Generations Fall 2021 – Investing in digital assets, a race towards the general public: the emergence of institutional depositories

In a recent survey of more than 150 family offices around the world, Goldman Sachs reported that around 15% of family offices around the world and around 25% in the Americas are exposed to cryptocurrencies to date. While most of those surveyed are not currently invested in cryptocurrencies or other digital assets, nearly half plan to expose themselves in the future as a hedge against liquidity.

Among those surveyed who were not currently exposed to cryptocurrencies, their most cited reason for caution stemmed from skepticism about cryptocurrencies as a store of value. In addition to cryptocurrencies, Goldman Sachs expects family offices to monitor the evolution and potential use cases of other digital assets, such as utility tokens and non-fungible tokens (NFTs), and the blockchain technology more broadly for future investment opportunities.

There are unique risks associated with digital trading platforms and custody solutions available to secure digital assets. Digital asset custodians operate, in many ways, in a similar fashion to traditional financial custodians, in that their primary role remains the custody of the investor’s digital assets. However, unlike traditional assets such as fiat money, stocks, bonds, and gold, a digital asset custodian secures the custody of a digital asset such as cryptocurrency by holding the private key on behalf of the holder of the asset, ensuring that it is not accessible to anyone else. . The private key is the only access to digital assets, and its loss is likely to result in the loss of all assets, with little or no possibility of regaining access.

In Switzerland, where the regulation of digital assets is very advanced, private banks have been looking at cryptocurrencies and other digital assets for some time and have developed fairly robust, albeit opaque, service offerings for trading and acting as custodians of these digital assets. In North America, where regulators have been slower to respond to rapidly emerging digital asset markets, traditional custodians have also been slower to respond. The solutions emerging in the United States and Canada, however, appear to offer greater transparency than previous solution providers. Family offices who are considering allocating a portion of their portfolio to this space will likely find this higher level of transparency appealing.

Family offices are encouraged to look to established custodians to secure their digital assets for a number of reasons. In practice, it may be best to go to a company with which they already have a relationship. However, the main driver of this decision is often the increased comfort found with the support of an important institution with strong governance and control as well as a strong track record.

Significant obstacles remain to be overcome for traditional custodian banks to engage in this emerging asset class. First, unlike more traditional assets, such as stocks, bonds, and fiat currencies, digital assets don’t easily fall into clear categories. Some digital assets are more like commodities than currencies. Others look like securities, and some look like certificates of title or authenticity for collectible assets. The characteristics of some, such as utility tokens, are difficult to compare to traditional assets. The institutions that hold these assets must demonstrate a clear understanding of how clients will deal with their digital assets. In addition, given the absence of regulations in this space, the management of settlement risk and settlement deadlines must be clearly explained to the client.

Second, custodians must clearly demonstrate the ability of their systems to secure and manage key pairs to provide secure custody of digital assets. This means protecting private keys and developing secure workflows to support deposit and deposit transactions (deposits and withdrawals). Until now, custodians have relied on cold (offline) wallets created and managed in vacuum environments to provide an acceptable level of security. Conversely, most of the hackers have focused on hot (online) wallets, which are used to provide clients with quick access to their assets. Multi-signature wallets and wallets based on threshold algorithms such as state space search (SSS) and predictive pattern control (MPC) mitigate some of the risks of hot wallets. In short, to protect against cybersecurity and theft risks, clients should demand clear and concise documentation and agreements outlining the technological architecture of each custodian, including the use of cold, hot and hot wallets, to storage ; the use by each custodian of risk and fraud detection tools to block hackers and money launderers; and the strategy of each custodian to provide a secure bridge between the traditional financial world and the new ecosystem of digital assets.

Third, it’s no surprise that digital assets pose significant risk and compliance issues for traditional custodians. Today, for the most part, digital asset markets do not offer any contractual relationship or standard of membership and provide no means of settling transactions. Unlike regulated financial markets, most digital asset exchanges and other digital asset operators currently do not have a legal or technological framework to obtain, hold and transmit identifying information for their trading counterparties. Additionally, while there has been clear progress in various jurisdictions when it comes to digital assets, service providers operating in different countries meet different regulatory requirements, with very limited global consensus on cross-border activities.

Over time, it is likely that a trusted ecosystem of institutional participants will evolve to facilitate the trade and maintenance of these public assets within a smaller, pre-validated network. Currently, however, clients who rely on institutional custodians rely on these custodians to control the reputation and governance structures of any selected digital exchange in order to protect against hackers and fraud and to manage operational, regulatory and reputational risks. Anyone entering into a digital asset custody arrangement should be encouraged to engage in in-depth technical and legal due diligence covering all characteristics of a custodian’s internal processes and procedures.

Although very few global regulators have provided formal frameworks for managing digital assets, clients should carefully consider the custodian’s plan to manage the potential for unanticipated regulatory actions regarding digital assets, including cryptocurrencies and NFTs. . While regulation of custodians and digital asset exchanges remains limited, following the dramatic increase in cryptocurrency investment and trading activity in recent years, regulators are focusing on this growing part of the cryptocurrency industry. financial services. An example of regulatory interest is the new guidance released in June 2019 by the Financial Action Task Force on how its members should regulate digital asset trading.

As government agencies increasingly make new statements about the likely direction of regulation in each of their jurisdictions, clients will need to continually re-evaluate guidelines on regulatory matters and develop flexible custodial agreement language that takes into account emerging regulatory trends.