Cryptocurrencies have two faces that present two different sets of custodial issues. One face of these digital assets is that they are weightless strings of binary code that can be flashed around the globe instantaneously. They are accessed through a network of servers with heavy encryption at every step the main custodial tactic.

The other face is physical. Cryptocurrency investors have become highly aware of the fact that “hot” storage of digital assets (storage in an online encrypted file) is more risky than “cold” storage in an offline “wallet” because the online storage methods have proven vulnerable to hacks of different kinds (phishing, social engineering, etc.). The custodial risks of offline cold storage have a lot in common with the physical risks of other small but highly valuable items, but they include some digital risks as well.

A growing number of firms ranging from startups (like Bitgo) to financial giants (like Fidelity) have devised or are in the process of devising cold storage services—a kind of vault for digital assets—for the growing number of investors who want better protection for their crypto assets. A cold storage vault provider has to assess the risks of digital assets in offline storage and devise methods to mitigate them. Note that these risks exist in a largely unregulated system where normal fiat currency controls do not exist.

Here are seven risks providers need to assess and address:

1. Is the safe or vault the right kind for the level of risk, for the value of the asset?

The physical security of the vault must be strong enough to match the value of the asset. Since literally billions of dollars in value can reside on a tiny device, physical resistance to penetration is not a trivial matter.

2. Are digital threats adequately controlled through electronic and physical means?

Digital assets are vulnerable to magnetic or radio radiation, by malicious intent or by accident. Storage areas should be shielded, including all access routes on the premises. No devices capable of memory or carrying magnetic fields can be allowed in the vicinity of the asset.

3. Is physical access to the vault properly controlled?

Almost every armored car robbery begins with the thieves evaluating the access route. To generalize, cold storage providers have to do the same kind of assessment and control the risks. CCTV coverage of access areas is essential, and recordings should be kept 30 to 45 days. Guard presence is required, with escorts for people asking to access the vault.

4. Do procedures sufficiently check the identity of individuals seeking access?

The absence of a legal system of Know Your Customer controls means that storage providers have to develop other means for identifying the people who seek access. This includes every person involved in the chain of custody, such as drivers, guards, and managers. The level of control established by the entities in the chain of custody will vary, and could introduce risks during hand-offs.

5. Are dual control procedures in place at each step in the access process?

Every hand-off and every episode of access to the asset should be under dual control, with appropriate segregation of duties.

6. Are logs maintained to document access and hand-offs of assets, either in or out?

In addition to the CCTV record, every event in the vault that includes access to an asset should be logged according to an established procedure. Personnel on the ground should make the entries and sign off on them.These records should maintain an audit trail including the nature and value (if known!) of the digital asset.

7. Is every member of the staff researched for security and trained in all procedures for control?

Training and understanding of the mission of the vault, as well as job-specific duties, must be verified for every vault employee. Again, outside individuals in the chain of custody may present unknown risks, so efforts should be made to determine the level of control they are under.

Many of these risks are familiar to vault service providers in the cash management industry. For some risks, the addition of digital cold storage is a matter of extension of policies that already exist. However, the addition of the digital issues, especially since cryptocurrencies do not have an external source of control like a fiat currency has, raise the level of risk and the related need to mitigate risk for cryptocurrency.

Download and read Lowers & Associates new white paper, Custodial Crypto: Transportation and Storage, to get a broader understanding about how crypto affects custody.

Custody of cryptocurrency in transit or in storage poses some specific risks that differ somewhat from the usual high-value small sized items, like jewelry. Cash in Transit (CIT) service providers will have to adjust security routines to take these differences into account.

By definition, providing transportation or storage of crypto means that it is in “cold” storage, meaning that it is offline — there is an air gap between the crypto and the Internet or some other digital network. Given that cryptocurrencies are always stored in digital files means that access to them is controlled via strongly encrypted “private keys” using 128-bit encryption generated by a “wallet” (a storage file).

Some risks carriers and vaults must take into account for secure custody of crypto include:

1. Items in custody come in small, somewhat fragile packages.

Even if the digital asset is worth millions of dollars, it can reside on a device the size of a thumb drive. The private key may be written on a piece of paper. Obviously, either of these would be easy to slip into a pocket, and neither weighs more than a few ounces. Packaging and handling have to take into account how easily these items can be damaged, as well as maintain an absolute lack of description of the contents to the casual observer.

