A digital custodian is not a digital depository

State Street’s digital product expert Swen Werner highlights the challenges of integrating different digital assets into existing frameworks for regulated funds and their asset managers, and why more clarity is needed around depository duties – which differ from digital custody - as this market continues to grow.

The emergence of digital assets such as Bitcoin as well as tokenised financial instruments has brought the topic of digital custody to the top of the agenda. However, one of the core issues of the global custody industry has not yet appeared on the agenda: the integration of different digital assets into the existing framework for regulated funds and their asset managers. This includes regulated fund structures such as UCITS or AIF in Europe, or ’40 Act funds in the US.

Why does this matter? A custodian performs a number of tasks for regulated funds: while the safekeeping of their assets is a core tasks, they also perform various control and other administrative tasks usually referred to as depository services. A growing market for digital assets will likely increase the importance of how depository duties and the consequential liabilities under the AIFM and UCITS provisions apply to the servicing of crypto funds or funds investing into digital assets more broadly. 

The existing crypto portfolio managers investing in bitcoin or similar assets operate special funds that – unlike mutual funds – have little or no investment restrictions. A custodian servicing securities issued in today’s centralised market has the power of booking an asset from one account to another. Blockchains whose governance structure contains certain validation mechanisms, such as proof-of-stake or proof-of-work, will not provide the possibility to make such bookings, regardless of whether the custodian holds the private keys or not. This is one of example of how the future market environment could differ from today’s securities infrastructure. In essence, a digital custodian is not a digital depository.

Several jurisdictions across the world have introduced new license requirements for entities providing private key management solutions for crypto currencies and other digital assets. This is usually referred to as “crypto custody”, which extends to cold, warm or hot storage of private keys. The draft EU Regulation on Markets in Crypto Assets (MiCA) contains such an approach. However, the reference to “custody” in such regulatory proposal does not change the fact that safekeeping private keys differs substantially from traditional custody. As mentioned before, the ability of maintaining private keys in a safe place says little about the custodian’s ability to complete a blockchain transaction, for instance.

Besides safekeeping, depositaries must carry out certain control functions in order to protect investors. More clarity is needed on how this relates to crypto or other digital assets. There are a number of core control functions:

  1. Ownership verification and record keeping for crypto assets such as Bitcoin that presumably cannot be held in custody (under AIFM and UCITS)

Generally speaking, digital assets are controlled by access to private keys, and in turn,  private keys are created by the operator of a wallet. So, whilst it may be unlikely, it is not impossible that another investor would be using the same private key. A Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities by the US SEC and FINRA from 2019 stated that maintaining a private key may not be sufficient evidence to have exclusive control over a digital asset, because one cannot demonstrate that no other party has a copy of the private key. It therefore appears unclear how ownership verification should be performed at a level that meets regulatory requirements.

  1. Verify that that investments into crypto assets are eligible investments

Many public blockchains are subject to what is commonly referred to as ‘fork risk’ (i.e. the divergence of validators leading to duplicated records) and security tokens purchased before a fork event may lead to multiple tokens. Does this therefore engender a requirement that a fund’s investment guidelines describe which kind of technical blockchain protocol would be eligible?

  1. Other control duties such as Net Asset Value (NAV) controls, investment limits and market compliance checks

The adequate valuation of crypto assets is a particular challenge, given the plethora of trading venues without established reference prices. The uncertainties regarding the determination of a fair value for many crypto investments is a key challenge at structuring crypto portfolios. Reliable market prices for crypto assets will be needed for verifying NAV calculations, investment limits and eligibility criteria.

The next step in the evolution of digital assets will need to resolve these issues.