Custody Battle

With the growth in digital assets, there’s a growing need for secure custody. Fintech startups are ready, but where are the banks?

The disruption taking place in the financial industry is assuredly exciting. Whether due to regulations or technology, change opens new avenues for business. But it closes others. Accenture has calculated that under the EU’s Second Payment Services Directive, traditional banking may lose 43% of retail payments revenue.

Banks are thus showing new interest in managing cryptocurrencies and other digital assets. They have been encouraged by clients, including global pension and endowment funds. Money managers for these multibillion-dollar investors have been laying the groundwork for crypto investing, possibly as soon as later this year, according to some pension-industry advisers. Providing custody and other services opens a door to profiting from cryptocurrencies without taking on their risk—a possible point of entry for banks.

Boston-based State Street, the world’s second-largest custody bank, is already considering safeguarding clients’ digital assets in a move that would see it become the first major global bank to provide services for bitcoin-related investments. State Street, which has around £24 trillion ($31.8 trillion) in assets under custody and administration, said growing demand from its largest clients to invest in digital currencies led it to consider offering related services.

“We are actively looking at servicing digital assets, based on the demand we are seeing from our institutional investors,” says Ralph Achkar, a managing director of digital solutions at State Street. “As the asset base of our clients expands, we follow suit.” Achkar, whose brief covers Europe, the Middle East and Africa, says that investors interested in the new assets are being held back by market infrastructure that lacks appropriate trading and post-trading arrangements.

Crash Or Bounce?

Since they first appeared, cryptocurrencies have been viewed with skepticism by many investors; and for some, their recent precipitous declines have validated that view. The total global value of all virtual currencies, highly volatile and nearly impossible to know, peaked just shy of $814 billion on January 7 this year, according to CoinMarketCap. By June 30, it was down to $254 billion.

The volatility doesn’t faze Michael Fitzgerald, CEO of Digital Asset Custody Company (DACC) in New Jersey, however. A financial-industry veteran in senior prime brokerage roles at Morgan Stanley and J.P.Morgan, he sees the volatility as growing pains. “I’m not overly concerned,” he says. “We’re well-positioned and we understand market cycles.” DACC, which is registering as a broker with the SEC, serves as custodian for a range of digital assets, including more than 60 different tokens, for institutional clients seeking a white-glove service offering from a team with deep experience.

To date, fintech upstarts like DACC have had something of an open playing field. In the UK, “challenger bank” Revolut has offered crypto trading since December (bitcoin, Litecoin and Ethereum), and is now adding XRP and bitcoin cash. Revolut also introduced an app that lets users round up transactions and convert the excess to cryptocurrencies, and tens of thousands of its customers immediately signed up.

Liu, Coinhako: In the medium term, I see insurance coming into the space that will allow exchanges to guarantee users funds.

Since the launch of bitcoin in 2009, an estimated $2 billion worth of cryptocurrency has been stolen in hacks and other frauds. The soaring value of cryptos at the end of last year made a tempting target; and according to Crypto-aware, a not-for-profit that tracks crypto frauds, 2018 is on track to be the worst year yet for crypto losses, with a first-quarter score surpassing $670 million.

Many frauds exploit weaknesses inherent in the exchanges essential to the trading of crypto. “As an exchange handling a significant volume of transactions, we get alerts of hackers running scanners on our endpoints every day,” says Yusho Liu, founder of Coinhako—a well-established dedicated cryptoexchange and wallet in Southeast Asia. “Attacks target our networks and even the personal devices of our staff.” Crypto malware is overtaking passkey hacks and phishing scams. Security is the essence of this business. At DACC, Fitzgerald says, “I have to pass through four biometric scans just to get to my desk.”

Maximum security is attained with “cold storage”—meaning on devices that do not connect to any network. For an individual, that can be a slip of paper with a passkey written on it held in a safe. Coinhako keeps a minimum of digital assets stored online—“only what is needed for immediate transactions,” Liu says.

But the time it takes to access assets in cold storage hinders timing trades. “That’s something people struggle with: If I see an opportunity in the market, can I take advantage of it?” says Fitzgerald, adding DACC can typically get clients their assets out of cold storage in 15 minutes, rather than a more typical 24-48 hours.

Even 15 minutes may be too long for some, which signals another opportunity. “In the medium term, I see insurance coming into the space, allowing exchanges to guarantee users’ funds,” says Liu. “This will give us security comparable to the conventional banking system.”

Where Are The Banks?

Mainstream banks, perhaps rightly, mostly steered clear of cryptocurrencies during the hype phase. More recently, however, announcements such as State Street’s indicate their growing interest.

In March, Barclays opened an account for major cryptoexchange Coinbase. In May, J.P.Morgan created a new position—Head of Crypto-Assets Strategy—and set insider Oliver Harris to seek out crypto projects with market appeal. BNY Mellon—the world’s largest custodian bank and asset-service company, with $33.3 trillion of assets under custody as of December 2017—is reportedly interested in offering digital custody services. Goldman Sachs launched a crypto-based business in May—not direct trading in cryptos but derivatives and other crypto products. “A good healthy [cryptocurrency] ecosystem would have multiple custodians, from big ones to boutiques,” notes Fitzgerald. “But it’s not that easy.”

Governments play an outsized role in this nascent industry. Singapore, Dubai and Malta, among others, have welcomed digital currencies, crafting laws to support development of fintechs and related business. Others, such as India, have effectively banned them. But each side is wobbly, with Singapore issuing warnings and considering new regulations, while India’s leaders contemplate a digital fiat currency.

In some cases, the battle between traditionalists and disruptors is shown in high relief. Switzerland ranks behind only the US for the volume of initial coin offering funds generated by a single country in 2017. Yet Swiss banks have not permitted crypto or blockchain startups to open accounts, to avoid falling afoul of anti-money-laundering rules. Swiss fintechs seek to work around these constraints by finding more crypto-friendly countries for their banking needs, or possibly getting into financial services themselves. Swiss governing bodies are looking to support a startup ecosystem without destroying traditional banking.

Gibb, Lowkey Capital: This isnt a time when doing nothing is a better solution than doing something.

In fact, some regulators want to expand the role of traditional banks, to counteract financial criminals. In June, the UK Financial Conduct Authority issued an advisory on cryptoassets and financial crime, encouraging banks to focus on cryptocurrency flows and outlining its concerns about the risks of ICOs as conduits for breaches of legislation.

It makes sense for banks to offer crypto services, providing much-needed security. “Banks are already digitizing. Documents, transactions and other assets are turning digital,” says Viren Mantri, Singapore-based head of applications and software security engineering at Standard Chartered Bank. “If you own a range of digital assets, you may struggle to manage the wallet that contains them. Banks can better manage exchanges and the critical conversions to fiat money.”

Japanese financial-holdings company Nomura and cryptowallet manufacturer Ledger recently announced a collaboration to form Komainu, a securE digital-asset custody solution. The initiative aims to create compliant digital-asset storage options for institutional investors and crypto firms that have large storage needs.

“Global investment managers have long been held back from full participation in digital-asset markets, limited by operational and regulatory risk,” Jezri Mohideen, Nomura’s global chief digital officer for wholesale, commented in a news release. He believes that a good crypto-custody solution could facilitate the entry of new institutional investors.

But the challenge is significant. Sam Gibb, partner in Singapore-based Lowkey Capital, says banks can continue to wait for security and regulatory issues to be resolved and hope to jump in, but he doesn’t suggest it. “Given what is at stake, this isn’t a time when doing nothing is a better solution than doing something,” he says. “Doing nothing may exclude many banks from the market altogether. Doing something could enable them to reap dividends.”