If a crypto exchange or financial platform goes bankrupt or gets hacked, it causes real pain for its customers. If you store crypto on these platforms, you may wake up to find you can no longer access or withdraw your assets.
The good news is that for those who aren't interested in providing their own custody, 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 your crypto.
What is a crypto custodian and why is a trustworthy crypto custodian important?
When you buy cryptocurrency, your access to your coins is stored in a wallet (i.e., a digital account). A crypto custodian is the organization that manages the security for this wallet.
Unless you choose to provide your own custody, the custodian is usually either the platform you bought your crypto on, or a third-party custodian they're using for your assets. In simple terms, the platform manages the security of your 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 your investments temporarily, or worse, forever.
It's also important to know which service providers you're using to trade and custody your assets, as they are sometimes the same entity.
How to identify safer crypto custodians
There are several things you can look for to identify custodians with relatively strong custodian practices. You 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 2-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 your 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 (e.g., a trust charter from the New York State Department of Financial Services).
Protect your data: Your personal data should be yours alone. Evaluate whether or not the platform you're using prioritizes protecting your information. Avoid those that sell client data.
Weigh risk vs. reward: If a custodian is offering rewards that may sound too good to be true for keeping your crypto assets with them (sky-high interest rates, for example), there is likely significant risk. Consider a custodian that doesn't lend or rehypothecate your assets (see below for how this works), or if they do, does so transparently and with your full understanding of the risks. Always read the customer agreements and make sure you're comfortable with the terms you are accepting.
What is rehypothecation?
Assume you borrow $50,000 from Bank 1 to buy a house. Bank 1 designates the house as collateral, i.e., if you can't repay the $50,000, Bank 1 has the right to confiscate your house. Now assume Bank 1 wants to borrow $50,000 from Bank 2. Instead of putting up their own assets as collateral, Bank 1 designates your house as collateral for their $50,000 loan from Bank 2.
This is called rehypothecation, and it can involve a third, fourth, or even more parties, all borrowing with your house as collateral. The risk here is that if Bank 1 collapses, but you're in no danger of failing to repay your $50,000, every party up the chain is left with no collateral to confiscate. This can severely damage their finances and even cause them to go bankrupt.
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 your crypto assets safely
The crypto industry is still developing and can be vulnerable to poor internal security practices. If you understand the risks and you've decided it is right for your portfolio, buying crypto on a secure platform is key.
Choosing a crypto platform that implements strong custodial principles may help you avoid falling victim to a vulnerable exchange or investment platform. And the research involved in finding a secure custodian may provide you with invaluable peace of mind in the long run.
As always, keep in mind that crypto in general is highly volatile, and may be more susceptible to market manipulation than securities. 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, it's also not insured by the Federal Deposit Insurance Corporation (FDIC) or the Securities Investor Protection Corporation (SIPC), meaning you should only buy crypto with an amount you're willing to lose.