Summary
- Crypto custody is a term used to describe the process of securing assets from theft.
- Self-custody is one of the two main types of crypto custody.
- It provides the owner with complete control over their assets, but comes with risks, most obviously, the loss of these if the individual loses their device or key.
- For more articles like this, please visit our Explainers pages.
What is crypto custody?
Crypto custody is a term used to describe the process of securing assets from theft.
Custodians – third parties that can be hired to look after an individual’s crypto – act as safeguards of this money, be it cash, securities, gold bars or virtual assets. Custodians have been around since the 1960s and are one of the pillars of the traditional banking system.
Digital asset custodians do not technically store any of the assets because all data and transactions exist on a public ledger called the blockchain. Instead, they guard the users’ private keys – the important part of a crypto wallet that grants access to the funds held in it.
How does crypto custody work?
Crypto custody means securing the private key that proves an individual owns the funds held within their crypto wallet. In traditional banking, all custodians are financial institutions, as required by law. With crypto, however, holders have the opportunity to become their own custodians, i.e. self custody.
Using gold bars as an analogy, a person can either store them under their bed to keep them safe or pay a third-party custodian to lock them in a vault protected by security guards.
There are two main types of crypto custody:
Self-custody
Self-custody is when someone personally holds the private key for their own wallet. This means that they are the only one who can prove ownership of their funds and access their holdings.
This also means, however, that if the person loses access to their physical device (cold wallet) or forgets the private key, their crypto will most likely be gone forever.
Third-party custody
Those users who do not want to take the responsibility of managing their own accounts or find it too intimidating to deal with the technology might want to turn to a third-party custodian. These are registered, regulated financial institutions who have acquired a state-level or national license to act as a custodian.
This type of crypto custodian holds clients’ private keys to their wallets in a safe manner and ensures the security of their holdings. From the user’s perspective, it is similar to having a checking account with a bank. When a user registers to open an account, they must undergo know-your-customer (KYC) and anti-money laundering (AML) checks. When an individual stores crypto with a third-party custodian, they will be expected to complete the same sort of checks.
There are three different kinds of third-party crypto custodians:
- Exchanges: All centralized cryptocurrency exchanges take care of their customers’ crypto custody.
- Digital asset managers: Acting like banks for crypto holders, these institutions are regulated and licensed to offer crypto custody.
- Custodial banks: In some countries, such as the US, nationally chartered banks are authorized to provide crypto custody services.
Advantages and disadvantages of crypto custody
Self-custody: This offers the user complete control over their assets. Only they have access to their account and there is no counterparty risk. Less positively, if the user loses their key or are hacked, they lose their digital assets. These assets are uninsured.
Third-party custody: This offers easier access, making it ideal for those just starting out in crypto. Also positively, the custodian takes care of everything, and have insurance on the assets they manage. Disadvantages include the fact that the custodian controls access to the assets and could, for example, block access or limit withdrawals. They may also increase their fees. There is always the risk that a custodian could be hacked or go bankrupt.
A version of this explainer first appeared on Coinbase.
