Taking centre stage
18 September 2018
Justin Chapman of Northern Trust and Walter Verbeke of Euroclear discuss their views and the hype around crypto custody
Image: Shutterstock
The emergence of crypto custody and the role it might play in the development of cryptocurrencies into mainstream finance is a hot topic in the finance industry. Previously, Securities Lending Times spoke to Lendingblock’s Steve Swain and Archax’s Graham Rodford on this topic.
Now, Justin Chapman, head of global market advocacy and innovation research at Northern Trust and Walter Verbeke, global head of business model and innovation at Euroclear, take the spotlight to share their thoughts on the subject.
When asked to define crypto custody and to consider how it will differ from traditional custody, Chapman replied: “Crypto custody solution providers are third-party providers of storage and security services for cryptocurrencies. Users are seeking cryptocurrency custodians to secure them from theft and loss of their digital assets.”
He adds: “Cryptocurrencies are stored in ‘addresses’, which are based on public and private digital key pairs. For most cryptocurrencies, each address is based on a single private key. Anyone who knows the one private key corresponding to a given single-key cryptocurrency address can move those funds. This is extremely important as digital key management is not something most traditional custodians have dealt with, resulting in the need to build the capability to move into this space.”
Northern Trust, through its private equity blockchain solution, has been successfully managing digital keys for a couple of years now, he adds.
In February last year, Northern Trust launched what it claims to be the first commercial deployment of blockchain technology for private equity. It also announced that audit firms can now carry out audits of private equity lifecycle events directly from blockchain. Northern Trust has won two US distributed ledger technology (DLT) patents and says its blockchain development is part of a broader digital strategy for asset servicing.
So why does Chapman think crypto custody is important? He explains: “If you look wider than just cryptocurrencies, say to the digitisation of marketplaces, the custody of digital keys will become commonplace. We have had certificated holdings, immobilised then dematerialised. Digital asset issuance is simply the next evolution of our marketplace.”
Traditional incumbent providers would be well advised not to rest on their laurels if he is correct in his assessment of the changing industry landscape, he says: “New players are already here.”
He adds: “We have crypto exchanges offering custody services right now with most promoting cold-storage type solutions. While this may be suitable for some individual investors, what we see from the institutional area is the need for a truly scalable and secure solution with immediate access.”
“Cold-storage options are costly, operationally burdensome with a significant impact on liquidity.“
“Digital key retrieval options measured in hours, or in some cases, days, are generally unattractive to institutional investors. We will eventually see traditional custodians moving into this space with immediate access to custody solutions with consolidated client reporting across both traditional and crypto holdings.”
“As part of our market advocacy and technology innovation process, we are exploring the potential for safe, secure custody of cryptocurrencies and digital assets. Northern Trust continues to evaluate and advocate strongly for more clarity globally from governments and regulators regarding classification, market practice and taxation of crypto. This is required before we will offer this service,” he ends by saying.
Verbeke explains: “There is a lot of hype around this topic and the material volatility in cryptocurrencies is a clear indication that the hype needs some time to settle down.”
“While cryptocurrencies such as Bitcoin and Ethereum seem to take centre stage for the moment, there is a much wider crypto world out there, ranging from utility coins to security—and asset-backed cryptos, some of which regulators are already considering as securities. Central securities depositories (CSDs) are assessing which roles would fit into our natural remit, where our resilient systems could bring genuine value.
He views initial coin offerings (ICOs) as an interesting evolution. They provide access to liquidity to small- and medium-sized enterprises (SMEs) who would generally not list on an exchange, nor issue fixed income. An ICO issuance cost of $150,000 is significantly lower than the cost of a traditional initial public offering (IPO), but as the quality of the ICO material increases, so will the cost, he adds.
He observes: “Regulators such as the Autorité des Marchés Financiers (AMF) in France are already offering a kind of quality label.”
Verbeke adds: “If such ICOs become one of the ways to bring oil into the liquidity machine, in particular for SMEs which are the foundation of the so-called ‘real economy’, then I believe CSDs should see where and how we can support cryptos and their ecosystems.”
