Since the arrival of Bitcoin, we now have digital money that is sailable across space and time; in a way that anyone could perform this action. The network allows any participant to custody funds by running a simple software package and proving ownership with a set of private keys. Bitcoin eliminates the need to use a third party to hold your funds to ask permission to spend or receive funds and provides a truly global payment system.
Over the last decade, developers have improved Bitcoin software to make it easier for the average person to interact with the network, and we all adopted self-custody and lived without major rug pulls since no one was trusting and everyone was verifying, right?
Wrong; that is not the future we got. The future we got was, wow, this is an amazing asset to speculate on; let’s create third-party custodians who would hold and manage the funds, and we trade paper contracts that are meant to represent those funds but have no real enforcement.
The reality is very few people take self-custody of their Bitcoin for a host of different reasons, and managing Bitcoin on behalf of other people has become a popular business model. Yes, it’s the recreation of the banks and, many times, fractional reserve banking; the only thing that’s changed is the institution uses public ledgers and not private ones.
In an era dominated by digital currencies and virtual wealth, the role of digital asset custodians has become increasingly popular as a business model. These custodians serve as the trusted guardians of your assets, ensuring their security and integrity. Custodians are used to manage individual investors’ funds, companies, trusts, family offices and even the exchanges themselves.
But what exactly does their job entail?
The attraction to digital asset custodians
Despite Bitcoin’s ability to self-custody, custodians were always going to be a part of the market; if there’s profit to be made in something, businesses will spin up to service these needs. There will never be a world where there is no custody because there will never be a world where everyone opts for self-custody. Consumers want simplicity, they want to offload their liabilities, and they want the same experience they get with their fiat, and custodians check all these boxes.
Now are consumers right to want these benefits based on the trade-off? History would say no, but people will only learn as they feel the pain of financial losses.Â
Custodians are banks that manage digital vaults for your funds, and the business of digital asset custody revolves around the safekeeping of a private key, but a private key would need funds to command for it to be valuable.
Funds are typically sent to a custodian in one of two ways for them to be managed.
- A user would send their Bitcoin to a custody provider, moving that UTXO to a private key controlled by the custodian.
- Alternatively, a user would send the custodian fiat and instruct them to purchase Bitcoin and store it in a private key controlled by the custodian.
Private keys are used to store, manage, and transfer digital assets by the owner and help with the decryption of messages and authentication of transactions; they represent a single point of failure in the system, as anyone who gains access can then move those funds.
Therefore, private keys require sophisticated technologies to prevent theft, loss or destruction. It is the control and management of these private keys which have given rise to the frameworks supporting the custody of digital assets as a distinct and specialist service offering.
When it comes to Bitcoin, custody becomes more expensive and technically more complex as it scales, and custodians can easily get over their skis, but since there is no way to really know what’s going on internally other than withdrawing your funds, custodial failures can go undetected for many months even years and then end in a bank run in a matter of days.Â
If individuals or businesses do not wish to the custody of their own funds, if they never learn to custody, if fear of custody is bred into them, or self custody is made illegal or highly complex to pull off, then you’re going to create a moat where custodians can thrive with very few checks and balances.Â
Why the need for custodians?
One of the primary reasons why digital asset custodians hold such significance is their ability to provide a robust level of security and make it easier for individuals to purchase claims on Bitcoin while the custodian manages the private keys. If I told you custodians are managing 12-24 words for individuals, it might sound silly, but in essence, that’s what is going on.
Who would have thought, right?
Digital asset services
Additionally, digital asset custodians offer the expertise needed to navigate the complexities of accessing capital markets via your Bitcoin, such as selling your Bitcoin and clearing transactions either in-house with other market participants to get you the best deal or to securitise your Bitcoin to access loans.
Traders want to trade
Custodians’ expertise extends to regulatory compliance as well, ensuring that your assets remain in accordance with legal requirements. So, for investors who only see Bitcoin as a trade, custodians give them peace of mind and lend an element of legitimacy to the asset. As they don’t believe Bitcoin has value, only that there’s a market where they can trade in, facilitated by the custodian.
Digital asset complexity
Another popular reason for custodians is the complexity theatre created by altcoins, which try to mimic the properties of self-custody, even when their token is centrally issued and controlled.
Since individuals and certain businesses do not wish to deal with all this complexity, talking to different blockchains, custodians are brought in to handle these operations, remove the complexity from the user’s point of view and give them pretty little IOUs housed in SQL database that can be rendered on an app or web browser with ease.
Considerations when selecting a custodian.
The game of custodians is one of trust and research, and accepting you will never get the full picture, so you need to account for what you know and accept there is a large margin for error based on what you don’t know or will only find out when it’s too late.
