Stepping stone or roadblock? Institutional Custody in The Era of Tokenization

Since the current landscape contains significant flaws keeping institutional money from flowing into the Digital Assets ecosystem, the question remains: who will close the gap? 
A couple of candidates identified

1.Digital Asset (Crypto-) Exchanges
Exchanges moving from the current intransparent model to a fully licensed business model where they could extend their offerings with custody solutions (e.g. Coinbase). Exchanges already own the crypto end-customer (retail) and could even consolidate to fewer exchanges with increased market depths.

Limitations:

● As Digital Assets are expected to become regulated, so do Digital Assets (Crypto-) Exchanges

● Security regulation across jurisdictions (e.g., German BörsG) foresees that exchange market participants need to be “qualified” — leading to the tiered system that banks currently participate in for traditional financial exchanges. This trend would likely also happen to Digital Assets (Crypto-) Exchanges

● Exchanges are currently unlikely to adapt their technology stack — their management teams have strong web software development backgrounds but they do not necessarily come with a core banking know-how

2.Cold Storage Providers

Cold storage providers could develop hot-storage (online-) solutions and offer them to their existing client-base. In general, this requires them to build an entirely new tech stack as the main problem of hot-storage is not the key storage itself but developing an access system that only executes fully validated, non-hackable transactions towards Hardware-Security-Modules (HSM) where the private keys are stored.

Limitations:

● The reason why cold storage providers do not offer hot storage today is that they are not capable of delivering a non-hackable access technology e.g Hardware-Security-Module (HSM) where the private keys can be stored

● In traditional web development, most systems are indeed hackable — we see hacks even on leading players such as Google, Facebook, Target, etc

● Cold storage providers will need to build up an entirely new tech stack to provide hot storage — they currently lack this scarce talent (see also crypto exchanges with same reasoning)

3.Traditional Banks

Traditional banks could start offering Digital Assets including custody services. In general, they have three ways how to enter into the Digital Assets offering:

  1. Embed Digital Assets natively in their core banking system to be able to handle/process them (like currently with securities and currencies)
  2. Connect to a third-party system as technology provider for Digital Assets
  3. Rely on a third-party Digital Asset custodian as a financial service

Limitations:

● Embedding Digital Assets natively in core banking systems is difficult as today’s core banking systems usually only support 6 decimals after the comma. Reprogramming an already deployed core banking system (CBS) is a large-scale IT project of >12 months. Taking into consideration that data types (in the very bottom of the stack) need to be adapted towards blockchain-/private-key-methodology, experts expect that a complete switch to a new CBS would be more cost-efficient than deployment of Digital Asset methodology into an existing CBS

● As long as Digital Assets are not consistently regulated, banks would incur the highest possible equity charge in their risk weighted asset calculation according to Basel III — this means that they would incur substantial equity requirements due to holding Digital Assets on their balance sheets. This is not mitigated by having a 3rd party system like Metaco (Switzerland) as it does not provide a balance sheet for those assets

4.Traditional Custodians

Traditional Custodians could build up the necessary tech infrastructure and start offering Digital Asset custody. This sounds like a logical move, as traditional custodians are already serving those institutional customers that are likely to drive the growth in the Digital Assets ecosystem (e.g. banks and asset managers).

Limitations:

● Traditional Custodians need to change their business model to offer Digital Asset custody — this translates into an increased internal approval hurdle for such a project

● They will need to provide value-added services (as in advanced blockchain-protocol-functionalities) like staking, voting-rights or dividend-payouts. They do not do this in the traditional asset context and will need to assume the full risk of private keys disappearing. As such, this could put the rest of their balance sheet at risk

● Scenarios such as a “51% attack” could trigger liabilities for custodians and put their existing business at risk. This likely reduces their appetite for Digital Assets at current volumes

● Traditional Custodians tend to be the least innovative players in the financial industry as their business is scale-driven and has been automated already a decade ago

● They would incur the highest possible equity charge in their risk weighted asset calculation according to Basel III and incur substantial equity requirements due to holding Digital Assets on their balance sheets, just like Traditional Banks

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