Third-Party Custody Solutions

While self-custody grants you full control and responsibility over your assets, there’s another path for those who would rather have someone else manage their accounts?

This is where third-party custody comes in. Like the name implies, this is the type of custody where your crypto assets are managed by a third party offering crypto custody services (can also be called third-party custodian or simply custodian).

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Think of a third-party custody as a digital parallel to how traditional banks work. To get started, you need to verify your identity through know-your-customer (KYC) procedures that require you to share your full name, personal details, government-issued IDs, proof-of-residence, and other relevant documents. The custodian then sets up your account similar to an online bank account where you only need to remember your username or email and password. 

Behind the scenes, the third-party custodian takes on the tedious tasks of managing transactions, including verifying wallet addresses. This convenience does come with a trade-off: your private keys must remain in their hands. As the saying goes, “not your keys, not your crypto”. Should something happen to the custodian, there’s no guarantee you’ll recover all your funds.

Third-party custodians differ in how they handle your assets. Some use hot storage; others prefer cold storage, or a combination of both. Some keep clients’ funds pooled together, while others maintain separate accounts.

Regardless of their approach, all third-party custody providers must comply with government regulations and have security controls in place for storing, trading, and managing your assets. Also, compared to most self-custody solutions, they usually support a wider range of altcoins and fiat currencies. This gives users versatility in crypto dealings.

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In contrast with self-custody solutions, a third-party custody provider usually:

• Requires customers to undergo a Know-Your-Customer process for identity verification;
• Has the authority to ban accounts for non-compliance with their policies;
• Allows you to easily recover lost or forgotten passwords; and
• May impose transaction limits in terms of number and volume.

Now, let’s take a closer look at the three main types of third-party custody solutions available in the crypto world.

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1. Crypto Exchanges 

Most people purchase and store their crypto assets on crypto exchanges. This approach offers convenience but also presents certain vulnerabilities. In the past, some exchanges have mishandled or misused users’ funds, leading to significant issues. 

For instance, Mt. Gox, once the world’s largest Bitcoin exchange, suffered a massive security breach in 2011 to 2014. It lost a substantial amount of Bitcoin due to hacking and technical problems. This unfortunate incident resulted in the exchange filing for bankruptcy and a partial recovery of the lost funds. Only less than 30% of missing bitcoins were recovered. 

Similarly, in more recent times, FTX, the world’s second-largest crypto exchange, faced controversies.
Reports suggested that user funds were redirected to partner companies, leading to liquidity problems and withdrawal issues. The situation escalated to the point where FTX filed for bankruptcy, and its CEO resigned. Subsequently, the exchange claimed to have fallen victim to a hack, resulting in the theft of millions of dollars in tokens.

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Additionally, crypto exchanges are prime targets for hackers since they are known to have substantial funds stored in them.

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2. Dedicated Crypto Asset Managers

What about institutions that need a higher standard of security for significant and diverse crypto assets? Their best option is to entrust their funds to companies that specialize in managing crypto assets. These crypto asset managers are paid to invest and manage their client's crypto assets. First, they evaluate the client's risk tolerance and investment goals. Then, they create an investment strategy using risk management techniques such as diversifying the client's portfolio. They continually monitor the performance of the investments, send regular updates to the client, and suggest changes to the portfolio as needed. Crypto asset managers prioritize security, offering a more robust option as compared to crypto exchanges. They typically provide insurance coverage for their clients’ funds, comply with local crypto regulations, and offer comprehensive services for tracking and safeguarding crypto portfolios. However, such professional management comes at an expensive cost.

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3. Traditional Financial Institutions Offering Crypto Services

Here comes the banking option. For those seeking a straightforward way to invest in crypto, traditional financial institutions, such as banks, now offer crypto investment options. This is one of the easiest ways to invest in crypto because the bank provides you with its own wallet services. This allows you to easily convert your savings into crypto and facilitate transfers to other crypto-friendly bank accounts.

