Custodians, Data, and Digital Assets
The modern custodian's data aggregation processes and the greenfield opportunity of digital assets
Banks have been in the news a lot lately as people have been wondering if their assets are safe. Let’s zoom in on the custodial segment of the broader banking industry and examine the available services, data configurations, and the adoption of digital assets.
Let’s start with an example. Say that you own some stocks in a brokerage account at a large custodial bank. You’ve ceded control of those assets to a bank, and while you have a claim on those assets, you can’t hold those assets in your hands or stuff them under your mattress. The structure of this relationship works well for most people. Who wants to hold on to that paper anyways? What if my house gets broken into and my assets are stolen? Or, what if I misplace the paper?
Once upon a time, stock buyers used to hold the physical stock certificates, pieces of fancy paper, that had some details about the shares, the company, etc. They looked like this:
Custodial banks, a.k.a Custodians, charge fees to hold your assets and ensure they are kept safe. But that over-simplifies the services offered by modern custodians. Technically advanced custodians like Charles Schwab have built a platform of applications and products on top of their custodied assets and data.
Notably, custodians offer brokerage services where asset holders and investors can find willing buyers and sellers of all types of securities. The brokerage will charge a small fee to transact on their platform. Brokerage fees have plummeted to near zero so this cost is relatively insignificant for the consumer and this line of business is much less lucrative then it once was for custodians.
Custodians will charge other fees for maintaining accounts and asset security. Custodians have massive expenditures devoted to organizing assets, ensuring the latest security measures are implemented, and keeping their websites and mobile apps up-to-date. Custodians are also making an effort to transition from the back-office to the front-office by adding more services like investment advice and reporting features.
The pure custodial banking business model is different from the traditional banking model employed by most commercial banks. Traditional banking deals mostly in using customer deposits to generate returns for the bank by issuing new loans or investing in securities to generate yield. One similarity between the two models is both retain significant amounts of cash to meet redemption requests as required by law.
Custodians do not typically rehypothecate, or repackage, your assets to ultimately create more wealth for the bank. Think of a custodian as a company that is selling lockboxes for your assets. You park your assets with them, and they ensure that they will remain in the lockbox for as long as you’d like.
Custodial data
Technology has redefined the requirements for modern custodians. Access to a marketplace with fair prices and low information latency has driven the cost to transact down. Data is at the center of the custodial business model, and savvy custodians can use the data on their platforms to understand user behaviors and build new product lines.
When clients log in to their custodial accounts, they expect their assets to be reflected correctly. If they trade those assets with a counterparty, they expect the assets to settle in the intended account on schedule. The process of ensuring that the assets details are correct is labor intensive and requires a lot of data analysis and processing.
In the wealth tech world, we build applications on top of this custodial data by transforming the raw information to feed into applications that complete additional data transformation. The challenge in this work is that each custodian has a different way of organizing and remitting its data. Algorithms that clean, sort, and transform the custodial data must be built and maintained in order to achieve seamless dataflow into applications.
Digital asset custodians
Difficulties in custodying digital assets represent a major reason why investment managers are not deploying capital in this new industry. Crypto custodians of large size and solid reputation do not yet exist, and high-profile blowups in the crypto industry have shaken the public’s faith.
Some exchanges like Coinbase will custody digital assets for you, but many investment professionals are hesitant to trust crypto organizations after the FTX debacle. If you decide to custody digital assets yourself, you are responsible for the safekeeping of the device where the assets are stored and the keys to access those assets. This presents the risks of loss or theft, and most investment managers simply cannot accept those risks.
In addition to the operational security risks of holding digital tokens, the reporting and compliance features offered by crypto companies are not yet competitive. There are thousands of financial reporting and accounting applications that produce reliable outputs that outperform current crypto offerings.
Zooming out, investment advisors are feeling strained as the fees they charge for their services continue to be impacted by robo-advisors and low-cost investment products like ETFs. The preservation of capital is essential to advisors that want to maintain and grow their business. It’s no wonder that advisors are unwilling to take on additional operational risk through the process of storing crypto assets.
Despite all of the negative headlines in the past year, there is still a lot of demand for digital assets. Custodians who are interested in winning crypto business will need to provide both safe methods for storing digital assets and enhanced services that meet industry standards. It’s a difficult task, but the opportunity for digital asset custodians is large.