July 16, 2024

The Evolving Landscape of Digital Asset Custody

Where you store your bitcoin and other digital assets is extremely important. With so many options out there, which one is right for you?

What is Digital Asset Custody?

Digital asset custody involves the secure storage, administration, and protection of digital assets on behalf of individuals, institutions, or organizations. For digital assets like bitcoin and Ethereum, custody specifically pertains to the secure storage of private keys. These private keys are essential for accessing and transferring digital assets.

Self-Custody vs. Qualified Custodians

Self-Custody

When you self-custody your digital assets, it means that you store these assets at a digital address or a “wallet” that is completely controlled by you and only you. You control the private key to that wallet, and no one else has access to the private key. These “wallets” may be referred to as self-custody wallets, non-custodial wallets, or self-hosted wallets.

As the holder, you can choose to send digital assets to whichever other addresses they choose without restriction. Once you input your private key, you have full access to all assets held in the wallet which exist in their entirety. Put very simply: your keys, your digital assets.

Self-custody has its risks–if a nefarious actor gains access to your private key, they can transfer money without your knowledge. This responsibility elevates the needed knowledge of digital security needed versus the more “convenient” option of parking that risk (and control) with a qualified custodian.

Qualified Custodian

A qualified digital asset custodian is a financial institution expert in guarding and managing your digital assets (like bitcoin and NFTs). Qualified custodians securely store digital assets and support digital transactions with advanced cryptography and hardware security measures.

A qualified custodian has a fiduciary responsibility to look after their clients’ best interests. While relatively uncommon, risks include theft or loss of private keys, bankruptcy, and regulatory risks.

“Hot” Wallet vs. “Cold” Wallet

There are many self-custody options, including what’s known as a “hot” wallet and a “cold” wallet. “Hot” wallets are connected to the internet, which allow you to move funds quickly. Most people choose not to store large amounts in hot wallets. Understanding that if a nefarious actor is able to access your key, they can send funds out without your prior knowledge.

You can also store your digital assets in a hardware wallet (known as “cold” wallet). Typically “cold” wallets are not connected to the internet, and require physical input.

Splitting funds is common, with many deciding to use hot wallets for spending and cold wallets for savings.

The Difference Between Bitcoin Self-Custody and Bitcoin ETFs

Bitcoin ETFs allow investment exposure to bitcoin without direct ownership. This differs from self-custody, where you’re holding your bitcoin directly with private keys for full control and responsibility. To learn more about the approval of spot bitcoin ETFs, please check out our article, “In Focus: Spot Bitcoin ETF Approvals.”

My Take

The challenges and risks of properly owning and custodying bitcoin aren’t all that different for self-acknowledged custodians (Coinbase, Fidelity, Gemini, etc.) than they are for individuals. Most of my clients are used to outsourcing a majority of their financial management.

While I believe that proper self-custody may help limit your counterparty risk (the risk that any of those self-acknowledged custodians gets hacked or has their bitcoin stolen), most self-acknowledged custodians are significantly more prepared than any of my clients typically would be. This can be seen in the form of internal controls, cybersecurity protocols, and other safety measures.

Based on an overview of the ETF bitcoin custodians below, taking a diversified approach to which custodians you use – rather than loading up with just one custodian – may help diversify your counterparty risk. This may help protect you in case any of these custodians have their bitcoin ETFs compromised in the future.

You can read more about digital asset custody here. It’s worth noting that the regulatory environment is rapidly changing here, and the SEC’s interpretation around “qualified custodians” is still in flux.

Looking to Learn More About Digital Assets?

At Crossover Capital, our number one goal is to provide people with the support, knowledge, and access to make informed decisions about their financial futures. Building a foundation for success starts with steady support and a customized approach. Crossover Capital is here to provide the necessary tools we believe are required for growth and to be a champion for our clients’ success.

If you want to receive tools, knowledge, and digital asset insights delivered directly to your inbox once a month, subscribe here.

Investment advisory services offered through Crossover Capital Brands, LLC (dba Crossover Capital), a Registered Investment Advisor with the U.S. Securities and Exchange Commission.

This material is intended for informational purposes only. It should not be construed as legal or tax advice, and is not intended to replace the advice of a qualified attorney or tax advisor. This information is not an offer or a solicitation to buy or sell securities. The information contained may have been compiled from third party sources, and is believed to be reliable.

