In the first part of our commentary on cryptocurrency custody, we explained how it works and a couple of the biggest drawbacks.
In this article, we'll look at more reasons why custodians are not in the spirit of the cryptocurrency revolution and outline how easy it is to set yourself up for self-custody.
Custody Introduces Extra Costs
Custodian solutions introduce more costs for investors. For instance, if we take Coinbase's custody solution as an example, it can cost up to $10,000 plus a 50 basis point annual fee. It's cheaper for cryptocurrency users to set up their own Cold Storage solutions.
Since we can lend bitcoin out on exchanges or we can deposit coins into interest-bearing cryptocurrency accounts, there is an opportunity cost involved when using a custodian. Another potential opportunity cost includes missing out on forked coins (e.g., Bitcoin Cash or Bitcoin Gold).
Does the custodian also take custody of those assets too? What happens if custodians take these forks and airdrops from you, are they legally liable? These are some unresolved questions.
Restricted Access to Liquidity
When you hand over the responsibility of managing your digital assets to a custodian, you give up some control of your bitcoin.
Most custodians need over 24 hours' notice to withdraw your coins. Because of these restrictions, you may not be able to access your funds in the event of market volatility.
You can move funds in and out of self-custody to exchanges or other services whenever you want.
Estate Planning
A third-party custodian may not be able to transfer your assets to your family/heirs in case of an emergency. While there is at least one custodian with estate planning, there's no industry standard, and the majority haven't got it in place. If the custodian disappears, your bitcoins are lost forever.
Charles Phan
Most custodians offer multi-signature schemes, which provide a backup key so you can still manage your funds without their involvement. Instead of using one private key to transfer ownership of some bitcoins, a combination of keys is required.
For example, there are three private keys associated with your bitcoin holdings in a 2-of-3 multi-signature scheme, where two private keys must sign a transaction to confirm it. But this is not any different from setting up your own multi-signature scheme. You might as well give the extra key to a third party you trust (such as a family member).
Privacy
Using a custodian means that your identity could potentially be linked to a set of private keys. Even if you have nothing to hide, there is a risk that the custodian's client base may become targeted by hackers.
Being Your Own Crypto Custodian
There's no need for a custodian if you have the right security in place.
Banks store your money for you, and custodians hold on to your private keys. There's not much difference. If retail traders relied on custodians, it would turn the cryptocurrency revolution into something like the banking system it attempts to overcome.
It is misguided to think that trusted centralized exchanges are suitable custodians. Many of the problems highlighted above also apply to exchanges. The various hacks over the years, exit scams, and the widely implemented KYC requirements prove that self-custody is preferable.
Despite taking a few hours of effort and a couple of checks every year, self-custody is not as difficult as you may think. It is surprising that some users will give up their sovereignty for convenience.
Secure Self Custody Solutions Exist Today
How exactly do you secure your own digital assets?
At the very least, you'll need:
- a hardware wallet (preferably open source),
- or a BIP 38 encrypted paper wallet (generated using an air-gapped computer).
Open source guides are available, with one example being the SmartCustody guide on GitHub. You'll need two safety deposit boxes, a hardware wallet, written instructions for your heirs, and a fireproof steel device to inscribe your seed phrase into. We can also take estate planning into our own hands using the articles and templates here.
Best practices for the custody of cryptocurrency are still evolving. Given the radical difference between crypto-assets and the dematerialized securities financial institutions deal with, the standards for safeguarding crypto-assets will need to combine the traditional concept of custody with aspects of cybersecurity and cryptography. There also seems to be no satisfactory solutions to adviser fraud and mismanagement.
With great individual empowerment comes great responsibility. Being in charge of your own wealth is more desirable than trusting a third party. Since custodians want to generate rent from holding your crypto-assets for you, they stand in direct opposition to the essence of the cryptocurrency revolution.
Charles Phan is the Chief Technology Officer at Interdax.com
