Considerations for Institutional Digital Asset Servicing
By Lloyd Nichols and Ankush Zutshi, executive directors for securities processing and corporate actions services at IHS Markit
There is much written about cryptocurrencies and crypto-assets and how these, in combination with blockchain networks, will disrupt the players and processes in the investment world, dis-intermediating banks, brokers and CSDs in the process.
There are many examples of tokenized crypto assets already in existence but the potential to tokenize assets classes like securities and things like fine arts have growing appeal, due to the many benefits ascribed to tokens on chain, including 24-7 trading, immediate settlement and the absence of traditional banking intermediaries for reconciliation and other purposes.
Unfortunately, there are also many instances in loss or theft of crypto assets with estimates running into billions of dollars per year and it is evident a more secure and regulated environment needs to exist before it becomes a widely-accepted framework in mainstream finance.
A new paper from the International Securities Services Association (ISSA), produced in collaboration with market participants, including IHS Markit, peels back some of the layers behind the hype and outlines practical considerations of how crypto assets and technology can emerge in a regulated environment, affording end investors similar protection as provided in the current securities processing environments.
The paper explores the considerations related to the issuance and the tokenization of crypto assets, trading and settlement, safekeeping and corporate actions, bringing forward perspectives from brokers, global / sub-custodians, CSDs and other intermediaries like CCPs. It identifies several key areas such as settlement, regulation and risk and technology standards in which questions must be resolved before institutional-grade asset transfer and servicing can take hold in a tokenized framework.
The concept of immediate trading and settlement on a crypto platform which technically obviates the need for any settlement parties or intermediary banks is predicated on a number of basic assumptions. Having immediate position check of a crypto asset being sold and the funding availability of the cryptocurrency being used to pay for the asset (assuming a TVT world) creates a significant challenge to many common market practices in liquid instrument trading such as market makers taking temporary short positions to facilitate liquidity and the block trade/allocation process. Furthermore, technical latency may well need to be proved before it is acceptable to algorithmic trading.
Even more fundamental, when considering a tokenized asset like security tokens where the value is in the underlying asset (equities or bonds) itself, how will DVP be managed if the payment relies on fiat currency?
Token versus token (TVT) environments raise a host of regulatory questions including who is the issuer of the payment token? This is a key area to consider for platform providers as they likely will need to become regulated for both the safekeeping of the crypto asset, similar to existing sub-custodians and CSDs, and money laundering regulations for the “cash leg” as typical for correspondent banks in the current world.
In some scenarios, it is easy to envisage that a platform provider will be required to hold a banking license in order to hold “client money” if the payment tokens themselves are deemed to represent “cash” from a regulatory standpoint.
In addition, in the case of security tokens, regulators in different jurisdictions are likely to want them to fall under their current securities laws. Harmonizing different regulatory requirements could become another major hurdle to overcome.
Standards and interoperability
Interoperability remains another unanswered question, particularly in capital markets where multiple markets and standards need to coexist. Despite decades of effort toward standardization, many market differences persist. Even standards like SWIFT require significant customization to achieve interoperability and it is hard to imagine how blockchain will make these disappear overnight to the satisfaction of all stakeholders.
We look forward to continuing to work closely with ISSA and other market participants on exploring the issues raised in this paper. We are optimistic that appropriate applications for crypto assets will emerge and that custody and asset servicing solutions will evolve along with the market.