Navigating the future: network managers get to grips with digital assets

Hitherto a niche corner of the market traded mostly by retail investors, digital assets are becoming popular even among large institutions. Network management teams at banks and broker-dealers are having to update their strategies in response to clients’ growing appetite for digital asset trading, writes Hugo Jack, senior manager, Thomas Murray Digital.

Institutional exposures to digital assets are rapidly rising. A recent study conducted by Global Custodian and Citi found that 43% of asset managers anticipate interest in digital assets and their related services will grow, while 38% of respondents acknowledged they were already actively participating in the nascent market.

As institutional investors increasingly pile into digital assets, some of the leading banks are beginning to develop their own proprietary crypto-custody solutions, providing safekeeping of private keys to digital assets, as well as crypto-brokerage and even crypto-derivative clearing services. For example, SC Ventures, the innovation arm of Standard Chartered, recently collaborated with Northern Trust to launch Zodia, an institutional-grade custody solution for cryptocurrencies. Bank of New York Mellon,  State Street and US Bank have also thrown their hats in the ring. Elsewhere, Citi is reportedly looking to expand upon its digital asset servicing capabilities including in areas such as trading, financing and custody.

Beyond the banks, a number of FinTechs have also established digital asset custody solutions aimed at supporting the growing chorus of institutional investors now participating in the market. As institutional-standard providers increasingly offer these services, investors will become more comfortable with buying digital assets. This comes following the Citi/Global Custodian survey, which found that broker-dealers’ biggest concern about digital assets is the absence of secure market infrastructures.

Central Bank Digital Currencies on the horizon

Aside from investing into digital assets, a number of central banks are looking to launch so-called Central Bank Digital Currencies (CBDCs); that is, digital versions of their own national currencies. These are distinguished from today’s mostly electronic forms of money by their cryptographically secured and fault-tolerant distributed nature. While they differ from the original goal of cryptocurrencies to avoid centralised control, they still bring many of the advantages of crypto to governments’ toolkits. CBDCs should not necessarily be seen through an investment lens but rather as a tool by which to obtain massive trade settlement efficiencies through ‘wholesale’ CBDC forms, in addition to potential ‘retail’ use cases such as payments or distribution of welfare benefits.

Proponents of CBDCs argue that the technology could even result in the emergence of instantaneous settlement or DVP (delivery versus payment). “CBDCs [are] mostly about settlement and the unification of asset and payment cycles. The adoption of digital tokens would allow exchanging tokenised financial instruments by simple token swaps to enable instant and atomic exchanges where both legs of the transaction need to succeed or none of them will, thereby eliminating open positions in trading and all settlement and credit risks,” says an article by Ousmène Jacques Mandeng of the London School of Economics.

A number of tests involving CBDCs have been conducted. For example, one high-profile CBDC pilot involved a EUR 100 million bond issuance by the European Investment Bank on the Ethereum blockchain, which was subsequently settled using a CBDC from the Banque de France, the country’s central bank. Elsewhere, the Bank for International Settlements is currently overseeing four pilot schemes – Project Nexus, Project Dunbar, Project Jura, and the Multiple CBDC (mCBDC) Bridge – to build prototype platforms in order to conduct cross-border settlements in CBDCs between multiple countries. The BIS recently announced that early mCBDC Bridge tests have “demonstrated the potential of using digital currencies and distributed ledger technology (DLT) for delivering real-time, cheaper and safer cross-border payments and settlements” – a sign of potential disruption to come for the current cash correspondent banking model.

Network managers must prepare for change

The shift away from traditional financial instruments towards digital forms will create challenges for network managers, but these ought not to be insurmountable. As demand for digital assets increases, network managers have a greater imperative to recalibrate their due diligence efforts to conduct checks on digital asset servicers and infrastructures. Today’s assessment questionnaires and methodologies are not entirely appropriate for the digital asset ecosystem, and omit several new critical considerations.

“At the most rudimentary level, network teams will need to familiarise themselves with new technologies, principally the distributed ledger technology that facilitates the trading and settlement of digital assets, and how asset servicing requirements such as income distribution, tax, corporate actions and proxy voting work in this environment,” says Andrew Wright at Thomas Murray Digital. “They may also need to assimilate new ‘blockchain events’ – akin to corporate actions or income events – such as forks, airdrops, staking and mining into their processes.”

Network managers will need a firm grasp of the mechanisms that support the core ‘custody’ of digital assets – chiefly the protection and management of the private cryptographic keys that unlock the transfer of assets. The transparency of public blockchains means that clients may verify their holdings against their custodian’s reports by tracking wallet addresses held for their benefit. Cryptoassets exist ‘live’ on the internet in distributed ledgers. For cryptocurrencies, this differs greatly from the traditional model of a central ledger in which a central securities depository (CSD) acts as the ultimate trusted record-keeper of ownership, although CSDs for digital equities and bonds are starting to appear.

In addition, network managers should improve their understanding of cyber-security, given some of the challenges cyber-crime has caused in the digital asset marketplace. This is an area where they will need to call on IT experts from within their organisations and trusted advisors to support them.

“Apart from these new areas, assessments of digital asset service providers – versus traditional custodians – will still rely on most of the principles familiar today. Many of the standard risk assessment components such as reviewing balance sheet capital strength or monitoring straight through processing (STP) levels and settlement rates will continue to contribute to the due diligence process when applied to digital asset service providers,” says Wright.

Adaptations to the market review process will also need to be made. Whereas some of the more advanced economies are introducing meaningful regulations to help oversee digital asset trading and settlement, such as the EU’s Markets in Crypto-Assets Regulation (MiCA), there are concerns about some of the more laissez-faire policies being pursued in certain emerging markets such as El Salvador. “Network managers must ensure regulatory standards, investor protection measures and asset safekeeping mechanisms – as they apply to digital assets – are robust across markets and at the service providers that operate in them. Again, this will require network managers to leverage the expertise that they have obtained when conducting traditional market reviews and to apply it in a digital asset context. Bringing this rigorous approach to the sector will be one of the ways that banks can begin to make up for the ground lost to FinTech providers, who may lack the risk management approaches and depth of regulatory relationships enjoyed by traditional service providers,” notes Wright.

Moving into a new investment universe

Traditional assets are not going to be swept aside abruptly. Instead, the general consensus within the industry is that conventional financial instruments will co-exist alongside digital assets for a long time to come, until the point at which they have all transferred to run on digital rails – either as new assets issued natively on blockchains, or existing assets represented in new token form. As Wright concludes, “Network managers undoubtedly need to improve their understanding of digital assets and how they work if they are to remain relevant and flourish moving forward. Fortunately, many of the skillsets synonymous with contemporary network management can be adapted so that they can be applied to digital assets. Opportunities are there for those that are willing to invest that effort.”

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