Custody in Crypto: Not Your Keys, Not Your Coins
What is Custody in Crypto?
Custody is best understood as ownership within the crypto space and entails the safekeeping of assets.
The owner is ultimately responsible and in charge of said assets, and custody revolves around protecting digital assets from malicious actors. Because digital assets exist on the blockchain, a public ledger, no physical storage is required. Instead, users prove ownership of their assets at any given address with a private key.
This marks one of the most significant departures from TradFi (traditional finance). At the heart of TradFi rests a custodial operation model. Citizens globally trust banks to look after their funds, and although this comes with certain benefits, citizens cannot be said to own their money. Banks can freeze accounts on a whim, a grim reality for millions of citizens globally. DeFi mandates a non-custodial wallet, and the true beauty of cryptocurrency rests in the fact that investors retain complete autonomy over their funds.
Two Important Concepts
Seed Phrase: This random string of words acts as a backup mechanism allowing users to retrieve a lost wallet.
Private Key: This secret randomly generated number is used to make transactions and represents the final ownership of digital assets. If a private key is compromised, the user forfeits the ownership of assets contained within the wallet. The importance of keeping a private key secure cannot be understated, and the private key is the most essential component of custody in crypto.
MoneySwitch Tip: Investors should write down their seed phrase on paper and store it somewhere safe where no one else has access. Never store a photo online as sophisticated programs search cloud data for seed phrases.
The Current Climate
Bear markets inevitably result in business closures, and cryptocurrency is no exception. With large centralized exchanges (CEXs) looking to cut costs to maintain profitability, some exchanges have implemented hiring freezes, others have fired portions of their workforce, and in the most severe cases, large exchanges like Celsius and Zipmex filed for bankruptcy and halted withdrawals from their platforms.
Most recently, FTX has filed for bankruptcy rocking the crypto markets’ foundations. This multi-billion dollar hole in FTX’s balance sheet resulted from an undisclosed relationship with Alameda that saw customer deposits freely moved between the two institutions. Millions of investors have lost billions in funds, and this is because centralized exchanges hold the private keys to wallets and therefore own the funds.
These events are painful to crypto holders and go against the core ideology of DeFi (decentralized finance). As a result, the topic of custody has again grown in prominence. The last fallout of this size was the Mt Gox hack in 2014 that brought the market to its knees. Thankfully, crypto now is a far more mature market and naturally more resilient. The shaking out of bad actors, SBF, is a net gain to the space long-term.
Types of Custody
Broadly wallets are divided into Custodial and Non-Custodial, with subcategories existing within the latter. The main difference between the two is that with a Custodial wallet, a third party, typically a CEX, owns the private key and, thus, the coins. With a Non-Custodial wallet, the user is fully responsible for their private key and, therefore, their funds.
Custodial
Custodial wallets are prolific because they are more convenient: the burden of responsibility for safeguarding the assets falls to the third party. It is far easier to access a custodial wallet if the user loses their password. Another benefit is that users often do not have to pay transaction fees to operate within an ecosystem such as Binance, where investors can trade and move funds around the exchange free of charge. This centralized model has huge overlap with TradFi and why many investors naturally feel comfortable with this set up.
However, the ownership of the assets firmly stands with the private key holder, and recent events have highlighted the dangers of trusting third parties to keep investors’ digital assets secure.
Non-Custodial
The user is in complete charge of their private key and their assets. Non-Custodial wallets are differentiated primarily between hot and cold wallets. Hot wallets are browser extensions, the most popular being MetaMask, and cold wallets store users’ funds offline in a hardware device, the most popular being Ledger products. The key distinction being the private key being stored online or offline.
Hot Wallets are how users interact with DeFi, and cold wallets, typically regarded as the most secure, are suited for long-term storage of assets or significant sums of assets.
MoneySwitch
MoneySwitch is truly DeFi. Liquidity in the form of stablecoins deposited to MoneySwitch liquidity pools is linked to the wallet’s private key. The smart contract interaction is signed with the private key, and the balance is registered to the wallet that signs the transaction. To withdraw funds, users’ must use the same private key.
Decentralized finance is about removing intermediaries and centralized control. We at MoneySwitch thoroughly encourage users to self-custody their assets and practice good digital hygiene to ensure the security of their funds.
We are bridging the real world and DeFi by providing uncollateralized loans to cross-border payment providers through non-custodial liquidity pools. And in light of the recent actions of centralized exchanges halting withdrawals and filing for bankruptcy, we recommend all investors take the time to protect and secure the digital assets they have worked so hard to acquire.
Want to learn more about MoneySwitch and the changing reality of global payments? Please join us here, and for further information on how to help power the cross-border payments of tomorrow whilst earning yield on your stablecoins, visit us here.
