Headline: What is a digital currency custodian?

Date: 8/6/2022

Body:  Let’s say you have an older-laptop, 5 years old or so.  (Like the one I’m using now…hmm)  Anyway, let’s assume that you have a cold wallet, and you keep your Master password on a file within this computer.   If your hard drive crashes and you forgot your Master password, and you had $2,000 in cryptocurrency in that wallet, it is not good, but you will financially recover.  Now, let’s change things a bit.   Let’s say that you are in charge of a pension fund, and you have several million dollars of cryptocurrency on that device.  Now, you’re well and truly screwed.  But, what if, instead of this cold wallet, there was a business that would keep your cryptocurrency safe (and accessible) all the time, and they are insured to do this very business.  They have an IT department where every programmer seems to wear a cape: They’re awesome!!  Might it be worth paying this notional “bank”  just a little bit?  Yes, it would be, and this “bank” is known as a custodian for your digital currency.

Why are these services so badly needed?

OK, let’s take the example of a cold wallet used for offline storage of digital assets.  Usually, it is protected with a very complex alphanumeric password (resembling a nuclear launch code) and these codes are easily forgotten.  So, these services stand in as safer ways to secure our cryptocurrency and digital assets.

Second, even if it is a custodian hosting your hot wallet, stored online, it is much more secure than other solutions.  These services employ some very good programmers and your digital assets started safe and are now, even safer.  Most custodians offer a combination of hot and cold storage.   Coinbase advertises that 95% of the assets in their care are stored offline in cold wallets which are much more secure.  This arrangement allows for you to use your cryptocurrency online while keeping the majority of your cryptocurrency, [

The other important reason for the existence of cryptocurrency custody solutions is regulation. According to SEC regulation promulgated as part of the Dodd Frank Act, institutional investors that have customer assets worth more $150,000 are required to store the holdings with a “qualified custodian.” The SEC’s definition of such entities includes banks and savings associations and registered broker-dealers. Futures commission merchants and foreign financial institutions are also included in this definition. Within the cryptocurrency ecosystem, very few mainstream banks offer custodian services. Kingdom Trust, a Kentucky-based custodian, was the largest such service for cryptocurrencies until it was purchased by BitGo, a San Francisco-based startup. 

Let’s meet the Players in this drama

First, there are exchanges.  (We are only speaking of centralized exchanges here.   Decentralized exchanges are a different breed.)  A centralized exchange  will serve as your custodian; Said a different way, the will hold your private key to disburse cryptocurrency.  There is a risk if the exchange is hacked, but, this is probably a small risk compared to you losing your private key and not being able to access your cold wallet.  Plus, they have security personnel who are likely VERY good.

Second, there are Digital asset managers.  These managers act like banks.  They are licensed and regulated to an extent.

Third, there are custodial banks.   Per a letter from the OCC (remember them?) dated July 2020, custodial banks within the U.S. can now be custodians for cryptocurrency and digital assets.  But, please remember that not all custody arrangements are for everybody.  Some are aimed at institutional investors only and some are only willing to help ultra-high net-worth individuals

How much does third-party crypto custody cost?

If you go shopping for a new car, the price on the window is not what is charged: The dealership will add on all sorts of fees (freight fees, the financing fee, etc.)  Should it be any great surprise that cryptocurrency custodians charge a similar roster of fees?   There are 3 main fees:

Type of fee charged.Commentary.How much is this fee?
Custody FeeBecause they are safeguarding your assets, these custodians are taking on a risk, and they need to be compensated for this risk.Usually less than 1%.
Setup FeeThere are some initial file management tasks that must be done to prepare for the acceptance of your digital assets into the custodian’s digital architecture.This fee is not much, and might be waived entirely to entice new customers.
Withdrawal FeeYou might have to pay an amount every time you take currency out of your account.Sometimes this is a flat amount, sometimes a percentage of the amount withdrawn.

What’s next for these digital asset custodians?

This is difficult because you have the confluence of 2 different dynamics: banking and Cryptocurrency.  Banking has for a long time, been traditional in outlook.   At the same time, cryptocurrency firms have to stay on the leading edge of technology.  Custodians have to speak both languages and have the skill sets represented by each.  Stepping into this shifting milieu,  are two changing attributes.  First, some of the traditional banking institutions  have been dipping a toe into these waters, and this could improve a lot of things within the industry.  Second, the government is cautiously beginning to become involved, in terms of regulation and in terms of taxation.  This could serve to allow others to get into the space.  Remember, for the most part, competition is good.

And these sentiments were also reflected in the letter from the Office of the Comptroller of the Currency.  I won’t bore you with the whole letter, but I suspect that the thought process might be salient.  They concluded that providing digital asset custodian services is a modern form of traditional bank activities and that custodial services of this type may involve more than holding keys.  Said the acting Comptroller of the Currency, Mr. Brian P. Brooks, “From safe-deposit boxes to virtual vaults, we must ensure banks can meet the financial services needs of their customers today.”

The Verdict

In the Old West, there used to be Wells Fargo stagecoaches that would take custody of the deposits going to the bank, and they had to be guarded by strong boxes, men on horseback and men carrying shotguns.  Custodians for our digital assets are just an updated version of this Old West figure.  In the place of handkerchief-masked banditos, there are  organized gangs of crypto-warriors, trying to separate us from our  digital assets.   To fight against this, it might make sense for you to consider deputizing  a custodian.  It costs a little, but, to sleep well is invaluable. 






Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

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