Crypto Custody

The reality is that in the crypto space there have been several horror stories about stolen funds, hacks, and lost passwords (private keys). This brings me to a topic that will aim to educate you around crypto custody, wallets, and storage as this is a critical aspect of preventing these horror stories. It will also show that these are not events that happen merely because it’s a crypto asset, which is a stigma that the asset class has inherited due to the lack of understanding and proactive steps to ensure the safety of ones digital asset portfolio.?

As we are all aware, cryptocurrencies do not have any physical form, unlike cash forms of fiat. However, this is much like your bank account, they exist and operate through IT technology and are stored in digital form. These are called cryptocurrency wallets, similar to how your banking application works, where you keep track of your funds in different currencies.?

What is custody?

Before we enter the conversation around crypto custody, let us start by speaking about custody in the financial world today. Custody can be defined as “a safekeeping service that a financial institution provides for a customer’s securities” and these services are performed by custodians. Custodians are those who hold responsibility for assets in custody and by virtue of reputation, are relied on as a trusted pair of hands for storing funds. In this space, trust was the real currency of custodianship and reputation more than nearly everything else. Traditionally, these custodians store your assets and albeit a simple example, think of it as you keeping your money in a bank account as opposed to cash under your bed.?

What is crypto custody?

Crypto custody, although it works slightly differently from traditional custody, the principal remains the same. Crypto custody is merely a term used to describe the process of securing these assets from theft. The lack of trust in crypto custodians has been a hindering aspect of widespread adoption, to understand crypto custody, one needs to first understand how a cryptocurrency wallet works.?

A crypto wallet consists of two components: The two are inherently linked, just like a username and password or a bank account number and pin code.?

1. Public key: think of this as your wallet address (like your bank account number), it is publicly used to send cryptocurrency coins or tokens just as you give someone your bank account number to enable them to EFT you.
2. Private key: think of this as your password that is linked to your wallet (like your password to enter your internet banking account), it is never disclosed. It is used to authorise sending cryptocurrency out of that wallet as well as access any cryptocurrency in that wallet.?

We can then derive from this understanding that in the world of crypto custody, it is the safekeeping of the?private key?of a cryptocurrency wallet. This is because all data and transactions exist on a public blockchain, digital custodians do not technically store any of the assets but rather the private key that grants access to what is held in the crypto wallet.?

What are the types of crypto custody?

Often you will hear about different forms of “hot” and “cold” wallets. Terminology such as exchange wallets, software wallets, hardware wallets, and paper wallets are regularly referred to in this industry. Firstly, let’s simplify this concept:

- A “hot wallet”: in its most basic definition is a wallet that is connected to the internet (inherently this is less secure than a cold wallet as it is theoretically possible for it to be hacked)

- A “cold wallet”: in contrast, is a wallet that is not connected to the internet?

This leads us to the three most common types of crypto custody, each bringing along its own pros and cons.

1. Self-custody:

• This is when an individual personally holds the private key to their own wallet, where that individual is the only one who can prove ownership of funds and access the holdings of the wallets that private key gives access to.?
• These can be in the form of hot wallets such as a metamask desktop wallet which is a browser extension or in the form of a cold wallet that is completely disconnected from the internet like a keep key cold card.?
• The advantage of self-custody is that you are in complete control of your cryptocurrency at all times but the disadvantage is the responsibility that comes with it.?

2. Joint Custody:

• An example of when an individual is not the only person who holds the private key to their cryptocurrency wallet, it is not commonly done as there is high risk due to the trust required for this to be effective.?
• In its most basic form, it is a person sharing their private key with someone that they trust. Which, in my opinion, is not an optimal security measure.?
• Alternatively, there is a form of joint custody known as a multi-signature wallet, where multiple private keys are created for the same cryptocurrency wallet and these private keys are shared among the trusted parties. These wallets can be customized to send a transaction when a specific set of conditions are met.?

3. Third-party custody:

• In the case of third-party custody, this is where someone else holds the private key to an individual’s cryptocurrency wallet. For those who do not want to take the responsibility for their own accounts or find it too intimidating to deal with the technology, this is normally the go-to solution.?
• These are registered, regulated entities that undergo similar security measures to a bank. Similar KYC and AML checks must be completed by an individual to store their private key with these custodians.?

Types of third-party custodians we are accustomed to are:

• Exchanges: platforms such as Luno, these centralised exchanges take care of their customers’ crypto custody. (The exchange may outsource their security needs but are ultimately in charge of providing the service). It is important to note that you do not hold the private key to an exchange wallet and exposes an individual to potential losses if the exchange is hacked.?
• Digital asset managers: as cryptocurrencies have matured as their own asset class, there has been an emergence of digital asset managers that act like banks for crypto holders. These parties are regulated and licensed to offer crypto custody.?
• Custodial banks: depending on jurisdiction regulation, some custodial banks have been permitted to provide custodial services for crypto. Currently, these are often limited to institutional investors or high minimum balance requirements.?

Safekeeping and knowledge of risk management solutions are vital in safe participation in the infancy of this market. However, the concept remains similar to that of traditional custody as we know it today.?

Follow our weekly insights as we continue to close the knowledge gap, piece by piece. Please feel free to contact me if you have any queries in the space.?