Who Needs to Get Ready for the Coming of the Token Economy

Many factors inhibit institutional issuers and investors from adopting security tokens as readily as some institutions have taken to crypto-currencies. But an asset class in need of tokenization – privately managed assets – has been identified and an institutional grade infrastructure is being built to welcome institutional investors.

Alex Kech, the CEO of the Singapore-based cryptocurrency and digital asset custodian Onchain Custodian, has drawn on 22 years in the securities services industry with BNY Mellon and SWIFT to build a service that makes institutional investors comfortable about investing in the token economy. He spoke to Future of Finance co-founder Dominic Hobson about the current state and likely development of the security token markets, what could happen to traditional service providers and the importance of standardising data exchanges.

Questions that are being asked

1. Onchain Custodian describes itself, among other things, as an “open finance” business. What do you mean by that?

State of the security token markets

2. www.securities.io records just 29 security token listings, 16 in the US and 5 in Switzerland, covering venture funds, real estate, mining and a lot of “tokenomics,” of which 12 are funded. If security token issuance is not even close to moving beyond the experimental stage to achieve scalability (i.e. thousands of transactions a second) , why should traditional custodians bother to do anything?

3. The Fidelity survey of 800 institutional investors in June 2020 found 36% investing in digital assets already and 80% finding “something appealing about digital assets.” Clearly, institutions were investing in crypto-currency a year ago, but they are not yet as engaged with security tokens. Is this a supply problem or a demand problem?

4. The institutional pioneers in crypto-currency investing were hedge funds, VCs and family offices. Should we expect them to pioneer investing in security tokens as well?

5. Privately managed assets such as private debt and equity, real estate and infrastructure (worth $7.4 trillion in 2020 according to McKinsey) have emerged as the major opportunity for early adoption of security tokens. Traditional custodians play a limited role in these markets. Should they not be massively excited about the growth possibilities in private markets, i.e. this is a great new business opportunity?

Security token custody techniques

6. Custodying security tokens (safeguarding private keys to assets recorded in a single decentralized ledger and using them to authorise transactions) is different from traditional custody of securities (safeguarding and reconciling stocks and bonds recorded in multiple centralized ledgers and settling transactions in them). How big a conceptual leap is it for investors, asset managers, brokers and custodians?

7. Protecting private keys used to mean storing them in a vault (“cold storage”) or using a Hardware Security Module (HSM) that can be plugged in for multi-signature procedures, but these techniques do not work well with newer blockchain technlogies and are too slow and cumbersome to support high levels of institutional trading activity in security tokens. Does multi-party computation (MPC) solve these problems for security tokens (and, if so, how)?

8. Technology is clearly not enough: multiple layers, including controls on human behaviour and rigorous internal policies and procedures, are needed to protect assets from internal and external threats and operational errors. What should investors be looking for from custody providers in terms of non-technological forms of security?

Differences from traditional custody techniques

9. Multi-lateral netting of exposures is another benefit of the traditional custody infrastructure, yielding significant savings in capital and liquidity. Can security token settlement services provide it?

10. Much of that netting in traditional markets takes place via central counterparty clearing houses (CCPs), which also act as counterparties to every trade. Are CCPs still relevant in fully developed security token markets?

11. CLS is another infrastructure whose value lies primarily in netting. Will it survive CBDCs?

Learnings from crypto-currency

12. Because security tokens have yet to take off, most token custodians are still focused on crypto-currency. How useful is that experience in preparing them to custody security tokens, i.e. what are the similarities and the dissimilarities between crypto-currency custody and security token custody?

13. Crypto-currency custody suffered initially from obvious conflicts of interest when exchanges and brokers provided custody as well as trading services, and created additional risk in the form of omnibus accounts, uncollateralized credit, mutualization of risk between members of the exchange and exposure to inside jobs, fraud and hacking. Has the emergence of independent custodians been sufficient to encourage institutional involvement in crypto-currency investing?

What happens to traditional custodian banks

14. Do the risks of security tokenization (private keys = ‘bearer’ ownership, instant settlement, asset servicing by smart contracts) mean custodians are actually MORE important to institutional investors in security tokens?

15. Is there any useful role that sub-custodians can play in security token markets?

16. Do you expect custodians to buy crypto-currency custodians (in the manner of PayPal buying Curv and Galaxy BitGo)?

17. The technical side of private key custody is evolving, from “cold storage,” through Hardware Security Modules (HSMs) and multi-signature procedures to multi-party computation (MPC), and the nature of the threats (both internal and external) mutates constantly. Do traditional custodians have the right culture and skills to keep up with developments and stay ahead of hackers and fraudsters?

18. How hard is it going to be for traditional custodians to adapt their systems and processes and procedures (as opposed to culture) to tokenised markets?

