Few industries exert such influence over the global economy as finance, where the actions of a reckless few can threaten the livelihoods of people all over the world. When the financial industry malfunctions, the economy can nosedive, with devastating consequences.
To mitigate this risk, financial entities are subject to strict regulation, and held accountable to a shared set of rules that force them to adhere to sound systems and controls.
These regulations are designed to protect consumers, promote economic stability and defuse systemic risk. Regulations look to define the operational standards of banking — including due diligence, transaction reporting, the amount of capital that must be held, and how a custodian must act when safeguarding or administering client assets.
The low bar of regulation
Unfortunately, these regulations are often seen by those financial entities as a burden—a minimum standard that must be maintained to be able to function. Meeting this standard is often considered an operational cost, with banks choosing to 'limp across the line' to avoid unnecessarily expending resources.
Once regulations are in place, and all banks are governed by the same rules, they are all theoretically equal, and so have little incentive to prove themselves beyond meeting these minimum requirements.
Indeed, the regulations for custodians have evolved over time — from the harmonisation and documentation of old institutions that relied on their reputations for business, and adjusting over time as operational failures exposed weaknesses and new technologies became available.
Today, reputations count much less, new custodians with no reputation can compete simply by gaining the stamp of regulatory approval, achieved by implementing standardised protocols and procedures, and then competing on fees.
Find out how cryptoassets will revolutionize custodial operations in our ebook, From Lock and Key to Cryptographic Code: Solving the Security and Compliance Challenges of Crypto Asset Custody.
These protocols and procedures are often carried out by staff without loyalty to the institution, and little personal liability for losses in the event of failure — or as Nassim Nicholas Taleb puts it — very little "skin in the game." This was evidenced in the financial crisis of 2008, which highlighted how few people could be held accountable for the actions of their firms within the system.
While regulations can test these operational processes by evidencing reporting procedures and verifying these reports through audits and data samples, this can only partially prove transparency, and cannot guard against corruption or the intent to deceive. Indeed, auditors are fallible, and in Enron's case possibly even complicit.
Cryptoassets: Don't trust, verify
With cryptographic assets, verification is simple — anyone can examine the blockchain to verify the presence of assets instantaneously, and review a breadcrumb trail of transactions.
Today's regulations are simply not designed for this class of assets. What is needed is a new framework to hold custodians accountable for holding cryptoassets.
Now that assets are digital and the full power of cryptography can be applied to custody, custodians need not hold the assets at all, but merely play a part in the release process.
This is exactly the way that some safe deposit boxes are used today—the bank holds the assets within their vault, the banker plays their part and has an initial key to start the process, and the holder has the key or code that allows the process to be completed granting access to the box. This can be replicated digitally and the process can be enhanced even further.
To move away from the 'limp over the line' mindset, regulators are now looking to draft rules that recognise the limitations of rule-based regulation, focusing on ensuring positive outcomes in a way that is neutral to the rapidly evolving technology. This should make it worthwhile for regulated entities to push for the best approaches and technologies to deliver their services.
Read more about Qredo's approach to digital asset custody in our eBook: From Lock and Key to Cryptographic Code: Solving the Security and Compliance Challenges of Crypto Asset Custody.