When it comes to selecting a custodian for your digital assets, there are several key considerations that should guide your decision-making process.
One of the most important factors to take into account is the reputation of the custodian. Trust is a foundational element in the custodial relationship, and it is crucial to choose a custodian with a proven track record of reliability and integrity. By partnering with a custodian who has earned the trust of the industry and its clients, you can have confidence in their ability to protect and manage your assets.
In addition to reputation, it is essential to consider the custodian’s ability to provide seamless customer service and support. Issues and concerns may arise at any time, and having a custodian that is responsive and efficient in addressing these matters is invaluable. By selecting a custodian with a strong focus on customer service, you can ensure that any challenges will be promptly resolved, allowing for a hassle-free management experience.
The locality is another important factor for a custodian; the last thing you want is for your custodian to be halfway around the world and in a country that’s legal system might not play ball. Ideally, you want someone whose doors you can knock on, who would be easy to file against should issues arise.
The above is generic advice, and past performances and track records can only get you so far; it’s by no means a predictor of the future. Regulations can change, operations can change, competition can change, staff can change, and there are so many moving parts and risks that you might not know about. While your custodian could be top-notch, it only takes one disgruntled employee in a key position to bring down the entire business.
Ultimately, trust is a fickle thing, and when you’re dealing with digital assets, trust means nothing. You might think you have legal claims to funds, but the blockchain doesn’t care about your claims and clawbacks; if funds are signed over to wallets you don’t control, you’re always taking a 50/50 chance those funds will never return.Â
Custodians come at a price.
When you self-custody, the cost will come in the form of time since you have to learn how to do it properly and consider practising with key creation and management before ever sending funds to a wallet. You could download free software and create a hot wallet, or you could set up something more robust that would cost you a few bucks; this would involve getting a cold storage signing device and a steel plate to etch your keys.Â
When it comes to digital asset custodians, secure storage and asset management play a vital role in safeguarding your assets, and they’re going to do it for free.
These custodians employ advanced security measures to protect your digital assets from unauthorised access and potential loss. They utilise state-of-the-art physical and digital security protocols, ensuring that your assets are stored in a secure environment. Through multi-signature wallets, cold storage solutions, and complex encryption techniques, custodians ensure that your assets remain safe and difficult to breach.
Asset management is another critical aspect of custodial services. These custodians employ meticulous tracking and reporting systems, allowing you to monitor your assets and their performance. With comprehensive reporting tools and analytics at your disposal, you can gain valuable insights into your digital investments and make informed decisions. By partnering with a custodian that offers robust asset management capabilities, you can have peace of mind knowing that your assets are being closely monitored and managed.
All these operations cost money and require staff that have salaries, so depending on the custodian you’re using, you’ll either pay in:
- Withdrawal fees
- Deposit fees
- Swap fees
- Management fees
If you feel the fees are not a deterrent and it’s still a better option than costing your set-up with a once-off fee, then by all means, take the option you think is best for you.Â
Compliance costs
Digital asset custodians understand the importance of compliance with regulatory requirements. They work diligently to ensure that their operations align with industry standards and regulations, providing an extra layer of protection for your assets.
Compliance measures include implementing strict Know Your Customer (KYC) and Anti-Money Laundering (AML) processes, as well as adhering to data privacy regulations. Now this might not bother the average user who feels that Bitcoin is just another asset in their portfolio; for those who see it as a freedom tech, this is a non-starter.Â
Having a central ledger with a custodian with a list of names, IDs, addresses, and Bitcoin balances can be a danger to you. They can either fall into the hands of criminals that could target you for extortion, or governments could target you for extortion, I mean tax.Â
The Risks of Digital Asset Custodians
It is important to note that while digital asset custodians employ a range of security measures, no system is entirely impervious, and custodians face potential risks in a host of areas.
Cyber security attacks
When it comes to digital asset custody, one of the most prevalent risks is the possibility of a cybersecurity breach. Hackers are constantly developing new methods to infiltrate systems and gain unauthorised access to valuable assets.Â
While custodians strive to stay ahead of these threats, it’s important to acknowledge that they are always evolving and adapting. But here’s the thing, the larger a custodian gets, the larger the payoff for the hacker, and the more resources they will throw at cracking a custodian.
There’s no real payout in trying to hack one or a few users who self-custody, but when you have a bunch of users’ funds all neatly tied up in one place, it makes for a much more enticing prize.Â
Internal and operational risk
Another risk to consider is the potential for internal vulnerabilities within the custodian’s organisation. While custodians may have robust external security measures in place, it’s important to ensure that their internal systems and processes are equally secure. This includes implementing stringent access controls, conducting thorough background checks on employees, and maintaining a culture of security awareness and compliance within the organisation.
