Who is in Control? From Traditional to Web3 Custody

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In the midst of last week’s banking crisis, the self-custody debate re-surfaced, leading to many investors moving their bitcoin into self-custody wallets.

70K bitcoin was taken into self-custody since the collapse of SVB (Mar 16)

Custody: The act of holding and safeguarding assets on behalf of someone else.

In the traditional financial system, custody is done through a centralised model where a third-party custodian (banks, trusts and other financial institutions) holds and manages assets on behalf of the client. Customers trust that these entities hold their assets securely and ensure their safekeeping.

However, in the last few weeks, some customers recognised that this centralised model includes limitations and risks, such as counterparty risk. For example, hacking, fraud, or insolvency of the custodian.

So, this week we will look at what Custody looks like in Web3, considerations and how traditional financial services can still play a role.

Custody in web3

In Web3, custody refers to the management of digital assets, such as cryptocurrencies, tokens, and NFTs. Custody can be either self-custody or third-party custody, depending on who controls the assets.

Self-custody:

The owner of the assets has complete control and is responsible for storing them securely. This is usually done using a digital wallet that only the owner can access and is protected by a private key.

However, self-custody bears a high risk to the owner, considering that they are solely responsible for protecting their assets from theft or loss, i.e. “being your own bank”.

Examples:

• MetaMask: a popular Ethereum wallet that allows users to hold their own private keys and interact with dApps directly from the browser
• Ledger Nano: a hardware wallet that allows users to securely store their private keys offline

Third-party custody:

Similar to the Web2 model, custodial wallets are managed by a third-party custodian, which takes care of the security and storage of the assets on behalf of the owner. This can benefit users who may not have the technical expertise or resources to store their assets on their own securely.

Examples:

• Coinbase Custody: a trusted third-party service for institutional investors that offers offline storage of cryptocurrencies and other digital assets
• Gemini Custody: a regulated and secure cryptocurrency custodian designed for institutional customers

Self-Custody Debate

“not your keys, not your crypto”

Web3 maximalists believe that self-custody is the only legitimate way to hold and manage digital assets in the Web3 world. They argue that users who rely on third-party solutions are not truly in control of their assets and are putting themselves at unnecessary risk by trusting third parties with their private keys and personal information.

While a maximalist view of self-custody may appeal to those who prioritise autonomy above all else, it is important to recognise that not everyone has the technical expertise or resources to manage their digital assets safely.

Indeed, the future of mass adoption will be achieved by providing familiar centralised experiences with the ability to move into self-custody at a later stage.

Institutional Custody Services

Given that custody is the bread and butter of traditional Financial Services, it is of no surprise that they are starting to adopt and explore the world of Web3 custody. Several major financial institutions, including Fidelity, Goldman Sachs, and JPMorgan, have launched or are planning to launch institutional custody services for digital assets.

Being provided by a trusted enterprise, these services are a good starting point for non-technology savvy customers who want to explore web3 but do not have the expertise or resources to manage their own custody and do not want to hold the risks associated.

From a bank’s perspective, these services ensure that they retain existing customers and offer new products and services in Web3 (i.e. new revenue stream).

Under the hood

Web3 custody presents a unique set of challenges that are different from traditional custody services, for example regulatory uncertainty and specialised expertise in a technology that continues to evolve. As such, traditional financial services adopt a cautious approach and build their solutions on permissioned ledgers.

Permissioned ledgers are controlled by a central authority or consortium, while permissionless ledgers are open to anyone.

By controlling who views the data and joins the network, traditional FS companies reduce the risk, ensure privacy and meet existing regulatory requirements.

Web3-born companies will typically build their custody solutions on permissionless ledgers. However, in the last few years, some have included a permissioned (ring-fenced) network to their portfolio in the hope of partnering/collaborating with FS institutions (B2B solution).

Examples:

• Anchorage - offers institutional-grade custody solutions for digital assets. They initially started with permissionless custody solutions but added permissioned solutions for institutional clients who require additional security measures.
• Fireblocks - provides an enterprise-grade platform for digital asset custody and management. They offer both permissionless and permissioned solutions for their clients.

Regulation

The regulatory landscape for Web3 custody is still evolving, and there is often ambiguity around which laws and regulations apply to digital assets.

In the US, for example, SEC proposal states that registered investment advisors must use an independent, regulated, qualified custodian. Qualified custodians, with a fiduciary duty to clients, would hold client funds in segregated accounts and meet regulatory standards.

Even though this proposal clarifies US rules, it can also be seen as an advantage for traditional FS companies already approved and vetted by the SEC.

Final Thoughts

The recent market turmoil and increasing regulatory scrutiny have highlighted the need for reliable and secure Web3 custody solutions. This has spurred greater interest in web3 and non-custodial wallets as people seek alternatives to traditional banking systems.

As the demand for Web3 custody solutions grows, we can expect to see increased innovation and growth in the industry. This presents exciting opportunities for companies and investors alike, as well as potential benefits for the broader financial system.

Until next time

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