National Banks as Digital Asset Custodians: Big Deal or Not?

When it comes to picking a custodian for cryptocurrencies and other digital assets, the US Office of the Comptroller’s decision to green light national and state banks might not be that much of a gamechanger for every fund manager. At least not in the short-term.

Currently, investors holding cryptocurrency can keep their cryptocurrency in a digital wallet, with an exchange, or with one of several firms which are licensed as state-chartered trust companies. In its interpretative letter late last month allowing banks to provide custodian services for digital assets and fiat bank accounts for cryptocurrency businesses, the OCC highlighted the distinction between custodial services for fiat money versus cryptocurrency. Because digital currencies exist only on the blockchain or distributed ledger, there is no physical possession of the investment. Therefore, a bank “holding” digital currencies will keep the cryptographic access key to that unit of cryptocurrency. If the bank loses the key or the key is stolen due to a cybersecurity breach, the fund manager is out of luck. Deposit-covering insurance from the Federal Deposit Insurance Corporation also doesn’t apply. The OCC cautioned banks to consider the risk factors before taking on the task of digital asset custody.

The OCC’s decision comes at an opportune time. Hedge funds focused on cryptocurrencies have managed to outperform their traditional hedge fund peers returning more than 50 percent in the seven months ending in July compared to the single digit gains of other hedge funds. Hence, cryptohedge funds are starting to generate some interest from institutional investors looking for higher returns in a volatile market.  Fund managers who have invested in cryptocurrencies and other digital assets already have some choices when picking a digital asset custodian. Anchorage, Bequant, BitGo, Coinbase, Gemini, Kingdom Trust and Paxos provide custody services for digital assets.

What makes the OCC’s announcement significant is that it might well allow registered investment advisers to fulfill the custody rule when they invest in cryptoassets. Here is why: the regulation requires registered investment advisers to select a custodian to safekeep their assets which falls under the category of a bank, a state-chartered trust company or broker-dealer registered with the Financial Industry Regulatory Authority. So far, all of the US-based providers operate under a US state trust company license issued either by the financial services watchdog in South Dakota or New York and claim they are qualified custodians. (Bequant is London-headquartered and registered with the Financial Conduct Authority). However, it isn’t clear whether the current players meet the SEC’s definition of a qualified custodian, because of how the SEC defines the tasks of a trust company. It isn’t even certain whether registered investment advisers must pick a qualified custodian when it comes to cryptocurrencies because cryptocurrencies haven’t been defined as securities. Fund managers are apparently either pressured by legal counsel or worried enough to select digital asset custodians which fall under South Dakota or New York oversight for no other reason than they hope they will on solid legal grounds.

While the SEC has not challenged the claims of South Dakota or New York trust companies as qualified custodians, the threat of enforcement action has been a strong deterrent for registered investment advisers to test the cryptoasset waters. The OCC’s interpretative release might just be the catalyst. “Based on the SEC’s category of financial institutions that are qualified custodians, there is now no ambiguity that a national bank would fulfill the SEC’s definition of a qualified custodian,” says Kristin Boggiano, president and co-founder of Jersey City, New Jersey-based CrossTower, a digital asset exchange operator. When it comes to state-chartered trust companies, the answer remains far less certain despite the OCC’s interpretative release. Legal opinions differ widely. “The OCC’s guidance is likely going to provide comfort to fund managers already active in the cryptocurrency industry that state trust companies are qualified custodians and it may encourage other funds to consider exposure to the asset class,” says Boggiano, who is also the co-founder of the Digital Asset Regulatory and Legal Alliance (DARLA), a New York-based networking group focused on digital asset regulatory compliance. However, several legal experts dispute the validity of her stance also shared by some attorneys specializing in state trust law that the OCC’s guidance levels the playing field between national banks and state-chartered trust companies. Some attorneys agree that some funds might now be motivated to dip their toes in the cryptocurrency space, but insist that state-chartered trust banks still miss the mark when it comes to being qualified custodians under the SEC’s custody rule because they don’t take deposits or have exercise fiduciary roles. What’s more the OCC does not define custody as a fiduciary responsibility.

Fund managers who have already picked one of the current providers aren’t likely to abandon their current provider for a bank if they are comfortable with its services and either believe or aren’t concerned about whether the service provider fulfills the SEC’s definition of a qualified custodian. For fund managers who are starting to dabble in digital assets and want to pick a custodian, there still isn’t much choice other than the current providers. “Traditional financial institutions, banks included move slowly. Most make turtles look like they’re in a hurry,” writes Alex Mascioli, head of institutional services for Bequant in an article appearing in late July in the cryptocurrency-specialist publication Coindesk.”So don’t expect, any to announce their brand new custody platform, immediately if at all.” Despite their technological savvy, banks aren’t up to speed with the cryptocurrency market. “The bulk of banks and other sophisticated players in the market don’t know much about our industry,” writes Mascioli. “Most of them don’t appear to have done anything to as basic as buying a fractional Bitcoin on Robinhood.”