Managing risk versus returns
Custodians who deviate from only offering custody can also be a red flag. When your sole operation was to charge fees to manage funds, and you start to offer products like interest accounts, or lending and borrowing services, it can be a sign that the business is being diluted and also spreading itself too thin and taking on more risk.
When custodians are actively trying to trade or trusting third parties to trade on their behalf, you’re only a few bad calls or being on the wrong side of a market turnaround to positions blown out, and custodians might end up short compared to their liabilities.
Regulatory risk
Additionally, regulatory and legal risks should be taken into account when selecting a digital asset custodian. The evolving nature of the regulatory landscape surrounding digital assets means that custodians must navigate complex compliance requirements. Failure to comply with these regulations could result in legal consequences or reputational damage. Therefore, it is crucial to choose a custodian that demonstrates a deep understanding of the regulatory environment and has a track record of compliance.
Third-party risk
Lastly, it is important to be aware of the risk of third-party reliance when working with a custodian. Many custodians rely on external service providers for certain aspects of their operations, such as cloud storage or data backup. While these relationships can enhance efficiency and effectiveness, they also introduce an additional layer of risk. It is essential to thoroughly evaluate the security practices of any third-party providers involved and ensure that they align with your own risk tolerance and requirements.
Migrating risk, not reducing risk.
There is a misconception among those who are not technically inclined or have not attempted self-custody. They feel that leaving your funds with a custodian can be safer than doing it yourself and that custodians are the lesser of two evils.
That said, it is important to understand that migrating risk does not necessarily equate to reducing risk. Transferring the responsibility of safeguarding your digital assets to a custodian does not eliminate all risk, but it does redistribute it.
While custodians are highly specialised in securing digital assets, they are not immune to vulnerabilities or breaches. Therefore, it stands to reason that custodians can be part of your setup but should not be the single point of failure. You could use custodians for short-term capital and for active capital management like trading or Bitcoin-backed loans, but they should not be your only method of Bitcoin exposure.
By diversifying the methods in which you custody Bitcoin, be that cold storage, a hot wallet and a custodian, you have more flexibility, and you spread your risk between your personal self-custody failures and the ones by the provider you chose.Â
Recreating fiat liabilities
The term “fiat liabilities” refers to traditional forms of currency that are backed by a government or central authority. These currencies, such as the US dollar or the euro, are widely accepted and trusted as a medium of exchange. In fiat, you’re trusting the government to back that dollar, and you’re trusting the banks to allow you to redeem that dollar because you have no control over the bearer asset; you only have a claim to it; these are fiat liabilities.
By entrusting your Bitcoin to a company, you create fiat liabilities only with a different unit of account. You can look at attestations or proof of reserves, but you will never know the true book value of funds held with a custodian and the claims issued on top of it. In essence, you’re hoping that custodians resist the urge to rehypothecate funds, and that is a dubious position to be in, ask holders of IOUS from past exchanges that failed to do just that.Â
Why self-custody beats custodians.
Do people who take self-custody lose their funds? Absolutely, there have been plenty of cases of this, but when compared to those who have lost funds via custodians, the ratio speaks for itself; it’s 1000 times more likely.
Self-custody requires personal responsibility, and while it can be daunting at first, it relies on the KISS principle, Keep It Simple Stupid.
Once you’re set up with a wallet and have a host of X-pub addresses to withdraw to when needed, you’re pretty much set; you can keep funding your wallet as you see fit without needing to touch your setup.
The only times you would access your keys is to check that your device is still up to date and running and if you need to remove some funds. Since this is fairly rare, as for most of us, Bitcoin is a savings technology; you have a limited attack surface when it comes to exposing your keys.
As for custodians, this is not the case; they are constantly rebalancing wallets, checking funds, doing coin control, signing over balances and conducting more complex signing transactions like PayJoins or Multi-sig, which introduce operational risk. Since they can never be as simple and infrequent as you can be when managing your funds, something as simple as not double-checking an address and signing funds to an incorrect address send can cause a lot of damage.Â
Don’t trust; verify.
Digital asset custodians serve as the gatekeepers to funds and are a necessary part of the way the Bitcoin market has developed. These businesses will never go away and will always be available in some shape or form, and it’s up to you to decide if you want to use them and in what form you use them.
Remember, your Bitcoin is not only a means of wealth but also a reflection of your hard work and dedication. So as you dedicated time and effort to earn that money, so too should you dedicate the same level of time and effort to protecting it, right?
As Benjamin Franklin once said, “An investment in knowledge pays the best interest.” Educate yourself about the world of digital asset custodians, stay informed about the evolving landscape, make informed decisions and eliminate points of trust where you can.