Bridging the Old and New Worlds of Asset Custody

[00:00:00] Seamus: Welcome to METACO Talks. I’m Seamus Donoghue, the VP of Strategic Alliances at METACO. If this is your first time joining, METACO Talks is a biweekly discussion with thought leaders in the industry. Today our topic is bringing the old and new worlds of asset custody together. I’m very happy to have Swen Werner here, to speak with us.

For those that didn’t catch the live streaming or aren’t able to listen to all of it, this will be available as recordings on most of your favorite podcast channels as well as YouTube. Let’s dive into it. Welcome, Swen.

 

[00:00:32] Swen: Good morning and thank you for the invite. I’m really excited to be here.

 

[00:00:36] Seamus: Great to have you here. We speak to many large tier one firms like yourselves, but I think you have a much deeper background in this space. You’ve been in the space since 2018, and at a very large institution that’s announcing moves in the space. We’d love to hear your background and how you got into this, and where you are now.

 

[00:00:54] Swen: I think that’s a good question. When I was at university, we could not study Bitcoin and crypto back then. It was a very organic transition into this. It’s not already in, I would say, a few years earlier, at the time I was working with a number of central banks on their market infrastructure, strategies, how they evolve RTGS systems, et cetera.

Then this thing came around called the stable coin. The question that was posed by some central banks was, what would that do to the way we process Euros or Sterling or US dollar, and how should we think about our long-term strategy? I was writing some papers and some analysis, and that was also at the time when the conversation started around a project called utility settlement coin, which is now Fnality. Remember at that time nobody had heard the term CBDC. I think that’s also just a couple of years old.

That work basically got me hooked, then as you said, in 2018 I started working full-time on digital assets and blockchain, and have been doing so ever since.

 

[00:02:03] Seamus: Interesting. Many people would’ve thought the industry was finished after 2018. It’s great to see you persevered as did State Street.

One of the themes, given there’s very few firms as large as State Street particularly in the global custody space, how hard has it been to innovate in that space? Obviously digital assets is something very new and fast-evolving.

 

[00:02:22] Swen: I spent my entire career at large global organizations that have a workforce of the size of mid-sized cities. In a way, I think that there’s a reason for size in terms of the scalability it gives you. But it’s hard. I wouldn’t say that we can’t improve. We do a lot of change. If I look at our applications, we were making over 3000 IT changes to our various systems per month. You have constantly to adapt and change to requirements.

When it comes to digital, there’s something very different now, which is the change is much faster. Traditionally you could weekly plan this, and now new requirements are popping up all the time and our delivery has to be even more agile than the traditional management methodology means.

The other thing which makes a change if you think of a big organization, is the risk that these new assets entail is somewhat hard to measure or there’s no real best practice. If you think about different custody models, this is hard to work up to the model. The deregulation is still evolving in this.

I would say, finally, Fintechs also have a different economic model: how they’re funded, how they’re looking at winning your business, and then how long they can sustain negative cash flows. Taking this altogether, you’re moving faster, you have more uncertainty, and you’re dealing with a new breed of competitors makes it quite hard. But that’s also one of the reasons why we proactively want to partner. Everything we do in State Street Digital, the new division we have around digital assets, is really trying to be open architecture. We need to embrace it, we need to work with organizations like yourself, that bring these new kinds of technologies at the forefront.

 

[00:04:12] Seamus: You’ve brought up State Street Digital. Obviously, the market has recently heard the announcement of this new launch. What is it? Part of that idea that you talked about partnering, is that different ethos? Does that require a separate division to, let’s say innovate faster than the bank otherwise wouldn’t?

 

[00:04:29] Swen: Its purpose is if you want to invest into the future. I’m a good example of that, we’ve had various activities within the bank, looking at digital assets and blockchain. But they were driven out of the existing business divisions or custody, or what have you.

If you look at our product portfolios, depending on how you measure this, I would say it has maybe 100 core products groups and activities that we provide to clients. What you have to look at as: A, how would these products transition into the future; but also which new ones do I need and which ones will I not need in the future? That requires a different level of focus. It can no longer be you do custody during the day and then you moonlight digital. You have to have a dedicated workforce that lives in breathes for this space.

