In the crypto industry, individuals or firms must have their digital assets stored in a secure way. This is where the concept of crypto custody enters the picture.
Crypto custody is the manner in which crypto holders, whether institutions or individuals, store the cryptographic keys that provide them with access to their holdings. Since losing access to these private keys means losing access to your digital assets, evaluating an efficient crypto asset custody solution is vital.
There are various types of crypto custody, including self-custody and third-party custody. Each of the crypto asset custody approaches has its unique benefits and risks. This post will give a detailed self-custody vs. third-party custody comparison.
What is crypto custody, really?
Digital assets are not actually stored on a device or on a crypto wallet. Rather, they are stored on a blockchain ledger. Instead, the private keys that facilitate the transfer of these tokens off the ledger are what are stored on the wallet or device.
Since blockchain systems are not designed with recovery options, it is important to safeguard these keys. When someone needs to make a transfer, the blockchain network requires authorization, often referred to as signing, using the private key.
If a private key is stolen, the attacker can transfer the funds immediately. If the private key is lost, assets can be permanently lost. This is why custody solutions are developed to reduce the possibility of theft, loss, or unauthorized access.
Crypto custody, therefore, refers to the activity of storing digital assets safely by securing the private keys that enable you to access them. Individual custodial decisions are often based on preferences, while institutions may be obligated by local regulations to opt for a particular crypto asset custody option.
Main types of crypto custody
Crypto asset custody comes in different forms, with each type of custody varying in terms of control, benefits, and risks. The most popular types of crypto custody are:
- Self-custody
- Third-party custody
What is self-custody?
Self-custody is an arrangement where the individual or organization that owns the cryptocurrency has full control over their own private keys. In this setup, the individual or organization stores the private keys in wallets of their choice, as opposed to letting a financial institution or an exchange store the keys.
The storage media for this crypto asset custody method can be in the form of paper backups or crypto wallets, such as hardware wallets and software wallets. Whichever the format, what matters is that the user is in full control of their cryptographic keys.
Upon the creation of a self-custody wallet, the user is provided with a seed phrase, which is mostly between 12 and 24 words.
The phrase is used as the backup for the wallet. It supports the restoration of the wallet and authenticates the transfer of cryptocurrencies stored in the wallet. Due to this design, users must keep their seed phrase confidential to avoid the loss of their digital assets.
Pros of self-custody
There are a number of benefits associated with self-custody. They include:
- Full ownership and control: The user gets full ownership and control over the personal keys and crypto holdings.
- Greater privacy and independence: Transactions can be made privately, and assets cannot be frozen by centralized entities.
- Reduced counterparty risks: User funds are protected from exchange failures, like the case of the FTX exchange.
Cons of self-custody
Self-custody has the following cons:
- Security risks: Users face the absolute burden of protecting their assets from theft and loss.
- No recovery support: Once the seed phrase is lost, the user risks losing their holdings permanently.
- Less convenient for active trading: Transferring funds from personal wallets to exchanges takes time and may involve transaction fees.
What is third-party custody?
Third-party custody is an approach in which an individual or an organization delegates the storage of their private keys to a third party. Under this setup, the custody service provider gives the user access to an interface through which they can manage their digital assets.
This setup is a duplication of the traditional approach used by banks to handle user funds. Most crypto exchanges, such as Binance and Coinbase, work in this model.
When one purchases crypto on a crypto exchange, the assets are transferred to wallets that are controlled by the exchange. While the holder can trade and transfer these assets, the exchange stores the underlying private keys.
Other than exchanges, professional crypto asset custody providers also exist. Coinbase Prime is one such example. These companies store private keys on behalf of other institutions, such as investment funds and high-net-worth individuals.
Pros of third-party custody
Third-party custody comes with several perks, which include:
- Accessibility: The user can view balances, purchase additional funds, or even sell assets through simple interfaces.
- Added security: Assets are secured through centralized security systems, thus making it hard to lose assets through theft.
- Additional financial services: Staking and lending are some other financial services that are supported by third-party custodians.
Cons of third-party custody
The disadvantages of the third-party custody include:
- No complete control over holdings: The custody service provider may freeze assets and limit access.
- Counterparty risks: In case an exchange is attacked by hackers, users may lose their assets.
- Strict regulatory exposure: Third-party custodians are forced to adhere to local regulations, which in most cases entail stricter verifications and restrictions.
Self-custody vs third-party custody: How they differ
The two crypto asset custody approaches are distinguished based on who manages or stores the private keys. From this distinction arise a few other differences, which are shown in the table below.
| Parameter | Self-Custody | Third-Party Custody |
| 1. Control | User gets full control over the digital assets. | Involves the delegation of control to an external service provider. |
| 2. Security | The owner is in charge of backups and security. | The custodian ensures the security of the assets. |
| 3. Accessibility | Users must carefully access the stored assets. | Assets can be accessed via a simplified interface. |
| 4. Risk | Risks include seed phrase loss and personal security failures. | Custodians bring about counterparty risks, such as being hacked and becoming insolvent. |
