The importance of a third-party custodian

Forkast.News: What is a custody solution? What’s the difference between simple cold storage and custody?

Phil Mochan: Custody is about a lot more than simply managing safes (or cold stores). The trade settlement process is an integral part of the function of the custodian. At Koine, we view the participation of humans in the handling of private keys, where there is even a remote possibility that they may have access to them, as inherently unsafe and unacceptable to institutional investors. 

We therefore do not use a cold store model (which requires humans to gain access), but a new engineering solution called Digital Airlocks, which is fully automated. With this approach, we are able to guarantee that humans never touch the private keys, which is a regulatory requirement in some jurisdictions. Furthermore, this solution delivers huge scalability and a lower unit cost without impairing the security model.

FN: How do custodians work with regulators?

PM: Each jurisdiction has its own methods of incorporating custodians into the framework of trading financial assets. Regulators create rules, defining when a custodian is essential or optional for a given asset class. They either specify what a custodian is or provide guidelines as to how a custodian should perform its functions.

There is the regulatory requirement for funds ensure that the fund manager and the depositary are distinct. The depositary and the custodian can be [and often are] the same. With unregulated assets (physical oil, Bitcoin and gold), the depositary may well appoint an investment manager for the safekeeping of the assets – as long as he or she can discharge their duties.

The most important role of a custodian is the administration of assets, which is the only activity that generates income. In the world of UK regulated financial services, safeguarding and custody are “reserved words” that each have a special meaning. In short, they mean looking after someone else’s investments. The contract in common law that underpins this relationship is called “bailment”, where the bailee (the custodian, in this case) temporarily gains possession, but not ownership, of the assets.

FN: How does insurance work with custody services?

PM: In digital assets custody, there are broadly two types of insurance cover. These are, respectively, assets at rest and assets in flow. In digital assets, this most often covers the flow into and out of custody, which only needs to cover the peak momentary transaction flow. An insurance policy is only as good as the policy and the creditworthiness of the underlying insurance company. Some policies are taken out purely for marketing or box-ticking purposes and must be seen as such, e.g., a $100 million policy for assets at rest is relatively meaningless, whereas a $10 million for assets in flow is much more significant.

FN: During the last year, what are the most interesting developments you’ve seen in the digital asset sector?

PM: The three most interesting developments have been: (1) COVID-19, which is likely to see asset allocations by family offices shift more into alternative investments, including cryptocurrencies. We expect the volume to start arriving in Q1 2021. (2) The issue of stablecoin regulation being given attention by central banks. (3) The beginning of the shift to digital amongst the incumbent financial infrastructure sector.