That’s really what State Street Digital is about. We want to build a service model, but also if you want some to traditional. Intermediary record keeping business towards more of that, you’re orchestrating data, you’re orchestrating a network of fintechs and bringing it together.

There’ve been announcements made in the past and since that we provide trading technologies for the digital asset platforms. All of these activities are now coming together into one group under one single leadership, and that hopefully will give us the focus needed to make sure that we can adopt to that change and also then help clients to transition it.

At State Street, most of our clients are heavily invested in traditional assets, and it is starting to add crypto assets. We need to add digital assets more broadly, and we need to bring this together and have a seamless service around it.

 

[00:06:22] Seamus: Very interesting. Given that you’ve announced this new division, is this a statement to the market that every major secure servers services premise, let’s say table-stakes, need to do a last offering? Is this what we’re seeing from the market?

 

[00:06:36] Swen: I would think so, and I think that’s shared by a lot of decision makers in that space. Digital is a very pervasive technology. Maybe some few years ago you had this debate of, is it really coming, is the technology ready? That is no longer a debate? It will become an existential question for not just custodians, but asset manager, and everyone in the broader financial ecosystems. Therefore, you have to have a critical blockchain and digital assets strategy.

The other question is, again, if you’re looking at crypto custody, which is a hot topic these days, last time I counted 70 or 80 different providers all across the globe, can the market sustain all of them? I don’t know. But you have to realize that there is now a demand for these kinds of services. If you want to stay relevant as an organization, I think you have to jump on the bandwagon and develop a service. Absolutely, I would say it becomes an imperative now.

 

[00:07:46] Seamus: The demand question, and I guess also the competitive pressures to move as well. What does a traditional legacy custodian need to do to embrace this new order?

 

[00:07:53] Swen: I think two things. Sometimes it’s very boring and you will hear this all the time, but it is nevertheless true: regulation. Also, sometimes we have these conversations; what exactly do you mean by this? Do I want a new digital asset custody law? I don’t know that that’s what I mean by this. But in terms of more certainty of what is permissible and what is not permissible, particularly when it comes to crypto, you may have seen the rent proposal by the Basel regulator on the potential treatment of crypto, which is obviously quite a disincentive for large banking organizations to potentially hold these assets in future. That needs to be clarified.

Then the whole question around, if you were to provide, for instance, crypto safekeeping or crypto administration services, is to say a service that requires a license jurisdiction say yes, if no jurisdiction say no. Then the whole integration between if you want a traditional asset management regulation, and new crypto regulations. In Europe, for UCITS funds and alternative investment funds, they usually require a depository, which the one inside safe-keeps these assets, but also provides a control and risk framework over that.

There’s very little regulatory guidance in terms of how you would perform these services, so it’s very important for large organizations like ourselves that we get some clarity of what is expected in order to be in regulatory compliance for providing these kinds of services.

The other thing I would add on this is, particularly when it comes to tokenized assets, security tokens and this kind of things, personally, I’m extremely excited about it. But we are in the early days of that adoption. You can call it a chicken-and-egg problem or whatever it is, but it’s the question of when do we see the distribution success of tokenized securities and all financial instruments into integer portfolios of asset managers? As soon as we see this happening, I think the market will follow relatively quickly. That’s a key requirement. You know what you’re supposed to be doing and how, then it’s happening, even at a small scale.

Somebody who’s not in tokenized funds and things like that, we see these initiatives popping up here and there. I think it will create a halo effect for the market to adopt that relatively quickly.

 

[00:10:16] Seamus: The first step to get there is firms like yourselves providing the capability to asset managers to hold these assets. I think that’s, as you said, in many ways chicken-and-egg.

It’s interesting that you mentioned the regulation. It’s funny how the markets reacted in the past few weeks, because regulations come to the forward whether it’s Gary Gansler or other initiatives in the Senate and Congress. The market is taking this negatively. But I think to your point, what we see from a lot of the large firms is really about clarity and having some regulation guidelines. Regulation very much enables you guys to move.

