Real Custody Means Higher Crypto Trading Volumes

National banks can provide cryptocurrency custody services for customers, according to the Office of the Comptroller of the Currency (OCC). 

“I think it’s one of the biggest announcements in the history of crypto,” says Rosario Ingargiola, chairman and chief executive of system provider Bosonic. “It’s a clarification, but the banks being conservative did not read between the lines in that grey area – they wanted a clarification. The big banks have been in the background preparing for this day.”

Market participants predict that engagement with investors will now increase as a result.

Steve Ehrlich, CEO of broker Voyager, says, “Institutional investment firms always disclose custody as via a custodian, not as self-custody, and [having custodians] allows them to enter this space because they get that protection as a fund manager on the risks to the customer.”

In guidance issued on 22 July, in a letter to an unnamed bank, Jonathan Gould, senior deputy comptroller and chief counsel wrote, “[W]e conclude a national bank may provide these cryptocurrency custody services on behalf of customers, including by holding the unique cryptographic keys associated with cryptocurrency. This letter also reaffirms the OCC’s position that national banks may provide permissible banking services to any lawful business they choose, including cryptocurrency businesses, so long as they effectively manage the risks and comply with applicable law.”

The issue of custody in crypto markets is highly sensitive because the trading of assets which are directly held by a trading desk carries several risks. 

The first of these is simply security; if assets are held on the trading desk it has to be built securely in order to avoid loss of assets, whereas holding them at a custodian which is built purely for security reduces the burden and risk on the desk.

The second risk is around control. In the equity markets, trade settlement happens on a time plus two-day (T+2) basis using a delivery vs payment (DvP) model. 

In a true DvP system, the exchange of cash and securities happens (almost) simultaneously. That reduces the likelihood of any mismatch between the two, which would create a risk to one of the counterparties. In some equity markets, settlement of securities can take place after the cash transfer, creating a risk for one side of the trade. 

In crypto markets settlement can happen on a T0 basis because the distributed ledger provides settlement at the point of trade. It also creates an immutable record of exchange, so the two counterparties do not need to reconcile their separate records of exchange. 

However, that does not prevent trades being made in error, or without authorisation. 

In the first situation there is not a T+2 timeframe for errors between orders and settlements to spotted and corrected. Instead they must be checked on T0 basis, so that any issues can be resolved. 

If securities are held directly by a broker, which does not have fiduciary duty to its clients under US law, there are risks that those securities could be sold on erroneously, or used by the broker as collateral whilst being held, without the investor’s authority. 

MF Global’s meltdown in 2011 was an example of this risk, as it held client money directly which was normal practice for a futures broker. After its bankruptcy it became apparent it had transferred US$700 million in client money, and loaned its UK subsidiary US$125 million of client funds. This was largely recovered after a lengthy process. 

By holding assets at the investment manager’s custodian, which are only released to the broker when authorised by the investment manager, this risk is mitigated. 

A solid custody, settlement and DvP model is a fundamental part of developed market structure, which index providers like MSCI use to rate market sophistication, a rating which in turn investment managers use to determine if a market is investible.

Within that are the regulations which frame the process of transferring securities, from custodian to broker to broker to custodian.  The regulatory framework that enshrines custody services gives piece of mind to investors that their assets will be protected. 

Ingargiola says, “Until there is a process by which institutions’ custodians can open accounts at exchanges on their behalf in some fashion, they are not really in a position to take those assets and direct them over there.”

Having that access by established custodians will drive market activity as real money moves into crypto, says Ehrlich.

“As we get regulated custodians is we get a more efficient market,” he asserts. “The market itself is so fragmented, there are exchanges around the globe, I think custodians will work with certain exchanges, and I think it will bring a more efficient infrastructure into the market.”

In part this will be driven by increased support by hedge funds, but also reduced fragmentation of the trading ecosystem as industrial scale and security are brought to bear. 

“A true prime broker business will come into play, but I also think this will weed out the weaker exchanges and custodians will only work with those exchanges that they feel abide by a standard that is equivalent to the equity markets that they work with today; no wash trades, valid trading, money can move quickly and not have to wait weeks,” says Erlich. “Weaker exchanges will be weeded out and the larger exchanges will be the ones that truly win. The next phase of this is that you will have more brokers like Voyager, connecting to multiple exchanges and connecting to various custodians.”

Dan Barnes is Editorial Director of Markets Media Europe