What is cryptocurrency custody and how does it affect me?
In our effort to stay abreast of the cryptocurrency sector, it has come to our attention that a number of technology and financial services providers are looking to get into the crypto custody business. Custodial services are in high demand and there doesn't seem to be enough providers to meet the need. That means plenty of opportunities for new players.
So what exactly is cryptocurrency custody? More importantly, how does it affect owners of Bitcoin, Litecoin, Ethereum, etc.? Those two questions will be answered in this post. Unless you are a crypto investor or trader, custody is probably not something you are concerned about. But it wouldn't hurt for you to understand how it all works anyway.
Custody of assets
Cryptocurrency custody is simply an extension of the principle of entrusting valuable assets to a legal custodian. Custody of assets is something that has been practiced by institutional investors for generations. In the simplest possible terms, investors use custodial services to protect their assets from harm.
An investor owning millions of dollars' worth of gold bullion does not have the resources or infrastructure to store it. Nor would it be safe for that individual to keep the gold in his possession. So he entrusts it to a custodian. He may have gold bars or coins stored in multiple safes at banks around the country. Or perhaps he converts the gold to certificates stored with an exchange.
Cryptocurrency custody works on the same principle. It is a little different, given that cryptocurrencies do not involve tangible assets.
Custody for investors and traders
A Bitcoin owner who uses his or her coins to make online transactions and play on their favorite gambling site probably has no need for custodial services. They are dealing with so little coin that they are not a high risk for theft. And because he or she is not an investor, they are not trading coins on a daily basis.
On the other hand, you may have another coin holder just getting started as a trader in hopes of building a steady income on the cryptocurrency market. It is neither practical nor safe for them to rely solely on a digital wallet to keep his crypto safe. So they may choose to use a custodian.
Alongside that trader is a serious investor who owns millions scattered across a variety of cryptocurrency platforms. The sheer volume of his holdings makes it extremely dangerous for him to store everything in a digital wallet. He also needs custodial services.
Indirect and direct ownership
Cryptocurrency custody can be accomplished in lots of different ways. It starts with a choice between indirect and direct ownership. In a direct ownership scenario, the owner of the coins owns them outright in the sense that they were obtained and transferred to that owner's wallet via purchase, trade, or both.
If you use bitcoins to play Mega Moolah online for example, you are practicing direct ownership. You would have a number of different options for cryptocurrency custody depending on your preferences. Those options include things like hard storage off-site and multiple paper ledgers stored at different locations. We will talk about those options a bit more later in this post.
In an indirect ownership scenario, the coin holder does not physically possess his or her holdings in a single digital wallet. Instead, those holdings exist elsewhere. A good example is trading on an exchange.
Imagine you are a trader looking to build your digital assets for buying and selling. In order to facilitate a larger volume, you have pooled your holdings with hundreds of others on an exchange. That exchange actually holds your coins for you. So while you are the owner of those coins, you do not possess them in your own digital wallet. You achieve custody by allowing the exchange to protect your assets for you.
Neither ownership option is necessarily superior or inferior to the other. However, there is a caveat: indirect ownership requires a bit of extra due diligence practiced by the trader or investor. It is important that holdings only be transferred to entities with the proper security protocols in place and a proven track record of reliability.
Direct ownership options for custody
Working on the assumption that most cryptocurrency investors and traders want to maintain direct ownership, we want to talk about some of the options for establishing custody. The best way to understand this is to imagine depositing stock certificates in a safe deposit box down at the local bank.
Such a scenario would not change ownership of the stocks represented by those certificates. If you were to do this, you would still own the stocks themselves. Depositing them into a safe deposit box simply safeguards those certificates against theft, fire, etc. Establishing custody of directly owned cryptocurrency holdings is no different.
Crypto holders can choose between both hot and cold storage solutions. A hot storage solution is one involving some sort of connectivity to the internet. A good example would be a company offering custodial services via cloud storage. That company would maintain custody of crypto assets in the same way a bank would maintain custody of stock certificates. The owner of those holdings can access them anytime by logging on to a cloud account.
Establishing custody through a cold storage solution involves placing crypto assets somewhere without access to the internet. Examples include external hard drives, flash drives, and even handwritten ledgers on paper. Believe it or not, some of the wealthiest cryptocurrency investors use the paper ledger method. They write down all of their addresses and keys in multiple ledgers and store those ledgers in multiple safes located in different places.
Pros and cons of both options
There are pros and cons to both hot and cold storage custodial solutions. Beginning with hot storage, the main advantage here is fast liquidity. Let us say you needed quick access to your bitcoins in order to take advantage of a lucrative trade. Having immediate access to your holdings via cloud storage means you can facilitate that transaction right away. You cannot do that if you are using a cold storage solution that requires you to travel any distance to retrieve your assets.
Hot storage also eliminates the need for you to keep track of individual flash drives, paper ledgers, etc. Regardless of the number of hot storage locations you utilize, all are accessible to you from your computer or mobile device.
The downside of hot storage is security. Any storage solution with internet connectivity is vulnerable to hacking. And make no mistake, it happens. Just recently there have been several stories in the news describing a number of exchanges that have been hacked by thieves who have drained wallets of millions of dollars worth of crypto.
Moving on to cold storage, its big advantage is security. A flash drive stored in a bank vault is a lot more secure than an online cloud storage account. The paper ledger is a form of storage that cannot be hacked no matter how hard thieves try. They cannot hack what they cannot access.
The downside to cold storage is its relative inconvenience. If you are keeping multiple copies of your paper ledger or digital files - and you really should - it can be quite a hassle to keep them all updated. Every location requires a visit every time something changes.
The inconvenience of cold storage also inhibits liquidity. It is more difficult to liquidate crypto assets when you have to travel to get your hands on them. What you can do in mere minutes with hot storage could take hours or days with cold storage.
The vault storage solution
A new form of cryptocurrency custody known as the vault storage is just beginning to emerge. This form of custody combines both hot and cold storage to give the investor or trader the best of both worlds. It is actually quite simple in practice.
Under a vault storage scenario, the majority of an individual's assets would be held in cold storage via paper ledgers or external hard drives. The remainder would be held in hot storage so as to give the individual quick access. This provides a certain amount of liquidity to accommodate immediate trading needs. On the other hand, it also protects the majority of the individual's assets by keeping them off the internet.
What it means to you
Wrapping all of this up is a matter of understanding how cryptocurrency custody affects you. Again, you probably have no need for custodial services if you deal in small amounts of bitcoins or other crypto options, primarily for the purpose of online gambling and making retail purchases. The volume of crypto you deal with is not enough to warrant custodial services.
On the other hand, establishing custody of your assets is a wise thing to do if you are a serious investor or a trader. The larger the volume of your crypto assets, the larger you are as a target to thieves. Moreover, there may be laws in your country mandating custodial services for assets exceeding a certain amount. That is something to think about if you are an investor.