Over the last few years, it’s become clear that cryptocurrency and blockchain technology represents one of the best opportunities, both for the market at large and specifically for financial institutions.
But with this opportunity comes a substantial amount of risk. It’s an innovative technology in the financial sector, which has made it a target for fraud. Additionally, a lack of knowledge on the part of individuals has led to people using it or avoiding it without fully understanding how it works.
This post will cover the differences between custodial and non-custodial crypto wallet solutions and how each can help institutions provide security to their customers.
What are custodial and non-custodial solutions for crypto wallets?
Custodial and non-custodial solutions for crypto wallets refer to how a person’s access to their crypto is secured. Individuals don’t have the actual “files” containing their cryptocurrency, just like they don’t have the gold their fiat currency represents.
Instead, a person has access keys. These keys are a type of PIN that gives the person access to make transactions with their crypto wallet. If they buy five crypto coins, those coins aren’t downloaded to their wallet. Instead, a transaction with those coins is registered in the blockchain associating them with a public key that represents the wallet. The public key shows that you own five crypto coins while the private key allows you (and only you) to move those coins around.
These access keys are how cryptocurrencies are traded, spent, and acquired, and they’re one of the core innovations of cryptocurrency.
However, they can also pose some issues. For instance, if someone finds out the access code to your wallet, they now have just as much access to your cryptocurrency as you do. Likewise, forgetting that your access code is akin to losing your money.
When a person has total control and responsibility for their access keys, this is known as a non-custodial wallet. It’s up to them to make sure they remember and secure their access code(s).
When a person doesn’t hold responsibility for their access keys, this is known as a custodial wallet. Typically, an app like Coinbase or Guarda will keep track of the access keys for the person conducting trades on their behalf.
You can think of a custodial wallet as letting Amazon hold the PIN to your debit card, so that you can make purchases very conveniently — while a non-custodial wallet is more like only you knowing the PIN and inputting it manually for every purchase.
Why is security a critical factor when it comes to digital asset custody?
We touched on it briefly in the introduction, but calling security a “critical factor” of digital assets is an understatement. Cryptocurrency is a prime target for all sorts of digital fraud. That target only gets more prominent thanks to most individuals’ limited understanding of cryptocurrencies.
Here are just a few of the concerns that stem from digital asset custody.
It is impossible to undo transactions
By design, you can’t undo cryptocurrency transactions. If someone finds your access key and uses it to send themselves all of your crypto, that crypto is as good as gone. There is no way to cancel the transaction or quickly undo it.
This is hardcoded into blockchain technology, and it’s part of what makes cryptocurrency so secure. By making the blockchain immutable, it can be the most transparent and reliable ledger ever invented.
The drawback of this is that blockchain’s rigidity means accidents and thefts can’t be undone. That’s why it’s crucial that preventative measures are effective and implemented with discipline.
Crypto keys are as valuable as the assets themselves
Another pertinent risk with digital asset custody is the value of access keys. Having access to someone else’s access keys is almost the same as having access to someone’s credit card and PIN.
The difference is that access keys are even more valuable because there are no protections for individuals whose access keys have been stolen. Most cryptocurrencies are decentralized, so there are no governing bodies or organizations to refund you or investigate fraud on your behalf.
In other words, keys give you total access to a person’s cryptocurrency, which means they’re just as valuable as the digital assets themselves.
The permanent nature of crypto makes it a target for fraud
Lastly, the permanent nature of crypto makes it an even bigger target for fraud. That’s because there are almost no consequences (at least at this time) for scamming/stealing someone’s digital assets.
These transactions can’t be undone, it’s nearly impossible to determine who committed the theft, and there are few legislative protections anywhere in the world.
Real-world example: Why BitGo custodial services are secure
As you may have noticed, many of the risks surrounding digital assets are tied to non-custodial storage. When you store assets with a custodial solution, an organization keeps track of your key(s) for you. This means it’s far less likely someone will steal your assets.
For example, let’s look at BitGo. BitGo is a digital wallet for storing Bitcoin, which, as we’ve covered, actually means storing access keys. It holds them in a way that’s more secure and convenient than what most users could accomplish without it.
When using BitGo, all of a user’s crypto transactions are funneled through BitGo’s service. This means that users never need to see or access their keys, keeping them safe from prying eyes.
Additionally, BitGo keeps access to your crypto behind a multi-signature account. This means that the user gets a key, and BitGo gets a key, and you need both to make a transaction. Similar to two-factor authentication, this adds an extra layer of security.
Crypto custody risks
As BitGo shows, custodial solutions can add extra layers of security that the average user won’t get any other way. However, custodial solutions are not wholly without risk. Below are a few concerns to consider when looking at custodial options.
First and foremost, a custodial wallet introduces a third party to your cryptocurrency transactions. This, in theory, reduces the anonymity that comes with most cryptocurrencies. That might not be a big deal for most users because putting your trust in a custodial wallet is similar to putting your trust in a traditional bank.
However, for many users, the confidentiality that cryptocurrency can provide is one of its key selling points. So it’s valuable to keep in mind that confidentiality is something you may be sacrificing with custodial services.
With custodial services, you trust the custodial provider to make your keys available. If they go out of business, are hacked, or simply close their proverbial doors every evening, then you lose access to your keys and funds.
Users also depend on custodial services to keep their keys in working order. If the files containing a person’s keys are deleted, corrupted, or lost, then so are your funds. For that reason, it’s essential to choose a custodial platform that you trust.
Many newer custodial services offer reimbursements up to a specific limit, similar to a bank, but these are not necessarily standard or comprehensive.
The best crypto custody providers of 2021
Gemini is a highly compliant, highly secure custodial solution. It stores users’ keys in military-grade storage facilities and is geared towards institutional crypto investors.
Coinbase is one of the oldest and most trusted names in crypto. Its custody services are not only high-grade and reliable but are also backed by insurance and simple interfaces.
Cheesecake Labs can help you navigate all of your cryptocurrency needs
If you’re looking for support in cryptocurrency investing, development, or integration, we can help. The team at Cheesecake Labs not only has a deep understanding of and excitement for blockchain, but we have the technical know-how to help you embrace it. Reach out to our team today!