What Is Custody?
In the context of Bitcoin and finance, custody is a service provided by a custodian who controls and safeguards assets which legally belong to another party. Custodians should be regulated and must be trusted, as they have full control over the assets in their custody.
Benefits of Third-Party Custody
There are several benefits to keeping assets under custody. Custodians can lend out assets under their management and earn interest for their clients. Custodians are also typically institutions with experience and expertise in custody, making them more secure and reliable than individuals. Custodians often provide superior convenience to their clients, affording them greater flexibility with their assets.
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For bearer instruments such as bitcoin, security is of utmost importance, as there is no way to recover lost bitcoin. Therefore, if an individual is uncertain about their ability to securely hold their own bitcoin, a custodial option might be more appropriate.
Drawbacks of Custody
There are also drawbacks and risks associated with custody. As with any trusted third party, custodians can be security holes. If a custodian is hacked or corrupted, a client may be unable to recover their assets. This is especially true for bitcoin, as it is an immutable, decentralized ledger.
In less extreme scenarios, custodians may have downtime or may not operate on weekends or holidays, restricting clients’ access to their own assets.
Custodians are also public institutions, and they are subject to regulations and government coercion. In the case of gold, custodians proved to be the critical weakness and allowed governments to confiscate privately owned gold and destroy the gold standard.
Bitcoin Custody
Bitcoin is a unique asset because it is the first digital asset which does not require a custodian. Stocks, digital dollars, video game items, and other digital assets are always controlled by a custodian, but bitcoin can be easily secured by any individual, affording users sovereign control over their wealth.
Self-sovereignty comes with self-responsibility. A user who stores their own bitcoin is solely responsible for its security. This can be daunting for many users, especially newcomers. For this reason, many brokerages, exchanges, and other institutions offer custody solutions. If you choose to store your bitcoin with a custodian, it is critical that you choose a well-established, reputable, security-focused institution.
How Is Bitcoin Controlled?
When Bitcoin is sent in a Bitcoin transaction, it is locked by a specific script, called a scriptPubKey. This script usually specifies exactly which keys must be used to sign the transaction, meaning that the owner of those specific keys is the only one capable of spending the coin.
In this sense, bitcoin is more accurately “controlled”, while the private keys used to spend the bitcoin confer ownership of the bitcoin. This explains a popular Bitcoin mantra “Not your keys, not your coins.”
Because bitcoin is controlled by private keys, if a private key is lost, the bitcoin is rendered unspendable. If a third party, whether a custodian or a thief, has access to a private key, they control all bitcoin locked to that key. The Bitcoin network offers no retroactive recourse to users who mishandle their private keys. However, there are ways of ensuring that your private keys are not stolen or lost.
Single Signature Bitcoin
A vast majority of bitcoin is locked in single signature scripts, which require only one signature, produced by a single, specific private key. Single sig is the simplest way to custody bitcoin, but if the private key is lost or exposed, so is the bitcoin. Thus, safe, redundant backups are critical to securing bitcoin.
Multisig
Bitcoin can also be locked so that multiple signatures from different private keys are required to access it. This is called multisig, and it offers several advantages over single sig bitcoin storage. In a multisig script, multiple entities or individuals can have joint control over a coin.
Multisig policies are flexible, and are described in m-of-n notation, where m is the number of signatures required, and n is the number of participants whose private keys can create valid signatures. For example, a 3-of-3 multisig locks bitcoin such that it can only be spent if all three specified participants sign the same transaction. Alternatively, a 2-of-3 multisig locks bitcoin such that any two participants of a specified set of three can spend the coin.
Bitcoin Multisig Custody
The existence of multisig scripts raises an interesting question of custody. If three individuals own one key each for a 2-of-3 multisig setup, no single entity can move the bitcoin, so who has custody?
