To provide a secure solution to store digital assets, the market for digital custody solutions evolved in order to accommodate for technical difficulties of digital custody. Furthermore, regulators start to incorporate digital assets and the corresponding custody into their legal codes. Introducing juridically and technically secure custody solutions paves the way for digital assets and their application by private and institutional investors.
Whenever a person holds an asset, it needs to be stored in some way. In the past, investors stored gold or stocks of a company in a vault at home or their bank. As soon as higher volumes were traded at the financial markets, physical possession of assets was not desirable anymore. To give investors the possibility to own assets without storing them, banks offered custody services through which they only had so-called custodial possession of the asset. In the last decade, custody requirements started to change dramatically, as all kinds of digital assets are added to the market. Blockchain technology enables self-custody of assets meaning, that investors can store and manage their assets.
Regulators reacted to this need by drafting and implementing first crypto custody regulations. The Liechtenstein Blockchain Act and regulatory approaches of the German and Swiss governments are examples of the efforts regulators currently make. The Liechtenstein Blockchain Act enables any physical object including its specific rights and obligations to be transformed into a corresponding digital asset.
This regulatory environment is crucial for institutional investors (i.e. insurances, funds, VCs, asset managers, family offices) because they require a certain regulatory framework in order to be able to invest in digital assets. Enabling institutional investors to hold digital assets enhances all financial applications of blockchain technology as large amounts of capital can now access the financial blockchain environment.
The essence of custody is directly linked to responsibility. In order to provide a secure and regulated custody solution, a responsible party for the management of the stored assets needs to be defined. Over the last few years, two main groups of custody providers developed: custodians and non-/self-custodians.
Custodians provide not only a soft- or hardware-based custody solution but are also responsible for the key management.This is the group of custody providers that are affected by the mentioned German requirement for BaFin approval. Examples of custodians are - amongst others - Finoa, Plutoneo, Tangany, and Trustology.
Non-/self-custodians on the other hand only provide the (soft- or hardware-based) custody solution without being responsible for the key management.The investor is obliged to self-custody. Due to the first drafts of German custody regulations, these custody providers do not require BaFin approval. Non-/self-custodians are for example upvest, Qredo and Riddle & Code.
Dealing with digital custody reveals that security plays a major role. There are different approaches to store digital assets, which have different features and security levels. One can differentiate between three major groups: hot, cold and warm wallets.
A hot wallet is a digital storage solution which is permanently connected to the internet. The following types of hot wallets exist:
The online wallet is an easily accessible, web-based wallet. Due to the permanent internet connection, it is very vulnerable to hacks potentially leading to the loss of assets. But thanks to fast and easy access, it is well-suited for online purchases and money transfers. All in all, it is recommended to use online wallets for these applications only while storing large amounts should be avoided. Examples of online wallets are CoinPayments and CoinSpace.
A mobile wallet is essentially the same thing as an online wallet but in the form of a smartphone application. It makes digital assets available on the go. Mobile wallets have the same security issues, but also the same practical applications as online wallets. Examples of mobile wallets are Edge, Coinomi, and Jaxx.
Combining both, the online and the mobile wallet creates a so-called hybrid wallet. These are accessible on the web and mobile devices,which makes this type of wallet very convenient for daily use. But the security issues remain. Therefore, online, mobile and hybrid wallets are recommended for small amounts only. Examples of those hybrid solutions are BitPay and GreenAddress.
There are also desktop wallets which – as the name suggests – are desktop applications. This type is the original form of cryptocurrency wallets and it is considered safer as online solutions, but it is still vulnerable to cyber theft because of possible malware on the respective device. An example of this type is Exodus.
The last type of a hot wallet presented here is the so-called exchange wallet. This is a wallet, which is directly linked to an account at a crypto exchange platform serving to buy or sell assets at the corresponding exchange. As these wallets are also very exposed to cyber risk and because there have been many incidents concerning cyber-attacks on exchange wallets, it is reasonable to transfer the assets not needed for exchange to another storage solution. Examples of this type are Bitfinex and Binance.
On the other hand, digital assets can be stored in so-called cold wallets, which are only connected to the internet when a transaction is conducted.
Hardware wallets are cold storage solutions consisting of a physical device, for example, a USB stick, storing private keys. It is considered very safe because hackers cannot access the keys stored on these devices,thus many digital asset investors use this kind of custody solution for larger investments. Although it is not accessible from anywhere,the device can be kept on person at any time. Ledger, KeepKey, and Trezor are examples of such hardware wallets.
Another type of a cold wallet is the paper wallet. This is a simple printout usually consisting of two QR codes – the public and the private key. The public key is used to receive, and the private key is used to send assets using the corresponding wallet. Paper wallets are also recommended for large amounts as assets can be stored securely. Since it is time-consuming to constantly scan the QR codes, the investments should be long-term. Most cryptocurrencies have a paper wallet generator, e.g. is BitAddress.
The biggest disadvantage of hardware and paper wallets is responsiveness. It can take hours to access the stored assets making cold wallets useless for active investing.
When deciding whether to use hot or cold wallets, there is an obvious trade-off between security and responsiveness.Warm wallets are a hybrid solution and tackle these issues.Assets are available within seconds and so-called hardware security modules (HSMs) are used to guarantee the necessary security.
This variety of different storage solutions may seem overwhelming, so how can one securely and accessibly store digital assets? There are three basic principles of secure digital custody. First, cold storage should be used for long-term investmentswhile both, warm and hot storage are suitable for everyday transactions.
All in all, digital custody solutions and corresponding regulations are the door-opener for digital assets into the world of institutional investment.This will significantly increase possible applications of blockchain technology in the financial sector. The trade-off between security and responsiveness of digital custody is tackled by warm storage solutions, providing clients with an applicable way to store digital assets and building the technical framework for the extensive use of digital assets. Regulators starting to build up a regulatory framework, on the other hand, are contributing to a promising future for digital asset use as well.All of these factors pave the way for digital assets and the use of those by institutions and many private investors.