The US Securities and Commission Exchange and the New York Department of Financial Services have both set requirements for the custody of digital assets which should boost institutional investment in the asset class.

Jack McDonald, chief executive of PolySign, which builds blockchain-enabled institutional grade infrastructure for digital assets, described the SEC proposals as a “big deal” as the regulator has said that providing custody services for digital assets is acceptable for regulated entities as long as they meet certain criteria.

“A lot of buy and sell side firms were looking for that signal,” he added.

In February the SEC proposed rule changes to enhance protections of customer assets managed by registered investment advisers. Gary Gensler, chair of the SEC, said in a statement that if the expanded custody rule is adopted, investors working with advisers would receive the time-tested protections that they deserve for all of their assets, including crypto assets. Custody has been highlighted as an important issue since the bankruptcy of FTX as many customers custodied assets at the crypto exchange, but found they were not segregated or protected in insolvency.

The SEC’s proposed rule would entrust safekeeping of client assets to qualified custodians, including, for example, certain banks or broker-dealers and help ensure that qualified custodians provide certain standard custodial protections when maintaining an advisory client’s assets, including ensuring client assets are properly segregated and held in accounts to protect the assets in the event of a qualified custodian bankruptcy or other insolvency.

PolySign owns Standard Custody & Trust Company, which was set up in New York in order to become a regulated qualified custodian under the New York State Department of Financial Services, and received authorisation in May 2021.

In January the New York DFS released regulatory guidance to better protect customers’ virtual assets in the event of an insolvency or similar proceeding and emphasised the paramount importance of the equitable and beneficial interest in the asset always remaining with the customer.

#ICYMI: Superintendent Adrienne A. Harris released Regulatory Guidance to better protect customers in the event of an insolvency or similar proceeding. Read more here: https://t.co/Nstz39M9Wo pic.twitter.com/FJ0fbrJBxH

— NYDFS (@NYDFS) January 23, 2023

“Both of these respective orders confirm that US regulators cannot ignore digital assets,” added McDonald. “In contrast, digital assets form a meaningful asset and there is now guidance and proposed rules that will help institutions navigate the industry.”

McDonald welcomed the proposals, as the lack of regulatory clarity has kept a lot of investors out of the industry. He said: “Regulation is positive and the industry is  going to see increased investment. FTX shone a very bright light on how many clients have assets held at exchanges, which never made sense to us.”

He described himself as excited about the regulatory pronouncements, because it very much speaks to Standard Custody’s model which, for example, has had segregated accounts since launch, regular billing, has been subject to regulatory examinations and assets held are bankruptcy remote.

“Standard Custody is a pure play custodian as we don’t trade,  don’t borrow, don’t make markets, don’t rehypothecate assets,” added McDonald. “I like to say boring is the new sexy.”

He continued that one of the challenges in the digital asset ecosystem is the need to pre-fund trades, because they have immediate atomic settlement. However, under the proposed SEC regulation it will not be possible to move assets from custody to an intermediary such as an exchange or lending platform, even for a short time.

Therefore, Standard Custody is delivering an escrow-like feature where the assets remain in custody, but could be pledged or delegated for other purposes.

McDonald expects regulated entities to make market share gains in digital asset custody. The larger regulated institutions will be choosing between scenarios such as buy-versus-build, licensing custodial software, acquiring digital native custodians or starting a business from scratch.

“When I look out five or 10 years from now, I don’t think there will be two distinct ecosystems for different types of assets.,” he added. “There will be a world where custodians hold a broad range of assets.”

Coalition Greenwich said in a report, Digital Asset Market Structure 2023: The Where and How of Trading after FTX, that  the decoupling of liquidity from custody and settlement will continue, and market structure to focus on greater capital efficiency and reduction of counterparty risk with end-of-day net settlement.

Report by @deasthope outlining recent changes to digital asset market structure, examining how traders are altering their trading practices in terms of trading methods & venues & looking at how market practices & regulation will alter the trading landscape https://t.co/NrncvOsht4

— Coalition Greenwich (a division of CRISIL) (@CoalitionGrnwch) February 7, 2023

David Easthope, who advises on market structure and technology at the consultancy, said in the report that he expects settlement networks at Anchorage, Etana, Cboe Digital, Copper (ClearLoop), and others will offer greater liquidity provider coverage. He added: “This will allow firms to seek more OTC liquidity/streaming liquidity (e.g., B2C2) without the need to physically move assets and pre-fund accounts for trading in exchanges.”

Regulatory clarity around custody (including a better understanding of what qualified custody means in the U.S.), along with education by the custodians about different institutional-grade custody options, will also help firms better integrate digital assets into their investment frameworks, while reducing the technology and operational risk that we’ve now come to know is very real said the report.

In 2023 Coalition Greenwich expects institutions involved with digital assets to focus on making sure their investment strategies are compatible with greater safety and security considerations.

“Custody has very much come into focus, with more emphasis on institutional-grade, third-party custody as opposed to exchange-based custody,” added Easthope.

2/ Registered Investment Advisors (RIAs) that engage deeply in the crypto space have developed novel and safe methods of safeguarding customer assets. https://t.co/S30Eir8vTr

— Crypto Council for Innovation (@crypto_council) March 1, 2023

4/ In our reading of this 400+ page rule, DeFi is only mentioned in passing once. The rules would prohibit RIAs from using trading platforms that require pre-funding trades to invest customer assets in crypto.

— Crypto Council for Innovation (@crypto_council) March 1, 2023

6/ Lastly, there is a lack of clarity related to how the new Safeguarding Rule would respect property rights in digital assets. The rule could conflict with property rights in digital assets as set out in Article 12 of the UCC (the set of private commercial laws in the US).

— Crypto Council for Innovation (@crypto_council) March 1, 2023

8/ Our comment letter will address our concerns and proposed solutions. We appreciate the opportunity to provide expert advice. Stay tuned!

— Crypto Council for Innovation (@crypto_council) March 1, 2023

Tokenization

One of the biggest themes of 2023, according to McDonald, will be the tokenization of traditional assets. The real opportunity set is future tokenization of all assets that will be issued and created, issued and distributed, traded and stored on chain which will have significant ramifications for the distribution of funds and different products, but also for creating middle and back office efficiencies.

“We preach evolution not revolution and it will happen over time,” added McDonald. “PolySign is helping to write a new operating system for capital markets, utilising distributed ledger technology.”

For example, Goldman Sachs has gone live with the bank’s new tokenization platform from  technology provider Digital Asset. PolySign has developed AtomicNet, a settlement layer that will be interoperable with other digital asset platforms, and is expected to go live this year as proofs of concept are currently running.

“We are cheerleaders for these developments and will collaborate, not compete, with them,” said McDonald. “We want to let the banks talk each other and to other digital asset initiatives in Europe and Asia.”