DZ Bank, Germany’s second largest by assets, is working on a digital asset custody solution. The move is driven by customer demand, less by cryptocurrencies and more by digital financial instruments, although the solution will handle both. On the securities settlement side, the bank wants to see the European Central Bank progress towards a wholesale central bank digital currency (CBDC) to enable distributed ledger transaction (DLT) settlement.

The bank has been working on the strategy and design of the custody solution for some time and is in the process of appointing a consultant to help implement the solution and assist with BaFin’s regulatory approval. At this stage, he does not plan to partner with one of the crypto-custody technology companies, but intends to develop his own offering.

Speaking to Holger Meffert, who heads the bank’s securities management division, he made it clear that a key factor is customer demand. One of the bank’s main clients is Union Investment. Although perhaps less well known internationally, Union has assets under management of €427 billion ($427 billion), which is only 7% less than the famous US KKR. “For most of the funds that Union Investment has, we are their custodian bank, so we should be able to cover their needs,” Meffert said.

Compared to other asset managers, Union Investment considers innovation to be a high priority. For example, last year, it made a significant investment in the European Investment Bank (EIB) €100 million Ethereum tokenized bond issue, with DZ Bank involved as well. At the time, Union’s Christoph Hock said, “We expect the use of blockchain in combination with tokenization to become a game changer for the industry.”

While DZ Bank focuses on its German clients, asset managers tend to invest internationally and DZ has to be able to support that.

Digital currency for securities settlement

Together with Union Investment, DZ Bank participated in the EIB bond transaction, which was settled in a CBDC wholesale pilot transaction provided by the Banque de France.

When Meffert was asked about plans to tokenize money for securities settlement, he was emphatic about the need to settle central bank money on the ledger.

Early last year, DZ Bank participated in the Bundesbank’s experiments to test settlement of DLT transactions using conventional central bank money. It involved a trigger mechanism that was integrated with TARGET2’s real-time gross settlement (RTGS) system, which enables delivery versus payment (DvP) transactions.

While the ECB has been working on a digital retail euro, it said for the past three months, it has quietly started canvassing banks about a digital wholesale euro. Over the past week, the ECB has confirmed this.

When asked about the Bundesbank’s activation approach, Meffert said: “This would be a temporary solution. Because really doing it the right way would need to have a ledger currency that can settle on the ledger.” Meffert clarified that it is the only way to take advantage of the efficiencies of DLT and all the large organizations he has spoken with consider a wholesale CBDC a “must do”.

Fnality, a consortium of 16 major institutions, has plans for a tokenized digital euro backed by central bank deposits, the so-called synthetic CBDC. Are you sure it’s a good solution? “This would help get closer to the goal, but it wouldn’t be the goal,” Meffert said. “Because any type of institution that supports these things is counterparty risk.”

Meffert noted that atomic or DvP settlement can be expensive but has clear advantages.

“It’s completely different if you have to settle a €1,000 retail trade versus if you have to settle a €10 billion issuance process. So the thinking around counterparty risk is completely different,” Meffert said.

While that may sound dismissive, on the contrary, Meffert was not. He emphasized that he would not exclude anything. The objective is to get more partners in the networks, accumulate experience and find efficiencies.

“Fnality would obviously be a great starting point for some of the protocols to start the settlement processes and the trigger solution could be one,” he added.

The road to institutional adoption of DLT

The custody solution is not DZ Bank’s first blockchain initiative. In 2019 it launched the finledger platform for promissory notes with DekaBank, dwpbank and Helaba. It was not a proof of concept. It’s in production but only has about two or three releases a year. Meffert believes it was an important first step and if it were to launch today it would gain more share simply because more banks are developing DLT infrastructures.

“DLT has the problem that any market participant you want to deal with has to be on the same ledger. To be on the same ledger, you have to integrate the ledger into your legacy,” Meffert said.

He pointed to a chicken-and-egg situation where legacy integration comes at a cost, which is only justifiable if there are sufficient volumes. But without integration, there is no incentive to generate volumes because these are manual steps.

To date, few companies have done legacy integration. He mentioned SocGen FORGE, which provided the platform for the EIB bond issue, and a few others. However, things are changing rapidly as all the big banks, both in Germany and internationally, are now building DLT teams. This is a game changer.

Because once there is a core DLT infrastructure integrated with the legacy system, there is much less effort to integrate with new DLT networks, lowering the barriers to entry.

“It is the right decision to increase our own custody solution to be able to participate in building networks,” said Meffert.