• Securities Services, Technology

    What will be the shape of digital custody?

15 October 2021

As investors build digital asset portfolios while they chase superior returns and diversification, custodian banks are building digital custody solutions to help them. Clarissa Dann reports on the risks and regulatory arms embracing these new asset classes

Digital assets – who is trading what crypto-currency?

Digital assets come in many shapes and sizes. The most commonly traded digital asset is crypto-currency, which in August 2021 boasted a market cap of more than US$2trn.1 In the flow article Token power (25 June 2021), we define and explain how Bitcoin’s current market cap is quadruple that of the second-most-traded, Ethereum and that most cryptocurrencies work the same way, with limited supply.  The website https://coinmarketcap.com provides an updated list of crypto-currency prices by market cap. Much of the trading activity in crypto-currencies − such as Bitcoin − is being driven by retail investors.

However, some institutions including hedge funds, family offices and wealth advisors have been incorporating them into their portfolios too. For instance, Brevan Howard, one of Europe’s largest hedge funds, recently established a business arm called BH Digital to trade crypto-assets. This comes as other high-profile hedge funds such as Marshall Wace increasingly invest in digital assets as well. “Wealth managers in Hong Kong and Singapore are also gaining exposures to digital assets such as crypto-currencies. This is partly because these wealth managers are now looking after the savings of younger, millennial investors – many of whom are more open about investing into digital assets,” says Anand Rengarajan, Global Head of Sales & Head of Asia Pacific, Securities Services at Deutsche Bank. The direction of travel is evidently moving in favour of digital assets. Analysis published in July by Fidelity Digital Assets, for example, found 71% of institutions intend to have digital asset allocations in the future, while 90% expect to have exposures by 2026.2

Figure 1: Current adoption and channels to exposure (investor segments)

Source: Fidelity, The Institutional Investor Digital Assets Stud3

Appetite for stablecoins is also on the ascendency. In contrast to crypto-currencies such as Bitcoin, stablecoins are a type of crypto-currency whose value is pegged to and collateralised by tangible assets including fiat currencies, which in theory makes them less volatile and more predictable. A more detailed definition can found in the flow article ‘Getting to grips with stablecoins’ (December 2019). Supply of stablecoins has jumped exponentially in the first three quarters of 2021.

In January 2021, there were US$30bn worth of stablecoins in circulation, its market cap has since grown to more than US$100bn as at May.4 While there is a certain degree of scepticism about crypto-currencies and stablecoins, there is institutional appetite for Central Bank Digital Currencies (CBDCs), something developed further in the flow article 'CBDCs and the impact on cross-border payments' (4 August)

Having observed the growing popularity of crypto-currencies, a number of Central Banks – most notably the People’s Bank of China (PBOC) – responded by developing distributed ledger technology (DLT)-supported virtual equivalents of their own domestic currencies. In addition to facilitating massive efficiencies in the world of cross-border payments, the ability for trading counterparties to use CBDCs during cross-border transactions could also potentially result in markets moving towards a T+0 (same day) or instantaneous settlement cycle.5 

Security tokens: Making progress but stuck in first gear

Beyond crypto-currencies, security or asset-backed tokens – namely tokenised, digital representations of tangible assets, which can be subdivided into smaller, tradeable underlying units – are gathering momentum among institutional investors. As security tokens can be split into very low denominations, it could also help make investing cheaper and more accessible, particularly for retail investors. The value of tokenisation could be felt most acutely in some of the more illiquid assets, such as art, real estate, private equity or venture capital. Through fractionalisation of assets, it will become easier to buy previously illiquid, high-cost assets, creating added liquidity in these markets. Tokenisation could make buying units in a private equity fund, for instance, as easy as purchasing an exchange traded fund.

But are there limits as to what type of assets tokenisation can be applied to? There is debate as to whether tokenisation should be extended to conventional equities, especially as the existing system works reasonably well already. Mike Clarke, Global Head of Product Management, Securities Services at Deutsche Bank, warns against tokenising equities as it could result in a ‘splitting up’ of the underlying liquidity across equity markets.

The argument for tokenising bonds is perhaps a bit stronger. In some mature bond markets, the process works well. However, some bond issuances can be very expensive and inefficient, and this could make it a viable use case for tokenisation. Clarke believes the use of self-executing smart contracts should help streamline the end-to-end issuances of digital bonds, shoring up liquidity.

