We Only Do This Once Every 20 Years or So: A (Digital) Custody Primer by ISSA
What is custody, what is digital custody and what's different between both? It doesn't sound much to go by for a whole dinner conversation. Yet I am sure the topic will give us plenty to talk about.
A new industry report on Digital Asset Custody was published today by GDF, ISSA, and Deloitte. Happy Birthday, Digital Asset Custody report!
This report holds special significance for a variety of reasons, including personal ones. To begin with, I had the honor of serving as the co-chair of the working group responsible for drafting it, which makes it particularly meaningful to me. However, I believe this document is useful for anyone considering investing in or servicing digital assets in an institutional setting and I hope you will agree with me on this assessment if you are inclined to read it: its succinct yet rich in detail and market colour and we aimed to challenge many commonly held believes and where we identified shortcomings we didn’t shy away from saying so.
Travelling back in time
ISSA is an intriguing organization. I first became involved with it as part of the G30 Final Global Clearing & Settlement Report, which examined improvements in institutional arrangements for securities processing at a time when the memories of 9/11 were still fresh in everyone's minds. It led to greater awareness of the importance of interoperability and the need for collaboration to manage our mutual dependencies arising from global integration and connectedness. It's a humbling experience to think about the organization's heritage, and we did our best to ensure the new report lives up to those standards.
The last time ISSA published a foundational report on the matter of 'Custody' was in 1992. I don't remember what my schedule looked like that year, but it certainly didn't involve thinking about custody. Since I wasn't present at the time, I'd like to offer a glimpse into what the working group responsible for drafting the initial report might have looked like. In case you have not noticed the rather unexpected choice of clothing for my protagonists, I can explain, but I left that for the very end.
Feel free to share your own imaginings:
The original report was updated about five years ago with Roger Harrold as a co-chair. This made my engagement even more daunting: he used to be the business executive of Deutsche's custody franchise, making him my ultimate boss back then. But he has been a mentor, friend, and a great source of wisdom ever since. I hope his critique of this report won’t be too harsh.
So you see, there were many reasons that compelled me to do my best. I talked a lot about ISSA and didn’t mention GDF yet but the report is sponsored by both organisations and the interaction with the organisation and its members has enriched my understanding of the issue at hand tremendously. I just couldn’t think of a funny anecdote for GDF, that's all. Contributing to the creation of this report allowed me to reflect on my involvement in the field of custody so far. What truly matters when it comes to digital custody compared to the status quo? This was my north star throughout, and I wish I had such guidance available when I first got involved in the safekeeping of crypto and tokenized instruments. The textbook definition of a ‘wallet’ is one thing; how it differs from an ‘account’ and why it matters is a different universe!
Key take-aways
This, in my view, is one of the biggest challenges holding the market back. When a custodian banker says 'I do custody,' and a friend from a crypto start-up says 'so do I,' they are both correct in what they say, but they don't do the same thing. Progress in the adoption of digital assets will be hampered unless we can resolve differences in terminology or definitions used. This required us to start at an even more fundamental level than the 1992 report in terms of defining what custody is in the traditional industry. Here we owe a great deal to another co-chair, John Siena, who provided greater clarity on this question. Custody is a contractual service, so the specifics of what needs to be done differ by market or client. But what is needed for a service to qualify as 'Custody' is an agreement between an investor who has an asset over which property rights can be established, and a third-party having control over said asset and tasked with safekeeping and administering the asset according to the investor's instruction whilst segregating the assets from its own estate, establishing controls to ensure this is done properly, which then creates bankruptcy remoteness if and only if the law recognises it.
The effectiveness of any custody system or operational processes is always a function of the law and the extent to which the contractual arrangements between the custodian and investor are not only enforced between them but recognised by the world. The evolving legal and regulatory landscape for digital assets often makes an assessment of such questions uncertain. This doesn't mean that a custodian bank cannot service such assets, but it requires a different, potentially reduced liability standard for the performance of certain service aspects. And this last bit can be controversial, but it's a debate that is needed. Moving from a centralised to a decentralised market structure impacts a custodian's ability to manage risk in a number of areas. We need a better understanding of where this might be the case and what to do about it.
Last but not least, I hope the report can create greater awareness of how blockchain networks drive efficiency and what this means for custody. Staking, for example, is often discussed in terms of so called slashing risk and profit opportunities. It has those elements, but at its core, it's a control mechanism for asset safety in Proof-of-Stake networks. I don't know when, but I can't wait for the day when the first thought that pops into a custodian banker's head when asked about staking will no longer be
'oh no, we can't do it, there is too much risk involved,'
but instead
'for the sake of asset safety, it's too risky not to do it.'
That is my sincere hope. Not for today but soon. One step at a time.
Outlook
I also do believe we need to maintain an open mind about digital custody. The report covers what we know today and what we can anticipate around the corner. However, this doesn't signal the end of possibilities. Technology has enabled one of the world's largest transportation companies, Uber, to operate without the need to own a single vehicle, and there are many similar examples (such as Airbnb). In my view, it is not inconceivable that in the future, we may see arrangements that qualify as custody, with a custodian providing all relevant services without having control in the traditional sense. A custodian without assets under custody! Crypto markets already feature intriguing concepts of decentralised custody, and who is to say that there isn't a stroke of genius in those models from which we can learn? So, I look forward to reconvening in 20 years to make the necessary updates to the report.
As far as imagined working group meetings go, here is another fantasy group photo showing our working group from 2023. It visualises quite well what my experience was - a fabulous bunch of people coming together and getting stuff done. Happy reading everyone!
The End.
Why would imaginary attendees of a custody bankers' meeting in Zurich in the 1980s wear pink outfits and white wigs?
#BreakingUnusualQuestionsRecord