2. The device is vulnerable.

The digital asset that the CIT or vault provider is responsible for will reside on some kind of electronic device that is capable of memory, and has a way to input the private key. The binary code that describes the asset contains its value, as well as the identity of its private key. Both of these are critical to access the value, and if either is lost, the value is permanently gone—it will be impossible to recover. Devices like this may be vulnerable to electronic or magnetic disruption, either by accident or intention, so CIT services have to be sure the files are not exposed to damaging fields.

3. The identity of the asset owner may be unknown.

Digital currencies were created in the first place to do away with the need for the regulations and controls imposed on fiat currencies like the US dollar. One standard control on ordinary currencies is the Know Your Customer(KYC) requirement. For crypto, where anonymity is a design feature, not a flaw, the custodian has the potentially large liability for criminal or terrorist activity if it does not know something about the identity of the asset owner(s). This information will have to come through procedures, not regulation requirements.

4. The carrier may not know the value of the currency they are responsible for.

Crypto carriers know Anti Money Laundering (AML) requirements, such as suspicious activity reporting, for values of any size. If custodial procedures depend in part on the value of the item, then determining that value is a critical matter. Beyond the ability of an owner to insure the item (whose risks must be known), the custodian is exposed to loss based on the value. This is a precarious situation.

5. Crypto requires unique access procedures that the custodian may need to help facilitate.

Custody of crypto means that there will always be two entities to protect: the digital file containing the currency, and a record of the private key, which may be physical. Since these two items can never be carried or stored in the same place, all of the risks described above apply to two complimentary assets that have to be brought together to access the value in the currency. This in itself creates the need for procedures to coordinate access in a way that ordinary items do not.

 In general, custody of digital currencies takes place outside the financial system framework that regulates business as usual in CIT businesses. For more information about the sources of risks of crypto and policies for addressing them, see our new white paper, Custodial Crypto: Transportation and Storage.

The fundamental risk of cryptocurrency (‘crypto’), aside from market risks, is custody. Simply put, the high value of crypto, with the equivalent of over $100 billion in circulation (at this time), provides ample motivation to steal it.

Hot vs Cold Storage

If the crypto is stored in a “hot” (online) environment, strong encryption is the essential safeguard, but the entire environment must be secured. The digital asset and the private encryption key that accesses it must be stored separately. Since the online account storing the asset is generally known to the public through the blockchain, the biggest risks are hacking attacks on the online storage or theft of the private key. Whoever holds the private key controls the asset.  History has shown that online storage is highly vulnerable to theft.

If the crypto or its private key are held in “cold” storage (offline)—as many experts recommend—then both digital and physical risks exist. As large and more traditional investors choose cryptocurrencies for value stores and transactions, the cold storage option is likely to increase. The need for strong encryption remains, and specific kinds of threats against digital assets, like electromagnetic radiation, have to be mitigated.

That said, once the crypto and its private key are in the physical realm, many of the risks of crypto are similar to those that apply to compact high value objects like gems, bearer bonds and cash. A small cold storage “wallet”—a digital device that might be the size of a thumb drive—can hold and transfer any amount of cryptocurrency. These tiny devices are highly vulnerable to damage or theft, and even if a thief does not get the private key, they can still hold it for ransom.

A second major source of risk to crypto is the very reason it exists: it is outside of any traditional currency ecosystem, without the insurance and security protocols that accompany fiat currencies. No institution is monitoring crypto transactions, and no law enforcement agency is routinely tracking suspicious actors. In fact, the identities of investors in crypto may not be publicly known.

Financial institutions are beginning to evolve private ways to duplicate some of the protections of traditional currencies, like Know Your Customer (KYC) and Anti-Money Laundering (AML) protocols. Cash in Transit providers are building on their experience in cash management to devise secure ways to store and transport crypto.

Crypto is still in the wild west phase. It is growing very rapidly, and a financial system is developing to make it a reasonable option to fiat currencies.

For more information about the risks of crypto, and how to manage them, request a copy of our new white paper Custodial Crypto Transportation and Storage: Understanding and Mitigating the Risks.