As the cryptocurrency market grows in popularity, many new investors are becoming familiar with the important concepts of "cryptocurrency asset custody" and "stablecoin". These two concepts are related to virtual currency security and asset stability respectively, and are the basics that everyone who wants to enter the crypto world should understand.
This article will introduce beginners to crypto asset custody, stablecoins and their types in plain language, explain why they are important, discuss the associated risks (e.g., asset theft or stablecoin delinking in the context of cryptocurrency risk), and give practical advice.
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What is crypto asset custody?
"Cryptocurrency Custody" is simply the safekeeping of your cryptocurrency private keys to protect your digital assets from unauthorized access or theft. In traditional finance, banks or brokerage firms hold assets for their clients, but in the cryptocurrency world, the ownership and control of your assets is entirely dependent on how you hold your cryptocurrency.Private Key。
Once a private key is lost or stolen, the corresponding cryptocurrency asset may be lost permanently and cannot be recovered. Therefore, how to securely manage private keys is one of the core issues of virtual currency security.
Why is escrow important?
The irreversibility of cryptocurrency transactions and the lack of traditional regulatory mechanisms make it easy to lose assets through hacking, fraud, or operational errors if they are not properly custodied. The importance of escrow has been highlighted by many past events, such as the hacking of large amounts of Bitcoin from famous exchanges Mt. Gox and Coincheck, and the bankruptcy of the FTX exchange at the end of 2022, which left millions of user assets unclaimed. That's why it's important for every cryptocurrency investor to learn and adopt proper custody practices to protect their digital assets.
Common Custody Methods: Exchange Custody, Self-Custody and Third-Party Custody
Currently, there are three common approaches to crypto asset custodianship: storing assets on an exchange (exchange custodianship), keeping the private key by oneself (self-custodianship), or handing over to a professional independent custodian organization for safekeeping (third-party custodianship). Each of these three methods has its own advantages and disadvantages, and is suitable for different situations:
Exchange Custody
The so-called exchange custody refers to storing your crypto assets in a centralized cryptocurrency exchange, where the exchange holds the private keys on your behalf. Most newbies will choose this method when they get started because using an exchange wallet is not only user-friendly and easy to operate, but it is also very convenient as you can quickly buy, sell and trade directly within the platform.
When you use an exchange-provided escrow wallet, you are actually entrusting your assets to the exchange for safekeeping, and you need to trust that the exchange will protect your funds. The advantages of exchange hosting are great convenience: you don't have to manage your private keys yourself, and exchanges often provide security measures (e.g., double-checking, asset insurance) to keep your account safe osl.com. The downside, however, is that you have to assume the risk of trust. In the event of an accident (e.g. hacking, malfunctioning or even closure), your assets may be affected.
The FTX incident mentioned earlier is a lesson: in November 2022, the well-known exchange FTX suddenly went bankrupt, and a large number of users' crypto assets were frozen on the platform and could not be retrieved, resulting in a cumulative loss of billions of dollars. Therefore, if you choose to place your assets on an exchange, it is recommended that you use a major mainstream exchange with a good reputation and strong security measures, and that you turn on security features such as double authentication (2FA) to enhance your account protection.
Self-custody: Cold wallet vs hot wallet
Self-Custody is a way of controlling your private keys and being responsible for your own asset management. As the saying goes, "Not your keys, not your coins," self-custody gives you true control over your assets, so you no longer have to worry about third parties misappropriating or freezing your funds. However, this also means that the responsibility for security falls entirely on you - you need to back up your private keys carefully, keep your wallet safe, and raise your security awareness, otherwise no organization will be able to help you recover your assets if they are lost or compromised.
Self-hosting is usually accomplished through cryptocurrency wallets. Wallets can be categorized into Hot Wallets and Cold Wallets, depending on whether they are connected to the Internet or not.
