Fidelity Talks About ‘Custody in the Age of Digital Assets’

On Monday (15 October 2018), Fidelity Digital Assets, which was introduced by parent company Fidelity Investments yesterday, published a white paper "intended to be an educational tool for institutions seeking a better understanding of the custody issues surrounding" digital assets.

History of Financial Assets Custody

The paper starts by explaining the concept of a custodian in the context of the financial world:

"In the simplest terms, custodians safekeep financial assets. Financial institutions acting as custodians do not have legal ownership of stocks, bonds, commodities, or other assets — those rights remain with the individual or institution that own the asset — but they are tasked with holding and securing these assets, as well as performing other functions such as settlement services, recordkeeping, and foreign exchange transactions."

Until the "Stock Market Crash of 1929" occurred, "investors were responsible for securing the paper certificates that claimed rights to their investments." After the crash, "trust companies and other financial intermediaries evolved to provide custody services for the holders of stock certificates."

During the next few decades, the rapid increase in the number of securities exchanged in the U.S. and the rapid growth in trading volumes on the New York Stock Exchange led to "a significant increase in the paperwork required to custody, clear, and settle these transactions" and "trust companies and intermediaries" getting "overwhelmed with these changing ownership records." This gave rise to the creation in 1973 of what later became The Depository Trust & Clearing Corporation (DTCC), which "established the first set of centralized ledgers and certificates of clearing", the idea was that "depository functions throughout the United States would be consolidated into the DTCC."

The "Employee Retirement Income Security Act of 1974" (ERISA) made "significant changes to how US pension funds invest and manage assets"; among them was "the requirement that plans separate investment management and custody of plan assets." As investing by U.S. mutual funds grew, it created a need for global custody services, with today four U.S. banks --  BNY Mellon, J.P. Morgan, State Street, Citigroup -- owing the majority of this market.

The Current Landscape for Digital Asset Custody

Although existing centralized crypto exchanges provide custody of digital assets in addition to a trading venue, they are "not immune to security failures", and "institutional concerns for client safety have fueled the demand for custodial services, separate from exchanges that can provide safe, secure storage for digital assets."

Custody of digital assets has security issues that are quite different from "safekeeping of stocks and other types of assets." 

To make owning digital assets simpler, "custodial wallet providers and exchanges hold digital assets on behalf of the individual owner, giving the wallet provider (or exchange) full control over transactions." One advantage of this is that "if the keys or passphrases to access the account are lost, the wallet provider can take steps to verify identities, making it easier to recover access." Since" custody services require that the owner of digital assets hand control to a third party",they need to show that they employ "vigorous security measures and robust technological protections" since otherwise "digital assets could be put at risk."

The paper then lists the various ways in which private keys can be safeguarded:

  • Hot Storage: "Hot storage makes accessing and transacting with digital assets easy by keeping the private key online for accessibility by the user, which can leave the wallet and its user vulnerable to a security compromise... for security reasons, most people prefer to keep as little of their digital assets in a hot wallet as possible."
  • Cold Storage: "Cold storage is considered by many to be a preferred solution (some firms use cold storage exclusively)... adds a manual step to accessing digital assets but provides an additional level of security."
  • Multi-Signature: "This new type of security provision is unique to digital assets and could affect the way the financial industry designs custody for other asset types in the future."

Although "security solutions for individual investors continue to evolve", only a few of these focused on "the unique challenges of institutional investors." 

So, who are these institutional investors?

"Institutional clients represent a broad spectrum of financial firms, including mutual funds, investment managers, family offices, public and private retirement plans, registered investment advisers, insurance companies, corporations, endowments, and foundations."

Since many of these institutions are holding assets for their clients, they "must work with a custodian that can demonstrate a significant track record and experience in safeguarding client assets", and they "need to know who is holding on to — and securing — the private keys." Self-custody is not a viable approach (due to "regulations and the legal obligations that define their fiduciary responsibilities").

The good news is that "the ecosystem is evolving to help increase access to products that will provide the same level of custodial service expected for other assets, despite the regulatory uncertainty."

Fidelity says that the main issues for institutional investors fall into the following categories:

  • Regulatory: "How will existing regulations be applied to digital assets, and how will regulators respond to the growth of this asset class with new rules and guidance? Will policymakers take a dim view of pension plans investing in digital assets? Will digital asset firms pursue bank charters to offer bona fide custody services? Is every custodian in a multi-sig protocol considered an equal-part custodian?"
  • Market/Network Challenges: "For custodians, trading digital assets in a volatile environment with a third party carries its own challenges. How will custodians respond to token “airdrops” or bitcoin forks, for example? Will digital asset volatility limit the number of firms offering custody services?"
  • Security: "How will security processes and standards evolve? How will institutional clients and custodians implement the highest levels of protection for digital assets? Will there be industry insurance solutions that will give institutions and their clients more comfort?"

It then says that with custody, we have the old chicken-and-egg problem:

"Before traditional custodians go too far in their development of institutional quality services, the industry is hoping to see more institutional money in the space. However, institutional investors are finding it difficult to commit fully to digital assets until there is a reliable and respected custody solution."

Fidelity believes that "as additional reputable firms enter the space, there will be an increase in market participation, contributing to the viability of digital assets", and that over time, "securities will also become digitally native, and these assets will be more quickly introduced to market compared to new issuances today."

Featured Image Courtesy of Fidelity Investments