How to choose a crypto custodian
CryptocurrencyUpdated on August 23, 2022
Table of Contents
- Why cryptocurrency is set to become a mainstream asset
- Family offices to lead with caution
- The role of asset custodians
- Why custody is so important in the cryptocurrency market
- Options for crypto custody
- Hot storage vs cold storage?
- Don’t go it alone
- Four key considerations when choosing a crypto custodian
- Importance of digital asset custody
As the crypto industry grows, so does the demand for reliable crypto custodians. While their responsibilities aren’t dissimilar to that of traditional asset custodians, the crypto space is vastly unique in and of itself, with a constant influx of new players and technology. For family offices, choosing the right crypto custodian is the key to engaging in crypto confidently and efficiently.
Why cryptocurrency is set to become a mainstream asset
The digital asset market is still considered to be in an early adoption phase but the recent growth in cryptocurrency market capitalisation to over $1.5 Trillion suggests that it is fast becoming a more mainstream asset class. No longer just the realm of speculative investors, cryptocurrencies and digital assets are receiving increasing attention from institutional investors as well as family offices, raising the possibility of a massive surge in crypto investment over the next few years.
Family offices to lead with caution
According to a Goldman Sachs survey, 15% of family offices across the globe and 25% of family offices in America have already invested in cryptocurrencies, with another 45% globally expressing interest in doing so. With significant capital to invest and a long-term horizon, family offices are expected to not only ride the crypto-wave but propel it to new heights as they diversify their assets and look to new stores of wealth. The combination of rising inflation and low-interest rates are also contributing factors to this projection. However, the risk, volatility and regulatory uncertainty that is associated with the digital asset market requires family offices to approach this investment with some caution.
The role of asset custodians
Asset custodianship has traditionally been associated with capital market financial institutions that are responsible for the safeguarding of investors’ assets as well as providing other services like trade settlement, exchange, clearing, and corporate action execution. These custodians are temporarily entrusted with assets and are expected to minimise the risk of fraud, theft or loss to those assets. In line with accelerating investment into the crypto space, the demand for digital asset custodianship has grown tremendously. However, this has proven to be a space that is vastly different from traditional asset custodianship, hence the plethora of new players and technologies that are emerging all the time.
Like their traditional capital market counterparts, digital asset custodians are also responsible for the safekeeping of a client’s crypto assets, however the difference is that these custodians do not hold the asset itself but are responsible for the custody of the keys to these assets. Through safe key management, digital assets are cryptographically secured and the custodian, therefore, ensures that the asset cannot be accessed by any other party. For a family office to have transactional access to an asset, both a public and private key needs to be used.
Why custody is so important in the cryptocurrency market
Asset security and transaction efficiency are common requirements for most investors, whether they be single investors, family offices or large institutions. Crypto custodians play a vital role in achieving both of these objectives. With the amount of value beginning to accumulate in the digital asset space, the safeguarding of this wealth begins to take on a new priority. It should also not be forgotten that digital assets are, by nature, more vulnerable, which means that crypto custodians play a key role in limiting the associated risks. Over the past few years, family offices have been increasingly targeted by cybercriminals so it would make sense for this sector to consider the services of a third-party custodian when exploring crypto investment.
Options for crypto custody
Lets first define a few common crypto terms that are used in this section:
A public key is a long numeric code that is cryptographically derived from a specific private key and is publicly available. A public key allows you to receive cryptocurrency transactions. Anyone can send transactions to the public key but you need the correct, corresponding private key to “unlock” them and prove that you are the owner of the cryptocurrency received in the transaction.
A private key is a randomly generated binary number that is used to encrypt and decrypt information and is only made available to the originator of the encrypted content. A private key gives you the ability to prove ownership or access the funds associated with your public address.
A cryptocurrency wallet is a device, physical medium, program or service which stores the public and/or private keys for cryptocurrency transactions. In addition to this basic function of storing the keys, a cryptocurrency wallet often also offers the functionality of encrypting and/or signing information.
There are many custody options available to both individual investors and institutional players, falling within three main categories:
Self custody: These include hardware, software or paper wallets in which the digital asset investor independently stores private keys.
