It takes quite a while to explain what cryptocurrencies such as bitcoin are exactly. They exist only in digital form. There is no central governing authority such as a central bank. They’re borderless, open and public. And just like with fiat currency, their value is derived from people’s belief that it’s valuable. But there’s one thing about cryptocurrency traditional financial professionals and laypeople often overlook. Namely, despite only existing in digital form cryptocurrencies are non-custodial in nature, and frankly, that’s a big deal.
What are Custodial Assets?
Custodial assets are any type of currency, derivative, instrument, money, debt, or security where the bearer does not take possession of it or is not currently taking possession of it. Rather, some type of custodian has possession and ownership of the asset and effectively issues the bearer an IOU denoting that they owe it to the bearer. The majority of financial assets are custodial in nature. Custodial assets include any money in your bank account, stocks, ETF’s, mutual funds, precious metals (when held by a custodian), and most bonds.
Non-custodial assets are owned and held by the individual or entity themselves. Examples of non-custodial assets include banknotes (cash), precious metals (when not held by a custodian), physical assets, and cryptocurrency (provided it’s in your own wallet and not with a custodian or exchange).
Historically, most financial assets have been non-custodial in nature since custodial assets usually need to be able to be represented in digital form or in databases in order to be non-custodial. As more and more countries have transitioned to digital assets and have become increasingly cashless over the past 50 years, most financial assets are now custodial in nature.
Importance of Custodianship
A non-custodial asset can only be taken from an individual if that individual decides to allow it, or if it’s stolen or physically taken from them. Cryptocurrency, in particular, cannot even be physically taken as it only exists in digital form. No court or authority can ensure the seizure of such assets since the individual owns them and nothing physically exists to take possession of. This is one of the crucial aspects to understand about cryptocurrency and why it’s important. It’s arguably the only significant digital non-custodial asset, and in a digital world, that’s pretty important.
In contrast, custodial assets are typically held by corporate entities like banks who then issue IOUs to the bearer (their clients). And because the custodian owns the asset, they:
- Can revoke the IOU for any reason they choose
- Be unable to follow through with IOU (e.g. if they’re insolvent or bankrupt)
- Can have their servers go down, leaving you unable to access assets you’re entitled to
- Impose any restrictions they choose (e.g. you’re now required to complete a questionnaire, or you can be forced to come to their office in person during their business hours)
- Are obligated to ‘freeze’ assets in the event a designated authority in their jurisdiction tells them to do so.
Governments and law enforcement no doubt prefer having people use custodial assets since it allows authorities to seize or freeze such assets much easier. Cryptocurrencies are described in many different ways, but it’s important to understand that cryptocurrencies like Bitcoin are a form of non-custodial digital money.
Use of Non-Custodial Assets
There are a variety of occasions whereby it would be considered important or at the very least useful to use a non-custodial asset rather than a custodial asset. Examples include:
Ransomware & Extortion
If an individual is seeking a ransom or money in exchange for not committing an actually that would cause significant harm, it isn’t a good idea for the criminal to request a bank wire transfer as is typically shown in movies. Wire transfers can be reversed without too much difficult in such cases, leaving the criminal out of pocket. Instead, most criminals primarily insist on cash as a form of payment. However, there have been numerous cases where cryptocurrency has been utilized instead such as in Lake City, Florida.
Banking / Service Provider Issues
If you’re having issues with your bank or custodian you may want to be responsible for conducting your own transactions rather than relying on them or their platform to complete it, you may not want to use a custodian or a custodial asset. Examples include poor customer service, hours of service issues or technical issues.
Illegal immigrant and/or Documentation Issues
If you’re unable to get set up with traditional financial entities due to your immigration status or aren’t able to provide the documentation necessary to get set up with such entities, the solution is to avoid working with centralized organizations that require such documentation. No documentation is required to own or use cryptocurrency or gold, although you may find it challenging to acquire or dispose of without providing such documentation.
Hacking & Theft
Any money stolen from a bank account can easily have the transaction reversed, so there’s not much point in trying to steal an IOU for an asset.
Political or Privacy
Perhaps you might believe that you should be in control of your own money and that you should authorize transactions. You may have received a call from a financial institution in the past asking you about a transaction you’ve done in the past, whether it was legitimate, and what the transaction was for exactly. In most cases, saying “it was legitimate” won’t be enough. They’ll insist on knowing what the transaction was for exactly. The natural reaction some people would have is that “it’s none of their business”. But if you tell that to your bank, it’s a surefire way to get your bank account shut down quickly. The solution is to be your own custodian, so you don’t have to answer to anyone.
Hiding wealth or assets (e.g. divorce, bankruptcy, tax evasion)
If you’re trying to hide wealth, it’s inadvisable to store it with a custodian like a bank as custodians typically know identifying information about their clients and try to prevent things like fraud, money laundering, and tax evasion. This is why cash, high-priced collectibles (like art), jewelry, and sometimes cryptocurrency are most frequently used to launder money and hide wealth from authorities. Although cryptocurrencies are non-custodial in nature, cryptocurrency can be tracked to a large extent, far more so than cash and other physical assets.
If you need a transaction to be immutable or unchangeable, you probably want to use a non-custodial asset. You’d want to make sure a transfer of money can’t be reversed if it’s a high-value transaction (e.g. for a house or car). The gold standard that’s used right now are bank drafts since they are very difficult (but not impossible) to forge, and they’re almost never reversed except in instances of fraud which are quite rare compared to other forms of payment (like credit cards). These transactions aren’t quite immutable but they’re not too far off since transactions are so rarely reversed. Plus, given that the trade is for a physical asset like a house, identifying information is often known about the buyer or they can be easily found (living in or accessing the house), making it too risky for a buyer to attempt fraud in most cases.
You’d also want to make sure the transfer is immutable if there’s a high likelihood of fraud on the part of the buyer. For example, if you’re selling a Superbowl ticket last minute. Buyers often use stolen credit cards, and Paypal transactions can very easily be disputed and reversed as well, so they’re not a secure means of payment. Bank drafts often aren’t an option in these cases either since it requires the buyer and seller to meet in person; even then the transaction isn’t quite immutable. Non-custodial assets are highly useful in such situations, and if the buyer and seller are unable to meet in person but want to use a non-custodial asset, their only real option is cryptocurrency.
It’s clear that there will always be a need for non-custodial assets, and since cryptocurrencies like bitcoin are the only truly digital non-custodial financial assets that act as a medium-of-exchange, its significance is profound. And such cryptocurrencies won’t be disappearing anytime soon.