Crypto Custody: Everything to Know

By  Beluga Research September 9, 2023

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Summary

  • Cryptocurrency custody is the secure storage and management of digital assets, which provides protection against theft and loss
  • Since users are responsible for securing and managing digital assets, they turn to crypto custody solutions to ensure tokens, NFTs and other assets will not be stolen or misused
  • There are two primary types of crypto custody solutions: Self-custody, in which the user controls their assets, typically in a device like a digital wallet
  • Then there is third-party custody, in which a management company takes on the job of guarding the assets

Overview

Cryptocurrency custody is the secure storage and management of digital assets, which provides protection against theft and loss. Digital assets exist on the blockchain, not as physical items.

This means that a user or a third-party crypto custodian secures the information that a user needs to access the assets. The information is typically a private key, a password to a user's digital wallet. A third-party crypto custodian usually must have a state or national license. The three types of third-party custodians are exchanges, digital asset managers and custodial banks.

A Brief History

In the early days of the crypto ecosystem, users stored digital assets in personal wallets on digital devices. The self-custody approach offered control but exposed users to risks like loss or theft. Some users lost assets due to hardware failures, accidental deletions and cyberattacks. The first custody solutions addressed the challenges of novice users who had relied on self-custody.

Xapo, now a Bitcoin-enabled bank headquartered in Gibraltar, offered one of the earliest third-party custody services: Storage of private keys offline in secure facilities. Other companies followed Xapo's lead to provide a varied set of third-party custody solutions for individuals and institutions.

Crypto Custody: Everything to Know

  • Types of Crypto Custody. The two primary types of custody are self-custody and third-party custody. Self-custody involves individuals storing private keys using personal wallets or hardware devices. This method offers total control but places the burden of keeping the private keys secure on the user. Third-party custody outsources storage and management to specialized custodians. This method uses robust security measures and often features insurance, multi-signature authentication and regulatory compliance. Institutional investors and large holders prefer third-party custody for security and risk mitigation.
  • Security Measures . Custodians use various security measures to protect assets from theft, loss and unauthorized access. These measures include:
  • Offline Storage. Custodians store private keys offline, or in cold storage, to reduce hacking risk. The keys are not connected to the internet.
  • Multi-Signature Authentication. Custodians use multi-signature authentication, which requires multiple keys to authorize transactions. This method enhances security by preventing a single point of failure.
  • Physical Security. Custodians use secure facilities, surveillance systems and access controls to protect private keys from physical threats.
  • Insurance. Custodians offer coverage against theft or unforeseen events. This increases users' confidence and willingness to increase risk.
  • Regulatory Compliance. As cryptocurrencies gain mainstream acceptance, governments are developing regulations to reduce users' risk. Governments also want to limit scams and curtail the use of cryptocurrencies for activities of concern, like money laundering and the sale of illegal drugs. Today's third-party crypto custodians implement Know Your Customer (KYC) procedures to verify client identities. They want to adhere to Anti-Money Laundering (AML) and Counter Financing of Terrorism (CFT) regulations. Compliance ensures integrity and fosters trust.
  • Institutional Adoption. Institutional investors like hedge funds and asset managers require secure and compliant storage solutions before acquiring cryptocurrencies. Reliable third-party custody services offer institutions more security and insurance than self-custody solutions. Third-party crypto custodians thereby drive institutional interest in digital assets.

Getting Started

  • Set up a Secure Storage Solution for Digital Assets. Personal wallets are an option, but dedicated third-party crypto custody services offer enhanced security and peace of mind. Choosing a third-party crypto custodian involves these steps:
  • Research and Select a Custody Provide r: Thoroughly research and evaluate custody providers to find a reputable and trustworthy option. Consider factors like track record, security measures, regulatory compliance, insurance coverage and supported cryptocurrencies. Look for custodians with robust security protocols like multi-signature (multisig) wallets, cold storage and strong authentication.
  • Account Setup : Create an account by providing necessary information and completing verification procedures. This may involve identity verification to comply with KYC and AML regulations. Follow the crypto custodian's instructions for account setup.
  • Fund The Account: After creating and verifying the account, fund it with chosen cryptocurrencies. Generate a deposit address from the custody provider. Then initiate a transfer from a personal wallet or exchange account to the custody account. Double-check the accuracy of the deposit address to avoid the loss of funds.
  • Security Measures : Custody providers often enforce additional security measures to protect assets. These may include two-factor authentication (2FA), withdrawal limits and access controls. Follow the provider's recommended security practices to reduce the risk of unauthorized access.

