Cryptocurrencies such as Bitcoin are digital currencies that secure transactions using cryptography. Complementing the traditional banking system for now, they are expected to integrate with mainstream finance as regulations evolve and acceptance grows.
Custodial wallets are an integral part of the Bitcoin (BTC) ecosystem. These wallets function similarly to traditional bank accounts as users access their funds through them, but the similarity is superficial. Under the hood, Bitcoin custodial storage works quite differently from a traditional bank account.
Banks are gradually waking up to the advantages of the burgeoning crypto industry. They have shown interest in understanding how digital custody works and are exploring ways to institutionalize custody services. The Singapore-based DBS Bank, for instance, offers custody services for digital assets, including Bitcoin, and BNY Mellon, based in New York, is developing a multi-asset digital custody platform. The convergence of Bitcoin’s trust model with the reliability of traditional banks has the potential to significantly reshape banking services.
This article explains the functioning of traditional bank accounts and Bitcoin custodial storage. It also demonstrates how conventional bank accounts and Bitcoin custodial storage differ in parameters like security, fund accessibility, faster settlements, lower costs and time and financial inclusion.
How traditional bank account works
Traditional bank accounts work on the principle of fractional reserve banking. In this system, banks hold only a portion of customer deposits. The remaining funds are utilized to sanction loans, increasing the money supply and stimulating economic growth by making more capital available for lending.
While the banking system supports economic activity, it also exposes depositors to the risk of counterparty default. Bank failures in the past, such as during the Great Depression of the 1930s, demonstrate how susceptible this approach is. A bank may not have enough liquidity to fulfill demand if there is an unexpected spike in withdrawals, which might result in depositors losing their money.
In the United States, the Federal Deposit Insurance Corporation reduces this risk to an extent, but account holders need to understand that their deposited money isn’t just sitting in a vault but is used by the bank to generate returns in the form of interest on new loans, creating potential liquidity challenges during unforeseen events. Cyberattacks targeting banks and individual accounts are another threat introduced by the digital age, stressing the need for constant vigilance.
What is Bitcoin custodial storage, and how does it work?
Bitcoin is a digital currency designed to operate independently of any government, institution or individual. It uses cryptographic technology to encrypt transaction data for security and a proof-of-work (PoW) consensus mechanism within its decentralized network. PoW, also known as mining, is a mechanism requiring network participants to solve cryptographic puzzles to add new blocks to the Bitcoin blockchain.
Bitcoin storage refers to a software solution or wallet that allows users to access their digital assets stored on blockchain networks. The assets may include cryptocurrencies, non-fungible tokens and other digital tokens. Custodial wallets entrust private key management to a third party rather than the users. For instance, wallets provided by centralized exchanges like Binance function as custodial wallets.
Fundamentally, users have two options for Bitcoin custodial storage: hot storage and cold storage. When a user chooses hot storage, Bitcoin is stored online via exchanges or software wallets, making it convenient for frequent transactions but vulnerable to online threats. On the other hand, cold storage secures Bitcoin offline using devices like hardware wallets or paper wallets, prioritizing security but sacrificing ease of access.
Custodial wallets bring convenience but at the cost of entrusting a third party with the security of digital assets. On the other hand, self-custodial platforms such as decentralized exchanges allow users to have complete control over their private keys.
Custodial storage carries inherent risks. If the custodian’s security is breached, user funds will be at risk of theft. If the custodian encounters technical problems or is under investigation by authorities, users may be unable to access or transfer their Bitcoin. Notwithstanding these risks, custodial storage is particularly popular among users who are not technically proficient or choose convenience over security.
Comparison between traditional bank accounts and custodial storage
Here is a comparison of traditional bank accounts and Bitcoin custodial storage against several parameters, as discussed below:
Security
Banks protect the data and funds of account holders by requiring multifactor authentication and using advanced encryption. Custodial wallets offer a higher level of security than bank accounts. Robust encryption techniques protect the digital currencies stored in digital wallets. Moreover, blockchain technology is inherently transparent and immutable, which minimizes the threat of data manipulation or unauthorized transactions.
