With an urgent need for safe, secure storage of cryptocurrencies, there is a growing variety of custody options available. Here are the five most popular ones.
It’s no secret that cryptocurrency continues to be plagued by security issues. Although the technology underpinning such digital assets – blockchain – all but guarantees a tamperproof environment, coins remain vulnerable to hackers, especially whilst they remain on exchanges – most of which operate as centralized entities.
Indeed, the last few years have seen many hacks that have often resulted in hundreds of millions of dollars’ worth of crypto being stolen – Mt.Gox, Bithumb and Coincheck being just a few high-profile casualties.
And when not on exchanges, plenty of reports emerge of individuals losing their crypto through manual errors on their part. Broken computers, incorrectly entered deposit addresses and sheer forgetfulness have led to painful losses of their precious holdings.
So, with an urgent need for safe, secure storage, we are now seeing a growing variety of custody options available for digital assets, both to individual investors and institutional players such as hedge funds and banks.
As a reminder, the concept of ‘custody’ as per the SEC, is “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.“
We take a look at some of the most effective custody options:
The most common form of storage of cryptocurrency is the wallet, which enables you to perform ‘self-custody’, i.e. it does not require an external custodian.
Normally a wallet will have a public address for you to receive cryptocurrency, as well as a private key which is used to access your holdings and send crypto from your wallet.
There are a few different kinds of wallet from which you can choose:
1. Hot wallet
A hot wallet is one that is connected to the internet at all times. This storage method will normally require a private key to access your stored crypto. But while a hot wallet does provide a more secure storage environment than a pooled wallet on an exchange, internet connectivity means that your crypto could be at risk if hackers manage to gain access to your phone or computer.
It is therefore recommended that you keep only a small amount of crypto in this wallet, especially if you need to conduct crypto transactions at short notice.
Jaxx is an example of a hot wallet and can store several cryptocurrencies including Bitcoin, Ethereum, Litecoin, Bitcoin Cash and Dash. It is conveniently available as a mobile app, as well as a Chrome extension for Windows, Mac and Linux.
2. Cold storage – paper wallet
Unlike the hot wallet, cold wallets are not connected to the internet. This makes a cold wallet less exposed to potential hacks. As such, a greater proportion of your holdings should ideally be kept in cold storage.
A paper wallet is one type of cold storage custody, in which your public address and private key details are printed on a physical slip of paper, usually in QR form and then stored it in a safe place of your choosing. Given that paper can be easily lost or damaged, it is wise to have several copies of this slip as back-up.
- Mycelium, arguably the safest paper wallet due to its use of a USB dongle that connects directly to your printer, and thus never interfaces with your computer;
- Bitaddress.org which generates random address and keys using your browser, so nothing is sent over the internet.
3. Hardware wallet
Just as gold investors require storing their holdings in a safe or vault, crypocurrencies can be stored in a hardware wallet, another type of cold storage custody solution.
But unlike a paper wallet, a hardware wallet stores the user’s private keys in a hardware device. Hardware wallets are “air gapped,” which means they are only connected to the network until you choose to do so. This can usually be done via USB.
Ledger provides two of the most highly rated hardware wallets – the light USB pen-style ‘Ledger Nano S’ and higher-end USB/Bluetooth wallet both allow crypto to be stored offline.
Last year, Ledger also moved into the institutional space last year with Ledger Vault, designed to safeguard much larger amounts of cryptocurrency for enterprises and hedge funds.
*For added security, the option of a multi-signature wallet is also available for both hot and cold wallets. Accessing a multi-sig wallet requires more than one private key, each of which can be held by different entities. Thus, authorising a transaction will require all keyholders to sign off, which makes multi-sig wallets safer.
As assured as you may feel with a self-custody solution, the risk remains that either your wallet gets hacked (particularly under the hot wallet option), or you lose your wallet (especially hardware wallets).
Although laws are not yet in place for cryptocurrency, institutional investors such as hedge funds are required to use a separate regulated custodian for most other asset classes. As such, if you invest in a crypto fund, for example, you will most likely want your crypto holdings to also be guarded by such a custodian, an entity that should enable greater security and governance than a wallet.
As for the fund itself, the benefit of using of a custodian is that it can be detailed in its Offering Memorandum as a ‘selling point’ to potential investors.
4. Exchange custodians
Some exchanges and cryptocurrency brokers offer custody as part of their overall service.
Gemini is a good example of a licensed digital asset exchange which offers custody services. The company is a New York trust company regulated by the New York State Department of Financial Services (NYSDFS). Gemini offers two distinct custody solutions:
- A Segregated Custody Account – Suited to institutional customers, “digital assets are segregated, using unique digital asset addresses in Gemini’s Cold Storage System, which are independently verifiable and auditable on their respective blockchains. All segregated digital assets are custodied and secured offline in Gemini’s proprietary Cold Storage system.”
- A Depository Account – the default for all customers. Client digital assets are commingled. The majority of funds are custodied and secured offline in Gemini’s proprietary Cold Storage System. No annual fee is required, and assets are available immediately for trading.
Popular cryptocurrency broker Coinbase has also recently begun offering its custody service, which according to CEO Brian Armstrong, is specifically tailored to help institutional investors securely store digital assets. As such, Coinbase Custody is only available to institutional investors with a minimum of $10 million in deposits.
5. Dedicated custodians
These are custodian entities outright, as opposed to being part of an exchange or brokerage, as above.
This makes a dedicated custodian less likely to attract hackers who, as we’ve seen repeatedly, have a penchant for attacking exchanges. It also means the business is not tied to the performance of any exchange, so can’t be at risk of going bankrupt should the exchange go out business (perhaps from mismanagement of risky margin/derivatives trading).
From a governance perspective, moreover, a clear separation between the trade execution and custody process is clearly a more desirable scenario for both investors and institutions, although such custodians will be also the most expensive of all custody options available. Fees usually range from 0.5%-1% of assets under management.
Interestingly, it’s a small firm based in Kentucky, US that’s been grabbing the headlines in crypto custody at present. Kingdom Trust provides custody solutions for digital assets for both individuals and institutions. The firm was recently purchased by another popular custody firm, BitGo. Together, they provide a comprehensive platform that will be “the only full-stack, at scale provider of onsite and online protection for digital currency investments held by institutional investors”.
At the other end of the scale, meanwhile, State Street, the world’s second largest custody bank with a staggering $24 trillion under custody, is also now considering the move into digital asset custody, which would make it the first major global bank to provide such a service.
Clearly, as the crypto market continues to gain interest from big institutional players, and as regulators achieve more clarity over the appropriate requirements for managing digital assets, we should expect demand for dedicated custodians to swiftly rise. Indeed, McKinsey sees securities services firms playing “an important role as custodians for cryptoasset” in the future. Such firms “have an opportunity to tap these new revenue pools by expanding the classic custodian value proposition to include a new asset class”.
This article was originally published by Data Driven Investor (DDI)