Hot walletA wallet that is connected to the Internet, such as a mobile wallet app, a computer software wallet or a browser extension. Hot wallets are convenient to use because they are always online, and are suitable for frequent transactions or when you need to transfer money immediately. However, because the private keys are stored on a networked device, hot wallets are relatively susceptible to hacking or malware threats, making them less secure.
Cold walletThese are completely offline wallets, such as specialized hardware wallet devices (that look like USB flash drives) or paper wallets that store private keys offline on paper. Cold wallets are much more secure than hot wallets because they are not connected to the internet and are theoretically almost impossible to hack remotely. Cold wallets are ideal for users who hold large amounts of crypto assets over a long period of time, minimizing the risk of theft.
Its disadvantage is that it is more troublesome to use: every time you transfer money, you usually need to temporarily connect your cold wallet to the Internet to sign the transaction via USB cable, Bluetooth or scanning QR code, etc. The operation steps are cumbersome and have a certain technical threshold. Therefore, most people will store large or long-term investments in their cold wallets, and put small or frequent transactions in their hot wallets, in order to maximize both security and convenience.
Third Party Escrow
In addition to exchanges, there are also independent third-party custodian service providers or organizations in the market that can be entrusted to hold crypto assets for their clients. These custodians are usually specialized firms with highly secure wallet infrastructure, stringent risk control measures, and possibly insurance coverage.
Most of their service targets are institutional investors or high net worth individuals, but some of them are also open to general users. The advantage of third-party hosting is that users do not need to manage their private keys by themselves, and the professional team will keep the security for you. Moreover, many hosting organizations are subject to regulation and need to be audited on a regular basis, which makes them more trustworthy.
Particularly in light of the many regulatory requirements, some large funds, banks and other institutional clients must place their assets in the custody of a compliant custodian to ensure that there is a separation between the person and the manager and to reduce moral hazard. However, third-party custodianship, like exchange-traded custodianship, involves trust: you must select a reputable, compliant custodian and understand its risk management practices.
Losses may also be incurred if there is mismanagement or internal fraud on the part of the custodian itself (although such institutions usually have more stringent internal controls in place to guard against such incidents). For the average retail investor, the use of third-party custodian services is limited as they tend to be expensive and mainly target large assets.
The average investor is more likely to trade off between exchange custody and self-custody. However, as the market develops, innovative "hybrid custody" solutions are emerging, such as exchanges partnering with third-party custodians to keep user assets in an independent custodian, while retaining the convenience of trading. Whichever approach is adopted, the most important thing is to understand the risks and take appropriate protective measures.
What is a Stabilized Currency? Why is it important?
After understanding how to keep crypto assets safe, another common question from beginners is: "What is a Stablecoin?" Stablecoin is a special type of cryptocurrency with a relatively stable value, usually anchored to a real asset or fiat currency (e.g., the US dollar, euro, or gold) to maintain price stability.
The most common stabilized currency is pegged to the U.S. dollar equivalent.Maintains a value of approximately 1 stabilized coin = 1 U.S. dollarStabilized Coins The purpose of stablecoins is to serve as a bridge between the cryptocurrency world and the fiat currency world: on the one hand, they provide a stable store of value and a unit of account like the U.S. dollar, and on the other hand, they have the easily transferable, decentralized nature of cryptocurrencies.
Why do I need a stablecoin?
Most cryptocurrencies (e.g., Bitcoin, Ether) are so volatile that it is difficult to use them directly for everyday payments or as a medium of exchange. Imagine if the price of Bitcoin could move up and down by more than 10% in a single day, merchants and consumers would not be able to use Bitcoin to price their goods or make transactions with confidence.
With the emergence of Stablecoin, which provides a relatively stable trading unit, people can temporarily exchange their crypto assets for Stablecoin to hedge their risks, or directly use Stablecoin for pricing and settlement, reducing the risks brought by drastic price fluctuations. In addition, in some regions where trading between fiat currencies and cryptocurrencies is restricted, stable coins also provide a convenient channel for funds to move freely in and out of the crypto market.
