What is digital asset custody?

What is digital asset custody?

December 30, 2022

In traditional finance, the term “custody” refers to when a trusted third party entity directly safekeeps clients’ investment assets on behalf of the client. Dedicated service providers offering custody are referred to as “custodians”. Custodians are responsible for safekeeping client assets, and protecting the assets from loss, theft or misuse.

Custody as a business model also exists in the digital asset world. However, the digital asset market is still nascent, and has yet to establish itself as a clarified and grounded asset class. 

What is digital asset custody?

When it comes to digital asset custody, one must first understand the fundamentals of digital assets which in turn have implications on its custody. In particular, the lack of security in the digital asset world means secure custody is even more important than for traditional financial assets. Digital assets are also created and transferred using cryptography and a public ledger called the blockchain. When one invests in crypto for example, the transaction data gets recorded on the blockchain, and the investor is provided with a cryptographic key (also known as private key) to prove their ownership. The key is also used to sign transactions for transferring the assets. So digital asset custody works a bit differently – custody of digital assets doesn’t mean physical storage of assets, rather the storage of cryptographic keys that provide access to the assets. 

These cryptographic keys are stored in something called a wallet. Each wallet stores two types of keys: private and public keys. Each public key matches one private key, and they work together to secure each transaction. 

Private keys are a string of long, randomly generated numbers that prove ownership of a particular digital asset. The private key is used to sign/verify each transaction. They can be compared to a bank account PIN number. 

Public keys are also a string of long numbers, but like its name implies, it is shared publicly. The public key is used to generate deposit addresses for an investor’s wallet. Every digital asset transaction between participants requires sharing of deposit addresses to indicate where the assets are being transferred to. Public keys can be compared to a bank account number itself. 

TradFi Custody vs. Digital Asset Custody

Digital asset custody resembles traditional finance custody in many ways. 

First and foremost, custodians in both traditional finance and the digital asset sector have the same basic function: to store and safeguard client assets. They also operate on the same underlying principles

  1. Custodians only act as agents of the respective client;
  2. Custodians always segregate client assets, holding client funds in segregated accounts;
  3. Custody of assets offers protection from creditors;
  4. Custodians operate on bankruptcy-remote structures.

Additionally, both TradFi custodians and digital asset custodians offer global access to international trades, and facilitate trade settlements across multiple markets. 

But the traditional finance and digital asset world are fundamentally different in terms of the nature of the financial instruments, as well as market structures. This inevitably forms differences between TradFi custody and digital asset custody. Unique to digital asset custody are the following features:

  • Relies on blockchain technology, which provides a single source of truth
  • Fewer financial intermediaries as compared to traditional financial markets
  • 24/7/365, as the digital assets market is constantly running
  • Adopts new technology as compared to legacy technology in the TradFi world
  • Involves immutable and irreversible transfer of ownership due to blockchain technology
  • Offers different wallet types with different levels of security
  • Provides novel products such as staking, liquid staking, and yield farming
  • Operates on less jurisdictional regulatory clarity
  • Offers different asset lifecycle events such as forking and airdrops

What is digital asset custody really?

The digital asset market is still very nascent, especially compared to traditional financial markets. So yes, the custody business model exists in both sectors, but the definition of “custody” in the digital asset world is yet to form a concrete identity. Custody in digital assets is used much more flexibly, and is a rather broad term which encompasses the idea of safekeeping assets on behalf of their owners.

Many ‘custody’ providers in the digital asset space do not actually offer real custody – they simply offer hot wallets to store customers’ private keys, without actually holding custody of anything. When one deposits their funds into a centralized exchange, centralized borrowing/lending platform or yield generating solution, the funds are deemed ‘custodied’ on behalf of the customer, via a hot wallet provided by the respective platform. These wallets do not guarantee asset segregation nor ensure that the funds are safe from theft, loss or misuse – meaning the ‘custody’ providers merely provide a tool for customers to hold the funds themselves, and do not actually hold the assets on their behalf. 

Such solutions do offer greater liquidity, but because they only provide hot wallets which are connected to the internet, they leave more doors open for hackers to attack. And given the wallets are operated by the respective service provider, there is no guarantee that a customer’s funds are safe from the provider’s activities unrelated to the customer’s decisions. 

When looking towards digital asset custody, there will be plenty of options available. But choosing the option that provides custody reflecting the traditional finance world is the only way to guarantee full protection of your digital assets. Before choosing a digital asset custody provider, remember to ask the right questions. Do they offer real custody or just the tools for you to self-custody?

About Hex Trust

Hex Trust is a fully-licensed digital asset custodian that provides solutions for protocols, foundations, financial institutions, and the Web3 ecosystem. We have offices in Singapore, Hong Kong, Dubai, Italy, and Vietnam.

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