The Law and Macroeconomics of Custody and Asset Segregation Rules: Defining the Perimeters of Crypto-banking
Despite the original vision of ‘self-custody’ advocated by the creator(s) of the first cryptocurrency, custody rules have become a recurring theme in the cryptoasset markets due to practical needs for safeguarding cryptoassets. One of the most important issues related to the custody of cryptoassets is whether to consider the cryptoassets that are left with an intermediary as being lent or granted custody of to the intermediary. It seems that in the industry there is no clear distinction between the two, and evidence suggests that certain cryptoasset exchanges may have treated clients’ assets as if the funds are lent to the intermediary similar to the conventional banking practices in accepting customer deposit. Not only can this practice raise certain investor protection issues as the client of the cryptoasset firm may lose his assets if the intermediary becomes subject to insolvency proceedings, but it may also have profound macroeconomic impact which is rather under-investigated.
My recent paper highlights the macroeconomic impact and importance of defining custody rules for the cryptoasset industry. It argues that the debate on the custody rules has more profound and broader macroeconomic implications than the much-discussed impact on the protection of investors. By exploring the roots of the difference between banks and non-bank financial institutions and highlighting the role of deposit taking activity in the banking business, the paper argues that one of the main factors that differentiates banks from non-bank financial institutions is the custody (and asset segregation) rules applied to non-bank financial institutions from which the core banking business, ie, deposit taking, is exempt. In this perspective, a deposit contract could be viewed as the disapplication of custody rules, where the depositor’s funds are comingled with those of the bank. By comingling the customer deposits and using them for their own account, banks have been able to create money (credit) and play an idiosyncratic role in the economy by providing backup liquidity to all other financial and non-financial institutions and a transmission belt for monetary policy. In other words, defining custody rules can be viewed as an architectural tool to design financial markets and institutions.
In addition, the paper highlights one of the main methods used by financial institutions other than banks to step into the banking business by issuing deposit-like liabilities while avoiding the risk of being treated as banks and studies the potential development of such practices in the cryptoasset industry. The main contracts entered into between counterparties to obtain leverage and liquidity are repurchase agreements (repo), securities lending, and certain derivatives transactions. In such transactions, the legal treatment of collateral posted to secure the transaction could be similar in substance to the bank deposits as the collateral taker does not segregate the collateral and reuses it on its own account just as banks do not segregate clients’ money (funds) and reuse it (in lending) for their own account. Seen through this lens, it appears that the reuse or rehypothecation of collateral is very similar to the process of money creation in commercial banking through deposit taking and lending.
The insights derived from studying the impact of the custody rule on the design of the financial markets could equally be transposed to the cryptoasset industry. Given the lessons from the custody and asset segregation rules in traditional finance, the paper suggests defining clear rules for custody and asset segregation for centralized cryptoasset intermediaries such as exchanges and custodians and clearly delineating the scope of the activities that are similar to deposit taking. Creating a presumption of custody is a first and critical step because presently there is significant uncertainty as to the current practices in the cryptoasset industry about whether a client’s assets are treated as belonging to the client or are being comingled and lent out (forming part of the balance sheet of the firm holding such assets).
I argue that, in the absence of such clear custody rules, not only investors could be left inadequately protected, but also potential creation, expansion, and contraction of crypto credit could happen in a way that would cause systemic problems as the cryptoasset industry is adopting the same practices long adopted by banks and the participants in shadow banking system in conventional finance. If the industry were to become large and interconnected to the traditional financial system, the absence of clear custody rules providing at least for a presumption of custody may prove detrimental to financial stability through potential contagion channels from the cryptoasset industry to the conventional finance and the real economy. Therefore, rather than focusing on the immediate impact of custody and asset segregation rules on the protection of investors, lawmakers should consider the broader macroeconomic implications of imposing custody rules on cryptoasset service providers.
Hossein Nabilou is an Assistant Professor of Law & Finance at the University of Amsterdam, Amsterdam Law School, and UNIDROIT - Bank of Italy Chair at the International Institute for the Unification of Private Law (UNIDROIT).
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