In short, Stablecoins play a key role in reducing cryptocurrency risk (especially price risk) and are an important tool in connecting the virtual economy with the real economy. Many novice investors even choose to buy Stablecoins first and then use them to trade other cryptocurrencies when getting started because it is relatively easy and less risky.
Types of stablecoins: fiat-guaranteed, crypto-asset-guaranteed and algorithmic
Although they are all called stablecoins, there are several types of stablecoins according to their value backing and stabilization mechanisms. There are three main types: fiat currency-guaranteed stablecoins, crypto asset-guaranteed stablecoins and algorithmic stablecoins. They are different in terms of their operating principles and risk characteristics, and are introduced below:
FX Guaranteed Stabilized Currency
Fiat-backed stablecoins are stablecoins that are backed by fiat currency assets. The issuer will reserve an equivalent amount of cash or cash equivalents in an institution such as a bank for the amount of stablecoins issued, ensuring that these stablecoins can be converted back to fiat at any time at a ratio of 1:1.
Ideally, the prices of these stablecoins should be the most stable because they are backed by real assets. For example, two of the most well-known USD stablecoins, USDT (Tetcoin) and USDC (US Dollar Coin), are typical fiat stabilized coins, issued by organizations such as Tether Inc. and Circle Inc. respectively, and backed by US Dollar reserves.
Fiat stabilized currencies are usually centralized because they rely on the issuing company's management of the assets and reputation.
The advantage is the simplicity of the anchoring mechanism, which usually stabilizes the price around the anchor price as long as the issuer ensures a sufficient reserve and allows the holder to convert the currency at any time. As a result, fiat stabilized coins are still the most stable and largest type of stabilized coins in the market.
The disadvantage is the risk of centralization and credit risk due to issuance by a single company or consortium. For example, there have been many questions in the market about whether USDT issuers have sufficient US dollar reserves to fully back up USDT in circulation, and if the issuing company misappropriates funds or reserves assets in a non-transparent manner, there may be a risk of a run on the market when a large number of users request cash at the same time (insufficient reserves may make it difficult to exchange the USDT).
The good news is that mainstream fiat stabilizers have become more transparent and compliant in recent years, with USDC issuers publishing monthly audit reports, holding 100% in cash or equivalent reserves, and following strict regulatory standards. Overall, the risk of fiat stabilized currencies is still much lower than other types, but investors still need to pay attention to the issuer's disclosure and financial status.
Crypto Asset Guaranteed Stablecoin
Crypto-backed Stablecoin is a stablecoin issued with other cryptocurrencies as collateral assets. The most typical example is the DAI stablecoin issued by the MakerDAO protocol: users can use crypto assets such as Ether (ETH) and Bitcoin (BTC) as collateral to lend DAI through the smart contract mechanism.
Since the collateralized assets themselves are subject to price fluctuations, to ensure that the value of the DAI is stabilized, an overcollateralization mechanism is often used - meaning that the value of the crypto asset you are collateralizing must be higher than the value of the stabilized coin that is being minted. For example, MakerDAO requires that for every $100 worth of DAI minted, it may need to collateralize at least $130 worth of ETH to prevent market fluctuations from undervaluing the collateral.
If the collateral price plunges and hits the liquidation line, the smart contract will automatically sell the collateral to recover the corresponding stabilized currency, maintaining the adequacy of the system's assets.
The advantage is that this type of stablecoin operates through smart contracts on the blockchain, the process is open and transparent, and reduces the trust reliance on a single centralized institution, so it is also known as decentralized stablecoin.
At the same time, because the collateral is a crypto-asset, the issuance volume will not be limited by the amount of fiat currency reserves, and can theoretically be flexibly adjusted in line with the market's demand for stablecoins.
