Though demand for cryptocurrencies is again on the rise, few investors appreciate the risks associated with storing their cryptocurrencies.
Most elect to purchase cryptocurrencies directly through an exchange and hold these assets in their exchange wallet as opposed to appointing a broker to execute the trade, and a custodian to store the cryptocurrencies.
Exchanges, and by extension their customers, have fallen victim to billions of dollars in theft.
Hackers target exchange users with sophisticated phishing techniques (by, for example, using emails to get you to disclose confidential information such as passwords) and exploit vulnerabilities in the storage and security systems of major exchanges.
Unfortunately, as assets being held on exchanges increase, so does the threat of hacking. Seen as ‘honeypots’, exchanges are continuously targeted, leaving users vulnerable.
Crypto exchange hacks
A recent exploit of a Poly Network smart contract (while not an exchange platform per se) provides a stark reminder of this ever-present threat. The hack resulted in more than R8.4 billion worth of digital assets being stolen (some funds were subsequently returned by the hackers).
What alternative storage options do investors have?
The majority of cryptocurrency exchanges give investors the option of transferring their cryptocurrency to an alternative exchange or storage device. This option allows investors to decide which storage solution best suits their needs.
Alternative storage methods include:
Paper wallet: Given that cryptocurrency is simply a long string of information, investors can remove their cryptocurrency from an exchange and record their keys on a piece of paper. The obvious risk associated with this option is that the paper is trivial to copy, can easily get damaged, and becomes illegible over time.
Hardware wallets: A hardware wallet is a dedicated device designed to store private cryptocurrency keys. These devices are significantly less vulnerable to external attacks but require technical knowledge to use effectively. There is also a risk that the device can be misplaced, stolen or damaged.
Third-party custodian: This is the option of outsourcing cryptocurrency storage to a custodian. The client enters into a legal agreement where they appoint the custodian to securely store their digital assets.
Digital asset custodians are akin to the companies providing the physical security used to protect precious metals, except these vaults exist in the digital realm.
As a result of the continued rise in value of cryptocurrencies, custodians have seen a sharp increase in demand for their services.
Individuals wouldn’t typically keep R100 000 under their mattress, and neither should they feel comfortable with large amounts of cryptocurrency stored on insecure devices or in their bedroom cupboard.
Custodians are sought after for their proven security methods, which are otherwise too technical or too complex for many cryptocurrency holders to implement themselves, giving clients convenience and peace of mind.
Key features include multi-signature storage, strict operational procedures, no single-point of access, redundant emergency backups and estate planning.
Crypto security options
It doesn’t take a cryptocurrency expert to deduce that an offline storage solution with multi-signature access is by far the most secure form of cryptocurrency storage, offering strong protection while remaining convenient to transact when needed.
Furthermore, for institutional investors, most third-party custodians offer bespoke multi-signature solutions that can be tailored based on the institution’s internal requirements.
The best option for an individual or institution to store cryptocurrencies will depend on their unique needs and situation, such as:
- The value of the coins
- The frequency of access needed
- Trade frequencies
- Risk appetite, and
- Country-specific regulations.
What these investors should be mindful of is whether it’s the best decision to keep their cryptocurrency on an exchange and, if not, what the best alternative storage solution is for them.
Andoni Nicolau is head of digital assets at alternative investment fund manager Jaltech.