Inside State Street’s new digital asset unit

State Street in Boston has taken a big step to meet rising client interest in digital assets.

It opened a new division, State Street Digital, on Thursday that will do three primary things: create technology and policies to help customers invest in cryptocurrencies; modify existing platforms or devise new ones to support central bank digital currencies; and develop blockchains, smart contracts and the ability to tokenize assets.

The reason is simple: Even amid the high-profile volatility in bitcoin, cryptocurrency investments rose 300% from February to April at the trust bank. It declined to give dollar figures.

“This space is moving very, very quickly and we've also seen an increase in client assets and interest just skyrocketing as well,” Nadine Chakar, the head of the division, said in an interview during her first few hours in the job. “We needed to pull together all of our resources and dedicate them in a way where we can make a bigger impact. At the end of the day, this division was a conscious decision by our CEO to make sure that we can pull all the talent we have and all these products and services in one division.”

Chakar, formerly head of global markets, will continue to report to Chief Operating Officer Lou Maiuri. She will oversee 425 employees, a mix of company veterans and new hires.

State Street is not the only bank dedicating resources to cryptocurrency efforts. Bank of New York Mellon announced in February it’s building its own crypto-custody system with the help of a technology partner. Goldman Sachs has reportedly formed a cryptocurrency trading team.

But for most banks, offering cryptocurrency services is a matter of outsourcing. JPMorgan Chase has turned much of its cryptocurrency work over to Consensys, though it continues to run distributed-ledger projects. Several small banks are working with the New York crypto-services company NYDIG to let their customers invest in digital currencies from their bank accounts through NYDIG.

The most radical aspect of State Street’s digital currency strategy is its belief that decentralized financial markets are coming. Decentralized finance is a concept in which people and companies trade and do business with one another directly, without financial intermediaries such as banks, brokerages or exchanges. Instead they rely on smart contracts — legal contracts written in and enforced by software — that are executed automatically on distributed ledgers.

“We don't believe they'll be totally decentralized,” Chakar said. “If you look at a Venn diagram, you have decentralized and centralized, and I think our sweet spot is going to be that overlap between them.”

In the bigger picture, State Street would like to transition from being operations-driven to being technology and data driven.

“We need a different workforce, a different type of culture,” Chakar said. “We need traders that can code and coders that can trade, because that's where the industry is heading.”

The unit might also acquire and make investments in fintech companies.

“In the brave world of digital, it will be more of an ecosystem that will emerge,” Chakar said. “It will be more platform driven than it is today.”

At this point, State Street is not investing in or holding cryptocurrency itself. The Basel Committee on Banking Supervision came out with rules Thursday that said that for every dollar of bitcoin, a bank has to hold a dollar of capital.

“It's not appealing,” Chakar said. “So today we just can't. In the future, we may facilitate trading as an agent, but right now, for us to make markets and liquidity, it's prohibitive.”

State Street wants to support foreign exchange clients with electronic trading platforms enhanced to support crypto trading. Chakar’s group is also looking at ways to use blockchain technology effectively.

“The objective here is to be able to operate and thrive in this new digital economy, and to help clients bridge that digital divide,” she said. “Our main purpose here is to create a digital stack that will enable our clients to thrive in this new digital economy we have today.”

Her group is also going to work on tokenization and smart contracts.

“If you think of our environment today, being a custodian is messy,” Chakar said. “We still deal after all these years with loads of paper, we have an army of people that reconcile accounts, we still manage corporate actions in a way where all you need is one person to misinterpret a comma or a period in a sentence and you incur a loss. We are striving to totally reimagine and reinvent the way we do things. And if clients want to trade crypto, we'll be able to support that. And if the central banks decide to launch digital currencies, we’ll support that.”

Chakar’s team will manage the tech stack for digital assets across the company. It will continue to manage the GlobalLink electronic trading platforms. And it will work with fintechs and regulators.