The disadvantage is that overcollateralization is taken for security, leading to inefficient use of capital and the need to lock up a higher-value asset in order to generate a smaller-value stablecoin.
In addition, users may face the risk of additional collateralization or compulsory liquidation in the event of sharp fluctuations in the price of the collateral. Compared with fiat stablecoins, the price stabilization mechanism of such stablecoins is more complicated, and there is a certain threshold for users to understand and participate. Therefore, the scale and popularity of decentralized stablecoins are still far less than that of centralized fiat stablecoins.
Taking DAI as an example, although it is the largest decentralized stablecoin, its market share still lags behind centralized stablecoins such as USDT and USDC. Nevertheless, crypto asset-backed stablecoins have an important place in the DeFi (Decentralized Finance) space, as their decentralized nature is in line with the crypto community's quest for a trustless intermediary.
Algorithmically Stable Currency
Algorithmic Stablecoin refers to a stablecoin that does not rely on traditional asset collateralization, but rather on purely algorithmic and market demand and supply adjustments to maintain currency stability. These stablecoins are usually not backed by fiat or crypto assets, but rather by smart contracts that expand or contract the supply of stablecoin according to pre-set algorithmic rules to keep the price anchored near a target (e.g. $1).
Because it does not require collateralization of physical assets, Algorithmic Stablecoin is considered to be the most theoretically centralized and capital-efficient solution. If successful, it is tantamount to "printing money" out of thin air, and project owners and early participants can make a lot of money. However, in reality, purely algorithmic stablecoins face great challenges and risks. If market confidence is low, the asset-less stabilization mechanism can easily fail, resulting in a so-called "death spiral": when the price of a stablecoin falls below its anchor value, the market's trust in the stablecoin collapses, triggering a wave of selling, and the algorithm's attempts to save the coin accelerate the price decline, and ultimately the stablecoin collapses off the hook.
TerraUSD (UST) is the best-known example of this type: UST was originally stabilized by a two-token algorithmic mechanism between UST and another token, LUNA, and at one point it grew to be a large stablecoin with a market capitalization of tens of billions of dollars. However, in May 2022, due to a flawed trading mechanism and a confidence crisis, the UST price was unable to remain stable at US$1 and quickly collapsed and delinked, eventually reaching near-zero and rendering the associated LUNA tokens virtually worthless.This incident has dealt a major blow to market confidence and brought to light the potential dangers of purely algorithmic stablecoins.
The advantage is that if the Algorithmic Stablecoin can be successfully run, it will require no collateral assets, be extremely capital efficient, and be completely decentralized and unencumbered by the traditional financial system. This is attractive for the long-term development of decentralized finance. Some improved algorithmic stablecoins have also emerged in the market, such as hybrid models that are partly collateralized and partly algorithmic (e.g., FRAX), or models that increase reserves (e.g., Cardano Ecology's DJED) to improve stability.
The downside is that there are no successful examples of completely unsecured algorithmic stablecoins. Most such projects eventually fail, and UST is not the first and may not be the last. Investors should be particularly cautious with such stablecoins and should not commit large amounts of assets to them until the mechanism has been proven reliable over time. Regulators in many countries and regions also tend to restrict or ban purely algorithmic stablecoins to protect the investing public from potential risks.
The Risks of Stabilized Currencies: Decoupling and Reserve Transparency
Although stablecoins are designed to maintain price stability, it does not mean that they are risk-free. The following are some of the major risks that stablecoin investors need to be aware of: Delinking Risk: Delinking refers to a situation where a stablecoin fails to maintain its established exchange rate anchorage, and its price deviates significantly or even collapses. This is the highest risk amongst algorithmic stablecoins, as in the case of the UST crash mentioned above, where the UST fell from $1 to near zero, resulting in investors losing all their money.
Even asset-backed stabilized currencies may at one point deviate in price by as much as $1 during an extreme panic. For example, the market briefly sold USDT at the height of the Luna/UST crisis in 2022, causing the price of USDT to fall to about $0.95. Although it later recovered, the impact of a run on a stablecoin is still visible.