“Not surprisingly, our clients—the brokers, custodians, and agents—are asking Euroclear to look into whether we could take up a role in order to inject our robustness, resilience and reliability into the new crypto ecosystem,” he says.
“They want the security we bring. At this stage, we at Euroclear are assessing the new crypto dynamic by engaging actively in the industry and in the regulatory dialogue, and by putting use-cases in place—to help us understand where we could bring genuine value in line with our core DNA.”
On risk mitigation, he states that when asset managers and funds invest in capital markets they face not only investment risks, but also many other types of risk, including legal risk, settlement risk, liquidity risk, counterparty risk and others.
There is no reason why that would be different for cryptos.
“Over the years, the capital markets have put pieces of infrastructure in place such as stock exchanges, CCPs and CSDs to mitigate these risks and to bring resilience, robustness, efficiency and security into the markets,” he goes on.
“Some of those roles and pieces of infrastructure will certainly also need to put be in place in the crypto world to ensure the same level of security—allowing asset managers and funds to invest in cryptos in a business-as-usual way through their brokers and custodians, and for regulators to feel just as comfortable.”
Turning to governance, he begins by noting that most cryptocurrencies are issued in a DLT blockchain environment, which adds complexity and also unfamiliarity to the equation.
The distributed nature of such environments makes it critically important that the right governance and operating models are put in place, he says.
“These are the kinds of things clients can currently take for granted in the securities settlement business,” he adds.
“CSDs ensure cash in transactions, settlement finality, and well-managed liquidity. The DLT and crypto world has not yet found similarly robust and resilient solutions.”
Constructive dialogue between stakeholders is needed, he states. “I find it quite remarkable to see how key stakeholders look and act in cryptocurrencies.”
“I see conversations going on among different CSDs to decide which roles would make the most sense for them to take up.”
“I also see a very constructive and collaborative dialogue between regulators, financial market infrastructures and the broader industry with regulatory sandboxes being created as safe testing environments.”
“This constructive dialogue is refreshing and powerful. Of course, our clients want the Euroclear group to be an engaged, active partner in that dialogue and that journey, and to contribute to creating a stable and robust environment for the crypto world.”
Now, Justin Chapman, head of global market advocacy and innovation research at Northern Trust and Walter Verbeke, global head of business model and innovation at Euroclear, take the spotlight to share their thoughts on the subject.
When asked to define crypto custody and to consider how it will differ from traditional custody, Chapman replied: “Crypto custody solution providers are third-party providers of storage and security services for cryptocurrencies. Users are seeking cryptocurrency custodians to secure them from theft and loss of their digital assets.”
He adds: “Cryptocurrencies are stored in ‘addresses’, which are based on public and private digital key pairs. For most cryptocurrencies, each address is based on a single private key. Anyone who knows the one private key corresponding to a given single-key cryptocurrency address can move those funds. This is extremely important as digital key management is not something most traditional custodians have dealt with, resulting in the need to build the capability to move into this space.”
Northern Trust, through its private equity blockchain solution, has been successfully managing digital keys for a couple of years now, he adds.
In February last year, Northern Trust launched what it claims to be the first commercial deployment of blockchain technology for private equity. It also announced that audit firms can now carry out audits of private equity lifecycle events directly from blockchain. Northern Trust has won two US distributed ledger technology (DLT) patents and says its blockchain development is part of a broader digital strategy for asset servicing.
So why does Chapman think crypto custody is important? He explains: “If you look wider than just cryptocurrencies, say to the digitisation of marketplaces, the custody of digital keys will become commonplace. We have had certificated holdings, immobilised then dematerialised. Digital asset issuance is simply the next evolution of our marketplace.”
Traditional incumbent providers would be well advised not to rest on their laurels if he is correct in his assessment of the changing industry landscape, he says: “New players are already here.”
He adds: “We have crypto exchanges offering custody services right now with most promoting cold-storage type solutions. While this may be suitable for some individual investors, what we see from the institutional area is the need for a truly scalable and secure solution with immediate access.”
