What are the safest ways to store cryptocurrencies?
The risks associated with losing access to Bitcoin and other cryptocurrencies are high. Therefore, we provide insights into the basics of cryptography, the principles of responsible investing and different types of crypto wallets with which we have gathered experience. Furthermore, we share a few ideas for your own custody strategies.
Before we explain how to keep your cryptocurrencies safe, we would like to answer the most important question: Why should family offices invest in Bitcoin and digital assets? Inflation concerns are steadily rising and increasingly threatening the long-term stability of fiat currencies. Family offices should no longer favour cash, as the cost of transactions and holding cash negligibly in the short term can put generational wealth at risk over a longer period of time. Holding Bitcoin as a deflationary asset is becoming increasingly interesting for family offices to diversify their portfolios. After all, the most important task of a family office is to ensure that assets that have been preserved and grown over time remain accessible to future generations. Another key advantage of Bitcoin is that, with safekeeping and proper legal documentation, it can be easily transferred between generations.
We first need to understand how we acquire cryptocurrencies and why we want to store them in a wallet. The most common way to buy cryptocurrencies is to deposit fiat currencies such as euros, pounds, and dollars on a central exchange such as Coinbase, Binance or Bison (Börse Stuttgart Digital Exchange). On this exchange, you exchange the fiat currency for a cryptocurrency, for example Bitcoin. Now you have your bitcoin on the exchange. The advantage is that you can quickly liquidate your Bitcoin and you can use additional services on the exchange such as staking and lending, where you can receive staking rewards or interest payments. So why should you take your Bitcoin off the exchange?
The field of blockchain and cryptocurrencies is developing rapidly, exchanges have not been tested for years and offer great incentives for hackers. Secondly, you lose the most important advantage of Bitcoin as a censorship resistant asset. Neither other people, companies nor the government can seize your Bitcoin on a wallet to which only you have access. For this reason, all experts in the field advise keeping most of your digital assets in your own wallet. Today we will share with you a strategy on how to keep your cryptocurrency safe and enjoy all the benefits of your crypto investment.
Cryptography
Private & Public Keys
For a simpler explanation of the cryptography model, we use Bitcoin as an example. Public-key cryptography involves creating a key pair based on a private key and a unique public key based on it. This key pair allows to access the Bitcoins. You need the public key to receive money and the private key to do transactions.
There is a mathematical relationship between the two keys that miners can verify using the public key without knowing the private key. When spending bitcoin, the current bitcoin owner presents the public key and a signature to the miner. Each transaction involves the same public key. The signature is always created with the same private key but differs per transaction. The public key and signature allow the Bitcoin network to verify the transaction and recognise it as valid. This confirms that the person who transferred the bitcoins was the owner of the bitcoins when they were transferred.
The private and public keys are two strings of letters and numbers that were not defined by you and are difficult to remember. You could write down both keys. However, this is impractical and risky. You could lose the piece of paper, forget where you put it, or someone could steal it from you. If you lose your private keys, you no longer have access to your money. That’s why it’s important to keep your keys safe. For this reason, wallets are designed to provide an easy and secure access to the blockchain.
Crypto Wallet Definition
A wallet is a device or program that stores the public and private keys for you and allows easier and more convenient access to the blockchain. Your cryptocurrencies are not stored in the wallet in the same way that files are stored on a USB drive, but the information that points to the location of your money on the blockchain is stored in the wallet. Certain crypto wallets offer additional features such as swapping between tokens, staking or access to dApps (decentralised applications). Nowadays, some wallets are used more as decentralized banking hubs, others as vaults. We will explain what the right wallet for each use case really is.
Not your keys, not your Bitcoin!
As a buyer of cryptocurrencies, I have three options: I can deposit my cryptocurrencies on the exchange, use a custody provider or I hold them myself. There is no definite answer to the question of which is the best option, rather it depends heavily on the purpose of buying digital assets. The advantages of using crypto wallets without custody include:
Self-ownership of money
The person who holds the private keys owns the Bitcoins. Money in a bank is technically the property of the bank and can easily be seized by a malicious government. The same goes for digital assets on exchanges.
Limitless & borderless transactions
Only with full control over your cryptocurrencies, you have the ability to send transactions to whom you want and when you want. One of the biggest advantages of decentralised cryptocurrencies is their resistance to censorship. Since no one controls the network, it is almost impossible for someone to stop a transaction.
Disadvantages of using crypto wallets:
User responsibility
If you are your own bank, you have to be 100% liable for anything that goes wrong. Using a crypto wallet requires basic computer skills and familiarisation with a new type of financial system. The key to avoiding bad decisions and using all the features of cryptocurrencies is education.
Crypto wallets
There are two general categories: Software wallets and hardware wallets.
