions offered by big players are going beyond simple custody. Savarè says: “Brokerage services are set to offer fiat money in return for cryptocurrency and vice versa, staking, liquidity providing for example in decentralised finance, fiscal services and the collateralisation of digital assets to open credit lines.”
“Relevant enhancements have been done around governance topics, implementing organisational schemes with segregated roles and operating models more in line with institutional clients’ needs,” he adds.
Challenges
The digital assets ecosystem is evolving at incredible speed with a constant stream of new assets introduced into the market, which could pose challenges.
Ong suggests this is especially challenging for digital asset custody institutions to keep up with and develop the technical requirement and operational agility needed to quickly embrace new requirements and standards.
Savarè suggests that major technological challenges stem from security, scalability and interoperability features, highlighting that much more still needs to be implemented mainly by small providers related to security.
Scalability is still a risk related to the foreseen volumes while interoperability across blockchain systems is probably the main challenge to guarantee the secure flow of digital assets among different protocols satisfying characteristics of atomicity, consistency and settlement of transactions, he explains.
Many research and development teams and start-ups are working to address these issues, often in collaboration with corporates, which is expected to be a game changer in 2021.
One example of this is SIA’s collaboration with Hex Trust to further strengthen its expertise and primary role in designing and delivering innovative infrastructures, primarily for the European financial community.
SIA aims to create an ecosystem where banks can manage their digital assets based on state-of-the-art technologies and comply with their internal procedures and regulatory requirements.
Building new services within the digital asset ecosystem will involve deploying new skills and technology stacks, which Sen explains will see institutions having to invest in the right talent and technology to ensure they can participate.
Another challenge identified is the lack of established market infrastructure and widely adopted standards around the digital ecosystem, which he suggests “facilitates the entire digital assets lifecycle from the primary issuance of the digital assets to secondary markets for trading and digital custody institutions for safekeeping and settlement”.
As digital assets are still not as liquid as traditional instruments like equity and bonds, Ong highlights there is still a concern among institutional investors around the ease of converting digital assets to fiat on demand.
He adds: “Moreover, the digital asset exchange still operates on pre-funded accounts for trading and uses the existing banking system to convert tokens to fiat, which further increases liquidity risk and introduces more cost for investors.”
As private keys are the only proof of ownership of the public address where an investor’s digital assets are stored, losing it would mean a loss of ownership to its associated digital assets.
Despite new wallet solutions introduced in the market, Ong argues there is still a risk where investors could lose all their digital assets due to hacking.
Ong notes: “We see a safer and more efficient ecosystem for digital assets to be created in the near future which will encourage even more institutional and retail investors to invest in digital assets. A clear legal framework will also need to be created in each jurisdiction with clear direction on taxation, settlement finality and governance of the distributed network to further encourage the adoption of digital assets.”
With an abundance of new digital assets, sitting on newly-installed technology, Sen suggests the industry will all experience an increase in hacking attempts.
“Advances in cryptography and use of military-grade security and highly controlled operating models should allow for a strong defence,” he explains.
Standardisation of business rules and technical specifications is another area essential for developing a consolidated view of all digital asset holdings by institutional investors across multiple distributed networks and jurisdictions.
Ong suggests that this provides visibility and clarity into their tax obligations and accounting requirements for their holdings.
Also agreeing, Duve says that the lack of standards is one of the biggest challenges around digital assets.
He says: “You do not know the exact specification of the ‘chain’ the most interesting and requested assets will be running on. This makes building the infrastructure difficult, as there is no industry standard and interoperability yet.”
As different types of digital assets will sit on various public/private ledgers, interoperability becomes a key obstacle, according to Sen.
“Some companies are working to solve this. Furthermore, markets and regulators will need to co-operate on a global level to agree on standards and platforms to represent digital assets, for example, for security token issuances,” he adds.
Changes ahead
Over the next five years, digital assets are set to become more mainstream. For custody, this could mean that digital asset custody could transform into digital asset banking.
Chapman says that custodians that have embarked on a digital strategy and embraced the new business opportunities “will drive innovation opportunities – helping to make sense of data and, as ever, safeguarding assets”.
