Crypto Security 101: Custodial vs. Self-Custody
If you read our last Crypto Security 101 article (if not, click here), you should have good password hygiene for your cryptocurrency account(s). Now, you have to make an important decision on where to hold your assets. Do you use a custodial platform or do you custody those assets yourself (i.e., “self-custody”)?
Convenience vs. Security
There are some pros and cons with each crypto custody option. What it may boil down to is if you prioritize convenience or security. Here’s a quick breakdown on the strengths and weaknesses of custodial vs. self-custody:
Custodial
- Security: Medium/Low
- Convenience: High
- Responsibility: Medium
- Technical Knowledge: Low
- Trust Required: Yes
Self-Custody
- Security: High
- Convenience: Medium/Low
- Responsibility: High
- Technical Knowledge: Medium/High
- Trust Required: No
Almost everyone starts by using a custodial model like Coinbase. You set up an account and send money to purchase crypto assets. Then, you leave your assets in your wallet at the exchange, which holds your private keys that are needed to transact or trade with your cryptocurrency holdings. It is a very simple and convenient option that doesn’t require much technical knowledge on your part. However, it is not necessarily the most secure option as these exchanges can be hacked and your assets could be compromised.
Self-custody will require more work and technical knowledge on your part if you want to have full control over your crypto assets without the third-party exchange system. This will provide much more security, but will be less convenient to manage. Many crypto investors will start with a custodial model and then shift to self-custody once they have built up more significant assets and understand more about how the technology works.
Custodial Options
The most common custodial option is an exchange custodian (Coinbase, FTX and Kraken are the three largest exchanges in the U.S.). If you are using one of these exchanges, you will want to take the following steps to provide additional security:
- Use a unique login password
- Enable two-factor authentication (2FA) on your account login
- Enable 2FA verification for any crypto trade or transaction
- Enable “allow listing” (or “whitelisting”) to specify which address(es) your crypto assets can be moved to
- Create a secondary wallet with additional restrictions for added security
Self-Custody
There may be a learning curve if you take self-custody of your crypto assets, but the security should be much stronger when you are acting as the exchange. There are many different ways to take custody of your assets. We won’t cover them all here, so it may take some additional education and research on your own to decide which method is best for you.
One phrase you should familiarize yourself with is “seed phrase.” The seed phrase is a 12- or 24-word list that is created when you set up your self-custody wallet. You must keep these words safe and private. They serve as a backup to access to your wallet should you ever lose primary access. If a bad actor finds your one of your seed phrase words, they could access your wallet.
Never save this list of words to any internet-connected device. You may want to write the words down on a piece of paper and hide that away. Or, use a product like Cryptosteel for secure protection. Just remember if you lose your seed phrase and access to your wallet, your crypto assets are lost FOREVER.
Hot Wallet vs. Cold Wallet
There are two primary ways to take custody of your crypto assets: hot wallets or cold wallets. A hot wallet can be web-based and accessed through mobile or desktop devices. It is easy to use and offers medium security because an internet connection is required. A cold wallet utilizes hardware or paper documentation to keep your wallet offline. It offers high security, but will be less convenient to manage.
A mobile wallet like Exodus or Coinbase Wallet would be an example of a hot wallet. It is less secure, but easier to use. A hot wallet is probably best if you intend to move your crypto assets often. If you are buying and holding crypto assets for a longer period, then a cold wallet may make more sense to keep everything better protected from bad actors online. There are hardware wallets like Trezor or Ledger available. Some crypto investors will use a combination of both hot and cold wallets.
No matter which you choose, you want to keep your wallet as secure as possible. Use digital security recommendations as listed above (or in last week’s article) for your hot wallet. Hardware wallets and paper documentation should be stored in a fireproof and waterproof safe, and you may want to keep your seed phrases separate from your cold wallet.
Make sure your receiving address are correct (sending and receiving address should match) and you follow the proper steps to transfer crypto assets to or from your wallet. Also remember Bitcoin cannot be sent to an Ethereum wallet and vice versa.
These are some of the basic concepts you need to understand if investing in cryptocurrencies and establishing your crypto custody model. For help with your full investment portfolio and crypto investment planning, contact Illumination Wealth today.
Special thank you to Jacob Phelps, CFP© for providing the source material for this article.