 

[00:10:49] Swen: Yeah. Maybe just to add on this also, and this is a two-edged sword. But if you take, for instance Japan, they had to already a year or two years ago a relatively prescriptive framework around crypto custody. I’m paraphrasing, but basically the only model is the custody of cold storage. If you talk to organizations in those markets, eventually my preferred model is X because this is what regulators want. If you go to another jurisdiction that doesn’t have that level of guidance, it makes it more flexible, but it also creates a million of permutations of what a good model would be. That kind of sometimes certainty, at least at this stage, can be helpful to move forward because you don’t have to question yourself or what you’re supposed to be building. You’re building towards a real template.

 

[00:11:34] Seamus: Absolutely. It’s the early days, so guidelines help. We’ve often seen too many options slow firms down in that sense.

As institutions like State Street get involved, scalability seems to be a big thing. We’ve seen small, firms in this space for a while, and now you have the large firms that bring institutional scale. How do you address operational scalability in this market?

 

[00:11:56] Swen: Yeah, that’s definitely an issue. What we have seen so far, particularly when it comes to crypto from the digital assets management side, it’s probably a bit more of a buy-and-hold strategy. But over time if you had more and more like intraday trading, then you will have to have cold storage. That’s something that we’re thinking about what the right model is, how we could address all these various different client segments.

I would say one of the issues for us, it’s not so much the scalability, but the safety. The crypto market traditionally had a pre-funded model where you have to hold your positions at base exchanges. That works very well from a retail perspective. But I think if we see the adoption from an institutional framework, we’ll need to move away from this a little bit. Like today, we will have the ability to hold equities and what have you within your custodian bank. You can trade on those positions without moving them out of custody in first place. That same concept will have to be adopted in crypto markets.

 

[00:13:01] Seamus: You touched there a little bit on what your asset management clients are seeing, but what more broadly or more specifically services are you seeing being demanded by your clients?

 

[00:13:13] Swen: It’s really a variety. Sometimes I surprise myself thinking this could not possibly be happening, and then it happens. For instance, when we had NFTs being sought constantly in the presses, we actually had some asset managers seriously contemplating the possibility to invest in art through an NFT concept. Whether it’s going to happen or not we would have to see, but there’s nothing too outlandish at the moment to not even consider.

I think key aspects are a security token, particularly in jurisdictions where there’s no framework to do that. Like in Germany, I think there is a lot of interest for that. There is interest in crypto safekeeping more from the asset owner space, smaller asset managers. A lot of the European, at least the pension funds probably want to stay away from crypto for now. But US pension funds at least would be open-minded. If you want regionally, a little bit diversity within the same client segment, then within the client segment itself, I think the traditional long only asset managers are probably more bullish on security tokens and all of financial instruments that come in tokenized from, and less so on crypto and then asset owners.

For instance, in the US a good example would be endowment funds. From universities, they’re early adopters, and they act a bit more like a private wealth, so centralized. Therefore, you see more interest on that. In Europe, I would say those banks and clients that have a large private wealth franchise behind them also are more open to crypto investments, because that’s what their underlying clients are asking for.

 

[00:15:01] Seamus: Do you think those firms that are comfortable with a crypto exposure, is it very narrowly defined crypto? Is it Bitcoin or Ethereum? I mean, there’s so many new protocols, Layer 2, Layer 1’s. How do you think they’re looking at that?

 

[00:15:15] Swen: I think in terms of the absolute market, it is probably Bitcoin and Ethereum. In the conversations I have had so far, very quickly you come to a discussion of ‘what else could you do’? Polka dots or what have you. We’re probably not talking about hundreds of old coins, but maybe tens. I think that increasingly will definitely be in scope.

In particular, this is another key aspect of how traditional custody and crypto custody more broadly differs. It’s no longer a standalone function. It’s very closely tied to trading, liquidity provisioning, as well as DeFi. If you’re looking at DeFi for a definition, you want to have DeFi protocols and you want to have stable coins. You want to at least have Ethereum-based instruments. That’s why there’s a natural need to not just look at Bitcoin, but some of these other instruments as well.