The industry will see a move towards a new standard and new ecosystems to evolve, not completely, but partly with new players and certainly with a few current ones missing out, which Duve says is “due to the opportunity to rethink the infrastructure and the decentralised nature and possibilities of the underlying technology”.
In addition to evolutions related to digital assets as qualified as financial instruments, Savarè says he expects the industry will also see technological developments that will improve privacy and performance features.
He highlights that there will be more challenges on the regulatory side that could be opted for specific, tailor-made rules for tokenised asset markets.
Environmental, social and governance (ESG) topics will become more and more crucial, according to Savarè, who explains: “Some of these assets are energy-intensive and it is necessary to find a tradeoff between security and reliability issues when shifting to an approach not based on ‘brute-force’ and energy greedy, in line with governments’ sustainability plans. If this is not happening, utilities and energy producers could take the opportunity to enter into this sector, with the risk of changing the current balance of power.”
Meanwhile, Ong says in the next five years, he believes the digital asset industry will be at a more mature stage, with clearer regulations around digital assets and establishment of an end-to-end digital asset infrastructure and vibrant digital ecosystem.
He says: “There will be more new use cases developed on top of this new digital infrastructure, bringing greater efficiency gains and offering access to all markets 24/7, with real-time trading and instant payment rails to support the settlement and ownership transfer. “
The current role of issuers, custodians, exchanges, brokers/dealers, central securities depositories and asset managers are also set to evolve.
New players such as wallet providers and blockchain hosting service providers will emerge, which Ong says will provide enhanced services and infrastructure needed to create an efficient end-to-end ecosystem for digital assets.
Overtime, Ong predicts that digital asset custody will “fully morph into digital asset banking, with more virtual and real assets with an intrinsic value that can be tokenised and exchanged at a transparent price on digital marketplaces, both centralised and decentralised exchanges as well as via peer-to-peer”.
He adds: “More digital asset constructed financial products — such as collateralised loans backed by tokenised assets — will also be made available.”
Research from Deloitte last year showed that digital assets are already disrupting traditional financial services, and they have a key role to play in the future growth of the sector.
The growth around digital assets has also sparked a change in attitudes within the industry.
Although there is scepticism towards pure crypto assets such as bitcoin, it is starting to shift as institutions like Fidelity and Nomura start to provide custody for those assets.
The scepticism around crypto stems from the 2018 cryptocurrency crash, which occurred after an unprecedented boom in 2017, when the price of Bitcoin fell by approximately 65 per cent during the month from 6 January to 6 February 2018.
However, the industry is starting to show a better understanding of the benefits blockchain can bring, especially towards automating workflows and more use cases are becoming apparent.
Simon Ong, director of product innovation, securities services at Standard Chartered, notes that digital assets have gained “much credibility among institutional and market infrastructure providers”, with the recent announcements on successful proof-of-concept and collaborations among banks, fintechs and market exchanges in building up the new digital asset ecosystem.
If you discussed digital assets a few years ago, the conversation would solely focus on crypto assets. However, now with a flurry of new regulation around the globe, Benjamin Duve, head of digital assets and custody at Commerzbank, says digital assets can soon be a traditional security in a modern wrapping.
According to Deloitte’s report, 50 per cent of asset managers expect to introduce cryptocurrencies to their funds over the next three years.
With this in mind, Justin Chapman, global head of market advocacy and innovation research at Northern Trust, says custodians will need to offer new, innovative digital solutions.
In the digital asset space, custodians operate in a similar fashion to traditional financial markets in that their primary role remains the responsibility for, and the safekeeping of customer’s digital assets. The Deloitte research paper explains that this is achieved through safe key management, which allows the assets to be cryptographically secured.
However, it explains that unlike for traditional assets, an entity has custody of a digital asset simply by holding the private key on behalf of the asset holder, ensuring that it cannot be accessed by any other party.
“As custodians adapt to this transformation, the focus will be on better access to data for clients with actionable insights that help them make better investment decisions,” Chapman explains.
As part of its efforts to meet the evolving requirements of clients, Northern Trust recently launched Zodia, an institutional-grade cryptocurrency custody solution, in partnership with Standard Chartered.
