From securing private keys to facilitating the buying, selling, and all-round management of digital assets, institutional, independent crypto custodians quite literally provide an invaluable service to the budding industry. But why are they required and how do they work?
When it comes to cryptocurrency private key storage and management, not everyone is as cautious as they should be. From storing the majority of funds on a centralized exchange to maintaining poor self-custody standards, many institutional investors expose themselves to what has been dubbed by accounting firm KPMG as a "high level" of risk.
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A recent report from the accounting giant argues that, despite their growing prevalence, cryptocurrencies are still inherently exploitable. According to the report, $9.8 billion worth of crypto has been stolen since 2017, with the main offenders being improper coding and security.
Given this, it's no surprise that crypto tycoons go to extreme measures to keep their virtual stash safe. A good illustration of this comes from former Facebook feuders turned Bitcoin billionaires, Cameron and Tyler Winklevoss—known collectively as the Winklevii. The twins revealed their unique approach to custody in a 2017 interview with The New York Times. To secure their fortune, the Winklevii reportedly cut a printout of their private key up into segments and stored them in multiple safe deposits around the United States.
While not everyone is likely to adopt that methodology, it goes to show the extent some are willing to go to keep their assets secure.
Why Independent Custody?
Every investor uses custody to some extent. Most choose to either self-custody via a digital or hardware wallet or opt to keep their cryptocurrencies on exchanges. For newcomers to the space, the latter is often the preferred choice. Although, this choice is often attributable to a lack of understanding around custody rather than an elected preference.
When leaving funds on centralized exchanges, users entrust them to the exchange's custodial wallet. However, as illustrated by the KPMG report, this isn't the safest practice. One glaring example of this was demonstrated in the QuadrigaQX scandal. After exchange boss, Gerald Cotten, suddenly passed away, it was discovered that he was the sole custodian of the exchange's private keys. This apparent lack of due diligence saw investors lose a total of $190 million. Furthermore, 2019 alone saw 12 crypto exchanges hacked and nearly USD$300 million stolen in assets.
It's incidents such as these keeping institutional investors at bay. But it's also luring more institutional-grade custodians into the industry as more regulation comes into play and better custodial solutions come to market. Spotting the gaping hole left by nearly $10 billion in appropriated assets, digital asset custodians have clambered to fill it.
How Custodians Work
Securing digital bearer assets is challenging and complex. Generally, convenience and security are inversely proportional. Acquiring fast, flexible, and easy transaction capability brings with it decreased security. Almost always, secure solutions are slower, more rigid in their protocols, and more complex to use safely. Solutions that offer both are rare, and if located, are generally expensive to implement and transact with frequently.
Digital asset custodians act as trusted mediators, providing maintenance and management of customer funds. One of the allures of this method of private key management is that—unlike their exchange counterparts—the dedicated approach of custodians rarely leaves room for error.
Custodians can secure private keys in several different ways. Some may opt for cold wallet storage. These endow a high level of security but also produce a relatively sluggish rate of transfer (approximately 12-48 hours). To combat this, others may choose to operate through a hot wallet—a digital vault connected to the internet. This allows for instant access, compared to the manual cold wallet route, but concedes explicit attack vectors.
More sophisticated firms, however, can combine these protocols, achieving a comfortable middle ground. By harnessing a mix of front-end software flexibility in conjunction with end-to-end hardware security it becomes possible to engineer a fully automated solution process that reduces operator risk and reduces transition delays. This, combined with automation and additional security controls such as multi-signature and white lists, allow custodians to support the current shortcomings of the market, giving investors the reassurance they need.
A Custodians Role
On the whole, a custodian's -primary objective is to safeguard client assets, but services can extend to a litany of offerings to support optimising profits from multi-account and multi-asset management through to providing more efficiency around risk management and operational processes, including blockchain-agnostic multi-sig controls on-chain and on-exchange, whitelisting, and providing insurance. Whitelisting is one such feature that isn't often seen outside of third party custody solutions. It enables the user to filter out undesired addresses while permitting transactions to trusted, pre-approved entities creating a “walled-garden” environment.
Custodial insurance acts as a safety net should the worst happen. Though, some firms only offer insurance over a specific asset threshold.
As well as omitting risk and liability through insurance, some custodial wallets also facilitate account recovery, meaning that private keys can't go missing—though this is a feature limited to a select few in the market. Moreover, depending on the wallet, regulatory compliance can be easily met via KYC/AML procedures.
This is one of the reasons why many hedge funds managers and other institutional entities opt for qualified third-party custodians over self-custody. The ability to store client funds in a secure and regulatory compliant way is a significant bonus for accredited investors.
Given the magnitude—and complexity—of the cryptocurrency ecosystem, hedge funds need custodians to navigate the space and facilitate the buying and selling of digital assets without compromising speed, security, or access. At the end of the day, it all comes back to security. If private keys are in jeopardy, so are client's funds.
About the Author
Alex Batlin is Founder & CEO of Trustology, an award winning global FinTech company focused on providing institutional investors and crypto funds with state-of-the-art, insured custodial wallet solutions to secure and manage cryptoassets in real-time on-chain and on-exchange.
Alex is an entrepreneur with extensive banking and blockchain experience, previously at BNY Mellon, UBS and JPMorgan.