Hogan Lovells and Zodia Custody have collaborated to produce a digital assets custody paper

Why is custody such an important consideration when dealing with digital assets?

With new and exciting projects being explored, institutions are gaining confidence in the use of digital assets, and many are beginning to dip their toes in this world. It has never been more important for those institutions to have a clear understanding of digital asset custody, how to distinguish between the different types of arrangement on offer, and to be able to evaluate risks when selecting a custody service.

This paper comes at a time where numerous institutions are already pursuing ground-breaking digital asset projects, many of which require the services of digital asset custodians. For example, the European Investment Bank recently announced that it would be launching its second-euro denominated digital bond on a private blockchain, in partnership with three banks (Goldman Sachs, Santander and Société Générale).¹ Likewise, UBS Wealth Management has recently issued blockchain-based securities to certain high net worth individuals.² Custodians play a key role in any such project, yet there seems to be a general lack of common understanding in the market regarding how digital asset custody arrangements work in practice and how they are regulated.

The risk of custodian insolvency, heightened at a time when the global economy seems poised to enter recession, means it is essential to ask the right questions before entering into a custody arrangement to ensure client assets are appropriately held and protected. Of particular importance is ensuring digital asset custodians are clear on the way in which assets are stored and safeguarded, and how insolvency risk is managed. 

What are the key takeaways from the paper?

At a high level, the paper identifies the following five key points that firms should consider before entering into a digital asset custody arrangement:

1. Legal structure of the custody arrangement – Not all custodians are alike. To avoid loss, it is important for clients to carefully segment custody providers and work through all asset flows to understand the vulnerability of their assets before choosing a custodian.
2. Operational approach to custody and resilience – Risk must be balanced with potential operational and commercial benefits. Considering the custodians approach to information security, business continuity and disaster recovery will provide some additional comfort to clients that key technology can be restored or replace if disaster strikes.
3. Security mechanisms – There is a need to build a picture of the custodian's risk tolerance and the potential worst case scenario. A key consideration relates to the custodian’s approach to hot and cold storage (or variations thereof, such as "warm" wallets), and other applicable security mechanisms (such as sharding or multi-signature wallets).
4. Regulatory compliance – Digital asset custody regulation is not currently uniform between jurisdictions. Custodians need to demonstrate, at a minimum, that they either have core regulatory building blocks or a regulatory road map in place.
5. The continued evolution of the digital asset industry and applicable regulation – What still lies ahead is greater clarity as to: (a) the regulatory characterisation of digital assets, (b) the precise nature of legal property rights associated with the asset class, (c) the approach to regulation of the services relating to digital assets, including custody. Institutions should keep pace with these developments.

Who authored the paper?

Zodia Custody, an institutional grade crypto custody solution backed by Standard Chartered and Northern Trust, worked closely with the Hogan Lovells team to cover the idiosyncratic features of digital asset custody when compared to the custody of traditional assets, the different approaches to digital asset custody and the key considerations for institutions when entering into a digital asset custody arrangement. Hogan Lovells and Zodia Custody sought to combine their collective legal, technical and operational knowledge throughout the paper, with the aim of demystifying the process and highlighting the key questions that should be asked when entering into a custody arrangement.

For further information and to view the paper, please click here.

References

1 https://www.reuters.com/markets/rates-bonds/eib-launches-second-euro-digital-bond-2022-11-29/

2 https://www.ledgerinsights.com/ubs-wealth-blockchain-digital-debt/