With the rise of blockchain technology over the past few years, many people have predicted the end of the need for custodian banks.
This is understandable.
Among other things, blockchain allows individuals and companies to make financial transactions directly between each other. There is no need for settlement, reconciliation, securing assets or providing proof of ownership, all key aspects of the custodial function.
Newer smart contract technology, which allows complex business logic to be programmed in to blockchains, makes it possible to automate many asset servicing functions traditionally performed by custodians, such as reporting, registering transfer of ownership, or communicating corporate actions.
In the face of these advances, why wouldn’t custodians be made obsolete?
There are several reasons.
Still work to do
When people think of blockchain today, they generally think of large, open platforms like Bitcoin or Ethereum. Public and free to use, these platforms do allow individuals to exchange and secure financial assets in a relatively safe and private way without the need for any intermediary banks.
But this technology is still new, and not without its problems.
While it remains difficult if impossible to hack the blockchain itself, other parts of public blockchain ecosystems, like exchanges, have been hacked. These platforms cannot guarantee security.
They are also difficult to use: a lost private key (analogous to a password) means the loss of funds in the same way as the loss of a key for a physical safe.
Public platforms are also unregulated and self-governed. While this has worked relatively well so far, there is no guarantee that these platforms will be properly maintained and upgraded over the long term.
And because smart contracts are only as good as their code, they cannot guarantee that they will perform as intended. In the recent case of the Ethereum DAO, a bug in a smart contract led to the loss of tens of millions of dollars.
Because of these and other issues, many in financial services have been focusing on “permissioned” blockchains – private networks that use blockchains and smart contract technology to automate payments and other transactions.
This requires expertise in asset custody, so custodians have a role to play in developing this kind of architecture. Since most of these permissioned platforms are or will be run by banks, it could be argued that on these platforms the role of custodian banks has been preserved – just in another form.
Eventually, however, blockchain technology will mature and public platforms without intermediary banks will become viable. This however need not mean the end of the role of the banking custodian either.
All platforms, public or private, must evolve. There will always be need for custodial expertise to help design new approaches and architectures.
Similarly, custodians will have a role as advisors to clients in the best – and safest – ways to make use of the new platforms and capabilities.
And while blockchains provide an excellent means for transacting with digital assets, they are only as good as the data that is put on to them. Custodians can help “onboard” assets onto chains, for example by verifying their provenance.
Finally, no matter how mature the technology becomes, there can always be surprises. What happens when things go wrong? Or if you make a mistake?
I can imagine that even in a fully decentralized world, people might find they prefer the added security of a trusted institution like a bank.
That means a role for custodian banks as safekeepers of vital data and services related to digital assets, for example the passwords that control them, or in providing other kinds of assurance such as the proper constitution of a smart asset.
While the blockchain is indeed disrupting the world of asset custody, as it is so much else, I do believe it is a bit too early to count us custodians out.