However, banks could end up taking the plunge. Based on their recent comment letters to the OCC, some banks suggest they might be willing to support digital asset custody as long as they had some additional guidance. In fact, the OCC’s interpretative letter was prompted by a bank’s inquiry. Therefore, fund managers waiting to invest in cryptocurrency until traditional banks enter the digital custody market, might also find it worth their while to procrastinate. So far, no national banks have announced their intention to capitalize on the OCC’s announcement, but one soon-to-be-launched state bank– Wyoming’s Avanti Financial Group– might well have the upper hand. “State member banks by law have the same power as national banks, so the OCC’s interpretative letter applies to nearly every bank in the US,” says Catlin Long, chief executive of Avanti in Cheyenne, Wyoming. Avanti also meets the SEC’s definition of a qualified custodian, according to Long and other legal experts, as it fits the litmus test of receiving deposits and exercising genuine discretionary fiduciary powers similar to those permitted by national banks.

Legalities aside, fund managers willing to consider either a bank or one of the other state-chartered trust companies as a digital asset custodian still have to do their due diligence. They might decide that picking the bank as the easy way out might not be the best approach. “The cost of the custody service, any ancillary services offered, consolidated reporting with traditional assets, the technology platform used, cybersecurity procedures, and asset segregation will all become part of the decisionmaking process,” says Joel Telpner, senior partner in charge of the fintech and blockchain practice at the law firm of Sullivan & Worcester in New York. “A fund manager has to weigh the risk factors of selecting a traditional player versus one of the newcomers. The traditional custodian may have been around a lot longer, but a younger dedicated player might have the better infrastructure.”

Despite the OCC’s blessings, banks might must not end up doing the work of digital asset custodians after all. “Some banks might decide they are better off teaming up with current players to have the established systems and procedures,” says Daniel Alter, an attorney in the blockchain practice of Murphy & McGonigle in New York. State-chartered financial institutions stand a good chance of being first in line as white label players partnering with national banks. Therefore, fund managers must ask a potential bank provider just who is doing the custody work and who is responsible for any cybersecurity breaches or whose law applies in the event of a bankruptcy- a bank’s or the underlying state-chartered trust company’s. “It comes down to evaluating the risks and rewards of liability and services,” Richard Shade, director of custody for Bequant, tells FinOps Report. The bottom line: fund managers need to pay close attention to the fine print. In the event of either a cybersecurity breach or bankruptcy of a third-party service provider hired by the bank to do the digital asset custody work, the fund manager could decide to sue only the bank or the bank and the third-party service provider. The bank might also decide to sue the subcustodian in the event of a cybersecurity breach and would have to wait in line as creditor in the event of the subcustodian’s bankruptcy proceeding. Ultimately, banks will have a hard time limiting their liability regardless of who does the actual digital asset custody work.

Given that the OCC said that banks should take into account the different technical characteristics of the cryptocurrencies when offering digital asset custody, cybersecurity risks might end up being top of the list of what banks and their fund manager clients have to worry about. Digital asset custodians have already come up with a variety of solutions such as cold wallets, multi-signature authentication, and cybersecurity insurance, so fund managers have to understand just how well banks can match those measures. The New York and Tel Aviv-based digital asset security firm Curv is promoting itself as a “The Secure Tech Stack for Banks” to enable digital asset custody for traditional institutions without having to worry about holding private keys. Curv’s cloud-based software-as-a-service model relies on multiparty computational protocol, a category of cryptography.

In the meantime, as banks either gear up to offer digital asset custody on their own or partner with an existing service provider, the competition will certainly give some fund managers a lot to think about. Crypto-asset based venture capital and hedge funds might not care too much about the OCC’s announcement as they don’t operate in a fiduciary capacity. However, for other fund managers and asset-owners, the OCC’s decision could be significant enough to tip the scales in favor of dipping their toes in the cryptomarket.”Mutual funds, endowments and foundations aren’t invested in this [cryptoasset]sector yet and legal reasons are near or top of the list of reasons,” says Long.

For their part, the current cryptoasset custodians will need to decide whether they can meet the potential growth in demand for their services– and potential rivalry– on their own or will have to team up. Bequant, for one, says that it hasn’t received any calls from the traditional banks, but expects it will be only a matter of time before the phone rings. “The competition could generate greater interest from investors and promote innovation or collaboration,” says Shade. “Either way, we’re ready for the challenge.”