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Understanding Digital Asset Custodians

| February 12, 2024

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When investing in cryptocurrencies, ensuring the protection of your digital assets is of paramount importance. Within this ecosystem, crypto custodians play a pivotal role by offering secure storage and overseeing the management of digital assets.

Opting for self-crypto custody service provides you with control. Still, it comes with substantial risks, including the potential loss of private keys and passwords or the need to handle security breaches independently. Additionally, it acts as a single point of failure; it fails to comply with the latest compliances and fails to identify risks and behavioural anomalies in transactions.

The selection of the right digital asset custodian is crucial in safeguarding your digital holdings. For cryptocurrencies to achieve broader acceptance, robust crypto custody solutions become indispensable for both individual and institutional investors alike.

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Key takeaways:

  • Digital asset custodians play a pivotal role in the blockchain ecosystem by providing crypto custody services for digital assets, ensuring the safeguarding of investors’ digital holdings.
  • Crypto custodians ensure secure storage and facilitate digital transactions through advanced cryptography and hardware security measures.

Explanation of Digital Asset Custody

Digital asset custody is a broad term that includes various methods of storing and protecting digital assets on behalf of their owners. Digital asset custody is in many ways similar to the custody of traditional financial assets; crypto custody providers take responsibility for securely storing investors’ assets and typically also offer other services, including the ability to buy and sell them.

However, there are also important differences. Notably, the nature of digital assets means that secure custody is even more critical than for traditional financial assets. Digital assets such as cryptocurrencies are created and transferred between owners using cryptography and a decentralized network called a blockchain. 

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Owners acquire digital assets in transactions recorded on the blockchain, and those transactions are typically the only documentation of the assets’ existence. The owners are issued cryptographic keys that prove their ownership of the assets, to be used when transferring them between owners or using them to buy things. So, technically, custodians don’t store the assets themselves; they store the owners’ cryptographic keys. Those keys must be protected to ensure the owner’s assets are safe. If they are lost or stolen, the assets may be unrecoverable.

Comprehensive Overview of Various Digital Asset Types

Digital assets encompass diverse categories distinguished by their characteristics and functionalities within the digital landscape. The principal classifications include:

  • Cryptocurrencies: Represented by digital currencies like Bitcoin and Ethereum, cryptocurrencies operate on decentralized blockchain networks. They serve purposes such as transactions and investments, and act as a store of value.
  • Utility Tokens: Tokens designed to access specific applications, platforms, or services, providing users with special privileges or discounts within the associated ecosystem.
  • Security Tokens: Digital representations of ownership in real-world assets like equities, debt, real estate, or investment funds. Security tokens adhere to securities regulations and often yield dividends or revenue shares.
  • Non-Fungible Tokens (NFTs): Unique digital assets verifying ownership or authenticity of specific items, including digital art, collectables, or in-game assets. Each NFT is distinctive and cannot be exchanged on a one-to-one basis.
  • Stablecoins: Cryptocurrencies’ pegged to stable assets, such as fiat currencies (e.g., USD), to mitigate volatility. Stablecoins offer stability and are commonly utilized for transactions and as a store of value in the crypto space.
  • Tokenized Real Assets: Digital representations of tangible assets like real estate, art, or intellectual property. Tokenization simplifies the division, transfer, and ownership of traditionally illiquid assets.
  • Governance Tokens: Tokens grant holders the ability to participate in decision-making processes within a blockchain network or platform, empowering them to propose and vote on changes.
  • E-Money Tokens: Digital representations of fiat currency issued by financial institutions or governments. Safely stored and transacted electronically, these tokens bridge the gap between traditional finance and the digital realm, facilitating seamless online transactions and payments.

 

Deep dive into digital crypto asset custody:

The digital asset market is still in its early stages, particularly compared to traditional financial markets. While the custody business model exists in both realms, the definition of “custody” in the digital asset space has not yet been solidified. In the digital asset landscape, the concept of custody is more flexible and represents a broad term that revolves around safeguarding assets on behalf of their owners.

Many purported ‘custody’ providers in the digital asset sphere need to genuinely offer custody. Instead, they provide hot wallets to store customers’ private keys without holding the assets’ custody. When users deposit funds into centralized exchanges, borrowing/lending platforms, or yield-generating solutions, these funds are considered ‘custodied’ on the customer’s behalf through a hot wallet provided by the platform. However, these digital asset custodian wallets do not guarantee asset segregation or ensure protection against theft, loss, or misuse. Essentially, these ‘custody’ providers offer tools for customers to hold their funds themselves but do not actually hold the assets on their behalf.

While such solutions enhance liquidity, they come with risks. Because they offer only hot wallets connected to the internet, they create more opportunities for hackers to exploit vulnerabilities. Additionally, as the crypto custody service provider operates these wallets, there is no assurance that a customer’s funds are immune to the provider’s activities unrelated to the customer’s decisions.

For robust digital asset custody, various options will be available. Opting for a solution that mirrors traditional finance practices is the key to ensuring complete protection of your digital assets. Before selecting a digital crypto asset custody provider, it is crucial to ask the right questions. Are they regulated? Do they have standard security measures and certifications? Do they follow key compliance checks? How do they protect private keys? How fast do they process transactions?

How does digital asset custody operate?

Crypto custody involves securing the private key that serves as proof of ownership for the funds stored within your cryptocurrency wallet. In traditional banking, custodians are typically financial institutions, as mandated by regulations. In the realm of cryptocurrencies, however, holders have the option to act as their own crypto custodians. To draw a parallel, envision the choice of either personally safeguarding gold bars under your bed or entrusting a third-party custodian to secure them within a vault protected by security measures.