Not all custody solutions are created equal, and selecting the right one is a crucial decision.Picture yourself in the process of choosing between two third-party custodians. Let’s explore your options: 

Custodian #1: This custodian takes full control of your private key, which means you have limited say in how your funds are managed. To keep bad actors from stealing your funds, it implements biometric security measures.

Custodian #2: In contrast, this custodian operates differently. It only holds a keyshare, a single fragment of the private key. You, as the account holder, retain the other keyshare, granting you more control over your assets. Here, the custodian needs your explicit permission to access them. Instead of relying on biometrics, it safeguards your account with 2-Factor Authentication. Moreover, it also has a network of backup centers around the world. These centers ensure the restoration of your account in the event of a security breach or a natural disaster, like an earthquake or fire. 

Now, let’s delve into some of the security measures commonly employed by third-party custody providers:

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1. Multi-Signature (multi-sig)

Our first security measure on the list is creating a multi-signature or a Multi-Party Computation (MPC) wallet. These innovative solutions enable multiple individuals to share access to a private key securely. In the case of a multi-signature  wallet, the private key is divided into several pieces, known as keyshares. No single party possesses the entire private key; instead, they each hold a keyshare. Accessing the wallet required the combination of these keyshares. An MPC wallet, on the other hand, gives each party a distinct private key. However, even with their individual keys, these parties must collaborate to access the account. Think of it as a gate with multiple padlocks – you need all the keys to open it.

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2. Insurance Coverage

Some third-party custody providers offer insurance coverage to safeguard against hacks, thefts, security breaches, stolen passwords, lost accounts, and damaged devices. Depending on the custodian, the insurance policy may cover assets stored online (hot storage) or offline (cold storage). However, insurance doesn’t cover everything that could go wrong. Any loss of funds due to market price volatility, failed investments, online scams, or human error is usually not reimbursed. Moreover, if the crypto exchange holding your funds suddenly goes bankrupt, there’s very little chance of you ever getting the full amount of your money back.

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3. Regular Audits and Compliance

Third-party crypto custodians routinely undergo security checkups and audits to ensure the safety of their clients’ assets. They also devise contingency plans to address security threats should they arise.The custodians also must adhere to the law. Countries like the USA have legal requirements before giving third-party custodians a license to operate, such as:

• Know Your Customer (KYC): The custodian must verify the real identity of all its customers.
• Anti-Money Laundering (AML): The custodian must monitor crypto transactions to make sure that its services will not be used to steal funds.
• Insurance: The custodian must provide insurance for the assets of every client.

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4. Reputation and Track Record

When entrusting a crypto custody provider with your assets, it pays to check its track record. Verify that the custody provider is licensed and accredited by the proper authorities. Choose one backed by an experienced, independently-verified security guarantees, and a well-established reputation for excellence.

Before diving deeper into the world of third-party custody, it’s essential to understand the potential advantages and drawbacks it entails. Just like any financial decision, there are pros and cons to consider when deciding whether this type of custody is the right choice for you.

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Time to ask yourself, is third-party custody right for you? Entrusting your crypto assets to a dedicated third-party custodian can be a smart choice in specific situations. Let’s take a closer look at who might benefits most from this custody:

• Planning for the future: If you have huge crypto investments and want them to be inherited by loved ones. Certain custody providers allow you to designate beneficiaries in your account, as outlined in a contract or will.
• Traditional financial institutions: Established institutions stepping into the crypto space that prefer insurance, safeguards, and asset management for diverse investments. In such cases, self-custody often does not align with government regulations or is too impractical for managing large portfolios.

Selecting the right custody solution hinges on your unique needs as an individual or institution, as well as  the nature of your crypto investments. Factors like liquidity options, security protocols, associated fees, and the service provider’s track record should all be considered. 

In the next module, we’ll delve deeper into these essential factors to guide you in making an informed decision when choosing a custody solution that best suits your requirements.

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