What Is Digital Asset Custody?

The global financial system is on the brink of a major overhaul powered by the mainstream adoption of digital assets. Streamlined online payments were only the first step. The next step involves a range of on-chain assets entering the mainstream. The rise of the digital assets market cap from less than $12 billion in 2014 to over $2.69 Trillion in 2024 tells a story of parabolic rise. However, the rising adoption of digital assets like Bitcoin comes with several risks.

These risks include security and regulatory risks. To tackle these challenges, the concept of digital asset custody came to the fore. This blog discusses the key principles of digital asset custody and why it is important for crypto institutions, businesses, and large-volume investors. But before that, let us better understand the risks involved in handling and managing digital assets at scale. 

Handling Digital Assets

Cybercriminals stole more than $3.8 billion in cryptocurrencies in 2022 alone, a 15% increase over the previous year. As compared to 2021, which witnessed 136 cases of cyberattacks or theft, 2022 witnessed 198 such incidents. Assets worth a whopping $2 billion were also stolen in crypto thefts in 2023, which was significantly down from 2022, but hacking as an underlying problem remained a constant risk

While the stakeholders have managed to reduce the complexities to accelerate onboarding, security is a critical factor that continues to act as a roadblock to the mainstream adoption of digital assets. From top exchanges to DeFi protocols and bridges, crypto businesses across industries have fallen prey to cyberattacks. Such attacks could be fatal to revenue as well as the reputation of businesses. That’s why crypto institutions and businesses need institution-grade digital asset custody solutions to safeguard their digital assets.

While the stakeholders have managed to reduce the complexities to accelerate onboarding, security is a critical factor that continues to act as a roadblock to the mainstream adoption of digital assets. From top exchanges to DeFi protocols and bridges, crypto businesses across industries have fallen prey to cyberattacks. Such attacks could be fatal to revenue as well as the reputation of businesses. That’s why crypto institutions and businesses need institution-grade digital asset custody solutions to safeguard their digital assets.

What Is Digital Asset Custody?

The term digital asset custody refers to the process of securely managing and storing digital assets on behalf of individuals or organizations. It involves the secure storage of private keys, which are essential for accessing and managing one's digital assets. Digital custody providers typically employ advanced encryption techniques, secure hardware devices, and multi-signature authentication to ensure the protection of these keys.

As security risks in DeFi increase, the significance of digital asset custody solutions will only rise. Now that we have understood the basic concepts of digital asset custody, let's discuss how digital asset custody solutions work.

How Do Digital Asset Custody Solutions Work?

The key objective of a digital asset custody solution is to safeguard private keys. Here’s a step-by-step explanation of how a crypto custody solution works:

Account Setup and Onboarding: Users, whether individuals or institutions, initiate the process by signing up on a crypto custodian platform. The onboarding procedure involves identity verification and compliance with regulatory requirements.

Creation of Wallets: Following successful onboarding, the custodian creates secure wallets for the user, which can be hot wallets (connected to the internet) or cold wallets (offline for enhanced security).

Generation and Storage of Private Keys: The custodian generates private keys for each wallet. These cryptographic keys provide access to the associated cryptocurrency funds. The use of specialized hardware security modules (HSMs) or secure enclaves ensures the secure generation, storage, and management of private keys.

Multi-Signature Technology: Many crypto custody solutions utilize multi-signature (multi-sig) technology, requiring multiple private keys to authorize a transaction. This approach eliminates the risk of a single point of failure. For instance, a 2-of-3 multisig setup necessitates two out of three authorized parties to approve a transaction

Transaction Approval Process: When a user initiates a transaction, such as sending or receiving cryptocurrencies, the custodian follows a predefined approval process. In multi-sig setups, the transaction requires the approval of the requisite number of authorized parties.

Monitoring and Reporting: Custodians typically offer users tools for monitoring their holdings and transaction history. Regular reporting on asset status, transactions, and security measures keeps users informed.

Compliance and Regulatory Reporting: Crypto custody solutions adhere to regulatory requirements, including Know Your Customer (KYC) and Anti-Money Laundering (AML) procedures. Custodians may also furnish necessary documentation and reports to comply with financial regulations.

It's important to note that the implementation process may vary across solutions, contingent on the type of wallet infrastructure they provide

Multi-Party Computation: Additional Security With Advanced Custody Solution Providers

The digital asset custody space has evolved significantly over the past few years in the wake of emerging security threats becoming more sophisticated. MPC (multi-party computation) emerges as a viable solution for sophisticated security risks. Just like multi-sig, MPC eliminates a single point of failure. But it does much more.

MPC divides a private key into “key shares” that can be distributed across multiple physical devices, making it impossible for hackers or cybercriminals to access the private key. Plus, MPC empowers businesses to change the authorization threshold, eliminating the implementation challenges that exist in the case of multi-sig.

As newer security and regulatory risks unfold, the role of custody solutions extends beyond just securing the private key. Thus, a custody solution provider offering MPC wallets has to be one of the many key criteria for selecting them. While traditional custody solutions fail to adapt to the changing industry requirements, innovative solutions like Liminal offer both hot and cold MPC wallets. With regulatory approvals like Travel-rule compliance, KYC, AML, and CFT, Liminal is one of the best institutional-grade custody solution providers

Future Trends In Digital Asset Custody

As the institutional adoption of digital assets rises, the stakes are bound to increase. Here are a few changes that one can expect in the digital asset space:

Managed Custody: Excessive risk-taking, single points of failure, and reliance on legacy custody systems have resulted in funds worth billions of dollars vanishing from the ecosystem over the past few years. With the daunting task of digital asset custody, manager custody is set to become a norm, with innovative custodians offering much more than asset protection at the forefront of it.

Interoperability: The launch of new Layer 1 and Layer 2 blockchains hints at a diversified on-chain environment, with institutions dealing with multiple crypto assets and chains. Thus, custody solutions must facilitate interoperability.

Compliance Integrations: As different countries develop new regulations for DeFi institutions, custody solution providers and institutions will be required to comply with their regulations. Custody solution providers must fulfill KYC, KYB, KYT, PMLA, AML, Travel Rule, and other regulatory obligations.

Regulatory Clarity and Collaboration: As the digital asset space matures, anticipate clearer regulatory frameworks that facilitate the integration of digital asset custody with financial systems. Collaborative efforts between regulators and industry players may lead to more standardized approaches.

Final Word

Digital asset custody is bound to play a crucial role in the institutional adoption of digital assets. Innovative digital asset providers are set to be at the heart of the pursuit of creating a favorable environment for crypto businesses and investors. As we move toward a decentralized, transparent, and bankless economy, bank-like asset security is a must, and that’s what digital asset custody solutions must strive to offer.