This article covers an under-discussed topic: How should cryptocurrency and digital assets be held.
September 13 2021
In the first installment to this series, we introduced the notion of a 'digital asset.' We explained our thesis for why digital custody — secure handling of valuable digital assets — is an important topic of discussion, given that the valuation of digital assets has increased dramatically over the past few decades. In our second post, we explained how the digital asset subclass of cryptocurrency has major security risks that magnifies the scope of how much digital asset custody is necessary. This article covers an under-discussed topic: How should cryptocurrency and digital assets be held.
As we all know, cryptocurrency is peer to peer — that means instead of a bank holding on to your money and keeping your funds intact, you, yourself are responsible. One the one hand, this gives people the ability to own their own money and appeals to the libertarian crowd. On the other hand, some argue that people are not capable of taking control of their finances — and rightfully so. Either way, maintaining a 48-character private key (which gives access to a cryptocurrency wallet) is difficult.
This article from the beginning of 2018 highlights many of the challenges with specific solutions, alas these challenges remain as we enter 2019.
Custody is a service given by professionals for the holding and maintenance of valuable assets; traditionally frequent among high net worth individuals and institutions. This service isn't common among the everyday consumer because their banks act as custodians to their assets; people can store the few valuables they have in a bank account or safety deposit box. While this culture of custody worked in the traditional finance realm, an era of peer to peer finance — where consumers own their assets and are thus liable for them — begs a new way of conceiving custody.
Digital custody will be a new wave in the institutional and HNW realm of peer to peer finance. This is because managing private keys of accounts upwards of a million dollars will not be left to single individuals to maintain them on a hard or stick drive.
Demand for digital custody of cryptocurrency assets has risen rapidly throughout the past few years as speculating on, holding, and using crypto assets became more popular. These options range from robust, institutional-grade complying custody solutions like Coinbase Custody to more flexible and controlled custody options like personal cryptocurrency wallets. With owners holding onto assets for the long term, and security threats standing their ground, digital custody will be an important topic of discussion for the future of the asset class.
One of the only compliant custody solutions on the market right now is Coinbase Custody. Coinbase Custody is a service that provides insurance, hierarchical control, segregated cold storage, SLAs on fund transfers, and 24/7 customer service for accounts on the platform. Coinbase works in collaboration with an SEC-registered broker-dealer and FINRA compliant company known as ETC to be fully compliant as a custody service provider.
While digital custody with the likes of Coinbase may be the best solution for high net worth individuals, this service is unavailable for typical retail investors. Moreover, institutions have grown to be skeptical of Coinbase Custody because the idea of custody of an asset typically entails disintermediating the asset from the market. Most hedge funds await big names like Goldman Sachs and ICE to open up custody desks, so that custody of their assets is handled outside of the hands of cryptocurrency businesses. Institutions also await the approval of a cryptocurrency exchange-traded product (ETP) which could turn out to be a powerful liquidity and custody solution to the market. However, many previous filings have been denied by the SEC, and it is unclear when the SEC will approve one.
Exchanges take custody of assets that speculators own. It's apparent that traders are very comfortable holding their funds on exchanges — as some of the largest exchanges hold a total of over 4% of Bitcoin's circulating supply. However, exchanges have not proven themselves to be bulletproof custodians in the past. Mt. Gox's hack in 2014, Bitfinex's hack in 2016, and Coincheck's hack in 2018 showed us that exchanges are not exactly what one would call risk-free.
Holding assets on exchanges is frequent among retail investors. Institutions with a lot of capital typically open up corporate accounts on multiple exchanges for more liquid trading. Exchanges like Bittrex, Poloniex, Kraken, OKex, and Huobi have opened doors to institutions where they provide more customized service and custody options.
Wallets are means of storing public and private key pairs that identify and give access to cryptocurrency on the blockchain. Wallets include both hot wallets and cold storage wallets. Hot wallets are connected to the internet. They could include original core software wallets or web wallets. Where this wallet is stored presents a point of failure — if a malicious actor gets hold of the wallet, they could steal a users funds.
Cold wallets are offline and isolated, such as a hardware wallet or a paper wallet. Hardware wallets are more secure but more complicated for the average user. Executing a transaction on a hardware wallet requires that one confirms the transaction using a button on the physical device. To protect individuals from losing funds if they lose their device, each hardware wallet is prescribed a seed phrase. This is a set of words that are entered into an app to regain access to a wallet without having to have that device. While hardware wallets are relatively secure and safe, the seed phrase is a central point of failure to the security of one's funds.
We've established a few things so far. Hot wallets present a single point of failure in wherever the private access key is stored. Cold storage presents a single point of failure in wherever the private key or seed phrase to restore the account is stored. Exchanges store funds in their wallets which could be compromised at any time. Professional digital custody solutions are not where institutions quite need them to be and are unavailable to average investors.
So how do we establish a universal and secure means of digital custody that does not entail some sort of a central point of failure? The way we at Vault12 plan to do so is by decentralizing storage of access points themselves — private keys and seed phrases — breaking them up into shares that are useless on their own, but then are combined to reconstruct these keys. This isn't a solution that would replace paper or hardware wallets per se, but rather would be an extra layer of security on top.
In other words, we'll spread these central points of failure out; to make the storage of access keys to cryptocurrency safer, more secure, and more practical. Instead of storing your private keys on a server, or on a fragile memory disk — your keys will be split up and stored on a mesh of devices around the world — completely resistant to targeted attacks and unfortunate occurrences.
Investment Panel: Naval Ravikant, Meltem Demirors, Garry Tan | Blockstack Summit 2017"Investing in Decentralized Applications Panel"Meltem Demirors, Digital Currency Group DirectorNaval Ravikant, AngelList FounderGarry Tan, Initialized Capita...
Digital custody of crypto assets remains an opportunity for innovation. We're looking to find the fine line between decentralization, security, and usability of cryptocurrency wallets and other containers of digital assets — and bring that solution to you in the Vault12 platform.