In the world of finance, custody refers to the practice where an institution holds assets on behalf of a client. Asset holders opt for custody services primarily to mitigate security risks such as theft or loss.
Unlike banks, a custodian cannot utilize the held assets for its own purposes. Given the responsibilities involved, institutions typically charge a fee for asset custody. This service may also include executing sales or other transactions as directed by the client.
Custody Solutions in the Cryptocurrency Sector
Within the cryptocurrency ecosystem, custody solutions involve a third party holding the private keys to user funds. Only the custodian has the practical ability to send and receive the user’s tokens. While the owner retains legal title to the cryptocurrencies, they do not have control at the protocol level. Nearly all trading platforms utilize a custodial approach to enhance the user experience.
From a security perspective, custodial solutions can be safer for new users who lack experience in managing private keys. However, it is important to note that this introduces counterparty risk. If the custodian suffers a hack, goes bankrupt, or ceases operations, users may be unable to recover their lost tokens.
The Role and Value of Custodians
This is not to undermine the importance of custodians. They play a vital role in the ecosystem, not only by onboarding newcomers but also by providing sophisticated trading tools for advanced users. A growing number of businesses are approaching asset storage and management from an institutional standpoint. Some custodians go a further step by offering insurance coverage to compensate clients in the event of fund loss.
Best Practices for Asset Storage
As a general rule, large amounts of funds that are not being actively used should be placed in cold storage. Active use includes activities such as staking, trading, or other methods of generating passive income. For everyday transactions or active trading, a custodial solution may offer greater convenience.
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Frequently Asked Questions
What is a custody service?
A custody service is a financial offering where a trusted institution holds and safeguards assets on behalf of clients. This reduces the risk of asset loss or theft for the asset owner.
What is counterparty risk in crypto custody?
Counterparty risk refers to the possibility that the custodian holding your crypto assets could fail, be hacked, or become insolvent. In such events, you might lose access to your funds permanently.
Are custodial wallets safe?
Custodial wallets can be safe, especially for users unfamiliar with private key management. Their safety often depends on the security measures, reputation, and insurance policies of the custodian service provider.
When should I use a non-custodial wallet?
You should consider a non-custodial wallet when you want full control over your private keys and assets, particularly for storing significant amounts of crypto that are not needed for frequent trading.
What is cold storage?
Cold storage refers to keeping cryptocurrency private keys completely offline, making them immune to online hacking attempts. Examples include hardware wallets and paper wallets, ideal for long-term savings.
Do all custodians offer insurance?
No, not all custodians offer insurance. It is a feature provided by some, but not all, service providers. It is essential to check a custodian's policy details before entrusting them with your assets.