Northern Trust, Fidelity join small club managing crypto assets

A handful of big financial firms are plunging into the world of cryptocurrency custody services.

Though some government officials had given the OK, many companies have had concerns about regulatory scrutiny and legal liability. They also lacked the technology and expertise that are necessary to do the job and feared the financial or reputational risks associated with such an unproven field.

Still, a few companies said this month they're entering or diving deeper into the business — including Northern Trust and Standard Chartered Bank, which announced a partnership, and Fidelity Digital Assets, which began providing crypto custody to clients who borrow from BlockFi against the bitcoin they hold.

The $151.6 billion-asset Northern Trust says it has been getting inquiries about crypto custody from wealth management and institutional clients, and executives expect that to continue.

Hedge funds, traditional asset managers, retail organizations and family organizations are all looking to either invest in cryptocurrency or create crypto products for their clients, according to Pete Cherecwich, president of asset servicing at Northern Trust, which is based in Chicago.

But these investors have concerns about the safety of the assets and the reliability of cryptocurrency service providers, Cherecwich said.

Northern Trust partnered with London-based Standard Chartered Bank to form Zodia, a stand-alone fintech that will be based in the U.K. and regulated by the Financial Conduct Authority. Both banks are investing an undisclosed amount in the venture and will advise and oversee it.

“We want to make sure we bring guidance to this entity, basically to up the game in terms of what it means to be a cryptocurrency custodian,” Cherecwich said. “We believe that cryptocurrencies with the appropriate regulatory oversight are going to play a role in the future in our industry,” he said.

To start, Zodia will have 25 employees with experience at banks and fintechs. They will adhere to know-your-customer standards and company policies set by the two banks.

The team has built a platform that will connect to multiple exchanges and blockchains, as well as bitcoin wallets.

Zodia should go live in early 2021. At launch, pending regulatory approval, Zodia will provide custody services for bitcoin and Ether. Those digital currencies will be followed by XRP, Litecoin and Bitcoin Cash.

Meanwhile, Fidelity Investments in Boston, which has $8.7 trillion in assets under management, formed a crypto-services subsidiary, Fidelity Digital Assets, in October 2018 and went live in the first quarter of 2019. It has hundreds of customers for its bitcoin custody and execution services, letting bitcoin holders buy and sell the cryptocurrency.

Through the unit’s new partnership with BlockFi, a company based in Jersey City, N.J., that makes U.S. dollar loans to borrowers based on their blockchain assets, Fidelity will hold bitcoin that BlockFi customers pledge against loans.

“This provides the borrower with a more traditional structure that they may be used to in other asset classes,” said Terrence Dempsey, vice president of product for Fidelity Digital Assets. “And it also provides independence for who is holding the collateral, so neither borrower nor lender is holding the collateral.”

Fidelity Digital Assets is also in discussions with other lenders about serving as their collateral agents, Dempsey said.

Fidelity gets an assets under custody fee, which in this case the borrower pays.

The unit’s first custody customers were digital asset firms. Today, more traditional firms are becoming clients, like hedge funds, equity funds, and pensions and endowments, Dempsey said. And more public companies have an interest in holding bitcoin on their balance sheets, he said.

Building the technology platform was difficult because the asset classes are so new, Dempsey said.

“The hardest part was the customer experience," he said. "It's marrying a lot of that brand new technology that you get from blockchains to providing a known and familiar experience that they may be used to in the equity or fixed income or foreign exchange world.”

For instance, bitcoin goes out to eight decimal places. Many traditional customers’ books and records do not.

“You immediately have reconciliation issues or accounting issues,” Dempsey said. “It's small details like that, that you really need to keep an eye out for.”

Crypto custody comes with a host of challenges.

There are risk questions. “There is an issue that they don't want to put their assets and balance sheets at risk or they have an issue about reputational risk, so they keep things at arm’s length,” said Monica Summerville, head of capital markets at Celent. “So you see things like Fidelity starting a different company and even JPMorgan has separated out some of its blockchain activities now.”

Crypto custody also brings technology challenges, Summerville said.

Storing the private keys to digital assets safely is one technology issue. Another is integrating digital wallets with banks’ systems. And there are logistical difficulties around delivery versus payment, because there is counterparty and credit risk.

“Big institutions are not going to be happy with the concept of, I'll send you the money and you'll send me the crypto,” Summerville said. “It's this issue of, how do you construct a system that can interface with the payment rails in a way that doesn't leave you holding the bag if the trade goes wrong or if the person disappears, and that has happened in the crypto world. There isn't a clearing network right now.”

A host of vendors have recently come out with various forms of help. On Wednesday, FICO announced a partnership with Crystal Blockchain of Bitfury Group, a digital currency analytics company, to provide cryptocurrency risk management and monitoring services. Chainalysis and CipherTrace provide similar technology. NYDIG, Kraken, Avanti, Coinbase, BlockFi and Curv are among the companies that help banks create and offer bitcoin-related products. BNP Paribas is working with Curv.

Another issue is that the bitcoin blockchain is a public ledger, where banks like the large transactions they place on behalf of clients to be confidential.

“You don't want the whole world knowing about a trade happening until it's completely settled because you don't want it to impact the price,” Summerville said.

Some banks have been exploring the use of currency-backed tokens that could be used in clearing.

Custodians also have to prepare to operate globally, Summerville pointed out.

“As an institutional custodian, you are more than likely going to be dealing with customers who have global interests,” she said. “You have to be very clear on which jurisdictions you can support and how you can comply with local regulations.” Countries have different licensing, anti-money-laundering requirements, for instance.

Northern Trust, State Street and Fidelity are all showing leadership in this space, Summerville said.

“They're visionary,” Summerville said. “It's companies like theirs that are going to signal to the rest of the institutional community that this is a safe asset to engage with. And interest is growing.”

The effort is imperative for custody banks, she said, "because core custody services are a commodity and revenues aren't increasing. They have to find some way to offer new services to clients, and this idea that they can actually attract new assets to custody is very exciting for them.”