Both systems, however, require adequate security measures at the user level to keep safe. Whether one uses a conventional bank account or a custodial wallet, having strong passwords and two-factor authentication is important.
Faster settlements
Transactions and payments through traditional banking systems are frequently delayed because of the complex processes. Here is a table mentioning the time taken by various methods for international transactions:
Bitcoin wallets, on the other hand, use blockchain technology to facilitate settlements quickly, regardless of the geographical location of users. Crypto wallets enable rapid access to transferred funds, making transactions highly efficient and eliminating delays in bank transfers between fiat currency accounts.
Lower costs
Transfers between Bitcoin custody wallets are usually more economical than traditional banking, which can have considerable associated costs such as account maintenance costs and exorbitant bank transfer charges if the receiver’s account is based offshore. In the case of international bank transfers, bank transfer networks are involved.
The process involves several players:
- Originator: The initiator of a funds transfer
- Beneficiary: The receiver of the funds transfer
- Originator’s financial institution: Bank where the originator has their account
- Beneciary’s financial institution: Bank where the sender has their account
- Payment gateway: Service that validates the sender’s payment details and ensures that they have adequate funds or credit
- Card processing network: Service that processes credit/debit/prepaid cards
Multiple intermediaries and networks, such as the Society for Worldwide Interbank Financial Telecommunications (SWIFT), increase transfer times and costs in global payments. Crypto wallet transfers eliminate these intermediaries, resulting in faster and cheaper transactions.
For instance, the median fees for incoming and outgoing international wire transfers in the U.S. are $15 and $45, respectively. When transferring a cryptocurrency between wallets on a crypto network like Polygon, the gas fee may typically cost from $0.0005 to $0.2.
Global accessibility of funds
Cryptocurrencies are global in nature, providing easy access to digital assets regardless of the user’s location, in contrast to conventional banks, which usually have set working hours or require physical presence for various tasks, crypto custody wallets allow users to manage their assets without restriction.
Financial inclusion
A major advantage of Bitcoin custodial wallets is their ability to improve financial inclusion. The banking system usually excludes applicants with a low credit history or no identity credentials. Backed by blockchain technology, Bitcoin custodial wallets facilitate access to the global financial ecosystem for these marginalized people, promoting economic empowerment.
Although most jurisdictions have mandated Know Your Customer checks, the induction process is still considerably less complex than conventional financial institutions.
Inflation of underlying currencies
Traditional bank accounts offer minimal interest, while fixed deposits and recurring deposits provide slightly higher rates. However, the real return is determined by inflation, which erodes purchasing power over time.
Bitcoin is an inherently deflationary asset, with a pre-defined supply of 21 million coins. Moreover, almost every four years, Bitcoin halvings occur, which reduce the supply of new BTC by half, keeping a tab on the supply of coins and steadily reducing inflation over time.
Moreover, Bitcoin is a volatile currency that is prone to sharp price changes. Wallet holders who ride an upswing are likely to get a return on their investment, though the opposite could also be true if they face a downswing.
Traditional banks vs. crypto custody: Which is the better option?
The choice between a traditional bank account and crypto or Bitcoin custodial storage is an individual decision, depending on their own preferences. Traditional bank accounts are a familiar option, with advantages like regulatory scrutiny, fund insurance and a wide range of services. However, the system suffers from centralized control, fees and potential currency inflation, resulting in less return for the account holders.
On the other hand, Bitcoin custodial storage offers the potential for increased privacy and higher returns due to its decentralized nature. However, it comes with higher volatility of the funds it holds and limited acceptance, making it more suitable for tech-savvy individuals with a higher risk tolerance. Ultimately, the user’s decision is based on their financial goals, risk tolerance and comfort level with technology.