By Hirotaka Hamada, President, Nomura Research Institute Europe Limited
Despite the recent rout in crypto and decentralized finance markets, digital assets will continue to disrupt and transform traditional financial markets. The case for the deeper integration of distributed ledger technology and blockchain into mainstream financial markets remains compelling. Near real-time execution and settlement offers the possibility of reduced operating costs and improved operating efficiencies across many applications.
Digital asset custodians will play a vital role in this transformation ensuring assets are safely stored and protected from new cyber threats. As the financial landscape journeys towards Web3, new categories such as the metaverse and increasing tokenization of the luxury market will see additional demands for the safekeeping of digital assets. Digitalization of existing asset classes that includes real estate and the near $127 trillion global fixed income market is gaining momentum that has major implications for current custody business models. Financial markets are changing fast and will test whether conventional financial institutions are ready to adapt and capitalize on the opportunities the nascent digital ecosystem offers.
In this new paradigm, qualified or regulated digital asset custodians provide peace-of-mind, but their role is more than storage and safekeeping of private keys. They are well positioned to benefit from new revenue opportunities in areas such as staking, lending, prime brokerage and accounting. Digital asset custodians can also speed institutional adoption and reassure regulators investors have similar protections to those found in traditional financial markets.
But entering the digital assets space will require traditional custodians to invest and increase digitalization if they are to maximize new revenue opportunities. Security remains the dominant issue in the digital space that challenges the technological capabilities of many legacy custodians. A recent report by Chainalysis found cryptocurrency theft grew 516% last year to approximately $3.2 billion. Around 72% of the 2021 total was stolen from DeFi protocols or exchanges.
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Custody of digital assets is a far more complicated task than the safekeeping of traditional assets and the technological barriers to entry are mounting. Decisions such as maintaining full control, partnering with a technology provider to build a custody solution or taking a hybrid approach, are some of the issues conventional custodians must consider.
A digital asset custodian will need to take into account the alternate digital storage options known as hot, warm and cold storage. Hot storage requires internet connectivity that allows investors to move funds quickly, but as recent events have demonstrated, it is vulnerable to predatory hacks. Warm storage combines both hot and cold storage options.
Cold storage is the most secure option. For added security the private keys are stored in offline digital vaults that may be physically hosted in different geographical locations. They are only accessible using two-factor authentication or other sophisticated encryption, such as multi-signature protocols.
Each digital asset class presents novel security and storage related challenges. There are fundamental distinctions between the custody of assets under a smart contract and those under a cryptocurrency consensus mechanism for example. There’s also a distinction between the requirements of various investors that may be active across multiple jurisdictions. A family office is likely to have different custody needs than a hedge fund for example.
Together these factors are forcing a rethink by many asset managers whether they have the technological infrastructure to service the digital custody market. It’s about costs too. Approximately one in four investors surveyed in 2021 by ThoughLab had a preference for a fixed fee structure when paying for custody services. Some 44 percent of firms surveyed said they expected to use a fixed fee structure in the coming two years.
Growth in self-custody is likely to be significant as retail investors increasingly gain exposure to digital assets. Recent regulatory reforms now include alternative assets as part of 401K retirement planning for retail investors.
Technology will continue to develop at a break-neck pace and the capacity to scale in parallel with evolving customer demands will be a mission critical consideration for digital asset custodians. Emerging digital asset classes such as GameFi will offer new custody opportunities that may challenge the culture of many traditional financial institutions.
The tendency for traditional custodian banks to historically centralize control of custody is counter wto the ethos of blockchain’s decentralization of control.. It is unsurprising these new apparently opposing technological demands concerning the future management of customers’ digital assets have provoked a flurry of M&A activity in recent months.
The transition to digital custody is not linear. Custodians of tomorrow are likely to operate in a dynamic and active marketplace where cross chain solutions promote universality, a precursor to a global digital custody market.