Software wallets are desktop programs or browser extensions that store the public and private keys for the user. In this way, they make it easy for people to send, receive and store cryptocurrencies. They are often used for funds intended for trading activities or simple liquidation.
Hardware wallets are physical devices that can be connected to a computer. Their advantage is that they do not have a permanent internet connection. This makes it much harder for hackers to attack the wallet and they are considered generally more secure.
Software wallets are given the synonym “hot” wallets. The funds are held online and are therefore exposed to a greater security risk. With hardware wallets, the private keys are kept offline and are more secure. For this reason, they are also referred to as “cold” wallets. Some examples of “hot wallets” are listed below:
Online Wallets
With online wallets, digital assets are stored online via external services. Importantly, these services have full control over the digital assets. Most are cloud-based, so they can be accessed from any device with an internet connection. Such wallets are very convenient to use, but they also pose enormous security risks. These security risks have been highlighted by numerous hacks in the past.
Desktop Wallets
Desktop wallets are downloadable programmes that run on your computer. A desktop wallet can only be accessed from your device. This makes the wallet more secure than an online wallet. However, there is a risk to your digital assets if you become a victim of a virus or personal hack.
In the following we present examples of “cold wallets”:
Paper Wallets
Paper wallets are printed software or web wallets. The private and public keys are written on a piece of paper, which you can then keep in a safe place. Paper wallets are a secure method, even if there is a risk of losing the sheet of paper. The disadvantage is accessibility and user-friendliness.
Hardware Wallets
Hardware wallets are basically much more secure than online or desktop wallets. With them, the private keys are stored on an offline device that can be connected to a local computer via a USB port, for example. They are more expensive but also provide more security for your digital assets. In addition, they are nowadays characterised by a high level of accessibility.
Custody Provider
Another option is to outsource custody to a custodian. This allows you to concentrate fully on your investment strategy. The custodian takes care of operations, accessibility, and security. The most important point when choosing crypto custody providers is a threefold approach that includes consideration of regulation, insurance, and connectivity with additional financial services, as these three features together provide maximum security and value of digital assets. One of the major players in the cryptocurrency custody space is Coinbase, a popular exchange for digital currencies.
The disadvantages are much higher costs and a single point of risk, which is the custodian. It is important to understand that the custodian holds the ownership of the private keys that control your bitcoin. Experts like to say: Not your keys, not your Bitcoin!
Defining of a custody strategy
An exact strategy depends strongly on the individual situation and the portfolio of a family office. However, there are some rules you can use to develop your own strategy. The first question is how much of your portfolio you want to invest in digital assets. Most experts agree that a 2–3% share of your portfolio is appropriate.
The next question is whether the investment serves only to increase returns and also as a financial instrument to hedge against specific scenarios. In our case, what percentage is needed to hedge against malicious governments. The investment is intended as an insurance policy in case you need to leave your country quickly and your banking access is restricted. Digital assets such as Bitcoin offer a perfect hedge in such a scenario due to their independence from censorship and their borderless properties. If you live in Germany, the probability is not that high. For this reason, you use small percentage of your portfolio to hedge against the risk. This means that you store those digital assets on a hardware wallet of your choice.
The other cryptocurrencies are held at a custodian or on a hot wallet. The purpose of this investment is more profit-oriented and reason on the outperformance of digital assets in the last years and the low correlation of Bitcoin to other investments in the traditional financial markets. For this reason, it is a perfect addition to traditional portfolios.
If a family office were to pursue a trading strategy, it would store Bitcoins on exchanges in order to be able to act quickly.
The financial takeaway
In this article we defined the basics of cryptography, the principles of responsible investing and different types of crypto wallets with which we have gathered experience. Software wallets are for convenience, while hardware wallets are designed for security. To get started, build your own knowledge, and learn about the options available, including cost and security. Those interested in holding large amounts of money in cryptocurrencies should go a step further and invest in a hardware wallet and a precise custody strategy.
We have been in the space for a few years and are happy to guide likeminded Family Offices with their first steps.
About the Author
Marcel Grimm is Portfolio Analyst at Decentralized Capital, Mentor of the DeFi Talents program and Financial Service Consultant. His biggest priority is helping companies and family offices understand the benefits of using and investing in exponential technologies like blockchain. He is passionate about engaging with the community and helping non-experts understand and appreciate the value of blockchain technology. You can contact him via E-mail (marcel.grimm@decentralized-capital.com).
Decentralized Capital (www.decentralized-capital.com) is a (multi) family office founded in 2020 with a concise focus on crypto assets, blockchain technology and projects in the field of “digital finance” that use this technology. We invest in crypto funds and individual crypto assets, but also in companies directly. In other words, in blockchain start-ups and strong founding teams.