 

[00:16:14] Seamus: The Bitcoin space seems to be well-populated now. We saw announcements in the past couple of days, of two large banks offering potential unit trusts around Bitcoin. But we hear more and more about Ethereum, and as you say, the banks, at least looking at DeFi. How do you think banks will approach DeFi, given all the decentralized nature of this?

 

[00:16:36] Swen: I am personally intrigued by it. Today, DeFi is very much a crypto play. The question is could you adopt the concept of DeFi to security tokens? Conceptually you could, but then you bring a lot of regulation because suddenly you’re dealing with regulated financial instruments. No way can the protocols today and the players in that space today, take what they have that works well for crypto and adopt it for security tokens? That’s a big question mark too.

The other thing I would also say is, the idea that an institutional investor is indifferent to the counterparty risk – which is just to say a trust in code and a trust in the collateral – is probably a bit too premature. Take security lending, today we are a large security lenders or asset managers, or lend securities with brokers. All of these transactions are fully collateralized, but typically an agency lender provides an indemnity in case something goes wrong. The institutional space is used to a double protection, and now you’re saying you’re stopping that and you’re moving to what could be perceived as a less safe model. I think there’s still a role for somebody to take some form of policing and additional insurance methodology, even if you were to use DeFi protocols for security tokens. But that’s my assumption as of today. If you ask me in two years’ time again, I may have to change. But that’s my hypothesis for the moment.

 

[00:18:15] Seamus: No question, two years is a very long time in this market. Does a centralized deployment undermine the whole value proposition of what crypto brings in terms of its decentralized infrastructure? How do you balance that?

 

[00:18:29] Swen: Yes, and no. This is where we’re coming back to regulation. We will need to allow the rise of decentralized market infrastructure. The idea, particularly in Europe, that we have right now, we have a CSTR that requires security tokens that they have to be issued into a CSD, which really means that if you want to tokenize anything that’s traded on an exchange you can’t unless you are a CSD. I think long-term that is something that has to allow more decentralization.

But on the other side, if I look at a lot of the initiatives that are being set up right now, I think the market is a surprisingly centralized in its deployment. That’s just a quick question of, is everyone ready? If you had an experiment a few times, where we may be in the POC to tokenize something, but then are all of these other counter parties that are ready at the right time to manage the wallet, receive these tokens. That’s always holding you back.

But there is, I think irrespective of blockchain, a lot to learn, and some of the pretty important aspects. For instance, with decentralized networks comes the need to operate in trustless networks. We’re seeing this also, that concept we know today, deploy into an application. The markets are already adopting that concept, that you have trustless access to these base applications, and therefore increasing diversity against the operational frameworks. Sometimes it’s important to get away from the blockchain. What are some of the common themes? They will apply whether we’re talking about digital assets or we’re talking about traditional databases that may be deployed.

 

[00:20:11] Seamus: A very good approach to it. I’m interested to get your take on, we’re talking about the regulation and some of the concerns around those decentralized infrastructure, lacks existing regulatory framework. Do you think there’s room as well for regulations to evolve?

We’ve seen, I think it was Hester Pierce who came out in the past couple of days, talking about a lot of the security rules for example were set up prior to computers existing and the there’s been a lot of evolution in how we look at things. A lot of the existing rights that have been put in place, do we expect to see some evolution there or movement as well?

 

[00:20:46] Swen: I think it’s a real challenge. Somebody said this, which I quite liked, that we use the 19th century legal constructs with 20th century technology to solve 21st century problems, or something like that.

It’s not a new problem. In most jurisdictions, security law is a hundred years old. Even if you today do electronic settlement, you’re operating legally in a fictitious world to assume that these electronic bookings in some way resemble the physical exchange of instrument, when they’re actually not physical instruments anymore.

Every time a convention has been tried many times to, on one side harmonize this, and then make these law changes more modern. What some jurisdictions have now done, in Switzerland, Germany, is to say: I leave my case law from a hundred years because it works and I’m creating something new on the side to create a new form of digital assets. That will receive similar protection as did the old one but basically you start from scratch. I think that that is more likely to work. But something has to move on that side, absolutely. I agree with that.

