What are cryptocurrency custody solutions? Understanding the importance of security and control

Cryptocurrency custody solutions are specialized systems for securely storing and managing significant amounts of tokens. They represent a recent innovation in the cryptocurrency ecosystem, seen as a key factor in attracting institutional capital to the industry. This article provides an overview of why cryptocurrency requires custody solutions and the various types available in the market.

What is the necessity for cryptocurrency custody solutions?

Cryptocurrency custody solutions are primarily aimed at safeguarding cryptocurrency assets. Private keys, which are used to manage transactions and access crypto holdings, are complex combinations of alphanumeric characters that are challenging to remember and vulnerable to theft or hacking. While online wallets offer one solution, they have also been targets of cyberattacks, as have cryptocurrency exchanges.

Offline storage of private keys, such as on paper or a disconnected electronic device, is another option. However, the risk of losing physical custody of the paper or device is real, and in such cases, recovering the cryptocurrency holdings can be impossible. While this risk is a concern for individual bitcoin holders, it poses an even greater risk for institutional investors, who take extensive measures to mitigate it. Some large investors have gone so far as to distribute portions of a paper wallet across multiple storage units in different locations.

Regulation is another key driver for the development of cryptocurrency custody solutions. According to SEC regulations under the Dodd-Frank Act, institutional investors with customer assets exceeding $150,000 must store these holdings with a "qualified custodian." This category includes banks, savings associations, registered broker-dealers, futures commission merchants, and foreign financial institutions. However, few mainstream banks offer custodian services for cryptocurrencies. Kingdom Trust, a Kentucky-based custodian, was a prominent service provider until it was acquired by BitGo, a San Francisco-based startup.

What do cryptocurrency custody solutions entail?

In essence, cryptocurrency custody solutions are services offered by third-party providers for storing and securing cryptocurrencies. These services primarily target institutional investors, such as hedge funds, holding substantial amounts of bitcoin or other cryptocurrencies. The solutions typically combine hot storage, which is connected to the Internet, and cold storage, which is disconnected from the Internet.

Both hot and cold storage methods have their advantages and disadvantages. Hot storage, being connected to the Internet, provides easier access to liquidity. However, it is more susceptible to hacks due to its online presence. On the other hand, cold storage offers enhanced security but may present challenges in quickly liquidating crypto holdings due to its offline nature. Vault storage, a hybrid approach, combines elements of both by storing most funds offline and requiring a private key for access.

Major participants in cryptocurrency custody

Coinbase, a prominent digital currency exchange, has become a significant player in the cryptocurrency custody sector. It ventured into institutional-grade custody solutions by acquiring California-based Keystone Capital, a registered broker, and later the institutional business of storage provider Xapo in August 2019. Additionally, Swiss bank Vontobel introduced a Digital Asset Vault targeting institutional investors in the cryptocurrency space.

The future of cryptocurrency custody

The popularity of cryptocurrency custody solutions has surged as analysts and institutional investors increasingly see them as a link between the traditional institutional investment market and the evolving cryptocurrency sector. Two key developments are anticipated to impact the future of cryptocurrency custody.

The first is the entry of major players. Established institutions like Goldman Sachs have yet to offer cryptocurrency solutions, but their potential entry could significantly impact the emerging market. Coinbase and Fidelity Investments have already made strides in providing or developing cryptocurrency custody services.

The second is regulatory clarity. Current regulations lack specific security provisions for cryptocurrency storage, and there remains ambiguity regarding regulations surrounding cryptocurrencies themselves. The industry is expected to mature once regulators establish clear rules for the market.