Virtual asset vaults: Understanding crypto custody

Cryptocurrency is intangible. You can’t physically hold it like gold bars, silver coins, or cash, and you can’t just pull it out of your wallet to prove you own it. That’s part of what makes crypto so appealing – but it also comes with its own set of challenges when it comes to keeping it safe.

Fortunately, there are several options for safeguarding your digital assets, depending on your security preferences and accessibility needs. In this guide, we'll explore various crypto custody solutions and services, along with their pros and cons, to help you choose the best way to store and protect your cryptocurrency.

What is crypto custody?

Every crypto wallet has a pair of cryptographic keys – private and public – used to send, receive, and securely store digital assets. The public key, which is safe to share, allows others to send cryptocurrency to your wallet, while the private key grants access to the assets stored within it. Crypto custody revolves around securing and managing this private key, as anyone with access to it can control the assets in the wallet. 

Though each crypto custody service has its own features and protocols, the core objective remains the same: protecting the private key from unauthorized access and preventing theft or cyberattacks.

Different types of crypto custody solutions

Crypto custody solutions vary depending on who manages the private key. Some investors take full control of their private keys, while others prefer to entrust them to intermediaries. There's no one-size-fits-all approach – each comes with its own features to consider. 

Self-custody

Investors opting for self-custody retain full control over their private keys and their assets. This option, whether through an app (hot wallet) or a hardware device (cold wallet), puts all responsibility in the hands of the owner. Self-custodial wallets typically generate a seed phrase (a series of 12–24 words) that serves as a backup for recovering the wallet if necessary. While offering maximum control, it also comes with the risk of losing access if the seed phrase is lost.

Partial custody

Partial custody services split private key management across multiple trusted parties. Each party holds a piece of the key, and the wallet only approves a transaction when a threshold of users provides their key details. While less convenient than self-custody, this method reduces the risk of theft by distributing control. Common strategies for partial custody include multisignature (multisig) wallets and multiparty computation (MPC).

Third-party custody

Third-party custodians, such as centralized exchanges (CEXs) like Coinbase or security firms like BitGo, manage private keys on behalf of investors. This service offers convenience, customer support, and insurance protections, but investors must forfeit direct control over their private keys. These custodians meet high standards for security, customer service, and regulatory compliance, especially when providing institutional-grade custody for large corporations or high-net-worth individuals.

Pros and cons of self-custody 

For crypto purists, self-custody is the preferred method for storing digital assets because it aligns with core web3 values like financial independence and decentralization. While many blockchain enthusiasts advocate for self-custodial solutions, there are potential drawbacks to consider.

Pros of self-custody 

• Financial autonomy: Self-custody wallets offer full control over digital assets, allowing investors to manage and transfer funds directly without intermediaries.
• No counterparty risk: Without relying on third-party custodians, self-custodial users avoid the risk of external mismanagement or account freezes. 
• Direct access to decentralized finance (DeFi): Self-custodial wallets open the door to DeFi opportunities like lending, borrowing, and staking, offering additional ways to earn passive income.
• No custodian fees: Managing your own crypto means avoiding ongoing custodian fees, enabling investors to maximize long-term profits.

Cons of self-custody

• Hacks and software bugs: Self-custody isn’t immune to security risks. Vulnerabilities in software wallets or poor coding could lead to potential losses, especially with devices constantly connected to the internet.
• No support or insurance: Unlike third-party custodians, self-custody lacks safety nets such as customer support or reimbursement policies in the event of issues or theft.

Pros and cons of third-party custody

Critics of third-party custody services argue they eliminate cryptocurrency's unique properties, shifting control away from users and reintroducing the trust-based model of traditional finance. Despite this, third-party custody remains a viable option in many situations, especially for investors who prioritize security and support over full control.