Therefore, when the secondary market price of a stabilized currency is seen to be below the anchor price for a long period of time, it is important to be alert to the risks that may be implied. Reserve opacity and credit risk: For fiat currency-backed stablecoins, the biggest risk lies in the adequacy and safety of the issuer's reserve assets. If the cash or assets in reserve is less than 1:1, or the reserve details are not transparent, it is difficult for investors to be confident that the currency can be paid in full in the event of a crisis.
The issuer of USDT, for example, has been questioned in the past for failing to provide sufficiently transparent proof of reserves, and the market is concerned that its claimed US dollar reserves do not actually 100% back up the USDT in circulation.
The quality of the reserve assets is also important: if the issuer invests a large portion of its reserves in risky or illiquid investments, such as commercial paper, corporate bonds, etc., there may be difficulties in realizing them in times of market volatility, which may affect the ability of the stable money to be paid out. Ideally, the reserves should be adequate and consist of highly liquid safe assets (e.g. cash, short-term treasury bonds), which are regularly audited and published by an independent organization.
If the issuer of a stabilized currency refuses to provide transparent audit reports for a long period of time, or if there are rumors of improprieties in its operations, you need to be very careful when holding that stabilized currency. Regulatory risk is also a concern: some governments are beginning to draw up regulatory requirements for stablecoins, requiring issuers to obtain licenses and ensure adequate reserves. If a stablecoin does not meet the regulatory requirements, it may face the risk of being banned or restricted. In short, stablecoins are not absolutely risk-free "digital cash".
When using and investing in stablecoins, it is important to select reputable and transparent products and pay close attention to their market performance and issuer announcements. In times of market volatility or adverse rumors, it is important not to over-concentrate on a single stable currency in order to avoid substantial losses in the event of a delinking.
How can investors keep their assets safe?
1. Utilize reliable exchanges and set up account security at the same time
If you find it difficult to manage your wallet on your own, start by choosing a large, compliant exchange to store and trade cryptocurrencies. Be sure to choose an exchange that has a good reputation, provides a Proof of Reserves or has an insurance policy to minimize platform risk. As soon as you open an account, enable 2FA, set up a high-strength password, and pay attention to the exchange's security announcements. Exchange custody is convenient, but don't leave your entire fortune in an exchange wallet for a long period of time.
2. learn to use your wallet and self-host key assets
It is recommended that newcomers take the time to learn how to use non-custodial wallets, even if they start with a small amount of assets first. You can download well-known software wallets (such as MetaMask, etc.) to get a feel for them, and gradually master the process of backing up helpers, transferring money and signing money, and so on. Once you are familiar with the process, consider transferring your larger, long term holdings to a hardware wallet for safekeeping. Self-custody allows you to truly control your assets and avoid third-party risks, but please be sure to take good backup and security measures: keep your wallet memos offline (do not take screenshots and upload them to the cloud or take photos to store on your phone), check backup availability regularly, do not arbitrarily click on wallet links or sign unknown authorizations for transactions, and develop good information security habits.
3. Third-party custody and risk diversification
If you have large assets or don't want to keep them all in your own custody, consider diversifying them appropriately. Some of them can be placed on an exchange for easy trading, while some can be kept by yourself for long-term storage. In addition, you can also find out whether there are legally licensed digital asset custodians in your country that provide services to retail investors. These organizations are usually subject to regulation, have insurance and better security management, which can serve as an additional safeguard (but at a higher cost, and you need to assess whether it is cost-effective).
By combining multiple hosting methods, you can strike a balance between "control" and "convenience" and reduce the risk of a single point of failure. In any case, please remember to regularly update your security knowledge, such as keeping an eye on the latest wallet vulnerability news, exchange dynamics, etc., to maintain risk awareness in order to securely hold crypto assets in the long run.
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