Unlocking digital asset custody terminology

As the digital asset market has matured, financial institutions now look to custodians for ease of transacting and speed of access to their assets. While the safety of assets is non-negotiable, reduction of counterparty risk is also paramount in a blockchain-based settlement environment. Connectivity and a move towards a secure and functional ecosystem create more opportunities.

Different layers of complexity exist in the market for custody of digital assets, partly due to regulatory differences between jurisdictions, which may affect the choice of custody solution. How clients may want to deploy their digital assets also affects their choice of solution – would they like the flexibility to wrap their assets, stake them or borrow against them, for example? Below we unpack and explain some of the key terms used in digital asset custody today and examine how they are shaping the custodial choices of the future.

Hardware-Based Security Modules (HSMs)

HSMs are tamper-proof servers that typically require multi-signatory verification to access and move digital assets. HSMs have been used by banks and payments providers for many years and are now used by more regulated digital asset custodians to hold keys. They are designed to repel any unauthorised attempt to break into them and are independently certified to validate this design principle. Using co-located facilities minimises risk, adding a further layer of operational resilience. Holding the master keys within a custody solution in an escrow account or using a trust structure also adds extra layers of security and resilience, as it provides resilience in the event of the failure of the custodian.

Air Gapping

An air gapped wallet is a hardware wallet disconnected from the Internet and generally never plugged into an internet connected computer. Instead, they communicate by using encrypted messages or specialised hardware (e.g. data diodes).

Sharding and Multi-Party Computation (MPC)

Another technique used to increase the protection of holding digital assets is multi-party computation (MPC) technology. MPC splits the client’s private key into ‘shards’ and distributes those shards (a portion of the original private key) to as many trusted parties as required. When the asset needs to be moved, the users coordinate as part of a signing scheme so there is no single point of failure. This reduces the risk of hacking and the threat of human error or theft.

Optionality – the future of digital asset custody

Institutional custodial services have now become ‘temperature agnostic’. The narrative has moved on from cold versus hot storage. Instead, a mixture of techniques exist which can be combined in different forms – including on-premise, physical storage; cloud-based SaaS solutions and multi-signature HSM solutions. Where once there were only a few options that would meet the need for institutional-grade digital asset custody, there is now increased optionality to choose from and clients can pick the one that best suits their needs. Regulation forces certain technical solutions in some jurisdictions limiting what can be done with assets and limiting access to wider ecosystems, stifling innovation.

Custodians are also becoming facilitators, enabling institutional participation in digital assets through access to wider networks of providers and services. Zodia Custody’s ecosystem, for example, is built on an integration layer working with multiple partners with a network which extends beyond crypto exchanges to market makers, OTC desks, exchanges and wider service providers, all with the aim of mitigating counterparty risk.

Clients can ensure regulatory compliance by selecting different custody solutions for different jurisdictions, as regulatory requirements vary so much from one place to another. Rather than needing to onboard with a whole range of providers, access to varied custody options can come via a single source allowing for faster settlements, streamlined workflows, and increased capital efficiency.

The future of digital asset custody will entail support for the increasingly sophisticated and dynamic needs of institutional clients, ensuring that their assets are not only safe but also readily accessible and deployable in a rapidly changing financial landscape. This ongoing evolution highlights the critical role that innovative custodial solutions will play in the broader adoption and integration of digital assets into mainstream financial systems.

 

 

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