How Digital Tokenization May Change Custodians’ Role

 

As digital tokenization of asset classes expands, the technology may not only change the role of traditional custody banks; it may also broaden the definition of an asset and modify how assets are traded.

Traditional custody banks are getting competition from new blockchain-native technology firms, as new custody models are beginning to emerge, including self-custody and third-party digital custody. As assets move from being physical products to digital ones and from centralized to decentralized storage, the concept of custody is changing. That gives bank custodians an opportunity to rethink what they offer clients, says Prakash Pattini, the managing director of digital transformation at IBM.

“Traditional banks are now having to think about what they do differently, as opposed to just being the physical custodians,” Pattini says. “They’re looking at offering new services around the entire lifecycle [of an asset.] It’s moving more from a passive to an active, custodian-type approach.”

Tokenization also offers opportunities to create liquid, transparent markets in traditionally illiquid assets such as private equity or real estate and to create new ways to own assets, such as fractional ownership. Tokenization also may make custody more efficient by automating back-office processes.

Digital tokenization could have a profound impact on the financial industry, but it remains at the early stages of many of these activities, and, aside from cryptocurrencies, most markets are illiquid. Additionally, a key part of custody—security—continues to be an issue as tokenization is rolled out.

How Tokenization May Change Custody

Boaz Avital, head of product at Anchorage Digital, says that, traditionally, custodians focused on physical safekeeping and back-office processes.

“But in the digital asset space, particularly with tokenized assets, custody is inseparable from functionality,” Avital says. “The ability to trade, transfer or settle directly from custody isn’t an add-on; it is core to the asset’s value.”

Anchorage Digital is a digital bank offering institutional investors a global crypto platform with custody, staking, trading, governance, settlement and security infrastructure.

Pattini concurs with Avital, saying that as fintech companies and blockchain-native firms move into tokenized custody, they remove manual processes, lessening the operational overhead and increasing efficiency. Automation is being built around smart contracts, compliance and jurisdictional requirements. Connectivity enables peer-to-peer settlement, which cuts out intermediaries.

Tokenization is moving toward 24/7 operations as the finance industry is getting closer to T-plus-zero settlement times. That is significant for institutions doing cross-border settlements that previously saw business slow because they were limited by custodians’ operating hours in different jurisdictions, Pattini adds.

Even at this early stage of development, Pattini says the industry is seeing blockchains able to exchange and make use of information, and interoperability between networks is allowing cross-chain protocols to emerge.

“People are able to create different asset classes across multiple blockchains because we’re starting to get s,” he says.

Justin Chapman, head of the digital assets group and financial markets at Northern Trust, which has had a digital asset platform since 2017, says custodians are aggregators of liquidity and asset pools, giving clients visibility across their assets. That remains true with tokenization, and much of the bank’s custodial work is now also focused on capturing market information and assets across different locations, so that clients can make investment decisions and move securities.

“Having both digital and traditional (assets) all in one bucket really, really helps … those capabilities,” Chapman says.

Greater Transparency

Cryptocurrency trade dominates tokenized markets activity, sources say, but the activity is starting to expand into liquid assets like bonds and funds, where the benefits of speed and transparency are already clear. Growth is strongest in digital tokenized money market funds and tokens for cross-border payments and liquidity.

The current market activity occurs at both public exchanges and over the counter, in asset pools and closed permissioned networks. However, Chapman says that outside of cryptocurrency and fixed-income trading, “there is zero liquidity in the tokenized markets at the moment. If you want to buy and hold, you’re good. If you want to trade this stuff, it’s really difficult at the moment, because of the lack of liquidity of the marketplace.”

The hope of those who expect tokenization’s growth to continue is that by automating back-office custodial systems and changing the nature of a physical asset into a digital one, tokenization could unlock liquidity for traditionally illiquid assets and broaden asset classes, especially in the alternative investment markets.

“Illiquid assets like private equity, real estate and unlisted equities are still in the experimental stages, but tokenization will likely unfold in waves, starting with use cases that offer the clearest incentives and regulatory feasibility,” Avital says.

Chapman pointed to an example of how tokenization could provide greater transparency and potentially broaden an asset class with a tokenized green bond initiative. Northern Trust launched a tokenized bond for the National University of Singapore to fund the university’s campus rebuilding. The token reflects the bond’s return, but also contains the environmental impact reporting data of the investment, which investors may need.

At the time of the transaction, Tan Kian Woo, the NUS chief financial officer, said in a that the tokenization project enables “investors and stakeholders [to] get access to prompt updates to support their sustainability reporting needs.”

As a buyer, “you’re acquiring the intellectual property of the underlying information associated with the fundamentals of that company that you’re investing in … so that allows more informed investment decisions,” Chapman says, adding that it also gives information in real time.

Pattini says he expects there will be opportunities on both the buy and the sell sides. On the buy side, there is the possibility for new asset classes, fractional ownership of certain assets—like private equity or real estate—and improved liquidity. For the sell side, tokenization can create new digital assets, new revenue and new custody models.

Security Remains Critical

The custodial model may change, but one part remains critical: security.

Chapman says the challenge is not with blockchain technology itself, but with onboarding and unloading assets into infrastructures.

“It’s no different from a hacking of an institution that holds a bearer asset or, back in the old days, a bank robbery,” he says.

Although interoperability between blockchain networks is advancing, there is more work to be done, Pattini says, as it is not completely standardized, and security risks are emerging as a result, especially if there are many third parties on the chain. Like physical chains, they are only as strong as the weakest link.

That’s where building strong infrastructure matters, according to Pattini: “We’re not there yet, but the direction of travel is to get to one platform where you can manage multiple assets.”

Tags: asset tokenization, Blockchain, cryptocurrency trading, digital asset, digital asset custody platform, illiquid assets, Information Security