Capital markets are changing, are you ready?

By Hirotaka Hamada, President, Nomura Research Institute Europe Limited

Despite the recent rout in the crypto and decentralized finance markets, digital assets will continue to disrupt and transform traditional financial markets. The case for further integration of distributed ledger and blockchain technology into traditional financial markets remains compelling. Near real-time execution and settlement offer the potential to reduce operating costs and improve operational efficiency in many applications.

Hirotaka Hamada, Nomura Research Institute Europe

Digital asset custodians will play a critical role in this transformation by ensuring that assets are stored securely and protected against new cyber threats. As the financial landscape shifts to Web3, new categories such as the metaverse and the growing tokenization of the luxury market will see additional demands for the custody of digital assets. The digitization of existing asset classes, including real estate and the nearly $127 trillion global fixed income market, is gaining momentum, with major implications for current custody business models . Financial markets are changing rapidly and will test whether conventional financial institutions are ready to adapt and take advantage of the opportunities offered by the nascent digital ecosystem.

In this new paradigm, qualified or regulated digital asset custodians provide peace of mind, but their role goes beyond the storage and custody of private keys. They are well positioned to benefit from new revenue opportunities in areas such as staking, lending, prime brokerage and accounting. Digital asset custodians can also accelerate institutional adoption and reassure investors from regulators who enjoy similar protections found in traditional financial markets.

But entering the digital asset space will require traditional custodians to invest and increase digitalization if they want to maximize new revenue opportunities. Security remains the dominant issue in the digital space that challenges the technological capabilities of many legacy custodians. A recent report from Chainalysis found that cryptocurrency theft increased by 516% last year to around $3.2 billion. Around 72% of the 2021 total was stolen from DeFi protocols or exchanges.

What is your temperature?

Custody of digital assets is a far more complicated task than custody of traditional assets and technological barriers to entry are increasing. Decisions such as maintaining full control, partnering with a technology provider to create a custodial solution, or adopting a hybrid approach are some of the issues that conventional custodians must consider.

A digital asset custodian will need to consider the other digital storage options known as hot, hot, and cold storage. Hot storage requires internet connectivity that allows investors to move funds quickly, but as recent events have demonstrated, it is vulnerable to predatory hacks. Hot storage combines hot and cold storage options.

Cold storage is the safest option. For added security, private keys are stored in offline digital safes that can be physically hosted in different geographic locations. They can only be accessed using two-factor authentication or other sophisticated encryption, such as multi-signature protocols.

Each digital asset class presents new security and storage challenges. There are fundamental distinctions between custody of assets under a smart contract and those under a cryptocurrency consensus mechanism for example. There is also a distinction between the requirements of various investors who may be active in multiple jurisdictions. A family office is likely to have different custodial needs than a hedge fund, for example.

Together, these factors are forcing many asset managers to rethink whether they have the technology infrastructure to serve the digital custody market. It is also a question of costs. About one in four investors surveyed in 2021 by ThoughLab had a preference for a fixed fee structure when paying for custody services. Some 44% of companies surveyed said they plan to use a flat fee structure within the next two years.

Growth in self-custody is expected to be significant as retail investors are increasingly exposed to digital assets. Recent regulatory reforms now include alternative assets as part of 401K retirement planning for retail investors.

Guard 3.0

Technology will continue to develop at a breakneck pace and the ability to evolve alongside changing customer demands will be a critical consideration for the mission of digital asset custodians. Emerging digital asset classes such as GameFi will provide new custody opportunities that could challenge the culture of many traditional financial institutions.

The tendency of traditional custodian banks to historically centralize custody control goes against the ethos of decentralizing blockchain control. It’s no surprise that these seemingly opposing new technological requirements for the future management of customers’ digital assets have prompted a flurry of M&A activity in recent months.

The transition to digital preservation is not linear. Tomorrow’s custodians are likely to operate in a dynamic and active market where cross-chain solutions promote universality, a precursor to a global digital custody market.