Protecting digital assets: Custodial innovation for institutions

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As custodians adapt to new regulatory frameworks and technological advances, the role of custodians is becoming increasingly important, not only in meeting stringent regulatory standards but also in protecting investor assets both now and in the future.

Custody solutions can be broadly divided into two main categories. The first is self-hosted, where technology service providers offer custody as a service, typically using cutting-edge technology to manage and secure assets. The second is hosted, which involves qualified custodians who are regulated under global frameworks, adhere to set standards, and provide an additional layer of security through strict regulatory oversight; this is typically the preferred option for institutions and their investors.

But nothing of value comes without its challenges. As custody solutions continue to evolve and digital assets gain more traction among institutional investors, a few important considerations have emerged for those considering entering and staying in the space.

The distance of bankruptcy

The first sign of increased institutional interest came when institutions began focusing on how custodians handle bankruptcy remoteness, a process that includes legal and operational measures that protect client assets from the custodian’s creditors and safeguard them in the event of the custodian’s bankruptcy.

In the absence of regulatory clarification and updates to national insolvency legislation, many firms are proactively addressing these concerns by implementing internal controls, ensuring transparency and separating client assets from their own funds. In general, regulators in various jurisdictions are moving towards mandatory segregation of client assets from custodian funds, reducing the risk of potential involvement in custodian financial distress.

For those familiar with common law, contracting under English law provides robust protection. This legal framework allows assets to be held in a trust structure and ensures that they do not become part of the custodian’s bankruptcy estate. The trust structure legally separates client assets from the custodian’s assets and provides a separate trust property that the custodian’s creditors cannot access. This protection ensures that client assets can be returned immediately, even if the custodian goes bankrupt.

Regulatory intervention will likely standardize asset separation practices, but the road is long. Until then, the level of satisfactory separation depends on the needs of institutional clients and the implementation capabilities of custodians. Full separation offers robust protection, but practical considerations and technological advances, such as on-chain solutions, are also important.

Liability provisions and insurance

Historically, custodians operated with widely undisclosed liability provisions; this norm has changed with the rise of exchange-traded funds (ETFs) and similar investment vehicles. The need for greater transparency has been driven by these new financial products that require disclosure of key terms, including those related to custodial liability.

In traditional finance, securing insurance to cover potential liabilities is relatively straightforward thanks to the deep-rooted relationships between financial institutions and insurers. However, the digital asset space presents unique challenges. In terms of diversity, availability, and cost, insurers struggle to assess the associated risks and therefore struggle to provide adequate coverage.

As regulatory attention to safeguards’ liability provisions grows, there has been pressure for mandatory contractual terms that extend beyond existing regulations. This means safeguards may need to add more comprehensive provisions to address potential liabilities and enhance investor protection. Examples include rigorous business continuity plans, disaster recovery procedures, and strict separation of personnel and duties, as well as geographic distribution of essential supplies. However, imposing overly stringent (and often costly) requirements can have unintended consequences. The balance between commercially viable business models and adequate protections should not be destabilized by disproportionate regulatory requirements.

While balancing transparency, regulatory compliance and practical operations remains a challenge, regulators should work closely with custodians, financial institutions and industry experts to create regulations that are comprehensive, practical and do not stifle innovation.

Differences between operational due diligence audits and regulatory oversight

The outsourcing of operational due diligence to counterparties is increasingly common, with many firms now specializing in these assessments and reports, with varying costs and quality. While transparency and effective procedural enforcement are essential to the industry, an emerging problem is the over-reliance on these reports by industry stakeholders. This can discourage interactions with digital asset businesses and potentially create a false sense of security by indicating that these data collections are voluntary and not subject to any standards.

Rebuilding trust is crucial in this scenario, but relying solely on third-party providers for assessments may not provide the full picture. However, these firms fill a gap as large auditing firms still often avoid engaging with digital asset firms due to their lack of familiarity with these new businesses.

To address these challenges, greater regulatory alignment and harmonization is needed. A starting point is the introduction of comprehensive licensing and regulatory oversight regimes. Going a step further, regulators would ideally adopt a recognition model similar to that used in other regulatory areas, ensuring consistent standards are applied across jurisdictions. This approach would help customers and stakeholders feel more secure, promote uniformity in regulatory practices, and increase overall trust in the digital asset ecosystem.

We are building a durable road ahead

The future of custody lies in balancing innovation with rigorous investor protection. By adhering to strict regulatory standards and leveraging advanced technological solutions, custodians will continue to play a vital role in ensuring the integrity and security of assets in the digital economy. While challenges remain, continued collaboration between regulators, custodians, and industry experts will be essential for further innovation. By creating a regulatory environment that supports innovation while protecting investor interests, the digital asset space can achieve greater stability, trust, and growth, paving the way for a safer and more resilient financial future.

Evelyn van den Arend

Evelien van den Arend is head of legal, compliance and regulation at Komainu. Evelien is responsible for leading the legal and compliance function and supporting the group’s business operations while designing and implementing the regulatory strategy, as well as supporting product and service expansion. Having held various senior regulatory roles in the financial and digital asset sectors, including EQONEX Group, Kraken and CME Group, Evelien brings significant experience in navigating complex regulatory frameworks while embracing new technologies. Evelien holds a master’s degree in business law and tax from the University of Toulouse, a postgraduate diploma in domestic business law from the University of Rennes and a master’s degree specializing in law and international management from HEC Paris/ESCP/EAP.