Exchange wallets: Control and management of public and private keys are handed over to an exchange, but the investor maintains access via an online wallet.
Third-party custodian: Typically aimed at institutional investors and large family offices, these service providers store digital assets on behalf of customers using institutional grade security and controls to protect investors’ assets.
Custodians safeguard digital assets by ensuring that investors’ private keys are maintained securely. This is achieved by either storing the assets online, a method called hot storage, or offline, known as cold storage, or through a multiple approval approach, known as multi-signature and smart contract wallets.
Hot storage vs cold storage?
The key benefit of hot storage is also its downside. Its connectivity to the internet provides investors with ease of access to digital assets but this convenience also leaves it vulnerable to cyber security threats. Additionally, online custodians often restrict access to the private key.
Cold storage holds keys offline which maximises security but does not provide an efficient user experience.
Don’t go it alone
Digital asset custodians are currently leading and shaping the crypto landscape and represent a significant disruption to the traditional financial services sector, however it is inevitable that the traditional asset custodians start playing a greater role in how this investment category grows and evolves. Either way, projections indicate a significant increase in family office investment into cryptocurrency over the next few years and appropriate measures need to be taken by the family office to ensure adequate risk management. Remember that the digital asset space is still quite new and is certainly very volatile. Partnering with the right crypto custodian is therefore a wise call to make before you take the plunge.
Four things to consider when choosing a crypto custodian
Selecting the right custodian is not an easy decision and should not be taken lightly. Here are some important questions that need to be asked when choosing a crypto custodian:
Does the custodian have the right credentials and is it governed by regulation?
Trust is a hugely important consideration. Your custodian needs to provide solid credentials and confirm their compliance with appropriate regulations. For example, is the custodian having to comply with a regulator that is a FATF member and therefore having to comply with the highest standards of AML, KYC and CTF?
What level of technical expertise does the custodian have?
A technical review of a potential custodian is always recommended. Certain standards need to be in place and adhered to by a custodian in order to demonstrate technical expertise. Systems need to be reliable and aligned to best-practice cryptographic standards. Systems and processes should be audited and stress-tested.
What unique service and system requirements do you have?
Consider the unique needs of your family office. What specific service requirements do you have? What customisation might you need to ensure that a custodian’s ‘product’ is an appropriate fit for your family office?
Is the custodian focused on individual or institutional investors?
Many crypto custodians are not geared to service family offices or larger institutional investors. Ensure that a custodian’s product offering is one that has the necessary level of sophistication and integration capability to suit your family office requirements.
Key reasons why digital asset custody is becoming so important:
1. Safer than exchanges
Storing digital assets on an exchange carries a greater risk of loss due to the susceptibility of exchanges to going bankrupt, being shut down or successfully targeted by hackers.
2. Recourse for investors
If investors choose to hold assets privately or with unlicensed custodians they carry a significant risk of loss from hacking or other events. However, licensed custodians are more likely to have access to trusted insurers and therefore provide some recourse and security in the event of a loss.
3. Reduced complexity
Potential investors in digital assets are often discouraged by the perceived complexity involved. However, custodians can leverage their technology and regulatory expertise to provide investors with a greater sense of comfort and improved ease of use.
4. Increased security
Due to the online nature of digital assets, the security risk associated with hackers and other cyber-crime is quite high. Custodians should have the necessary technology and resources to minimise these risks, providing investors with a more secure and regulated storage option for their digital assets.
What is cryptocurrency?
Cryptocurrency, or simply crypto, is a type of currency that exists digitally or virtually. It is secured by cryptography, which makes it almost impossible to double-spend or counterfeit it. To verify the transaction, cryptocurrency uses encryption, which is where its name is derived from.
How to buy cryptocurrency?
First, you need to choose a broker or crypto exchange. After you create and verify your profile, in order to buy crypto, you need to make sure that you have funds in your new account. Then, choose your desired cryptocurrency (Bitcoin, Ethereum, DOGE, etc.) and place your order. Finally, store your cryptocurrency, either by using digital wallets or leaving it on the exchange platform.
How does cryptocurrency work?
Cryptocurrency is a digital currency created by a process called mining. All transactions are recorded and verified by encryption and are secured by cryptography to prevent counterfeits or double-spends.
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