Within the sphere of crypto custody, there are two primary types to be aware of:

Self-Custody

As previously discussed, self-custody entails personally holding the private key for your wallet. This arrangement grants you exclusive proof of ownership and access to your holdings. While it affords significant control, self-custody also entails substantial responsibility. Acting as your own digital asset custodian means you bear the full spectrum of risks. If you lose access to your physical device (e.g., a cold wallet) or forget the private key, the likelihood is that your cryptocurrency will be irretrievably lost.

Managed Custody 

Third-party custodians offer managed custody alternatives for individuals and institutions who prefer not to shoulder the responsibility of managing their cryptocurrency accounts or find the technical aspects daunting. These custodians are registered, regulated financial institutions holding either state-level or national licenses to operate as custodians. 

Functioning similarly to a traditional checking account with a bank, third-party crypto custody solutions securely manage clients’ private keys and ensure their funds are kept in segregated accounts, in either hot or cold wallets based on their requirements and are protected by a layer of security protocols with 24/7 SOC monitoring.

Engaging with a third-party digital asset custodian involves undergoing know-your-customer (KYC) and anti-money laundering (AML) checks, integrating with Travel Rule compliance checks and following the latest mandates issued by financial bodies to comply within their operating jurisdictions. These compliance check-ups ensure the transactions’ legitimacy and prevent involvement in illicit activities.

There are three distinct categories of third-party crypto custodians based on the nature of the financial institutions:

  • Exchanges: Centralized cryptocurrency exchanges typically handle the custody of their customers’ assets. Some exchanges outsource their security requirements to external custodial service providers. It is important to note that when utilizing a centralized exchange, users do not possess the private keys to their exchange wallet, exposing them to potential losses in the event of a hack or the exchange’s insolvency.
  • Institutional custodian: Institutional digital asset custodians act just like traditional systems, providing bank-grade custody solutions to institutions that are seeking to safeguard their entire treasury. These institutional custodians’ support are regulated, insured, qualified to operate in licensed jurisdictions, and possess all the pre-requisites to provide fully managed custody of digital assets, promising their clients with utmost security, transparent segregation of assets, and highgest standard of key management and wallet management standards.
  • Custodial Banks: Since July 2020, every custodial bank in the U.S. has been authorized to provide crypto custody services following the Office of the Comptroller of the Currency (OCC) clearance. This regulatory development has paved the way for major custodial banks such as BNY Mellon, Citibank, and Fidelity to enter the crypto custody market.

Regulatory Compliance and Security Standards for Crypto Custodians

A reputable crypto custodian safeguards assets and adheres to applicable laws, regulations, and industry best practices. These standards are established by entities such as the U.S. Securities and Exchange Commission (SEC) and the U.S. The Commodity Futures Trading Commission (CFTC), including regulatory bodies in Abu Dhabi, Hong Kong, Europe and Singapore, are designed to ensure custodians implement robust security protocols to protect digital assets.

Selecting a custodian necessitates verifying compliance with regulatory requirements and confirming the adoption of contemporary security measures, including encryption and multifactor authentication, to restrict unauthorized access and mitigate cybersecurity threats. Here are key indicators that a digital asset custodian is a suitable choice for your business:

  1. Regulatory Compliance: Digital asset custodians must adhere to relevant laws and regulations, encompassing Know Your Customer (KYC) and anti-money laundering (AML) rules. Possession of proper licensing and oversight provides assurance that the crypto custodian meets reporting, auditing, and fraud detection standards, offering accountability and recourse in case of issues.
  2. Security Standards: A qualified digital asset custodian should employ state-of-the-art cybersecurity measures, such as cold (offline) storage, multi-signature wallets, multiparty computation, biometrics, and hardware security modules. Rigorous protocols, like proof of reserves, should undergo regular audits. Additional protection layers can be provided through insurance coverage. Security certifications like ISO, SOC and CCSS also are crucial to pose. Advanced cybersecurity measures include penetration testing, data encryption, defence against distributed denial of service (DDoS) attacks, and continuous 24/7 monitoring to prevent breaches and data loss.
  3. Asset Segregation: Custodians should implement protocols to segregate client assets from their own holdings, preventing the commingling of funds. This ensures protection for your assets, especially in scenarios like bankruptcy.
  4. Transparency: Digital asset custodians must maintain full transparency regarding how holdings are secured and managed. This involves frequent auditing and reporting. Real-time access to account overviews and transaction tracking should be provided, allowing clients visibility into their holdings. Legitimate and expert custodians uphold transparency without ambiguity.

What’s ahead for digital asset custodians?

Cryptocurrencies have maintained their presence for over a decade, demonstrating resilience in the face of regulatory uncertainties that characterized much of their existence.

As regulatory scrutiny intensifies and mainstream institutional interest grows, investments in cryptocurrencies are poised to gain popularity. The widespread adoption of these assets among institutional and retail investors will drive the inclusion of crypto custody services. This strategic move aims to retain customers and increase the share of wallets in an evolving financial landscape. Nevertheless, ensuring regulatory alignment for crypto assets poses inherent risks similar to traditional assets. Concerns such as the potential for large-scale fraud or the loss of private keys could undermine the credibility of cryptocurrencies as a reliable alternative asset class.

Custodian banks should exercise caution and address these challenges proactively when introducing crypto custody solutions. We assert that crypto custody represents a significant and timely business opportunity for banks. To capitalize on this opportunity, a comprehensive understanding of the requisite technologies for scalable crypto custody services, the associated security considerations, and organization-specific nuances is imperative. Taking confident and decisive actions is key, as banks must position themselves strategically to stay ahead in this rapidly evolving landscape.

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