Note: On December 12, the U.S. SEC officially published an article to educate retail investors on the basics of crypto asset custody, helping them decide the best way to hold crypto assets.
Compiled by Golden Finance:
The U.S. SEC's Office of Investor Education and Advocacy issued this Investor Bulletin to help retail investors understand the ways to hold crypto assets. This bulletin outlines the types of crypto asset custody and provides some tips and questions to help you decide the best way to hold your crypto assets.
I. What is Crypto Asset Custody?
Crypto asset "custody" refers to how and where you store and access your crypto assets. You typically access crypto assets through a device or computer program called a crypto wallet. Crypto wallets themselves do not store crypto assets; instead, they store the "private keys" or passwords to your crypto assets.
Crypto Assets. Crypto assets are assets that are generated, issued, and/or transferred using a blockchain or similar distributed ledger technology network, including assets referred to as "tokens," "digital assets," "virtual currency," and "cryptocurrency." Investors should understand that the characteristics and design of crypto assets, as well as the distributed ledger or blockchain technology used for issuance and/or transfer, can vary significantly. In other words, different crypto assets may present different benefits or risks.
When you create a crypto wallet, the following two keys or passwords are generated:
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Private Key. A private key is a randomly generated alphanumeric password used to authorize transactions of crypto assets. A private key is like the password to your crypto wallet. Once created, a private key cannot be changed or replaced. If you lose your private key, you will permanently lose access to the crypto assets in that wallet.
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Public Key. A public key is another code used to verify transactions and allow others to send crypto assets to your crypto wallet. A public key cannot access the private key in the wallet and cannot be used to authorize transactions. A public key is like the email address for your crypto wallet.
These keys together prove your ownership of the crypto assets and grant you the right to send, receive, or use the crypto assets.
II. Hot Wallets vs. Cold Wallets
There are many types of cryptocurrency wallets, and retail investors hold them in various ways. Cryptocurrency wallets are mainly divided into two major categories: "hot wallets" and "cold wallets." A hot wallet is a cryptocurrency wallet connected to the internet, which can be a desktop application, mobile application, or web application. Hot wallets provide convenient access to crypto assets for transactions but also expose your crypto assets to cyber threats.
A cold wallet usually refers to a physical device not connected to the internet, such as a USB drive, external hard drive, or even a piece of paper. For crypto asset transactions, cold wallets are generally less convenient than hot wallets. However, because cold wallets are not connected to the internet, they are generally more resistant to cyber threats than hot wallets. Nevertheless, the physical device of a cold wallet can still be lost, damaged, or stolen, leading to the permanent loss of your crypto assets.
Protect your seed phrase! Many crypto wallets generate a "seed phrase," also known as a mnemonic recovery phrase, backup seed phrase, or mnemonic phrase. A seed phrase is a string of random words that can help you recover your wallet if you lose your crypto wallet or private key, or if the wallet's hardware or software is damaged. Keep your seed phrase in a safe place and never share it with anyone.
III. Self-Custody vs. Third-Party Custody
You also need to decide whether to self-custody your crypto assets (self-custody) or entrust them to a third party for management (third-party custody). Both self-custody and third-party custody offer hot and cold wallet options.
Self-Custody
With self-custody, you have full control over your crypto assets and are responsible for managing all the private keys of your crypto wallets. This means you have complete control over access to your crypto asset private keys, but it also means you bear full responsibility for the security of those private keys. If your crypto wallet is lost, stolen, damaged, or hacked, you may permanently lose access to your crypto assets.
Key Questions When Choosing a Self-Custody Crypto Asset Solution
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Are you comfortable easily setting up and maintaining your crypto wallet? Setting up and maintaining a crypto wallet yourself may require some technical knowledge. Make sure you are capable of handling all the technical aspects required to set up and maintain your crypto wallet yourself.
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Do you want full responsibility for your crypto assets? With self-custody, you have complete control over your crypto assets. You are solely responsible for safeguarding the private keys and seed phrases of your crypto assets. If these keys or seed phrases are lost or stolen, you could lose access to your crypto assets.
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What type of crypto wallet do you want to use? As mentioned above, you can use a hot wallet or a cold wallet to store your crypto assets. Carefully consider your convenience and security needs when choosing the type of crypto wallet that best suits you.
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How much does the crypto wallet cost? Physical devices for cold wallets usually require purchase, while hot wallets may initially be free. However, using a wallet for transactions usually incurs fees. Be sure to understand these fees before choosing a crypto wallet or conducting transactions.
Third-Party Custody
With third-party custody, you can choose a professional custodian or service provider to hold your crypto assets. Third-party custodians include cryptocurrency exchanges and specialized crypto asset custody service providers. The third-party custodian is responsible for managing and controlling access to the private keys of your crypto assets. The accounts used by the third-party custodian to hold the private keys of your crypto assets may be hot wallets, cold wallets, or a combination of both. If the third-party custodian is hacked, goes out of business, or declares bankruptcy, you may lose access to your crypto assets.
Key Questions When Choosing a Third-Party Custodian
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Have you researched the custodian's background? Be sure to take the time to carefully research any third-party custodian. Search online for any complaints about the custodian. Find out how the custodian is regulated. Although the regulatory framework for the crypto asset industry is still in its early stages, some level of regulation already exists.
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What types of crypto assets does the custodian allow me to hold? Each custodian allows different types of crypto assets to be held. Be sure to confirm that the custodian allows the types of crypto assets you wish to hold in your account.
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What happens if the custodian goes out of business? Find out if the custodian provides insurance for lost or stolen crypto assets, and make sure you understand its terms and conditions.
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How does the custodian store and protect your crypto assets? Ask the custodian how they protect your crypto assets and private keys, and who has access to them. Does the custodian store your crypto assets in its own facilities, or does it outsource storage to a third party? Does the custodian use hot wallets, cold wallets, or other methods? Which type of crypto wallet do they primarily use, and how do they determine where to store your crypto assets? Also, ask about the types of physical and cyber security protocols and procedures the custodian uses to protect your crypto assets.
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How does the third-party custodian use your crypto assets? Some custodians may use the crypto assets you deposit as collateral for their own purposes (e.g., lending). This is sometimes called "re-hypothecation." To reduce costs, some custodians may also commingle crypto assets instead of holding them separately for clients. Find out if your custodian engages in any of these practices, and if so, whether your consent is required.
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What privacy protections does the custodian offer? Look for custodians that protect your sensitive personal information (such as your name, address, Social Security number, and the types of crypto assets you own or have traded). Ask the custodian if they sell any customer data to third parties, and if so, whether your consent is required.
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What account fees does the custodian charge? Ask the custodian about annual management fees (an annual fee based on the value of your crypto assets), transaction fees (the cost to use or trade crypto assets), transfer fees (the cost to move your crypto assets outside the custodian), and account opening and closing fees.
IV. General Advice for Protecting Crypto Assets
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Carefully research and choose any third-party custodian.
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Never disclose your private keys or seed phrase.
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Protect the privacy of your crypto assets. Do not share the amount or types of crypto assets you own with anyone.
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Beware of crypto asset phishing scams.
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Use strong passwords and multi-factor authentication for all online crypto asset accounts.
