Article written by Phumzile Rabula, Candidate Attorney, checked and released by Chantelle Gladwin-Wood, Partner at Schindlers Attorneys
7 October 2021
The need to develop a regulatory and policy regime in response to crypto asset activities in South Africa and other countries is driven by the increased demand for secure safe-keeping of crypto-assets. As such, this article seeks to provide a brief overview of crypto assets and the technology used to hold and store crypto assets.
Given that this article focuses on various types of custodies, custody should not be interpreted as “regulated custody,” but rather as “safekeeping of crypto assets.”
What are crypto-assets?
Crypto assets are digital assets that users can store and exchange electronically without the need for trusted intermediaries, thanks to a network of computers running DTL (Distributed ledger technology) software. There are two types of crypto assets available on the market namely: cryptocurrencies and tokens. A cryptocurrency is a digital or virtual currency that is recorded on a distributed ledger and uses cryptography for security. A cryptocurrency is designed to work as a peer-to-peer medium of exchange or means of payment, frequently referred to as a ‘coin’ or ‘digital money’. Examples are Bitcoin, Litecoin, and Monero.
A token is another type of crypto asset that is intended to function as a medium of exchange or means of payment within a limited ecosystem while also providing an additional feature, such as representing the right to access a product or service or ownership of assets (like securities). Tokens generally include utility tokens, security tokens and asset-based tokens. Some tokens are used as a medium of exchange for good or services other than those provided by the token issuer and can be referred to as cryptocurrencies or payment tokens.
The custody of crypto assets
Storage and custody services refers to the means of storing crypto assets. Before acquiring or transacting with crypto assets, it is important to have a safe place to store them and that place is referred to as a ‘wallet”. A crypto-asset wallet is a software program secured by private and public keys and interacts with various blockchain technologies to enable users to send and receive crypto-assets to and from their wallets and to monitor their balances. The following features are central to understanding the concept of crypto-asset wallet and how crypto-assets are safeguarded.
(a) Wallets can be created using Internet software services and the information can be placed on any computer or mobile device.
(b) Wallets can send and receive crypto-assets to any other crypto-asset wallet without the need for the transaction to be recorded or processed by a third party (such as a bank). Thus, transactions are anonymous to anyone other than the transacting parties.
(c) Each wallet is accessible only through the use of a cryptographic algorithm that sets the password. These algorithms are called public and private keys. In cryptography, a public key is a large numerical value that encrypts data and is used as an address to receive crypto assets. A public key (or public address) can be thought of as the equivalent of a bank account number, which suffices for the purposes of receipt of funds/other parties sending funds to an individual. Some compare a public key to an email address that can be used to receive and send crypto assets. However, unlike a bank account, the crypto-asset balance in a given public address can be viewed by anyone who knows the address, although the identity of the address owner is not recorded on the blockchain.
A private key is similar to a bank account password, security token and account number combined into one. The private key allows the owner of the crypto-assets (or any holder that knows the private key) to open a crypto-asset wallet and send crypto assets to another address (public key). Private keys provide a high level of security.
(d) Hot storage is where the wallet is held on line, and cold storage is where it is held on a device that is not connected to the internet (such as on a flash drive). These types of wallets can be used either by an exchange or by an individual user. Cold storage is an offline wallet for storing customers’ private keys, which allows access to and control over the customers’ crypto assets. With cold storage, the digital wallet is stored on a platform that is not connected to the internet. Methods of cold storage include various forms of hardware wallets (including the Nano Ledger).
The term “hot wallets” refers to the storage of private keys on an online device. Examples of hot wallets are web-based, desktop and mobile wallets running on connected machines. Hot wallets are generally used to store smaller amounts of crypto-assets and are generally suited to users that trade more frequently. The difference between a cold wallet and a hot wallet is that cold wallets are generally more complicated to access, usually involving longer waiting times. Hot wallets are usually faster and give faster access to funds. However, cold wallets are a safer means of storing the private keys for the crypto assets.
(e) Wallets can be safeguarded using custodial (third-parties) and non-custodial services (self-custody). Third party custodianship is another form of storage that enable a service provider to store crypto assets on behalf of customers using clearly defined features and controls to provide certainty over the safekeeping of the assets. Typically, this storage is designed for institutional investors, and will therefore implement institutional grade security and insurance. Custodial (third party) crypto-assets services include most exchanges, brokerage services, and platforms that allow the buying, selling, and storage of crypto-assets. Many custodial service providers charge a fee for undertaking this service. Some financial institutions provide custodial services for crypto assets. The service provider controls the private keys. A contract may be considered to control the crypto assets. An example of third-party custodial services for crypto assets is Swissquote.
Non-custodial services are provided by decentralised exchanges (referred to as DEXes). The user holds its crypto assets directly as it holds the private keys (even if the wallet service is provided by a third party). DEX platforms allow users to maintain control over their crypto assets and transaction settlement on DLT (Distributed ledger technology), using smart contracts.
A key difference between custodial and non-custodial services is that with non-custodial services users control the private keys. With custodial services users are not given the access to private key.
In conclusion it is evident that crypto assets offer a new dynamic and flexible way of transacting for individuals and businesses in a quicker, more efficient and cost-effective manner. Nonetheless, people should be aware of the various storage methods and security systems used to store and manage crypto assets. Additionally, it is critical for the issuers to read the terms and conditions of the custody contract/ arrangement before signing them or before agreeing to them by depositing their crypto assets with the custodian.
Understanding different types of custody for the purpose of law
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