• The SEC outlines the risks of hot vs. cold wallets for storing crypto assets.
• Investors must choose between self-custody and third-party custody for managing their crypto.
• Key questions for selecting custodians include security measures, fees, and backup plans for failure.

The U.S. Securities and Exchange Commission (SEC) has released a new investor bulletin to educate retail investors about crypto asset custody. The guide provides an overview of storing and safeguarding digital assets. It explains various methods, such as hot and cold wallets, and highlights key risks associated with each.

Hot Wallets and Cold Wallets: Differences and Risks

The SEC outlines two main types of crypto wallets: hot and cold wallets. Hot wallets are connected to the internet and allow easier access to crypto assets. However, they also expose assets to potential cyber threats such as hacking.

In contrast, cold wallets are offline and provide more security against online attacks. These wallets often take the form of physical devices, such as USB drives or hardware wallets. However, they come with their own risks, such as the potential for losing or damaging the physical device.

The SEC cautions that the two types of wallets have their own risk. In the case of hot wallets, internet connectivity increases the risk, whereas cold wallets have the risk of not being recovered in case the keys are compromised. Investors should be able to weigh well the convenience of the hot wallets against the added security of cold wallets.

Self-Custody vs. Third-Party Custody

Investors also have the option of keeping their crypto assets either in self-custody (self-managed) or enlisting the services of a third-party custodian. The aspect of self-custody allows the investors to have full control over their asset security and private keys, but the entire responsibility of their safety has been left in their hands. The investors who opt to self-custody would have to learn how to establish and maintain their crypto wallets in sequence, which in some instances may need technical skills.

On the other hand, third-party custody involves using a professional custodian, such as a crypto exchange or a dedicated custody provider. Third-party custodians manage and secure the private keys on behalf of the investor. While this can provide convenience, it also introduces the risk of potential failure, such as hacking or bankruptcy, of the custodian.

The SEC advises investors not to neglect the thorough research of the potential custodians. It is necessary to check if the custodians have reliable security measures and if the terms of service, like whether the custodian’s assets, are well understood. Additionally, investors should ask about the fees, services, and methods of private key protection of the custodian.

Guidelines for Selecting Custodians

Investors must pay attention to some important questions when selecting a third-party custodian. They are to ensure that the regulatory status is sound and in the custody of the custodian and to review any adverse reports and complaints. Another question to be answered is whether the services offered by the custodian are relevant to the kinds of crypto assets that the investor is planning to possess.

The SEC advises that investors should always ask questions about the way a custodian stores crypto assets and private keys. They should inquire if the custodian keeps the assets in hot wallets, cold wallets, or a mixture of both. Moreover, the investors should have knowledge of the physical as well as the cyber protection measures the custodian takes to secure the assets.

Lastly, understanding what happens if a custodian fails is critical. Investors should ask about insurance options, which may protect against loss or theft of assets. They should also clarify how the custodian handles personal data privacy and what fees are involved in holding crypto assets with the custodian. The SEC’s new bulletin offers essential insights for retail investors on how to safely manage their crypto assets. By addressing wallet types, custody options, and important precautions, it aims to empower investors to make informed decisions in the evolving crypto space.