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Banks must establish infrastructure for digital assets before it’s too late

09/27/2020

Crypto adoption in traditional legacy systems is moving fast, but a lack of technological infrastructure limits compliance and safe storage.

The adoption of digital assets in traditional legacy systems is moving fast. In the middle of the year, the digital asset custody industry saw welcome developments when the Office of the Comptroller of the Currency officially announced that all nationally chartered banks in the United States can provide custody services for cryptocurrencies.

The move, while positive for the ecosystem, is yet to be accompanied by a rigorous assessment of its technological infrastructure, like asking questions such as: Where are these newly acquired digital assets stored?

One thing is clear: We have entered a new paradigm of finance that requires a different approach to securing assets.

Digital assets offer great wealth potential, but asset custody providers have a responsibility to prevent their clients from becoming another figure of global crypto attacks, which reached a value of $1.4 billion in June this year.

According to the Financial Action Task Force’s yearly report, the industry’s lack of infrastructure is limiting compliance and safe storage of assets. As traditional financial markets begin to embrace the space, they must develop robust, tailored technology solutions with the strength of a legacy system.

Banks custodying crypto is a positive step in the maturation of digital assets

When the senior deputy commissioner stated in a letter that banks can hold cryptographic keys, it was clear banks were paying attention. It is a key sign of the industry maturing and that assets are being better understood and utilized. The OCC’s move will accelerate the confidence and development of regulators in the industry.

Banks have a unique opportunity with this move to dramatically increase wealth opportunities for millions of people across the globe through custodying digital assets. They could boost financial inclusion or prevent national economic collapse.

But they must do it correctly; they must understand how to effectively manage risks, how to comply with local and international laws, and how to be responsible for their customers’ assets.

Traditional banks are the pony express — and they must invest in telegraph wires

The story of traditional banks and new fintech digital asset providers can be compared to the old story of the Western Union and the pony express. In the Wild West of the U.S., messages were sent via the pony express, from one horse station to another. Riders carried letters on horseback for thousands of miles, passing messages from coast to coast. When Western Union came along and installed telegraph poles, suddenly, the pony express became obsolete.

The traditional financial system and the new financial system will run in parallel but with two different systems opening at one time. We’ll still call payments payments, and investments will still be investments. But the overarching infrastructure it runs on will be vastly different, like horse carriages and cars.

Technology has the power to be disruptive in a fast and transformative way — and banks need the right wires. This is a critical time for fintech actors to step up and usher banks in the right direction on their digital asset journey.

The future of finance is moving fast, and if banks do not incorporate the correct protective and regulative mechanisms, assets are at great risk.

In a new paradigm of finance, banks must understand new requirements

The first challenge for banks is understanding how the new industry works; they need to understand the implementation of atomic swaps and the development of smart contracts. This technology doesn’t play well with the traditional space.

We foresee a parallel system running in which players will use infrastructure that works significantly differently from traditional payment networks or settlement flows. There are many existing counterparties in the middle of those systems, and this is a status quo that won’t change. So, the only option for banks is to adopt these new technologies.

If banks move too quickly to capitalize on the booming space and do not incorporate the correct protective mechanisms, they may fail. The reputation of digital asset potential will be damaged, and the livelihoods of millions converting fiat may be lost.

The biggest loss to assets in the new world of digital finance is the theft of cryptographic access to keys. Custodians must learn how to better safeguard these from cyberattacks, which have been on the rise — up by 75% during the COVID-19 outbreak.

Many banks have yet to find ways to cost-effectively service and protect themselves from such attacks. They must also understand that digitized securities differ from traditional securities because they are essentially representations of value or contractual rights or real-world assets.

Digital assets are fraught with risks if not settled correctly, and qualified custodians will eliminate the risk of counterparties failing to fulfill a transaction.

To build or to buy? Banks offering custody will need to decide urgently

While the move of the OCC is positive, it’s important to recognize that the majority of banks simply do not possess the correct infrastructure to provide safe and compliant custody solutions.

Banks can facilitate exchange transactions, settlements, trade executions, record keeping, valuation and tax services, but the question lies in how they will be able to deliver these services while managing the risks. You cannot scale crypto asset markets or have traditional institutional adoption without the elimination of trading counterparty and settlement risk.

Banks entering crypto custody will need tried-and-true crypto asset technology developed specifically for the industry and will inevitably face the build-versus-buy decision. So, unless they’re planning to build from scratch, banks will need access to the right technology that can safely secure digital assets.

The implementation process is not easy, nor is it cheap. They cannot cut corners. Banks will need to develop a team to research and make recommendations, seek approvals, build a team, test prototype technology and conduct regular cybersecurity assessments.

This, in and of itself, can take years. Rushing the process will be detrimental to customers’ assets. Banks have an option to integrate with the existing infrastructure that niches specifically in the protection, regulation and security of digital assets with whom digital asset protection is a number one priority, not their second.

The cost to develop crypto-tailored infrastructure is expensive — but the cost to not include it will be worse.

Moving forward without risks for customers

Banks and financial institutions are notoriously slow at innovating, but customers should not have to suffer.

The fintech and crypto space moves at the speed of light, with even the most intelligent and forward-thinking leaders in the space stating they can’t keep up. Banks must find the capacity to consider the development of the necessary secure and compliant infrastructure.

The solutions need to come fast. As global markets begin to recognize that the existing financial infrastructure is on the brink of failure, banks must follow the digital asset industry to protect the future of the financial industry.

New on-boarders embracing the digital asset space must understand how to effectively manage risks, comply with local and international laws, and be responsible for their customers’ assets.

This article was co-authored by Gunnar Jaerv and Glenn Woo.

The views, thoughts and opinions expressed here are the authors’ alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Gunnar Jaerv is the chief operating officer of First Digital Trust — Hong Kong’s technology-driven financial institution powering the digital asset industry and servicing financial technology innovators. Prior to joining First Digital Trust, Gunnar founded several tech startups, including Hong Kong-based Peak Digital and Elements Global Enterprises in Singapore.
Glenn Woo is the managing director of APAC (Asia Pacific) at Ledger — an industry leader in developing security and infrastructure solutions for cryptocurrencies and blockchain applications. He has an extensive career in the financial services and technology industry, working for S&P Global Market Intelligence as the head of Hong Kong, Taiwan and Korea, and Shinhan AITAS as a consultant in financial asset custody.