Depositary in the age of digital assets – moving with the times

As investors turn to digital assets in the search for alpha and portfolio diversification, depositaries are adapting to support clients in this new asset class. In this article, we examine the challenges for institutional investors and their depositaries, and how BNP Paribas is evolving to support clients.

Digital assets are the big investment story of the moment. Cryptocurrencies have seen significant investor interest, with price spikes in bitcoin and ether helping propel the overall cryptocurrency market’s capitalisation above $2 trillion for the first time in April, although this was followed by a significant dip in May. The investment opportunities afforded by security and derivative tokens, as well as non-fungible tokens (NFTs), are further accelerating digital asset adoption, with the potential of outsized returns and diversification.

However, the regulatory environment is not yet standardised – requiring depositaries to adapt quickly in an uncertain landscape. Depositaries must develop appropriate safekeeping and oversight capabilities to support fund manager and investors’ interest in digital assets, while continuing to abide by regulatory responsibilities that were formulated for an analogue age. So what are the challenges institutional investors should be aware of?

Challenge one: Maintaining investor protection

In the traditional asset world, robust investor protections are founded on centralised asset safekeeping models, processes designed and proven over the last decades. How can asset managers maintain investor protection in a digital asset ecosystem run on decentralised blockchains?

The move to this new environment can open up additional security risks, including:

• Potential code errors and bugs in smart contracts.
• Loss or theft of the private keys that prove asset ownership.
• Difficulty identifying participants on a public blockchain.
• Reliance on smaller fintechs that are potentially more prone to bankruptcy.

Fostering trust will depend on investors understanding these risks from the outset. Ensuring investors are educated about a manager’s investment proposition and the attendant investment risks is a further priority.

Challenge two: Platform fragmentation

A plethora of platforms now offer investor access to digital assets, and their numbers continue to grow. Most are start-ups, often with no SWIFT connectivity in place to support automated reporting. The resulting infrastructure fragmentation and lack of common information formatting can make it complex and costly for depositaries to connect to every platform, and obtain the data needed to support their reporting and safekeeping obligations.

Challenge three: Lack of regulatory harmonisation

There is currently no consistent regulatory framework for digital assets. Many jurisdictions around the world have yet to issue any form of regulatory guidance. A number have, but in many cases the guidance differs.

One area of divergence concerns the classification of digital assets. In France and Luxembourg, for instance, tokenised securities can be considered “other assets” under AIFMD and UCITS V, whereas the German regulator BaFin views digitised bonds as financial instruments. Each designation brings a different level of safekeeping, oversight and liability responsibilities.

The European Union’s proposed Markets in Crypto Assets (MiCA) regulation, alongside amendments to the MIFID II regulation and a pilot regime for DLT market infrastructures, aims to establish a common regulatory regime across the Single Market, bringing all crypto assets under the purview of EU financial services regulation. The hope is for a more consistent set of rules across Europe. To help shape a coherent, efficient framework, depositaries will need to engage with regulators around the world to share our views and expertise.

BNP Paribas Securities Services’ approach is to examine each client’s portfolio on a case-by-case basis, to understand the asset’s characteristics and counterparties involved. Once we determine whether to consider it a financial instrument or other asset, we can provide appropriate support in line with the jurisdiction’s rules. Ensuring all depositaries take a consistent view of asset classification will be vital for the growth of the digital asset market.

Finding solutions: the role of the depositary

In the face of these challenges, depositaries are adapting their operating models in order to maintain the same service and safekeeping standards for digital assets as for traditional assets, and adapt to the changing regulatory landscape.

Safekeeping is a key area. Recognising this, and building on our experience as a global depositary and custodian, BNP Paribas Securities Services is working with a number of fintechs to develop a digital asset security infrastructure. Through a recent proof of concept, we showed tokens can be transferred quickly, safely and transparently on the blockchain, as we continue to develop an integrated custody solution that will cater for both traditional and regulated digital assets.

Oversight is another crucial task. With such fragmentation and proliferation of market participants, depositaries have an enhanced role in conducting ongoing due diligence on other service providers to ensure they are quality providers. At BNP Paribas, we are updating our due diligence processes to safeguard investors’ interests – for example, by ensuring fund managers’ risk control and monitoring policies are robust, and that the blockchain and crypto custodian they want to use are appropriate.

Differing approaches to digital asset classification makes it more important than ever for the depositary to maintain secure and independent records on a fund’s assets, to give reassurance to investors. We are also developing a consolidated reporting capability for our clients that encompasses digital and non-digital assets, to provide ongoing visibility of all traditional and digital investments.