BNY Mellon also recently launched a digital assets unit announcing plans to build a new multi asset digital custody and administration platform, while Deutsche Bank has revealed it is exploring options around crypto custody after collaborating with Singapore fintech Hashstacs to explore a proof of concept related to the technological and practical feasibility of digital assets interoperability.
Trends
There are many types of digital assets that require adequate custody such as cryptocurrencies and stablecoins, tokenised assets, and now central bank digital currencies.
Historically in the custody space, there were few available secure custody solutions, and early investors were mostly comprised of the tech/start-up community, some retail investors, as well as some wealthy individuals and family offices. But Samar Sen, head of digital products and data at Deutsche Bank Securities Services, suggests that has changed a lot now.
One of the bigger developments Sen explains is that regulators in many countries are now offering clear guidelines and licensing paths on how to offer digital asset custody in a responsible and regulated manner with investor protection in mind.
For example, in the US last July, the Office of the Comptroller of the Currency (OCC) declared that national banks and federal savings associations have the authority to provide cryptocurrency custody services to their clients. The OCC said it acknowledged the need for banks and other service providers to leverage new technology in order to meet clients’ needs.
Traditional banks supporting digital assets are also on the rise. Banks like Northern Trust, BNY Mellon, Standard Chartered are offering digital custody services for clients, either through partnering with a digital asset infrastructure provider or developing these new capabilities in-house and offering them as a new custody model.
Standard Chartered’s Ong says: “This is a result of increasing demand from institutional investors and asset managers who seek to diversify their portfolios for their clients.”
He suggests the interest in cryptocurrency was also further propelled by the recent surge in bitcoin prices, which he says has spurred even greater client demand for access and exposure to crypto and digital assets.
With many new start-ups focusing on digital custody as well as more traditional firms starting to show interest, Chapman says: “Tokenisation of mainstream assets is something that might change the industry — it has the potential to allow a wider group of investors access to investments which were historically only available to larger institutions.”
From a landscape made by several small players with basic offerings, Daniele Savarè, director of innovation and business solutions at SIA, has also observed the growth that has taken place of a few big players with many value-added services.
Savarè explains: “They invested a lot to be able to offer more complete and secure solutions to satisfy institutional clients’ strict requirements and to manage a large number of retail customers.”
Most players are currently based in the US, some of them in Asia and very few in Europe, including the UK and Switzerland.
There is also a trend that solutions offered by big players are going beyond simple custody. Savarè says: “Brokerage services are set to offer fiat money in return for cryptocurrency and vice versa, staking, liquidity providing for example in decentralised finance, fiscal services and the collateralisation of digital assets to open credit lines.”
“Relevant enhancements have been done around governance topics, implementing organisational schemes with segregated roles and operating models more in line with institutional clients’ needs,” he adds.
Challenges
The digital assets ecosystem is evolving at incredible speed with a constant stream of new assets introduced into the market, which could pose challenges.
Ong suggests this is especially challenging for digital asset custody institutions to keep up with and develop the technical requirement and operational agility needed to quickly embrace new requirements and standards.
Savarè suggests that major technological challenges stem from security, scalability and interoperability features, highlighting that much more still needs to be implemented mainly by small providers related to security.
Scalability is still a risk related to the foreseen volumes while interoperability across blockchain systems is probably the main challenge to guarantee the secure flow of digital assets among different protocols satisfying characteristics of atomicity, consistency and settlement of transactions, he explains.
Many research and development teams and start-ups are working to address these issues, often in collaboration with corporates, which is expected to be a game changer in 2021.
One example of this is SIA’s collaboration with Hex Trust to further strengthen its expertise and primary role in designing and delivering innovative infrastructures, primarily for the European financial community.
SIA aims to create an ecosystem where banks can manage their digital assets based on state-of-the-art technologies and comply with their internal procedures and regulatory requirements.
Building new services within the digital asset ecosystem will involve deploying new skills and technology stacks, which Sen explains will see institutions having to invest in the right talent and technology to ensure they can participate.
Another challenge identified is the lack of established market infrastructure and widely adopted standards around the digital ecosystem, which he suggests “facilitates the entire digital assets lifecycle from the primary issuance of the digital assets to secondary markets for trading and digital custody institutions for safekeeping and settlement”.
