The Importance of 'Third-Party Custody' for Web3
- Future of Finance
- Jul 21, 2023
- 5 min read
An article by Cactus Custody
Custodians have been integral to the traditional banking system, safeguarding various assets for decades. However, the rise of the Web3 era prompts us to question the role and importance of digital asset custodians in this new paradigm. As blockchain technology and cryptocurrencies gain prominence, it becomes increasingly crucial to examine how market participants should adapt to the evolving Web3 ecosystem and ensure the security of digital assets. The transformation of custodial services in this era presents both new possibilities and challenges that necessitate a careful evaluation of their evolving role in protecting and managing digital wealth.
Security First
Security has always been a top priority. From 2009 to 2023, the landscape of private key management and securing crypto assets has witnessed remarkable changes. Initially, individuals relied on paper wallets during the early stages of cryptocurrency adoption. However, as cryptocurrencies grew in popularity and complexity, more convenient and secure solutions were sought. This led to the emergence of third-party custody services, revolutionising the handling of private keys and digital assets.
Reputable financial institutions and cryptocurrency custodians began offering these services, allowing individuals and institutional investors to entrust their private keys and crypto assets to experienced professionals. Unlike custodians in traditional finance, digital asset custodians do not technically store digital assets; instead, they secure private keys as all data and transactions exist on the blockchain.
While security concerns historically focused on mitigating external risks, such as attacks on exchanges and private key disasters, the market has faced persistent threats from malicious actors.
Greater Calls for Transparency
Recent incidents, such as the collapse of prominent lending CeFi entities triggered by the Terra Luna collapse and the FTX implosion that resulted in the misappropriation of billions of dollars in customer funds, have severely damaged trust between users and CeFi entities. Consequently, customers now demand transparency and visibility, recognising the high cost of inaction. In response to this demand, some exchanges have published self-generated proof-of-reserves reports. However, the lack of independent verification of liability undermines their credibility.
Many exchanges have turned to third-party custody services to regain user trust and confidence. Digital asset custodians are dedicated to addressing these challenges by offering tailored solutions that enhance transparency, while maintaining an exceptional user experience.
Compliant Platforms to Secure Digital Assets
Institutional investors and their asset managers face regulatory restrictions that prevent them from directly handling assets in the same manner as individual users. This regulatory framework aims to safeguard investor holdings against potential risks such as theft and fraud.
As a result, custodians have emerged as crucial players responsible for securely holding assets on behalf of institutional investors. Major financial institutions, like Fidelity, with an impressive $7.2 trillion in client assets under administration, recognise the need for custodial solutions specifically tailored to digital assets. This development underscores the increasing recognition of cryptocurrencies within the traditional financial landscape and emphasises the significance of secure and compliant custodial services in managing and protecting institutional investors' portfolios.
Why Third-Party Custody is Essential
Two primary methods exist for securing digital assets: third-party custody and self-custody.
Self-custody is suitable for individuals who can keep up with timely updates and upgrades to protect their digital assets from evolving hacking methods. On the other hand, third-party custody provides effective support for non-Web3 native businesses, allowing them to interact with the Web3 ecosystem in a familiar Web2 environment.
Unlike self-custody, third-party custody eliminates the need for users to develop internal expertise in safeguarding private keys, as the custodian handles any technical difficulties. Keeping pace with rapidly developing public chains requires continuous research, development, and upgrades, which necessitates a significant investment in establishing a professional custody infrastructure.
Collaborating with a third-party custodian brings notable cost savings through economies of scale, benefiting from specialised and centralised private key management. Given that mismanaging private keys can result in the complete loss of digital assets, utilising third-party custodians efficiently mitigates such costs and risks.
Third-party custody also proves valuable for regulators in their supervisory efforts. In February 2023, the SEC proposed amending federal custody requirements to include cryptocurrencies, indicating that regulators recognise the role of digital asset custodians in ensuring client assets are segregated and held in accounts designed to protect them. The rise of peer-to-peer transactions has created a loophole wherein self-custody solutions can easily bypass important Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations. The inherent anonymity of blockchain technology poses challenges for regulators to effectively monitor transaction compliance. The lack of regulatory experience in overseeing the intricacies of the rapidly evolving crypto industry, including decentralised finance (DeFi), security token offerings (STOs), native staking, and more, makes third-party custodians even more valuable for both users and regulators. Third-party custody services can offer native solutions tailored to regulatory and audit-related concerns, ultimately reducing regulatory costs, and enhancing supervision capabilities.
Furthermore, working with third-party custodians has become a non-negotiable requirement in the digital assets market for asset management institutions, exchanges, and other financial service providers. Users are increasingly aware of the potential conflict of interest when a single legal entity offers both asset custody and investment services. Institutions are assuring users that their assets remain separate from bankruptcy risks by utilising third-party custodians to enhance security and bankruptcy remoteness. Without such assurance, users may hesitate to engage with these institutions.
Moreover, to satisfy regulatory requirements and internal control processes, the value of adopting third-party custody solutions becomes inherently clear. The availability of crypto-friendly functionalities, such as multiple administrative capabilities and enhanced smart contract security controls, has also facilitated the shift from self-custody to third-party custody for many users.
The Road Ahead
Third-party custody is poised to become the foundational infrastructure of the Web3 ecosystem, eliminating vertical integration and transitioning towards neutral and independent custody as mainstream adoption grows. As the industry becomes more specialised, prime brokerages, investment funds, and exchanges will focus on their core business strategies while entrusting asset security to compliant third-party custodians. Custodians will handle crucial tasks such as settlement, accounting, and safeguarding digital assets in strict adherence to relevant laws, regulations, and custodian contracts. Institutional custodial services will prevent asset misappropriation, ensuring the integrity and independence of digital asset management while protecting the legitimate rights and interests of investors.
In conclusion, the role of custodians is evolving in the Web3 era, with a focus on securing digital assets, enhancing transparency, and meeting regulatory requirements. Third-party custody offers convenience, expertise, and compliance, making it an essential tool for both users and regulators. As custodians continue to adapt to the changing landscape, they will play a crucial role in protecting and managing digital wealth in the future.
Cactus Custody™ is a qualified custodian and a Hong Kong Trust Company that meets the capital reserve requirement and acts within regulatory and AML guidelines. To learn more about our solutions, visit https://www.mycactus.com/en.