Custody and Digitised Assets: Why It is Needed
With the announcement of our newest partner, DAVOS, we invite the CEO and Founder Ville Oehman to explain just why custodianship is needed in the digital asset space.
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I'd like to start with Black's Law Dictionary of the word custody.
"Custody is the care and keeping of anything. A custodian is an AGENT that performs various duties on behalf of a client, including holding securities in safe CUSTODY, executing financial transactions under specific instructions, and collecting periodic CASH FLOWS from investments."
Now that's exactly what our tokenised custody company does. This definition was written and published in 1910, just short of a century before Satoshi published his whitepaper on Bitcoin. I don't think they were too worried about hackers in 1910, but they probably knew about risk management.
When applied to digital assets, custody simply means the creation, safekeeping and administration of digital asset wallets (keys) for a client. It means that the client keeps the ownership of the assets, but the custodian has possession and control of them.
Let's look at the reasons why custody is needed in the digital asset space.
A hundred years ago, they knew that the segregation of duties worked. It kept some form of objective check and balances in place in a process in which participants handled other peoples money and assets.
The segregation of duties was a risk management measure before any computers were used in financial services. Since then it has been a standard accepted practice of the financial industry for decades, for a reason.
Today, however, new questions have begun to emerge. Can technology make this ancient risk management measure obsolete? Can technology provide advantages that change the established structures and roles of the financial industry? Can't we just be our own banks?
Be Your Own Bank, Until You Make It
Being your own bank is great, up to a certain point. It's fun to talk about digital assets and show off your mobile phone to friends with a couple of thousand dollars worth of bitcoin on it. It's still kind of fun if the balance reaches ten thousand dollars, but you might not show it to as many friends anymore at that point. If the value reaches one million or so, I don't think it would be fun to walk around the city with the phone in your pocket at all. It's probably pretty scary even to have the phone in your bedroom drawer, even if it's switched to aeroplane mode. Now imagine the tokenised assets on your phone wallet belongs to your client.
Let's look at companies instead of private investors. How would you feel about your external asset manager asking you to drop your money to his office in cash notes, so he can then start investing it to various assets? Maybe you can decide what to invest in, and he will just go and pay your money to the seller for you. What if that asset manager is not an asset manager at all, but an IT startup? Well, we're pretty close to the description of how digital asset brokers and exchanges work, until they disappear, get hacked or get their assets seized because of money laundering suspicions.
Maybe the regulatory requirements of licensed asset managers to use a third-party custodian for client assets are not that annoying after all. The next question is if you are not required to have a third party custodian, why would you? Would you wear a seatbelt if you were not required to do so?
Just this week two promoters of the notorious OneCoin appeared in court in Singapore. One of their arguments, if I remember it correctly, was convenience. OneCoin was 'better than bitcoin'. If an investor just gives money to an IT startup and lets the unregulated company assume all the roles in the market, order matching, liquidity provider, market maker, auditor, custodian, broker and trading platform developer, then everything runs just great, and it's really convenient, right? Not exactly because that's how all Ponzi schemes run.
Is custody starting to make sense yet?
Let's look at the traditional financial market, and how it's structured. We have a central securities depository (CSD) for the safe-keeping of investment products, a central counterparty (CCP) providing clearing services and to mitigate the counterparty risk between traders and a securities settlement system (SSS) enabling the transfer and delivery of securities.
The market participants connect to these service providers for orderly trading, for the protection of their clients and themselves. The market participants don't hold their client assets because they don't want to be held accountable if the assets disappear. If you are interested in 188 pages of details about the reasons for this traditional structure read the Principles for Financial Market Infrastructures by the Bank of International Settlements.
These are the types of checks and balances that both regulatory authorities and institutional market participants are familiar and comfortable with. They are not familiar and comfortable with 'trustless systems that replace intermediaries with maths' or with comments like 'there's no need for custody because the assets are on the blockchain'.
For the regulatory authorities, this simply won’t work.
Technology vs Law
The current regulation of financial services is compatible with the digital assets, as long as asset managers understand that if their clients think of tokens as assets, the asset managers should treat these assets like any other asset class, with all the normal checks and balances in place.
For auditors, custodians, insurance companies and fund administrators, you do not need to bend the rules and principles of asset management just because you are dealing with a new asset class. Yes, it works to some extent, but at some point, you hit the limit in the quantity of money and people that are ready to take the risk in the name of new technology.
I think we hit this limit in the last crypto rally, and now we're back to building better solutions that can scale. And by scaling I don't mean transactions per second, I mean proper asset protection. There was no way an average investment committee for a pension fund would allocate any money to products where the manager did not know where the assets were.
Regulations on investor and asset protection won't change because of the tech-heavy nature of a new asset class. In fact, it will most likely have quite the opposite effect because everyone wants to (or should) be extra careful. Think what's happening with cloud regulation and data sovereignty. If countries think it's safer to have data stored in onshore datacenters, do you think they would easily accept the concept of 'storing security tokens in the cloud’ or on-chain'?
If we believe in technology we should understand that technology can adapt to regulatory requirements quicker than regulations can change due to advances in technology. We should also understand that restricting functionality, convenience and the movement of assets, we increase security, and protection of the assets. Offline is more secure than online. Ask any cybersecurity expert or insurance company.
Institutional Infrastructure for Digital Assets
I like the term 'institutional infrastructure' because it has some weight to it. It can't just be a guy and a laptop. With custody, it means heavy doors, security guards, body scanners, access passes and keys. It's also different from escrow. Escrow can be done in about two minutes on a Trezor of a blockchain enthusiast lawyer.
There's no such thing as two-minute custody. Custody is long term safekeeping, because you want to use the value for trading, but not lose the asset. Institutional asset managers can talk all they want about market risk and trading strategies, but it's a material omission not to consider the safety of the assets from risks not related to the market.
Using a custodial service for the monitoring, storing and safekeeping of the next generation of digital assets should be a no-brainer. That's where DAVOS Custody can help, and that's why we partner with leading token platforms like TokenMarket.
Together, we want to create a new marketplace with traditional security measures. We want to build the infrastructure that will allow this space to thrive and by applying measures like custodian services, we are sure that we can.
Ville Oehman is a co-founder and CEO of DAVOS Custody, a Singapore based purpose built custodian for digital assets, hard assets and tokenized assets. Before starting DAVOS, Ville was one of the first licensed asset managers in Asia, managing a regulated long-only mutual fund investing in equities and digital assets. Ville has been active in the digital asset space since 2013.
DAVOS Custody (www.davos.sg) is a third-party custodian for digital and tangible assets, including tokenised assets, with tailored insurance coverages available. Founded by a team of experts in fund management, cybersecurity and financial regulation, DAVOS was the first blockchain company to apply for the Capital Market Services license for Securities Custody in Singapore, setting it on an industry-defining path to becoming a qualified custodian for securities and security tokens.