Why Custodial Risk Is The Defining Issue In The World Of Crypto

As cryptocurrency adoption becomes more mainstream, the issue of custodial risk looms large, casting a shadow over other concerns in the digital asset space. Custodial risk refers to the dangers involved when third parties are trusted to store cryptocurrencies, which is growing more complex and pressing, making it the singular challenge in the industry.

When there was just Bitcoin, the issue was "how do I store my Bitcoins?" This became much less of a problem with improvements in software wallets and hardware cold storage solutions.

However, when users want to exchange currencies from different blockchains, custody is still a huge problem due to what is known informally in computer science as the 'fair exchange problem." For example, if you want to exchange your Bitcoin for my Ethereum, and we are separated in space, what prevents me from going away with your Bitcoin if you send me your Bitcoins first? The same problem applies in reverse if I send you my Ethereum first, expecting you to send me your Bitcoin later.

Almost all loss of users' digital assets, starting from Mt.Gox to FTX, and many more called "bridge hacks" are caused when people use a trusted third party to hold their coins while they buy or sell coins belonging to other blockchains.

Eras In Custody During Trading

From 2010 to 2019, the only way for third parties to custody coins and enable trading between cryptocurrencies belonging to different blockchains was by using centralized exchanges as the trusted custodians. There is extensive public information about the number of exchanges that have either collapsed, gotten hacked or outright stolen money from their users during this period, starting with Mt.Gox and the most famous one of them all, FTX.

From 2019 to 2024, developers tried to build on-chain custodians by various names: "Bridges," "Multisig custody," "Vaults," "Wrapped assets", etc. These have again proven disastrous for users' funds and security, as about $2.83B of user funds were lost in just 2023 from bridge hacks.

The era of Custody-Less cross-chain trading, where all user funds are secured by contracts on native chains, fully verifiable by both parties at all times, is coming very soon. I firmly believe that this will pave the way for the mainstream adoption of cryptocurrencies.

Understanding Custodial Risk

Fundamentally, custodial risk is the potential loss of cryptocurrencies through the failure of a custodian, such as exchanges or wallet providers, who hold assets for their clients. Several unique characteristics of digital assets elevate this risk. Unlike traditional financial systems, many cryptocurrency operations are decentralized and often anonymous. This means if a custodian is compromised or fails, users may be unable to reclaim lost funds. Additionally, the non-reversible nature of blockchain transactions implies that recovery is possible once assets are recovered or handled.

This risk is a theoretical concern and a tangible threat underscored by numerous high-profile security breaches. These breaches have led to substantial financial losses and diminished confidence in the cryptocurrency environment. For example, over the last two years, hackers have stolen approximately $2.5 billion from bridge protocols that facilitate asset and data transfers across blockchains, according to Token Terminal, with hacks of bridges such as Wormhole, HECO/HTX, Nomad, Harmony, Multichain, BNB bridge and Orbit. With few alternative solutions on the market for trading across blockchains, users are forced to rely on highly centralized, opaque and risky swapping solutions like wrappers, bridges and custodians, which have been vulnerable and insecure for as long as they have existed.

Challenges Of Technology And Security

Blockchain technology's rapid expansion and evolution, which underpins cryptocurrencies, highlight the delicate balance between promoting innovation and managing security risks. Blockchain is celebrated for its decentralized structure and robust encryption capabilities, which enhance transaction security and reduce fraud. However, maintaining security within this framework requires advanced technical knowledge and rigorous security protocols.

As cryptocurrencies become more mainstream, many users store their assets with third-party custodians. These custodians are often seen as a necessary component of the cryptocurrency ecosystem, providing the expertise and technical infrastructure required to manage and safeguard digital assets. Despite their role, these custodians face multiple security challenges. Cybersecurity threats like hacking and phishing attacks pose a constant risk.

Additionally, these custodians must contend with the risk of internal fraud and operational failures. Cases have been reported where employees of such services have misappropriated user funds or technical glitches have led to significant losses. The complexity of blockchain also adds another layer of risk, where minor code errors or mishandling of blockchain protocols can lead to irreversible losses.

Strategies For Reducing Custodial Risks

The cryptocurrency industry is actively pursuing various strategies to mitigate these custodial risks. For instance, decentralized finance (DeFi) protocols offer alternatives to third-party Custody by facilitating direct peer-to-peer transactions. This not only reduces the reliance on custodians but also empowers individual users. Technological measures like Custody Less solutions such as BitScaler and hardware security modules are being adopted to enhance asset security during cross-chain trading, return control to users, and decrease the likelihood of theft. This shift towards individual control and security is a significant step towards mainstream adoption and should reassure investors and professionals in the sector.

Conclusion

Custodial risk is a significant obstacle in the cryptocurrency world, with its mix of technological intricacies and inherent digital asset traits. However, it's a challenge that can be overcome. As the market evolves, addressing these custodial challenges will be vital to improving the security and stability of digital currencies. The future of cryptocurrencies will depend on collaborative efforts in technology and education to effectively mitigate these risks and create a more secure ecosystem.

About Chandra Duggirala

Chandra Duggirala is the CEO and co-founder of Portal, the safest and easiest path to Bitcoin from any other chain or Layer 2. A medical doctor turned entrepreneur, Chandra previously started a medical device company and founded an AI-based personalized nutrition company that customized diets based on genomic and metabolic levels. An advocate for free and unfettered markets, Chandra is passionate about innovating new market structures and leveraging the best available technology to deliver the value of financial self-sovereignty and super intelligence.

About Portal

Portal, conceived by a team of veteran Bitcoin and AI engineers, empowers financial self-sovereignty. The Portal Cross-Chain DEX Network is designed to match centralised exchanges' speed, liquidity and user experience while eliminating the inherent custody risks of bridges and CEXs. Portal is backed by Coinbase Ventures, Arrington Capital, OKX Ventures, Gate.io and many other prominent investors. For more information, visit https://portaldefi.com, X (Twitter), Discord, Medium and Telegram.