19. HQLA-x is an interesting development on the collateral management side. Do you see it disrupting the securities lending, securities financing and repo markets (e.g. easier mobilization of collateral, reduced capital allocations)?

Asset servicing of security tokens

20. Security tokens have corporate actions (e.g. dividend and interest payments, share splits etc.) which also create vulnerabilities that can result in loss of assets or entitlements – a risk increased in tokenised markets by the use of smart contracts, partly because of potential wekanesses in the code and partly because they are open to manipulation in extreme market conditions. Do the potential cost savings outweigh the risks of reliance on code?

21.

22. You are also a member of the Custody Working Group of the Global Digital Finance membership club. Can you tell us a bit about the work of that group?

What happens to Central Securities Depositories (CSDs)

23. What part has the experience of ASX with blockchain technology played in conditioning CSD attitudes towards tokenisation?

24. What pressure to act are CSDs experiencing from sub-custodian banks?

25. If security tokens are issued into and custodied in a digital wallet controlled by the investor or a third party service provider (such as a custodian bank) are CSDs still necessary?

27. Could CSDs evolve their offering to accommodate security tokens, e.g.:

– Digital wallet custody services (omnibus and segregated)

– Transaction validation services

– Government of permissioned security token networks (i.e. admission, administration of rules)

– Providing KYC, AML, CFT and sanctions screening check services

– Providing digital identity services

– Orchestrating independent provision of services to users of security token markets (e.g. auctions)

– Facilitating inter-operability between security token networks and between security token networks and traditional securities markets

– Expand into adjacent sectors that can benefit from blockchain technology (e.g. insurance, trade finance)

– Provide digital identity services

28. In the European Union (EU) the development of security token infrastructure is hampered by the requirement to use a CSD. Do you expect that requirement to be lifted in the foreseeable future (and is it an opportunity for the UK post-Brexit)?

Settlement of security token transactions

30. Security token settlement requires delivery of cash against tokens but fiat currency is not available on chain yet. Are payments tokens proving more popular than coming off-chain into the banking system?

31. Will stablecoins survive and thrive as settlement tokens (as alternatives, or complements, to CBDCs)?

32. After 18 years at SWIFT, and as Convenor and Singapore representative of ISO, the International Organization for Standardization, you are well placed to tell us how standards for into the token economy. We know you have been working on the ISO TC68 / SC8 / WG3 on ISO 24165 Digital Token Identifier, and on a standard for the identification of cryptocurrencies and other digital assets. Please tells us more

33. There is an ISO Working Group devising a digital token identifier (ISO/CD 24165). How helpful will that be?

34. The BSI in the UK is working on a cross-chain standard for security tokens (PAS 19668:2020). How helpful is that?

35. The FINP2P protocol allows investors to execute trades on one blockchain network and settle and custody them in another. How helpful will that be?

36. Without inter-operability, tokenization will fragment liquidity. Are standards an effective solution?

37. Do tokenised marketplaces need business or messaging standards (as opposed to technical standards or computer protocols) at all?

Law and regulation

38. Are pragmatic innovators not actually seeking regulatory approvals and licences now, i.e. the new and old worlds are converging ?

39. The technology to make security tokens possible is looking like the easy part by comparison with getting securities laws and regulations into alignment with the possiblities. However, Hong Kong, Switzerland, Liechtenstein, Luxembourg, Malta, Monaco and the UK among others have put in place legal and regulatory regimes designed to provide a degree of certainty in token investing. Are we close to the point at which law and regulation are not obstacles to the growth of securities token markets?

40. A division between blockchain “true believers” and blockchain “pragmatists” on the need to accommodate official regulation and supervision is now visible. Which is likely in the long run to prove most helpful in accelerating the growth of security tokens?

Learnings from Decentralized finance (DeFi)

1. How hard do you think traditional custodians and CSDs are trying to understand the experiments being conducted in the DeFi market?

2. DeFi offers high returns but institutional involvement is limited by the anonymity of the counterparties.I s DeFi just too risky and too hard to understand for institutional investors to invest in?

3The Cyphertrace report says that, because crypto-currency has become more secure, financial criminals are now moving from crypto-currency to DeFi, chiefly to exploit weaknesses in smart contracts (not coding but how they behave in extreme Inter-operability and standards 1. conditions, which can be manipulated). Is DeFi an area custodians are exploring?The future

. There are different blockchain technologies which struggle to inter-operate, and rising “gas” fees might increase their number. What is being done to solve that problem?

41. Can a security token infrastructure be made secure by design?

42. Legacy securities infrastructures are adapting very slowly to crypto-currencies and security tokens, if at all. Is that a sensible strategy on their part?