After buying bitcoin, investors must give serious consideration to how they will store their bitcoin. Custodial storage options are often the most secure method of safe-keeping, and they require the least amount of effort from the investor. A common misconception is that Bitcoin custodial storage is the same as traditional bank account possession of fiat currency. However, there are key differences, including physical possession of funds and fractional lending.
Traditional Bank Account
When fiat currency is deposited into a bank account, the same funds you deposited are not the same funds you are given when you make a withdrawal or purchase. Most funds deposited in a bank account are loaned by the bank to other banks or individuals, and the bank retains enough money on-hand to satisfy the immediate withdrawal needs. Essentially, customers contribute their funds to the bank’s asset pool, and the bank is promising its customers that they will let them withdraw the same amount at a later date. While banks generally make good on their promise, there have been historical incidents of banks being unable to return funds to account holders, such as the infamous bank run at the beginning of the Great Depression.
While banks are typically viewed as a safe vehicle to store funds, banks and their customers’ bank accounts have been victim to digital attacks that result in identity or money theft.
There are two types of Bitcoin custodial storage: hot storage and cold storage. Hot storage means that a user’s wallet or account associated with the custodian is connected to the internet. Cold storage means a user’s wallet or account is disconnected from the internet, removing the risk of digital attacks. The primary difference between bitcoin custodial services and fiat currency bank accounts is that bitcoin solely exists on the blockchain. Therefore, there is no physical ownership of bitcoin. Custodians can never “hold” bitcoin the way that banks take possession of physical funds. Instead, bitcoin custodians take possession of the private keys which control your bitcoin.
Another difference between fiat currency bank accounts and Bitcoin custodial storage is that bitcoin custodians do not commonly participate in fractional lending. As stated previously, banks use funds deposited by customers to add to their asset pool, and loan these same funds to other individuals or banks. This is possible, but not common practice with a bitcoin custodian; there are select custodians who lend bitcoin deposited in their account to other customers.
- Traditional bank accounts take physical possession of your funds and lend them to other banks or customers
- Bitcoin custodians never take physical possession of your Bitcoin or lend it to other customers
- Banks have historically been targeted by digital attackers looking to compromise funds and customers’ identity