Asia has seen some pioneering work in the past year. In September 2020, Thailand's central bank sold 50bn baht (US$1.6bn) in blockchain-based government savings bonds to retail investors; a move noteworthy for using fractionalisation technology and also DLT to displace some intermediaries. In Singapore, regarded as one of the front runners in digital securities, DBS Bank issued a US$11.35m digital bond via a private placement at the end of May 2021.6 Although there is much excitement about security tokens’ potential, the market is still immature with little trading activity to show for a handful of proof of concepts. Owing to this lack of liquidity, there has been very little investment into security tokens. “There have been one or two security token issuances, but I believe the market will move fast. Right now, the industry is in first gear in terms of its approach to digital assets. From next year and 2023, it will move into top gear,” notes Rengarajan.

Boon Hiong“Digital assets can be a portable store of wealth, a hedge and to diversify investment portfolios”
Boon-Hiong Chan, Head of Fund Services and Head of Securities Market & Technology Advocacy, Securities Services Product Management, Deutsche Bank

Digital asset investing – still a way to go….

But what are the fundamentals driving investors to trade digital assets? Inflows are being accelerated by several factors. From a returns perspective, investors could understandably be seeing digital assets as an alternative to gold and an effective hedging strategy in this low interest rate and low yield market environment.

Although calling into question the intrinsic worth of Bitcoin, one leading investment firm says trend following and quant hedge fund managers are increasingly trading off the erratic price movements of crypto-currencies, just as they would in any other market7. Elsewhere, risk management considerations are pushing some investors into digital assets. “Digital assets can be a portable store of wealth, a hedge and to diversify investment portfolios. Given its volatility and short history, views are still forming. Its inherent programmability is underexplored, DeFI has potentials and these innovations can introduce new interesting dynamics in the future of finance,” commentsBoon-Hiong Chan, Head of Fund Services and Head of Securities Market & Technology Advocacy, Securities Services Product Management, Deutsche Bank. On the [younger] retail investor side, it could be said that a large proportion of the digital asset trading is being fuelled by FOMO [fear of missing out] and media coverage about the asset class.

Figure 2: Appeal of digital assets

Source: Fidelity, The Institutional Investor Digital Assets Study8

Nonetheless, investments into digital assets do face constraints. For many investors, the price volatility associated with Bitcoin and other crypto-currencies can challenge it as an instrument for trading and is unappealing to facilitate payments. For example, in the month leading up to June 9, 2021, Bitcoin’s annualised 30-day volatility reached 117.04%, 9 which is simply an unacceptable risk for conservative institutions like pension funds or insurance companies.

As we note in the flow article 'Token Power', on 19 May, Bitcoin’s price dived by 30% to just above US$30,000 at one point (a plunge it repeated on 22 June), losing more than half the gain since it reached an all-time high of nearly US$65,000 in mid-April But in the world of trading crypto-currencies where there is limited supply and no central bank regulation, price spikes and drastic falls are the order of the day.

According to Fidelity Digital Assets, investors also expressed their misgivings about the absence of any fundamentals determining crypto-assets’ value.10 Other commonly-cited issues included fears about the heightened risk of market manipulation and money laundering. Furthermore, a lack of credible service providers offering digital asset solutions – along with the paucity of regulations overseeing digital asset trading – have also generated alarm among investors. However, some of these deficiencies are being rectified by regulators and custodians.

Regulators take a lead on digital assets

With more investors trading digital assets, regulators have been forced to intervene. In some jurisdictions, (for example China and India), the authorities have been swift to outlaw crypto-currencies in order to safeguard investors. Meanwhile, the US is undertaking a review into whether stablecoins threaten financial stability in what could be a precursor to tighter regulation. Others are not banning crypto-currencies outright, but they are introducing protections to bring order to this largely unsupervised corner of the market.

