What to look for in a crypto custodian

If a crypto exchange or financial platform goes bankrupt or gets hacked, it causes real pain for its customers. If a person stores crypto on these platforms, they may wake up to find they can no longer access or withdraw their assets.

Choosing the right crypto platform and understanding their custody practices may help reduce this risk.

But knowing what to look for is key. Let's explore critical factors to consider when choosing where to store crypto.

What is a crypto custodian and why is a trustworthy crypto custodian important?

When cryptocurrency is bought, access to the coins is stored in a digital wallet. A crypto custodian is the organization that manages the access to this wallet.

Unless a person chooses to provide their own custody, i.e. self-custody, the custodian is usually either the platform they bought their crypto on, or a third-party custodian the platform is using for their assets.

However, not every platform or custodian is created the same. Unlike the relatively regulated banking world, crypto is an emerging industry that doesn't have the same level of standardized safeguards in place yet.

As recent news events have shown, some crypto platforms implement practices that put their own or their customers' assets at risk. Some can also be more vulnerable to hacks resulting from weak security practices. In both scenarios, the result could mean losing access to the investments temporarily, or worse, forever.

It's also important to know which service providers are being used to trade and custody the assets, as they are sometimes the same entity.

How to identify strong crypto custodians

There are several things that can be looked for to identify custodians with relatively strong custodian practices. A person may be able to find out whether an exchange has these features by searching their FAQ page or contacting their customer service department.

Some key principles to keep in mind include:

Stay cold: Custodians should hold most assets in "cold storage" (i.e., offline, vaulted storage of your crypto). Cold storages have higher levels of security and can help protect assets from hacks or accidental loss.

Double down: Consider a platform that requires two-factor authentication (e.g., an email login plus a text-message code or authenticator app) in order to log in and execute buys, sells, and fund transfers. Many platforms already require text-message confirmations, but you may also want to consider platforms that require stronger security options, like authenticator apps. These apps provide another login code in addition to the password and text messages.

Prioritize transparency: Look for custodians that are transparent about their procedures and controls. Additionally, while the crypto industry is still emerging, some degree of regulation exists. Look for platforms that are supervised by regulators and hold the proper licenses to operate within existing regulations.

Protect your data: Personal data should be confidential. Evaluate whether or not the platform prioritizes protecting information. Avoid those that sell client data.

Weigh risk versus reward: If a custodian is offering rewards that may sound too good to be true for keeping crypto assets with them (sky-high interest rates, for example), there may also be significant risk. Consider a custodian that doesn't lend or rehypothecate assets (see below for how this works), or if they do, does so transparently and with the crypto holder's full understanding of the risks. Always read the customer agreements and make sure you are comfortable with the terms you are accepting.

What is rehypothecation?

Assume you have $5,000 of bitcoin stored with Custodian 1. Custodian 1 lends your $5,000 to Custodian 2 to earn interest. Custodian 2 then lends that same $5,000 to Custodian 3, also to earn interest. Custodian 3 lends it again to Custodian 4, so on and so forth.

This is called rehypothecation, where multiple parties are lending using your assets as collateral. The risk here is that if one of the custodians in this chain defaults, you may never be able to recover your original $5,000.

Rehypothecation played a key role in the recent collapse of several crypto institutions. Being aware of how it works can help you avoid platforms with exposure to this kind of risk

Storing crypto assets safely

The crypto industry is still developing and can be vulnerable to poor internal security practices. If a person understands the risks and they've decided it is right for their portfolio, buying crypto on a secure platform is key.

Choosing a crypto platform that implements strong custodial principles may help a person avoid falling victim to a vulnerable exchange or investment platform. And the research involved in finding a strong custodian may provide invaluable peace of mind in the long run.

As always, keep in mind that crypto in general is highly volatile and speculative, and may be subject to market manipulation and liquidity constraints. Crypto holders do not benefit from the same regulatory protections applicable to registered securities, and the future regulatory environment for crypto is currently uncertain. Furthermore, crypto is also not insured by the Federal Deposit Insurance Corporation (FDIC) or protected by the Securities Investor Protection Corporation (SIPC), meaning a person should only buy crypto with an amount they're willing to lose.