I see the readiness to this. There’s an intense interest to make sure, how can we adopt our legal infrastructure to make sure we cater for you and different consumer requirements? But I just don’t think it’s that easy to think around a little bit to a securities law and you’ve done. This would be from previous experience, quite hard, and also could not be done within a short timeframe. You’re looking at a 10-year reform project. By that time, we may have moved on and interested in other things.

 

[00:22:26] Seamus: New challenges! We’re looking forward to when there’s some more clarity and decentralized. What do you see as the role for a custodian in a peer-to-peer network?

 

[00:22:36] Swen: I think peer-to-peer is this fantastic theme. At State Street we rolled out a peer-to-peer repo and peer-to-peer securities finance. The fact that distributed ledger technology or digital assets, if you want to accelerate a trend to peer-to-peer, it an interesting and welcomed development. You will, at least how we think about today, still need a custodian to enforce a level of common rules and making sure that if something goes wrong the investors are protected. I mentioned earlier, already in DeFi protocols the need for instance, to provide additional indemnities. That is something that I think could continue in future.

There’s also an aspect of counterparty risk selection. We have a lot of institutional investors who will say: I will have certain minimum requirements on whom I’m trading with on, are they being enforced? Again, the custodian can help to make sure there’s a pre-selection and that there are certain entry barriers. Also this whole idea that you go to an extreme world of peer-to-peer, where everyone can play a thinking deregulated securities industry probably would take much more thinking before this becomes a reality.

 

[00:23:50] Seamus: It’s interesting you’re already making steps in the peer-to-peer trading in the areas you’ve just mentioned. That’s fascinating. So you’re already gaining an experience around existing regs, in that context.

Stepping back and looking bigger picture, where do you see the biggest gains and efficiencies and markets from digital assets?

 

[00:24:06] Swen: It depends. This is always an interesting debate. You will hear everyone saying about faster settlement and no reconciliation – these are all valid, interesting points. I’m personally interested in two or three things. One is that distribution could become digital. If you had a digital fund, a digital cash, you can basically buy directly from the asset manager for whoever you’re investing in, and have these assets in your own wallets. Maybe that’s more of a retail play initially, but it’s a different way of conducting business. You no longer have to go through a chain of intermediaries.

But also for institutional investors, that potentially brings better data distribution. Asset managers are always very interested to say: who is buying my funds? Why? Can I track this in real time? If you had a tokenized instrument, you could very quickly see in certain jurisdictions people want to buy ETFs investing and car companies versus something else. It would allow the asset management industry to act much more appropriately to changes in investor demand.

The other thing is around particularly digital cash, offering new forms of digital money. Like this idea of a stable coin. It deconstructs instruments. Today you have a cash account, you can pay from your cash, and you also earn interest from that because your bank is investing that money. With a stable coin, you can take this apart. These are two different decisions. The coin can pay, but the collateral that’s backing it up and earning the interest could sit anywhere else. This is a level of deconstructing the value chain that is not possible with traditional payment forms. I don’t think we have seen the end of innovation that this could bring.

Then related to this is the programmability of assets. You can have a self-enforcing asset. That is something that, again, in traditional setups is not possible. I would think that will be some very creative planning and invention coming from that side.

For me, these are the interesting things. It’s not so much about, which is important, efficiency gains. It’s really you can build new asset types and therefore build new business models, potentially.

 

[00:26:26] Seamus: I think that’s an exciting future. It’s great to hear that we’ve got people like you inside the organizations like State Street, thinking about this future. That’s definitely extremely dynamic, and that will be exciting.

Unfortunately, the time has flown by. It’s been great to have you here. If people want to reach out and connect with you, what’s the best way to do that?

 

[00:26:44] Swen: Find me on LinkedIn. I’m quite active there. Drop me a note, always happy to chat. Also hearing feedback, I think one of the interesting aspects, particularly in this digital industry is, the network is so much broader and people bring in so much interesting aspects. I think we all have to learn both from the traditional security services side as well as a number of new players that bring a fresh and interesting perspective.

 

[00:27:07] Seamus: Absolutely. Thanks Swen for joining us today. Thanks everyone for joining. As mentioned, the recordings will be available on your favorite podcast channel and YouTube. Join us again in two weeks, and thanks for joining today. Till next time.