Alternative investments – such as hedge funds and private equity/venture capital funds – are speculative and involve a high degree of risk. Likewise, the emergence of digital assets comes with its own speculative characteristics and involves a high degree of risk. Various digital assets have unique features, and the regulatory risk environment continues to change as governance requirements, rules, and lawsuits emerge. There may be material differences in the type of marketplaces available for digital assets, and there could be significant restrictions or limitations on withdrawing from or transferring these types of investments. Digital assets may incur higher fees when compared to traditional assets, and these expenses may offset returns.

Crossover Capital may not be able to independently verify digital asset valuations provided by institutions that hold or offer digital asset services. As a result, Crossover Capital will generally rely on information reported to it by third parties. As such, the information contained herein is for informational purposes. Clients should recognize that they may bear digital asset-based fees and expenses at the manager-level, as well as indirect fees, expenses, and performance-based compensation for digital assets. Spot bitcoin exchange-traded products were recently approved for listing and trading by the SEC. However, such approvals do not indicate SEC approval to use or invest in bitcoin. Clients should remain cautious and aware of the various risks associated with digital assets that have a value tied to bitcoin or other crypto related products.

Risk of Total Loss of Capital
There can be no assurance that an investment strategy will achieve its investment objective or that substantial losses will not be incurred. Clients should be prepared to bear a substantial loss of capital, including the risk that the entire amount invested may be lost. No guarantee is made that a Client’s investment program or overall portfolio, or various investment strategies used or investments made, will have low correlation with one another or that a Client’s returns will exhibit low long term correlation with an investor’s traditional securities portfolio. The use of certain trading counterparties and exchanges, in the context of digital asset transactions, may substantially increase transactional risks and increase the adverse impact to which a Client may be subject.

Risks Related to Custodial Processes of Digital Assets
The risks relating to the custody of digital assets include appropriate arrangements for which defined best practices and industry standards are not yet fully defined and the manner in which Crossover Capital interprets such rules and practices, may differ from interpretation from other regulatory agencies. Client accounts for and custody and trading of digital assets are provided through Fidelity Digital Assets Services, LLC, (“FDAS”) which is a New York State-chartered, limited liability trust company. While FDAS is an entity under the Fidelity branded companies, digital asset custodial services are not provided by the other related Fidelity companies such as Fidelity Brokerage Services, which is the custodian listed on the Firm’s ADV Part 1 with respect to the Firm’s traditional assets. Nor are custody services for digital assets provided by Fidelity Management and Research Company (“FMR”). For the purposes of digital asset custody, clients should be aware that FDAS is not in physical possession of bitcoin or ethereum, but they continue to use such phrasing of custody and storage, as they would with other traditional assets types such as equity and fixed income products, but such phrasing may be at odds with how the Securities and Exchange Commission (“SEC”) defines custody, which in turn poses an unknown regulatory risk to Clients.

Custodians often hold Client assets in physical or electronic form, typically charging fees for the secure, safe keeping of such assets represent a relatively new asset class which few state and federal legal frameworks directly address. As such, there is uncertainty as to how to attach and perfect a security interest over digital assets. A Client’s claim over such assets could be unsecured, increasing a risk of loss in the event of default.

Crossover Capital has limited knowledge of what capital requirements, reporting or system requirements that New York State-charter trust companies must abide by and cannot independently verify FDAS representations. Further, clients should be aware that despite the custodial efforts in place, wallets have been hacked and digital assets have been stolen. This is a significant risk for anyone investing in digital assets which cannot be completely protected against. There is a heightened risk of unauthorized withdrawals or theft of digital assets than there is with traditional asset classes as once a digital asset is removed from an account, it is more difficult to retrieve.

Any Crossover Capital client with digital asset exposure will have a high concentration of its digital assets with one custodian, which may be prone to losses arising out of hacking, loss of passwords, compromised access credentials, malware, or cyberattacks as described herein. Separate from risks relating to the custody of digital assets, there are also risks related to the custody of fiat currencies that are part of the Client account that are held by the digital asset exchange. Clients should also be aware that in 2023, a number of banks ceased operations, notably, Signature Bank, and Silvergate Bank. Such banks were partnered with digital asset exchanges and where client fiat assets were maintained in accounts associated with digital assets, there was an increase in risk of loss of the fiat currency assets held at the failed banks to the extent that the amount held was greater than available FDIC coverage limits. Clients should understand which banking partners are used by the custodians and/or exchanges for custody of fiat currencies.

Contact Us