Protecting digital assets: Custodial innovation for institutions | Opinion

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As a seasoned professional with years of experience navigating complex regulatory landscapes across various industries, I can attest to the growing importance of custodial services in the digital asset space. The role of custodians is no longer just about meeting regulatory standards; it’s about safeguarding investor assets now and into the future.

In light of changing regulations and technological developments, the significance of custodians in overseeing these services is growing significantly. They are not just responsible for adhering to rigorous regulatory requirements, but also for ensuring the security of investors’ funds, both presently and in the long term.

In essence, custody services can be divided into two primary types: self-hosted and hosted solutions. Self-hosted options involve tech providers offering custody as a service, utilizing advanced technology to handle and safeguard assets. On the other hand, hosted products are managed by qualified custodians overseen by global regulations, ensuring they meet specific standards and offer enhanced security through strict regulatory supervision—a preferred choice among institutions and their investors due to this oversight.

However, every valuable undertaking encounters hurdles. As the evolution of custodial solutions persists and digital assets grow in popularity among institutional investors, some crucial factors come into play for those aiming to join and sustain this sphere.

Bankruptcy remoteness

Initially, there were indications of heightened institutional interest as organizations began examining custodial practices concerning bankruptcy immunity. This procedure encompasses both legal and operational strategies designed to protect client assets from the custodian’s creditors, ensuring their safety if the custodian were to face insolvency.

Without clear legislative guidelines and updates to national bankruptcy laws, numerous companies are taking a preemptive approach by establishing internal controls, maintaining transparency, and separating client assets from their own resources. On a broader scale, regulatory authorities across different regions are leaning towards enforcing the separation of client assets from custodians’ funds, thereby minimizing potential exposure to a custodian’s financial instability.

For individuals conversant with common law, engaging in contracts under English law provides a strong layer of protection. In this legal system, it’s possible to keep assets within a trust framework, making them distinct from the custodian’s financial troubles. This trust setup legally separates the client’s assets from those of the custodian, creating an independent trust estate that creditors cannot access. Consequently, if the custodian faces insolvency, the client’s assets can be quickly restored without any complications.

It’s expected that regulatory action will lead to uniformity in how assets are separated, but this process may take some time. Until then, the degree of acceptable separation hinges on what institutional clients require and the ability of custodians to deliver these services. Completely separate management provides strong protection, yet it’s crucial to consider practical factors and technological innovations like on-chain solutions as well.

Liability provisions and insurance

Over time, custodians have typically operated under undisclosed liability provisions. However, this practice has evolved as exchange-traded funds (ETFs) and similar investment tools emerged, necessitating a shift towards increased transparency. This change is primarily due to the new financial products’ requirement for the disclosure of significant terms, such as those concerning custodial liability.

In traditional finance, it’s usually easy to get insurance for potential debts because there are long-standing connections between financial institutions and insurance providers. However, the world of digital assets introduces complex issues. Insurers find it difficult to evaluate the risks involved in digital assets from various aspects such as availability, cost, and type, which makes it hard for them to offer comprehensive coverage.

With growing concern from regulators about the liability aspects of custodians, there’s a trend towards enforcing contractual terms that go beyond current regulations. This could necessitate more detailed provisions from custodians to cover potential risks and improve investor security. For instance, these might involve robust business continuity plans, disaster recovery strategies, clear separation of duties and personnel, and geographical diversification of crucial resources. However, it’s important to avoid overly stringent (and often expensive) rules that could inadvertently impact the sustainability of businesses. Striking a balance between viable business operations and robust protections is crucial, and this equilibrium should not be disrupted by excessive regulatory demands.

As a researcher, I acknowledge the complexities in striking a balance between transparency, adherence to regulations, and operational efficiency. It’s crucial that regulators collaborate closely with custodians, financial institutions, and industry specialists to develop regulations that are both comprehensive and pragmatic. Such regulations should not hinder innovation but rather foster an environment where it can thrive.

Operational due diligence audits versus regulatory oversight

It’s increasingly frequent for companies to outsource operational due diligence on their partners to specialists who offer assessments and reports at different prices and qualities. Although transparency and proper execution of procedures are crucial in this field, there’s a growing concern about over-relying on these reports by industry participants. This excessive reliance can potentially limit interactions with digital asset businesses and may even give a misleading sense of safety since these data collections are voluntary and not regulated.

In this situation, restoring trust is vital, but overly depending on external assessors might not give us the full story. While these evaluators help fill a void because traditional auditors are hesitant to collaborate with digital asset companies due to their novel nature, they may not paint the whole picture.

To tackle these issues effectively, it’s crucial to strive for more uniformity and coordination among regulations. This could begin by implementing robust licensing and oversight frameworks across various sectors. Furthermore, an ideal scenario would be for regulators to employ a model similar to those used in other regulatory areas, ensuring that identical standards are applied universally. Such an approach would instill greater confidence in clients and stakeholders, foster consistency in regulatory practices, and ultimately boost trust within the digital asset community.

Building a resilient road ahead

The future of custodial services involves striking a balance between fostering innovation and maintaining robust investor protection. By strictly adhering to regulatory guidelines and utilizing cutting-edge technological tools, custodians will remain indispensable in preserving the authenticity and security of assets within the digital financial landscape. Although obstacles persist, cooperation among regulators, custodians, and industry thought leaders is crucial for continued innovation. By cultivating a regulatory atmosphere that encourages progress while prioritizing investor protection, the digital asset sector can attain increased stability, credibility, and expansion, thereby paving the way for a more robust and resilient financial system in the future.

Evelien van den Arend

Evelien van den Arend serves as the head of legal, compliance, and regulation at Komainu. In this role, she oversees the legal and compliance operations and aids in the group’s business activities while creating and executing the regulatory strategy, thereby facilitating product and service growth. With extensive experience holding senior regulatory positions within the finance and digital assets sectors at organizations such as EQONEX Group, Kraken, and CME Group, Evelien possesses valuable expertise in navigating intricate regulatory landscapes and embracing emerging technologies. Evelien holds a Master’s degree in business law and tax from the University of Toulouse, a postgraduate diploma in internal business law from the University of Rennes, and a specialized master’s in law and international management from HEC Paris/ESCP/EAP.

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2024-08-07 16:20