What is Cryptocurrency Custody?
Think of crypto custody as a secure 'holding place' for someone’s digital assets in Decentralized Finance (DeFi). Cryptocurrency, like any asset, requires a level of safeguarding, and this is where crypto custody comes into play.
Banks have traditionally held the role of custodians of people's money. However, they've been criticized over time due to the risk of insolvency if all customers attempt to withdraw their funds at once.
Blockchain technology enables a revolutionary feature - self-custody. It allows individuals to hold their assets without relying on a third party. This is especially valuable for those who wish to manage their own finances. But self-custody does come with its own set of risks, which are essential to understand. To get there, let's first comprehend how it operates.
How does it work?
In the world of blockchain, the 'holding' process is a bit different. The assets aren't physically held, but users hold 'private keys' granting access to these assets on the blockchain.
- Private Key
A private key is a uniquely mathematically generated key that authenticates ownership of a blockchain address. It allows the owner to sign transactions and control the assets linked to the address. As it is private, you must not share it, or risk losing ownership of your address, allowing anyone with the key to control your digital assets.
- Public Key
In contrast, the public key is available for all to see. It's used for receiving transactions and identifying wallet activity. If someone wants to send you a transaction on the blockchain, you provide your public key, and the transaction will be deposited in your wallet.
Public and private keys are cryptographically linked. While you can generate a public key from a private key, the reverse is nearly impossible due to the encryption methods used.
- Public vs Private Key
To simplify, consider the analogy of an email account. Your email address (public) is shared with anyone you want to receive messages from. The password (private) grants access to your inbox and should be kept confidential. In a similar manner, your public key is used to receive funds while the private key controls them, thus should remain securely protected.
Crypto wallets come into the picture when dealing with custody and private keys. These digital 'wallets' hold your private keys, allowing you to access your crypto assets.
There are two key types of crypto wallets:
- Hot Wallet
Hot wallets are a favorite amongst those who prefer managing their assets themselves. They are internet-dependent, making them susceptible to potential cyber threats - it is recommended that you use a hot wallet in a safe device connected to a safe network. They are free, user-friendly, and efficient, making them popular with frequent traders. Metamask, Trust Wallet, and Coinbase Wallet are a few examples.
- Cold Wallet:
Cold wallets offer higher security levels as they store your private keys offline. They are hardware devices that allow transactions only when connected to a computer or phone and manually authorized with a password.
Cold wallets are an optimal choice for long-term investors with a substantial asset base. While they offer heightened security, they do require an upfront investment (around U$50 to U$300), with popular choices including Ledger and Trezor.
If you’re interested in buying a cold wallet, make sure that you’re buying it from the original website of the company, and not third parties selling them.
Recovery Phrase and Safety Measures
The recovery phrase, also called the seed phrase, is a safety measure that exists in both hot and cold wallets. The phrase is a series of words, usually 12 to 24 that is randomly generated by a crypto wallet and gives access to the person who writes them all correctly and in the right sequence.
It’s very important to keep all words written in an offline safe place, like a piece of paper inside a metal safe box, to guarantee that no one can access them. If you have a cold wallet and someone finds your seed phrase, then there’s nothing you can do if the person uses it and withdrawals all of your assets.
If you forget your wallet password, lose your cold wallet hardware, or simply want to log in to your hot wallet on a different device, you need to have these words as a safety measure to access your funds.
Third-Party Custody vs Self-Custody
You may have noticed that crypto custody is not really easy and there are a lot of things to know to actually have a safe place to store your assets.
Because of that, many high-net-worth individuals and institutions, like asset managers, hedge funds, and many others prefer to outsource their custody to a company that is specialized in it. This service is not available to retail investors, for example, Coinbase Custody offers it with a minimum requirement of U$10 Million.
For retail investors who don’t want to self-custody their funds, the best and very easy-to-use option is a centralized exchange (CEX). It’s important to be careful with these companies because they’re not fully regulated, which opens some gaps to cases like the FTX bankruptcy, where customers lost all or most of their money.
Binance, Coinbase, and Kraken are the best-rated centralized exchanges today according to Coinmarketcap.
Self-custody, when managed responsibly, offers great autonomy and is one of the reasons blockchain applications are gaining traction. If you're not comfortable with the intricacies of blockchain wallets and security measures, centralized exchanges are a good alternative. To minimize risk, consider distributing your assets among more than one exchange and staying informed about their regulatory status.
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