As digital assets are still not as liquid as traditional instruments like equity and bonds, Ong highlights there is still a concern among institutional investors around the ease of converting digital assets to fiat on demand.
He adds: “Moreover, the digital asset exchange still operates on pre-funded accounts for trading and uses the existing banking system to convert tokens to fiat, which further increases liquidity risk and introduces more cost for investors.”
As private keys are the only proof of ownership of the public address where an investor’s digital assets are stored, losing it would mean a loss of ownership to its associated digital assets.
Despite new wallet solutions introduced in the market, Ong argues there is still a risk where investors could lose all their digital assets due to hacking.
Ong notes: “We see a safer and more efficient ecosystem for digital assets to be created in the near future which will encourage even more institutional and retail investors to invest in digital assets. A clear legal framework will also need to be created in each jurisdiction with clear direction on taxation, settlement finality and governance of the distributed network to further encourage the adoption of digital assets.”
With an abundance of new digital assets, sitting on newly-installed technology, Sen suggests the industry will all experience an increase in hacking attempts.
“Advances in cryptography and use of military-grade security and highly controlled operating models should allow for a strong defence,” he explains.
Standardisation of business rules and technical specifications is another area essential for developing a consolidated view of all digital asset holdings by institutional investors across multiple distributed networks and jurisdictions.
Ong suggests that this provides visibility and clarity into their tax obligations and accounting requirements for their holdings.
Also agreeing, Duve says that the lack of standards is one of the biggest challenges around digital assets.
He says: “You do not know the exact specification of the ‘chain’ the most interesting and requested assets will be running on. This makes building the infrastructure difficult, as there is no industry standard and interoperability yet.”
As different types of digital assets will sit on various public/private ledgers, interoperability becomes a key obstacle, according to Sen.
“Some companies are working to solve this. Furthermore, markets and regulators will need to co-operate on a global level to agree on standards and platforms to represent digital assets, for example, for security token issuances,” he adds.
Changes ahead
Over the next five years, digital assets are set to become more mainstream. For custody, this could mean that digital asset custody could transform into digital asset banking.
Chapman says that custodians that have embarked on a digital strategy and embraced the new business opportunities “will drive innovation opportunities – helping to make sense of data and, as ever, safeguarding assets”.
The industry will see a move towards a new standard and new ecosystems to evolve, not completely, but partly with new players and certainly with a few current ones missing out, which Duve says is “due to the opportunity to rethink the infrastructure and the decentralised nature and possibilities of the underlying technology”.
In addition to evolutions related to digital assets as qualified as financial instruments, Savarè says he expects the industry will also see technological developments that will improve privacy and performance features.
He highlights that there will be more challenges on the regulatory side that could be opted for specific, tailor-made rules for tokenised asset markets.
Environmental, social and governance (ESG) topics will become more and more crucial, according to Savarè, who explains: “Some of these assets are energy-intensive and it is necessary to find a tradeoff between security and reliability issues when shifting to an approach not based on ‘brute-force’ and energy greedy, in line with governments’ sustainability plans. If this is not happening, utilities and energy producers could take the opportunity to enter into this sector, with the risk of changing the current balance of power.”
Meanwhile, Ong says in the next five years, he believes the digital asset industry will be at a more mature stage, with clearer regulations around digital assets and establishment of an end-to-end digital asset infrastructure and vibrant digital ecosystem.
He says: “There will be more new use cases developed on top of this new digital infrastructure, bringing greater efficiency gains and offering access to all markets 24/7, with real-time trading and instant payment rails to support the settlement and ownership transfer. “
The current role of issuers, custodians, exchanges, brokers/dealers, central securities depositories and asset managers are also set to evolve.
New players such as wallet providers and blockchain hosting service providers will emerge, which Ong says will provide enhanced services and infrastructure needed to create an efficient end-to-end ecosystem for digital assets.
Overtime, Ong predicts that digital asset custody will “fully morph into digital asset banking, with more virtual and real assets with an intrinsic value that can be tokenised and exchanged at a transparent price on digital marketplaces, both centralised and decentralised exchanges as well as via peer-to-peer”.
He adds: “More digital asset constructed financial products — such as collateralised loans backed by tokenised assets — will also be made available.”
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