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Understanding the concept of crypto custody

Understanding the concept of crypto custody

    With police dramas being one of the most popular genres on television many people might only understand custody as having something to do with being locked up. The word actually has dual meaning, as it also refers to protective care of something or someone, and is widely used to indicate who is protecting your crypto, so it is crucial to understand what custody means when starting learning about crypto.

    As our lives move almost completely online, the use of physical money is rapidly declining. In the UK less than a fifth of payments in 2020 were made in cash, a trend that has accelerated given concerns around Covid19 transmission when handling bank notes. 

    Money, Storage & Trust

    If you talk to older relatives about money in the pre-digital era , when cash was king, you might hear references to ‘stuffing cash under the mattress’ or ‘hiding it under the floorboards’ which are hard to relate to. Others might have had a safe hidden behind a painting for storing money and valuables, built into a cupboard or hidden under the floor.

    The methods people employed to take ultimate responsibility for protecting their wealth can be described as self-custody - taking protective care of  their own wealth.

    Going back further in time it wasn’t uncommon for people to bury their wealth during times of conflict or uncertainty, which is what detectorists hope to unearth when scouring the countryside with metal detectors.

    Our relatives clearly had an alternative to finding a secret place to hide their loot, they could have just deposited it with a bank, who would then assume the responsibility for protecting it - giving the bank custody.

    One of the main reasons why people choose to self-custody money and valuables is trust. With something so important they preferred to protect it themselves. There is of course a big trade-off here. 

    Banks employ security to protect your money so you don’t have to, and if your money gets stolen or lost there is something called deposit protection which means it is likely to be covered, though the actual details will vary depending on the amounts involved, level of service and how funds go missing. 

    If you custody your own money, that responsibility - physically protecting it and not letting anyone know it is there - is on you. In most countries there is no legal limit to how much money you can keep at home, but you should expect a lot of questions from an insurer to prove the exact amount you hold and establish why you don't want a bank looking after it. Without insurance, there would be no safety net against loss, theft or damage.

    From cash to crypto

    The choices for custody of your crypto are very similar for those we’ve described regarding protecting physical money. Both come down to trust, though with crypto there are no banks involved, and the money being protected has no physical form, so the dynamics are different in terms of:

    1. what exactly is being protected
    2. what are the custody options & risks

    What is being protected?

    Though you might be new to the idea of custody, you should hopefully know by now that cryptocurrency has no physical form, it is a digital representation of value, but this isn’t a new idea.

    The balance in your banking app is also just a representation of the spending value of your bank account. When you make a payment the banking system deducts your balance, and somewhere else the recipient's balance is credited. No physical money changes hands.

    A similar settlement process happens with crypto, but what you are really protecting is the ability to spend funds.

    Your bank balance is maintained centrally, on a computer system, hooked up to the wider banking network. When you want to use your banking app you’ll need to provide some personal credentials - previously provided to the bank - to ensure you are the only one spending the funds. The bank will determine what is required, as they design the app and they are in custody of your funds.

    Crypto is decentralised - there is no central system. Your funds are represented as a spendable balance - called an address - on a ledger, a copy of which is held across many computers (not just one) that maintain agreement. An address is like a bank account.

    For funds to move, and that network of computers to agree on a new set of balances, a piece of information specific to that address must be shared to prove you have custody - called a Private Key.

    Private keys are ultimately what enable funds to be spent, and are, therefore, the thing that is protected by custody; think of them like a very strong password, but without a recovery process if you forget it or customer support line.

    You can have many crypto addresses, just like having multiple bank accounts, and they are controlled in a crypto wallet, which is the equivalent of your banking app. Wallets can combine the security of all those private keys into one piece of information, called a Seed, a collection of unique phrases (usually 12 or 24). So a Seed is a like a master password and the ultimate focus of your custody efforts.

    So if you want to custody your crypto yourself, to have complete control over it, you can use a wallet that manages all the private keys in the form of a Seed, which you need to write down and store offline in case you need to recover your wallet/addresses. 

    You don’t need it to spend funds, that can be authorised by biometrics or 2FA, but if you lose your phone or access to the wallet, your Seed is the only way to get access to your funds. This approach is often described as non-custodial, because no one is custodying your funds for you.

    If you don’t want to protect your crypto yourself you can use a wallet where someone else takes responsibility for the Private Keys, but grants you access through an account with all normal forms of credentials used by your banking app. This might be an exchange - where you buy/trade crypto - a service that is paying you interest on your crypto or a wallet/app for spending. This decision again comes down to trust.

    The relative risks of different approaches to custody

    Going right back to trade off between money stored under the floorboards or in a bank account, you have the comfort of knowing that if your bank is robbed, or goes bust, there is a level of protection in place. 

    This protection doesn’t exist with crypto (not yet anyway) and unfortunately the risks of theft are real, while the volatility of prices, completely novel practices or regulatory uncertainty mean crypto services may also shut down or simply go bankrupt. 

    It is for this reason that the mantra within crypto is ‘not your keys, not your coins’ which is essentially encouraging you to look after your keys yourself to mitigate those risks and retain control.

    Mitigation is the best outcome because by taking full custody of your crypto you face the  challenge of protecting your crypto alone. How do you minimise the risk of someone accessing your Seed/Private Keys? How/where can you store a Seed safe from loss or damage?

    Though self-custody puts all the responsibility on you, there are plenty of places you can go for good advice, such as Reddit, Twitter or reliable information services - like Learn Crypto. Here’s some links to articles that will help:

    By understanding the concept of custody you’ve taken the all-important first step to realising that crypto isn’t just about speculation. It is about a new powerful way of looking after your wealth, giving you independent control but also the sole responsibility for protection.

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