In most cases, traditional contract law is more relevant than the actual ownership of the keys. If three individuals are using Bitcoin’s native multisig feature to fund a venture, and they document their agreement, there is legal support to their joint custody of the bitcoin. If any of the parties break their agreement, the legal contract and a court can be used to adjudicate the situation.
It is important to note that regardless of how the court may rule, the Bitcoin network and its rules do not change. Therefore, practical control over the bitcoin will still require the same signatures from the same private keys. The enforceability of any legal outcomes relies on the compliance of the parties controlling the keys. This trait makes Bitcoin extremely robust against confiscation, asserting individual sovereignty over the use of force.
Bitcoin Lending and Custody
Bitcoin lending services are offered by several institutions. These services take custody of a user’s bitcoin, lend it out to other parties, and pay the user interest. Due to Bitcoin’s scarcity, these interest rates are typically higher than their U.S. dollar equivalents.
Peer-to-peer services also exist for Bitcoin lending, with the most popular being Hodl Hodl, which connects lenders and borrowers directly. In this situation, the borrower still takes full custody of the bitcoin and pays the lender interest directly.
Collateralized Bitcoin Lending
Bitcoin can be used to collateralize a loan. Several services allow clients to deposit bitcoin with them, granting them full custody of the bitcoin. These services then offer the clients loans, usually denominated in U.S. dollars. When the client pays back their loan, they will be able to reclaim custody of their bitcoin.
Sidechains, Federated Custody, and Other Models
There are other approaches to custody that seek to find a “middle ground” between 3rd party custodians and full self-custody. Federated custody can be loosely defined as the practice of “spreading” custody between a group of people or organizations to reduce counterparty risk while maintaining a high level of security.
Federated Bitcoin Sidechains
Among the oldest federated custody solutions, Liquid has been in operation since 2015 and is implemented as a layer-2 sidechain. The Federation is comprised of businesses, exchanges, infrastructure firms, game developers, and others, who oversee the network’s operations.
To interact with the Liquid Network, users must lock their bitcoin up with the federation—known as a peg-in—to then receive L-BTC. Along with a reduction in counterparty risk, users also benefit from faster block confirmations, confidential transactions, the ability to create and issue tokenized assets, and extended Bitcoin scripting capabilities.
Chaumian Ecash Mints
Another approach that has gained traction recently is to use a federated custody model on top of a Chaumian ecash mint. A Chaumian mint (or bank) is a system that accepts deposits from users—bitcoin, in this case—and issues them an equivalent balance of electronic cash (ecash) notes.
An ecash mint uses blinded signatures to ensure that the mint’s operator(s) are unable to determine users’ balances, transaction destinations, identities, and other transaction metadata.
Cashu is an open-source implementation of a Chaumian ecash where there is a singular mint operator—this enables user privacy, developer experimentation, and shortened protocol iteration cycles, but does not offer a reduction in counterparty risk.
Fedi, built on the open-source Fedimint protocol takes a federated approach to Chaumian mints. What this means is that a group of custodians (guardians) are responsible for maintaining the mint. The idea with fedimints is that mints and their guardians will serve the communities in which they live, thus enabling less technically capable, or less interested users to participate in the mint system without running any infrastructure.
These solutions seek to increase user transaction privacy considerably, while reducing the counterparty risk to a certain extent.
Notice: River does not provide investment, financial, tax, or legal advice. The information provided is general and illustrative in nature and therefore is not intended to provide, and should not be relied on for, tax advice. We encourage you to consult the appropriate tax professional to understand your personal tax circumstances.Key Takeaways
- Bitcoin is not directly tied to an individual’s identity. Instead each bitcoin is controlled by one or several private keys, which enable them to be spent.
- A Bitcoin custodian holds the private keys controlling certain bitcoin.
- A custodian is always a trusted third party, which means there is always counterparty risk. Greater security and convenience can outweigh these risks.
- Bitcoin custody can be distributed with the use of multisig, allowing multiple parties to hold joint custody and avoiding single points of failure or trust.