As Deutsche Bank Macro Strategist Marion Laboure points out, "It is no surprise that governments are disinclined to give up their monetary monopolies. Throughout history, governments first regulate and then take ownership. As cryptocurrencies begin to seriously compete with regular currencies and fiat currencies, regulators and policymakers will crack down.”11

The European Commission’s (EC) Markets in Crypto-Assets (MICA) regulations announced in 2020 applies to crypto-currencies and stablecoins and will subject crypto-asset servicers to heightened checks and balances.12

Britta Woernle, Director, Market Advocacy at Deutsche Bank, says the EC’s proposals make a clear distinction between crypto-assets covered by EU MiCAR – that fall outside of existing regulatory boundaries – and those crypto-assets which are already subject to securities laws. In the case of the latter, which will include assets such as security tokens as they qualify as financial instruments, Woernle says rules like MiFID II (Markets in Financial Instruments Directive II) will continue to apply. “The EU digital package introduced a pilot DLT regime for market infrastructures such as CSDs [central securities depositories] and multilateral trading facilities (MTF) to help support the trading and settlement of regulated crypto-assets such as DLT transferable securities,” she comments.

However, Chan emphasises that some EU rules – including Central Securities Depositories Regulation (CSDR)13 and MiFID II – will need updating to incorporate new concepts such as atomic settlement and shared ledgers. “Existing regulations are centred mainly on the principle of a centralised settlement system whereas in this new digital world, it is possible to operate in a decentralised settlement system. Regulations and regulators need to account for the changes that innovation will bring,” continues Chan. As regulation of digital assets becomes increasingly entrenched moving forward, leading institutions will become more comfortable about investing in these new instruments.

Service providers step in

Aside from robust regulation, institutions have made it abundantly clear that they want established service providers supporting them with digital asset investing. The Fidelity Digital Assets study found 63% of investors want to use a digital asset custodian which offers electronic trading, while 56% said data and analytics was very important to them.14

However, the study concedes that safety and security are the most important features of any custodial relationship. Clarke says providers including Deutsche Bank are developing digital asset capabilities, including private key management and storage. “The possibilities and opportunities for custodians in the digital asset universe are endless. At the most basic level, clients want to engage with custodians who can plug into both traditional and digital assets, and provide connectivity,” says Clarke. The expertise of traditional banks – relative to some of the new incumbents – is also critical.  While fintechs have moved into crypto-custody, customers who are considering trading digital assets will usually want to work with a trusted bank counterparty. This, explains, Clarke, is especially true for universal banks, who can offer an array of diverse services beyond just crypto-custody including FX, execution, collateral management and financing. “The balance sheet strength of major banks is also a strong draw for institutions,” adds Clarke. 

If digital asset trading is to become mainstream, the abilities to manage the interoperability of the asset’s underlying technologies are important. At present, many within the securities services industry are at different stages of their technology development, and these gaps ultimately need to be bridged. Similarly, Rengarajan says that in order to achieve milestones like instant settlement of digital assets, other components within the investment chain – such as FX and cross-border payments – also need to be expedited.

Nonetheless, he is confident the industry has the ability to handle these changes seamlessly. “The securities services industry has undergone and managed huge transformations in the past, most notably the de-materialisation of physical share certificates. Digital assets will be no different,” he concludes.


Sources

1 Bloomberg (15 August 2021) Crypto-market retakes $2 trillion market cap amid Bitcoin gains
2 Fidelity Digital Assets (20 July 2021) 71% of institutional investors plan to buy or invest in digital assets in the future, according to new research from Fidelity Digital Assets
3 See https://bit.ly/3oXap2C at fidelitydigitalassets.com
4 Crypto-briefing (26 May, 2021) StableCoins surpass $100 billion market cap
5 See also Accelerated settlement: the move towards T+0 (24 September) at flow.db.com
6 Coin Telegraph (1 June, 2021) Singapore’s DBS Bank launches digital bond security token
7 Financial Times (25 July, 2021) Crypto has no inherent worth but is good to trade, says Man Group chief
8 See https://bit.ly/3mJAmQp at fidelitydigitalassets.com
9 Forbes (1 July 2021) Bitcoin price volatility reached a 14-month high in June
10 Fidelity Digital Assets (20 July 2021) 71% of institutional investors plan to buy or invest in digital assets in the future, according to new research from Fidelity Digital Assets
11 See Token power at flow.db.com
12 See https://bit.ly/3FG7fWT at europarl.europa.eu
13 See CSDR: Settlement discipline regime client toolkit at corporates.db.com
14 Fidelity Digital Assets (20 July 20 2021) 71% of institutional investors plan to buy or invest in digital assets in the future, according to new research from Fidelity Digital Assets

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