Unique Aspects

  • Decentralization and Self-Custody : Cryptocurrencies operate on decentralized networks. This gives users full control over their digital assets. Self-custody solutions involve holding private keys and managing digital wallets. Self-custody offers a user more control than third-party crypto custody. It puts the responsibility of safeguarding assets entirely on the user.
  • Cold Storage and Hot Wallets : Crypto custody providers use different storage methods for asset security. Cold storage refers to offline solutions like hardware wallets or paper wallets. These methods of storing private keys are not connected to the internet. Cold storage offers high security as it is less vulnerable to hacking. Hot wallets are online wallets accessible through mobile or desktop apps. They are connected to the internet, which provides users with easy access and more convenience to conduct transactions. Generally, hot wallets are less secure than cold storage.
  • Multi-Signature Wallets : Multisig wallets add an extra layer of security to crypto custody. A user needs more than one private key to authorize transactions. For example, a 2-of-3 multisig wallet needs two out of three designated private keys to sign a transaction. This distributed control reduces the risk of a single point of failure. Malicious actors have a harder time getting access to a user's accounts.
  • Insurance Coverage : Some crypto custody providers offer insurance coverage for digital assets held in custody. Insurance policies help mitigate the risk of theft, hacking and unforeseen events. A user should carefully review the terms and conditions of the coverage. They should recognize limitations and exclusions.

Advantages

  • Security - Crypto custody services use robust security measures like multi-factor authentication, encryption, cold storage and physical security, such as vaults or secure data centers. These measures protect digital assets from theft or unauthorized access.
  • Expertise - Crypto custodians specialize in safeguarding digital assets. They possess a deep understanding of the security risks associated with cryptocurrencies. Crypto custodians employ knowledgeable security professionals who stay updated on the latest threats and best practices.
  • Insurance - Some custodians offer insurance coverage for the assets they hold. This provides an additional layer of protection against theft or loss. Insurance helps reduce the financial risks associated with holding cryptocurrencies.
  • Regulatory Compliance - Crypto custodians often adhere to regulatory requirements based on their operating jurisdiction. This instills confidence in individuals and institutions that the custodian operates within legal frameworks. The adherence to regulations lessens the risk of fraud and malpractice.
  • Convenience - Using a crypto custodian is convenient for individuals and institutions that lack technical expertise and resources. When custodians handle the technical aspects of storage and security, users can focus on other aspects of their cryptocurrency investments.

Disadvantages

  • Counterparty Risk - Users must trust the custodian to handle their assets properly. There is a risk that the custodian will commit security breaches, mismanagement and fraudulent activities. This type of risk is called counterparty risk. It involves the party who is not the user defaulting on their obligations.
  • Limited Control - In entrusting assets to a custodian, users relinquish some control over their digital assets. Custodians may have their own policies and procedures for accessing and managing assets. These may not align with user preferences. Users may need to rely on the custodian for asset access or transfers. This adds complexity, which can be a challenge for new and less experienced users.
  • Cost - Crypto custodians typically charge fees. These vary depending on the custodian and the level and type of service they provide. These fees can reduce overall returns, particularly for smaller investors. Fees may increase as the value and complexity of assets grow.
  • Single Point of Failure - Despite robust security measures, custodians represent a single point of failure. If a custodian experiences a security breach or ceases operations, the assets that the custodian holds could be at risk. This concentration of assets in a single entity is a concern for users who value decentralization and the elimination of single points of failure.
  • Regulatory Changes - The regulatory landscape for cryptocurrencies is evolving. Custodians will face changing requirements and regulations. This introduces uncertainty and potential compliance challenges for users and custodians.