“If somebody in our asset management team wants to explore tokenizing our [exchange-traded funds] or tokenizing our mutual funds, we'll be here to support them and provide the operational support that goes with it. If somebody in our alternative investment group says, hey, we want to start tokenizing real estate and trading those, we'll be able to do that as well.”

Where the demand came from

State Street has been heavily focused on digital assets for about 18 months, Chakar said.

In April, the bank was appointed the administrator of a bitcoin-backed exchange-traded note initiated by Iconic Funds. ETNs are unsecured debt securities that track an underlying index of securities and trade on a major exchange like a stock. The Ionic Funds ETN will be listed on the Frankfurt Stock Exchange if German securities regulators approve it.

In March, State Street was selected to be the fund administrator and transfer agent for a bitcoin exchange-traded fund for which the investment manager VanEck is seeking approval from the Securities and Exchange Commission.

In late 2019, the bank began working with the cryptocurrency exchange Gemini to let its institutional investor clients buy and sell bitcoin through Gemini. State Street provides statements that report on those crypto investments alongside the clients' traditional investments.

State Street worked with Pure Digital in London to enhance one of its GlobalLink electronic trading platforms last year to enable it to trade crypto-to-crypto and crypto-to-fiat currencies.

“But since as a bank, we cannot trade and hold crypto right now, we couldn't use it,” Chakar said. “So we started white-labeling that technology to other digital exchanges.”

Building a risk framework

Chakar and State Street Digital are working with IBM’s Promontory Financial Group to create a risk and compliance framework for digital assets.

This isn’t as simple as it sounds. Most of the regulatory guidance around what banks can do with cryptocurrency has yet to be written. Last July, Brian Brooks, then acting comptroller of the currency, wrote a letter giving national banks permission to issue and custody cryptocurrency. Since he left the agency, his interim successor, Michael Hsu, has indicated he’s rethinking this.

“This is still very nascent,” Chakar said. “I think we all have more questions than we have answers right now. We’re trying to reconcile between a risk framework that we have, that has served us well for decades, and trying to understand how to shift it now into something that's only been around for one decade. It's a huge amount of work.”

“Operational risk, compliance risk, liquidity, all of these categories have to now be assessed and addressed for digital,” said Bridget Karlin, global managing director in IBM's financial services business. “And one of the things that makes this additionally challenging is the fact that there isn't a lot of specific guidance from the regulators yet. These risk assessments need to be performed on an ongoing basis as regulations get defined and changed.”

Banks have to try to apply existing rules to these new instruments, she said.

“You have to put the procedures in place to continue to hold the institution against those traditional standards for safety and soundness and compliance,” Karlin said. “You've got to be prepared to define and mitigate a whole new slate of risks as more gets revealed.” One recommendation her team makes is banks use the highest levels of software and hardware security for digital assets.

First steps

Chakar said that during her first day running State Street Digital, she was already receiving streams of emails from colleagues with digital asset ideas for her to implement.

One definite item on her to-do list for State Street Digital is to introduce a digital wallet.

“I'm pretty sure that will happen before the end of the year,” Chakar said. “At least that's the ambition we're going for.”

The group will also “support whatever our clients want to do in that space,” she said.

The digital wallet would be somewhat akin to the kinds of crypto digital wallets some companies, like Coinbase, offer consumers.

"Institutional investors also need a wallet to hold their digital keys," Chakar said. "But this is a bit more complex than retail as it requires shifting between cold and hot storage."

So far, customers are asking most for education, she said.

“This is confusing because there are so many flavors of it,” Chakar said. “There are 6,000 coins, 300 exchanges and more fintech companies popping up every day that are looking at a very small component of a process that is long. They're looking to us to help them understand it, to help simplify and help make sense of all of that.”

The other thing customers are asking about is how to buy crypto and how to set up a crypto fund.

“There's plenty to do,” Chakar said. “And it’s going to be really important not to get overwhelmed, but to structure it in a way that makes sense and adds value to our clients.”