• SECURITIES SERVICES, TECHNOLOGY

    Building a future custody model

The investment landscape is embracing new technologies such as digital assets. Paul Maley, Head of Securities Services at Deutsche Bank, explains why the future of custody will require a co-existence of old and new technologies, how market structure for securities could change and the implications for clients

In May 2021, an Accenture survey of 250 investment professionals, including individuals from 17 of the largest asset managers globally,1 revealed that while 95% of them recognise the potential of disruptive technologies such as artificial intelligence and cloud technology, only 8% of them are in the early stages of adoption. Yet their potential to reduce costs amidst thinner margins, stemming from the rise of low cost passive investment and a structurally low interest rate environment, rings out clearly.

In addition to these market headwinds, the meme-stock (Gamestop) event in January 2021 highlighted potential shortcomings in the prevailing two day (T+2) cycle for securities settlement in many markets. It occurred when clearing broker Robinhood was unable to make a margin call at the US Depository Trust and Clearing Corporation, following high levels of short interest in a small number of stocks. These investment trends and the Gamestop crisis trigger two considerations: the benefits of shorter settlement cycles in the custody-chain and the exploration of new technologies, including distributed ledgers, to enable process automation.

Digital asset adoption

As digital assets start to become more widely accepted in financial services,2 driven by customer demand, given that custodian banks provide safekeeping and settlement services of traditional assets, providers of these services are being asked to offer the same for digital assets.

For those that are developing a strategy to provide these services, success will depend on an important consideration: the way in which these new technologies manifest themselves today is not how we might expect them to operate in the future, given that digital assets will co-exist alongside traditional ones and regulators will shape the path of how customer asset protection and anti-money laundering rules should be followed.

So what does that mean for how we provide tomorrow’s securities services? The model for digital assets, and the disruptive technologies that underpin them, will be shaped by three factors:

  • co-existence of old and new technologies - interoperability;
  • how these disruptive forces will spur the creation of a new market structures and new business models; and
  • how they will be regulated and governed, both locally and across jurisdictions

Co-existence of old and new technologies

These forces for change, combined with the pivot in market structure that they will create, will lead to further digitisation in the industry (which in turn should help to drive shorter settlement cycles). Ultimately, we see the custody landscape evolving whereby decentralised transaction logs will eventually become the norm over time. In the current model, custodians support securities settlement and safekeeping in a bilateral model involving buy side and sell side participants, exchanges and central securities depositories (CSDs) as intermediaries. Digital asset models have the inherent capability to be both decentralised and multilateral.

However, the legacy technology on which securities services businesses were built presents a processing challenge for banks trying to integrate these new digital services, or adapting to shorter settlement cycles. A flow article titled ‘Tomorrow’s technology today’3 observes how as organisations grow, so do their layers of legacy systems. While Deutsche Bank is tackling the migration to a more efficient architecture, the current custodial services are not suitable to absorb these new types of securities. However, digital assets and digital custody will need to be managed alongside traditional assets and traditional custody to offer clients a seamless customer experience.

Delivering interoperability between the old world and the new world is in itself  an interesting conundrum, and will further extend to the jurisdictional differences between how our bank and its peers will provide custody in different countries. For example, regulators in Germany passed an electronic securities bill allowing digital securities or tokens to be recorded on an electronic ledger and enabling digital custody4. Other countries might still be in the nascent stages of similar regulation. So a service that works in one country won't necessarily be completely fungible to another.

Disruptive technology as an enabler a new market structure

What does that mean for the current market structure? Custodians typically provide post trade custody (safe-keeping) and settlement services for securities that are bilaterally traded through an exchange and intermediated by a CSD in each market for settlement on T+2 (two days after trade date)? This question raises important concerns for the custody and safekeeping of cryptographic assets by financial institutions. As such, as a financial institution, we have been exploring how this new technology could enable permissioning and interoperability among providers in the custody chain.

For instance, given that a private key in digital assets proves ownership, the nature of how custody and clearing services could be supported in this context will likely require a new approach. Compared to the traditional custody models from an infrastructure perspective, in the future it could mean that a digital custodian does not hold a client’s private keys to the underlying assets but holds in safekeeping a private key that operates the client’s account on their behalf.

A potential decentralised environment would benefit from more definition to validate processes and identify the roles and functions of participants in the network, particularly where those networks are unrestricted.

Standardising custody and interoperability

In addition, a standardised approach between jurisdictions to the definitions of safe-keeping and settlement finality (with a shared understanding of equivalence and recognition) will be highly desirable for the long term adoption and development of the market. A commonality of rules and standards, given the current fragmented ecosystem, whose initiatives make use of different protocols and different technologies would also help.

What’s more is that while it is likely that access methods could change: clients may choose to connect directly to systems via APIs, and the custody function itself will evolve. Given that a custodian in a distributed ledger technology network will need to ensure customer asset protection, position management and record keeping, industry standards and messaging protocols will also help ensure smooth interactions between market participants and their service providers while interfaces could also help foster interaction between participants that use these systems.

Regulating and governing digital assets

Regulated custody of digital assets requires safeguards to protect them from misuse or malicious activity in the same way as a traditional checking or securities accounts held by commercial banks. Regulators in Europe are looking to address this and recently proposed a Markets in Crypto-Assets (MiCA) regulation and an additional proposal for a pilot regime for market infrastructures based on distributed ledger technology5. This guidance will be influential for the design of safekeeping and ancillary services that will underpin cryptocurrencies for clients.

In addition, more specific risks for financial services companies including Know Your Customer (KYC), Anti-Money Laundering (AML) and Combatting the Financing of Terrorism (CFT) obligations, could spell serious consequences for any contravention. The challenge of global co-ordination on a future regulatory approach, and the unregulated status of third-party intermediaries dealing with crypto assets, makes the operating environment ambiguous for traditional financial institutions.

If applied equally in the crypto-ecosystem,  preventive measures, including enhanced customer due diligence (CDD), transaction monitoring, and record keeping, and obligations to report suspicious transactions are an important component of many national AML frameworks already exist and in detecting, prosecuting and deterring instances of money-laundering and prosecuting offences.

Future custody market structure: new models based on industry partnerships

As the market continues its journey, custody is the most likely anchor product for financial institutions to develop services on which further use-cases and digital-asset services can then be built. As such, they are looking to offer safe-keeping for these new types of assets as a regulated entity and connect to various public/private ledgers.

Given the jurisdictional concerns, as a specialist multi-market provider of securities services in 40 markets (including 30 where we are on the ground) with a localised approach, we are developing a highly flexible, cloud native platform for digital assets that can be used in each country when the time, and the operating environment, is right.

In addition, we recognise that the disruptive potential of new technologies could upend the current market in the longer term. Same day settlement (like cash) could free-up capital and friction in the market but reduce the requirement to post margin between trade-inception and settlement. Right now, the market already has much to think about by contending with accelerated settlement towards T+1.


Sources

1 See https://bit.ly/3j2JzTB at worldbank.org
2 See Digital assets in 2021 at flow.db.com
3 See Tomorrow's technology today at flow.db.com
4 See https://bit.ly/3xHE156 at ledgerinsights.com
5 See https://bit.ly/3zNdLbh at europarl.europa.eu

Paul Maley

Head of Securities Services at Deutsche Bank

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