Pros of third-party custody 

• No technical skills required: Investors who aren't tech-savvy can avoid the complexities of managing crypto wallets on their own. Professional custodians handle tasks like transferring coins and securing private keys, reducing the likelihood of errors that could lead to loss of funds.
• Access to support and insurance: Third-party custodians provide customer support, guiding clients through the management of their assets. Many custodians also offer insurance, giving peace of mind in case of events like theft, hacking, or bankruptcy.
• High security standards: Regulated third-party custodians employ top-tier security measures, such as deep cold storage and multisig wallets, to protect assets. They regularly perform audits to ensure the accuracy of balances and compliance with regulations. 

Cons of third-party custody 

• Counterparty risks: Trusting a third party with your crypto introduces new risks. Custodians could mishandle funds, suffer hacks, or even face regulatory actions that compromise your assets. Additionally, users lose direct control of their private keys, creating a point of vulnerability if the custodian fails.
• Fees: Many custodial services charge for managing assets, adding costs to the process. Investors must factor in these fees when calculating their returns, which can impact profitability.
• Privacy concerns: Most third-party custodians require users to provide personal details through know-your-customer (KYC) procedures, which can feel invasive to those who value privacy. These details are stored in the custodian's database, raising potential concerns about data breaches.
• Fraud and theft risks: Even with strong security measures, third-party custodians aren’t immune from fraud or theft. Internal bad actors and cyberattacks could lead to lost funds, and while custodians may offer insurance or recovery options, full or even partial reimbursement isn’t guaranteed.

How to choose the best self-custody crypto wallet

Crypto traders opting for self-custody have two main choices: hot or cold wallets. A hot wallet is a software application available on desktop or mobile devices where a user’s private keys are always connected to the internet. In contrast, cold wallets – such as hardware devices or paper wallets with printed QR codes – keep private keys offline, only connecting to the internet when transferring funds.

Cold wallets generally offer greater security because they’re less vulnerable to cyberattacks. Even the best-designed hot wallets are online 24/7, increasing the risk of theft.

However, cold wallets do have some drawbacks. Hardware wallets typically have a higher upfront cost and a steeper learning curve. On the other hand, hot wallets are more affordable and offer a user-friendly interface, making them ideal for quick trades or interacting with DeFi platforms.

For traders who prioritize convenience and ease of use, hot wallets are usually the preferred choice. Those who value enhanced security lean toward cold wallets, particularly hardware devices. Either way, to find the best fit, it's important to research wallet longevity, compatibility with different cryptocurrencies, additional features like biometric security, and integration with DeFi protocols. 

Considerations for choosing qualified crypto custodians 

For crypto investors opting for a third-party custodial service, there are a few things to evaluate before choosing a provider. To simplify the process of selecting the right partner, be sure to compare factors like:

• Regulatory compliance: Custodians that adhere to multiple regulations demonstrate their commitment to security and legal standards. Look for providers with licenses, detailed audits, and certifications like SOC 2 or ISO 27001, which indicate strict oversight and compliance.
• Reputation and experience: Along with their regulatory credentials, reputable custodians have a strong track record of successfully managing large volumes of cryptocurrencies. Analyze their use of encryption technologies and security practices to ensure they maintain high standards.
• Management fees: Third-party custodians offer added convenience, but it comes at a cost. Be sure to calculate a custodian’s withdrawal, transaction, and management fees and compare them with other crypto custody providers to find the most cost-effective option.
• Customer service standards: One major perk of third-party custody is access to customer support. Make sure the custodian has a responsive and reliable support team so that any issues with your assets can be handled promptly.
• Insurance policies: Along with customer support, investors often choose third-party custodians for the added security of insurance. Review the fine print of a custodian's insurance policy to understand exactly what it covers in cases like hacks or other security breaches.

Balance security and convenience with CoinTracker 

Whether you're using a self-custodial, multisig, or third-party solution, CoinTracker ensures all your crypto assets are seamlessly accounted for. CoinTracker’s crypto tax software connects with the top exchanges and wallets and 50,000+ smart contracts to provide an accurate breakdown of your crypto transfers. When tax season arrives, CoinTracker allows you to quickly generate tax forms for your accountant or link directly to tax platforms like TurboTax or H&R Block.

Get started for free, and let CoinTracker simplify your crypto tax reporting.

Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.