“Cold-storage options are costly, operationally burdensome with a significant impact on liquidity.“
“Digital key retrieval options measured in hours, or in some cases, days, are generally unattractive to institutional investors. We will eventually see traditional custodians moving into this space with immediate access to custody solutions with consolidated client reporting across both traditional and crypto holdings.”
“As part of our market advocacy and technology innovation process, we are exploring the potential for safe, secure custody of cryptocurrencies and digital assets. Northern Trust continues to evaluate and advocate strongly for more clarity globally from governments and regulators regarding classification, market practice and taxation of crypto. This is required before we will offer this service,” he ends by saying.
Verbeke explains: “There is a lot of hype around this topic and the material volatility in cryptocurrencies is a clear indication that the hype needs some time to settle down.”
“While cryptocurrencies such as Bitcoin and Ethereum seem to take centre stage for the moment, there is a much wider crypto world out there, ranging from utility coins to security—and asset-backed cryptos, some of which regulators are already considering as securities. Central securities depositories (CSDs) are assessing which roles would fit into our natural remit, where our resilient systems could bring genuine value.
He views initial coin offerings (ICOs) as an interesting evolution. They provide access to liquidity to small- and medium-sized enterprises (SMEs) who would generally not list on an exchange, nor issue fixed income. An ICO issuance cost of $150,000 is significantly lower than the cost of a traditional initial public offering (IPO), but as the quality of the ICO material increases, so will the cost, he adds.
He observes: “Regulators such as the Autorité des Marchés Financiers (AMF) in France are already offering a kind of quality label.”
Verbeke adds: “If such ICOs become one of the ways to bring oil into the liquidity machine, in particular for SMEs which are the foundation of the so-called ‘real economy’, then I believe CSDs should see where and how we can support cryptos and their ecosystems.”
“Not surprisingly, our clients—the brokers, custodians, and agents—are asking Euroclear to look into whether we could take up a role in order to inject our robustness, resilience and reliability into the new crypto ecosystem,” he says.
“They want the security we bring. At this stage, we at Euroclear are assessing the new crypto dynamic by engaging actively in the industry and in the regulatory dialogue, and by putting use-cases in place—to help us understand where we could bring genuine value in line with our core DNA.”
On risk mitigation, he states that when asset managers and funds invest in capital markets they face not only investment risks, but also many other types of risk, including legal risk, settlement risk, liquidity risk, counterparty risk and others.
There is no reason why that would be different for cryptos.
“Over the years, the capital markets have put pieces of infrastructure in place such as stock exchanges, CCPs and CSDs to mitigate these risks and to bring resilience, robustness, efficiency and security into the markets,” he goes on.
“Some of those roles and pieces of infrastructure will certainly also need to put be in place in the crypto world to ensure the same level of security—allowing asset managers and funds to invest in cryptos in a business-as-usual way through their brokers and custodians, and for regulators to feel just as comfortable.”
Turning to governance, he begins by noting that most cryptocurrencies are issued in a DLT blockchain environment, which adds complexity and also unfamiliarity to the equation.
The distributed nature of such environments makes it critically important that the right governance and operating models are put in place, he says.
“These are the kinds of things clients can currently take for granted in the securities settlement business,” he adds.
“CSDs ensure cash in transactions, settlement finality, and well-managed liquidity. The DLT and crypto world has not yet found similarly robust and resilient solutions.”
Constructive dialogue between stakeholders is needed, he states. “I find it quite remarkable to see how key stakeholders look and act in cryptocurrencies.”
“I see conversations going on among different CSDs to decide which roles would make the most sense for them to take up.”
“I also see a very constructive and collaborative dialogue between regulators, financial market infrastructures and the broader industry with regulatory sandboxes being created as safe testing environments.”
“This constructive dialogue is refreshing and powerful. Of course, our clients want the Euroclear group to be an engaged, active partner in that dialogue and that journey, and to contribute to creating a stable and robust environment for the crypto world.”
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