On December 12, the U.S. SEC officially published a document to help retail investors understand the basics of cryptocurrency asset custody, assisting them in deciding how to best hold their crypto assets.
Translated by Golden Finance:
The U.S. SEC's Office of Investor Education and Advocacy released this investor bulletin to help retail investors understand how to hold cryptocurrency assets. This bulletin outlines the types of cryptocurrency custody and provides some tips and questions to help you decide how to best hold your crypto assets.
1. What is Cryptocurrency Custody?
Cryptocurrency "custody" refers to the way and place you store and access your crypto assets. You typically access your crypto assets through a device or computer program known as a cryptocurrency wallet. The wallet itself does not store the crypto assets; instead, it stores the "private keys" or passwords for your crypto assets.
Cryptocurrency Assets. Cryptocurrency assets refer to assets generated, issued, and/or transferred using blockchain or similar distributed ledger technology networks, including assets known as "tokens," "digital assets," "virtual currencies," and "cryptocurrencies." Investors should understand that there may be significant differences in the characteristics and design of cryptocurrency assets, as well as the distributed ledger or blockchain technology used for issuance and/or transfer. In other words, different cryptocurrency assets may carry different returns or risks.
When creating a cryptocurrency wallet, the following two keys or passwords are generated:
Private Key. The private key is a randomly generated alphanumeric password used to authorize transactions of cryptocurrency assets. The private key is like the password to your cryptocurrency wallet. Once created, the private key cannot be changed or replaced. If you lose your private key, you will permanently lose access to the crypto assets in your wallet.
Public Key. The public key is another code used to verify transactions and allow others to send cryptocurrency assets to your wallet. The public key cannot access the private keys in the wallet and cannot be used to authorize transactions. The public key is like the email address for your cryptocurrency wallet.
These keys together prove your ownership of the cryptocurrency assets and grant you the right to send, receive, or use them.
2. Hot Wallets vs. Cold Wallets
There are many types of cryptocurrency wallets, and retail investors hold these wallets in various ways. Cryptocurrency wallets are mainly divided into two categories: "hot wallets" and "cold wallets." Hot wallets refer to cryptocurrency wallets that are connected to the internet, which can be desktop applications, mobile applications, or web applications. Hot wallets allow you to conveniently access your crypto assets for trading, but they also expose your assets to online threats.
Cold wallets typically refer to physical devices that are not connected to the internet, such as USB drives, external hard drives, or even a piece of paper. For cryptocurrency transactions, cold wallets are usually less convenient than hot wallets. However, because cold wallets are not connected to the internet, they are generally more resistant to online threats. Nevertheless, physical devices for cold wallets can still be lost, damaged, or stolen, leading to permanent loss of your crypto assets.
Protect your recovery phrase! Many cryptocurrency wallets generate a "recovery phrase," also known as a mnemonic recovery phrase, backup mnemonic, or seed phrase. The recovery phrase is a string of random words that can help you recover your wallet if you lose your wallet or private key, or if the wallet's hardware or software is damaged. Keep your recovery phrase in a safe place and never share it with anyone.
3. Self-Custody vs. Third-Party Custody
You also need to decide whether to self-custody your crypto assets (self-custody) or entrust a third party to manage them (third-party custody). Both self-custody and third-party custody offer options for hot wallets and cold wallets.
Self-Custody
By choosing self-custody, you have complete control over your cryptocurrency assets and are responsible for managing all the private keys of your wallets. This means you have full control over access to the private keys of your crypto assets, but it also means you bear full responsibility for the security of those keys. If your wallet is lost, stolen, damaged, or hacked, you may permanently lose access to your crypto assets.
Key Questions When Choosing a Self-Custody Solution
Can you easily set up and maintain your cryptocurrency wallet? Setting up and maintaining a crypto wallet may require some technical knowledge. Ensure you are capable of handling all the technical aspects required for self-setting up and maintaining a crypto wallet.
Do you want to take full responsibility for your crypto assets? With self-custody, you have complete control over your crypto assets. You need to be fully responsible for safeguarding the private keys and recovery phrase of your assets. If these keys or phrases are lost or stolen, you may lose access to your crypto assets.
What type of cryptocurrency wallet do you want to use? As mentioned above, you can use hot wallets or cold wallets to store your crypto assets. When choosing the type of wallet that best suits you, carefully consider your convenience and security needs.
How much do cryptocurrency wallets cost? Physical devices for cold wallets usually need to be purchased, while hot wallets may initially be free. However, using wallets for transactions typically incurs fees. Be sure to understand these costs before choosing a crypto wallet or making transactions.
Third-Party Custody
With third-party custody, you can choose a professional custodian or service provider to hold your crypto assets. Third-party custodians include cryptocurrency exchanges and specialized crypto asset custody service providers. Third-party custodians are responsible for managing and controlling access to your crypto asset private keys. The accounts used by third-party custodians to hold your private keys may be cold wallets, hot wallets, or a combination of both. If a third-party custodian is hacked, goes out of business, or files for bankruptcy, you may lose access to your crypto assets.
Key Questions When Choosing a Third-Party Custodian
Have you researched the background of the custodian? Take the time to thoroughly investigate any third-party custodian. Search online for any complaints about the custodian. Understand how the custodian is regulated. While the regulatory framework for the crypto asset industry is still developing, some level of regulation already exists.
What types of cryptocurrency assets does the custodian allow me to hold? Each custodian allows different types of crypto assets to be held. Be sure to confirm that the custodian allows you to hold the types of crypto assets you wish to have in your account.
What happens if the custodian goes out of business? Understand whether the custodian offers insurance for lost or stolen crypto assets and ensure you understand the terms and conditions.
How does the custodian store and protect your crypto assets? Ask the custodian how they protect your crypto assets and private keys, and who has access to them. Does the custodian store your crypto assets in their own facilities, or do they outsource storage to third parties? Do they use hot wallets, cold wallets, or other methods? What type of wallet do they primarily use, and how do they determine where to store your crypto assets? Additionally, inquire about the types of physical and network security protocols and procedures the custodian uses to protect your crypto assets.
How does the third-party custodian use your crypto assets? Some custodians may use the crypto assets you deposit as collateral for their own purposes (e.g., lending). This is sometimes referred to as "rehypothecation." To reduce costs, some custodians may also mix crypto assets instead of holding them separately for clients. Be aware of whether your custodian employs any of these practices and whether your consent is required if they do.
What privacy protections does the custodian offer? Look for custodians that can protect your sensitive personal information (such as your name, address, social security number, and the types of crypto assets you own or have traded). Ask whether the custodian sells any customer data to third parties, and if so, whether your consent is required.
What account fees does the custodian charge? Ask the custodian about annual asset management fees (annual fees based on the value of your crypto assets), transaction fees (costs for using or trading crypto assets), asset transfer fees (costs for transferring your crypto assets out of the custodian), and account opening and closing fees.
4. General Recommendations for Protecting Crypto Assets
Carefully investigate and choose any third-party custodian.
Never disclose your private keys or recovery phrases.
Protect your crypto asset privacy. Do not share the amount or types of crypto assets you own with anyone.
Be wary of cryptocurrency phishing scams.
Use strong passwords and multi-factor authentication for all online crypto asset accounts.
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