- There are three main branches of crypto custody: exchange custody, self-custody, third-party custody
- Custody is important to the growth of the ecosystem as it can promote adoption and investment of crypto assets
- In Q2 2018, four of the largest custody banks held $114T worth of traditional assets under custody and administration
Traditional financial institutions do a tremendous amount of business as “custodians,” holding customers’ assets to protect them against theft or lost. In the second quarter of 2018, four of the largest custody banks held a whopping $114 trillion worth of assets under custody and administration. Custodial solutions are important for financial markets: Instead of firms spending time and resources to manage assets, they pay someone to take on that role — leaving more time for firms to operate in their areas of expertise.
For investment advisors, custody is required by law. The Rules And Regulations, Investment Advisers Act Of 1940 requires that any registered investment advisor who has custody over clients assets must have those assets stored with qualified custodians.
With the arrival of bitcoin and cryptoassets, custody takes on a whole new level of importance. Cryptoassets are essentially digital bearer bonds. Instead of cryptoassets being registered under an owner’s name, their ownership is intrinsically linked to a string of alphanumerics known as private keys. Control of those private keys means full access to transfer their associated cryptoassets — so safeguarding them is especially critical. And similar how bearer bonds work, the owner of a private key is the de facto owner of the underlying asset.
Unlike custody for traditional assets, where accessing funds require multiple approvals by different parties, custody of cryptoassets requires simply knowing the private key. This presents an issue for managers of cryptoassets: To access the assets you need a private key, but if multiple individuals know the private key how can you prevent theft? An individual with access to a private key can seamlessly move billions of dollars of value in a few minutes, knowing full well that this transaction is irreversible.
The growing cryptoasset market paired with the importance of custody has jumpstarted a new race to provide secure crypto custody solutions. From unicorn startups like Coinbase to century-old firms like Northern Trust Corp., everyone is vying for a piece of the crypto custody pie. In this piece, we will map out the state of current crypto custody solutions.
There are three main branches of crypto custody solutions: exchange custody, self-custody, and third-party custody. Here’s how they break down:
Exchange custody is the process of leaving one’s cryptoassets on an exchange such as Coinbase or Binance. There are over 200 crypto exchanges, all of which provide some form of exchange custody. While exchange custody is the most convenient form of custody, it is by far the most insecure. By leaving one’s cryptoassets on an exchange, one gives exchanges full control over their private keys. As we’ve detailed in our analysis of cryptocurrency exchanges, crypto exchanges are not particularly well-known for their security. In 2018 alone, investors lost over $860M to crypto exchange hacks.
Self-custody is the process of securing one’s private keys and cryptoassets through the use of software or hardware. Self-custody solutions come in many forms. Some users can download mobile apps or desktop apps to store their cryptoassets, such as Electrum or Bread Wallet. Other users can purchase hardware dedicated to securing and storing cryptoassets such as Trezor or Ledger. By our count, there are at least 85 varieties of self-custody solutions.
The security of self-custody depends wholly on an individual’s OPSEC. A user with the skills to properly leverage self-custody solutions and defend themselves against potential threats will have one of the best possible forms of crypto custody. On the other hand, a user with poor OPSEC can make the option of self-custody one of the least secure forms of crypto custody. We don’t have to stray far to find stories of individuals accidentally throwing away their bitcoin-filled hard drives or having their life savings stolen from exploited hardware wallets.
Third-party custody is the process of leaving one’s cryptoassets in the hands of third-party custodial services dedicated to storing and securing crypto. Third-party custody solutions are, arguably, the most secure form of crypto custody. Third-party custodians often leverage teams of security experts in addition to advance security tech and armed guards. By our count, there are roughly 15 operational third-party custody solutions.
What third-party custodians give in security, they take in accessibility. While cryptoassets are known for their trustlessness and circumvention of intermediaries, third-party custodians put the intermediaries/middlemen back into the equation. Trustlessness becomes trust; circumvention becomes reliance, individuals no longer get instant access to their cryptoassets.
Custodial solutions are vital for the growth of crypto. Many investors and users in this space are not yet comfortable managing their own money. An increase in custodial offerings would ultimately promote the adoption of cryptoassets and therefore promote the growth of the ecosystem.