Bitcoin Self-Custody: Risks, Strategies, and the Future

Bitcoin Self-Custody: Risks, Strategies, and the FutureThe rising popularity of cryptocurrencies has led to a surge in investors opting for self-custody of their digital assets, such as Bitcoin, often employing "cold storage" methods like hardware wallets rather than relying on cryptocurrency brokerage "hot wallets" or other third-party custodial services. However, events like war, extreme weatherincluding recent conflicts in Israel and wildfires in Californiahighlight the unique and evolving risks associated with self-custody

Bitcoin Self-Custody: Risks, Strategies, and the Future

The rising popularity of cryptocurrencies has led to a surge in investors opting for self-custody of their digital assets, such as Bitcoin, often employing "cold storage" methods like hardware wallets rather than relying on cryptocurrency brokerage "hot wallets" or other third-party custodial services. However, events like war, extreme weatherincluding recent conflicts in Israel and wildfires in Californiahighlight the unique and evolving risks associated with self-custody. The decision to hold cryptocurrency long-term and the method of custody are two key investor choices, with the latter perhaps being the more critical.

Recent California wildfires ignited discussions on social media about Bitcoin losses. Users shared anecdotes of incinerated mnemonic seed phrase storage media (e.g., metal plates) rendered unreadable, or described the complex process of retrieving cryptographic keys from damaged bank safety deposit boxes. While these accounts are difficult to fully verify, they undeniably illustrate a range of unique security challenges inherent in Bitcoin self-custody, and these risks are constantly evolving.

Cryptocurrency holders typically use "wallets" to store their assets. Key characteristics of wallets include their connection to the internet and the degree of user control over transactions and transfers. A fundamental question is whether investors rely entirely on third-party custody or maintain full custody and transactional control over their assets.

Traditional third-party platforms, "hot wallets" (like Coinbase or Blockchain.com), are constantly connected to the internet, making them vulnerable to cyberattacks. "Cold storage" or "cold wallets," conversely, refer to offline hardware devices (like USB drives) storing private keys, or even simply a mnemonic seed phrase (12 to 24 words used to recover access to a crypto wallet) written on paper or metal. When the offline backup of the hardware wallet or seed phrase is connected to the internet via another device, it can be used to access the cryptocurrency.

For third-party custodial options, security measures can help mitigate risks for owners, such as two-factor authentication and strong passwords to deter cybercriminals from attacking online platforms. The U.S. Marshals Service, part of the U.S. Department of Justice, uses Coinbase Prime to custody its seized digital assets.

Many Bitcoin investors prefer self-custody, partly due to a lack of trust in institutional control. While convenient, custodial wallets offered by crypto brokers are vulnerable to exchange hacks, shutdowns, or fraud, as exemplified by the collapse of FTX. Wildfires are just one example in a recent string of global events prompting a reassessment of cryptocurrency custody. The conflicts in the Middle East and the war in Ukraine have also led overseas Bitcoin investors to re-evaluate their self-custody strategies.

Nick Newman, co-founder and CEO of Casa, points out that physical risks like global natural disasters offer an opportunity to re-examine Bitcoin security practices and common vulnerabilities. "Most people are using a single private key to protect their Bitcoin. If that key is only stored on one device or written down on a piece of paper as a seed phrase, that's a single point of failure. Once you lose that key, the Bitcoin is unrecoverable," he emphasizes, highlighting that writing a seed phrase on paper is the most fragile method of protection, despite its prevalence. Placing the paper in a fireproof bag or safety deposit box offers some protection, but it's limited. Even with seemingly "indestructible" metal storage plates, points of failure exist: the plates may not be truly indestructible, and they may be impossible to locate after a disaster. Newman believes that given the location of the California wildfires and the anecdotes shared on social media, some Bitcoin has likely been lost, with some accounts being quite credible.

Casa conducts annual stress tests of seed phrase backups. Some self-custody services, such as Casa, offer multi-signature setups to mitigate single points of failure. Multi-key crypto "vaults" can include a mobile key, multiple hardware keys, and a recovery key held by the company on behalf of the owner. Multi-signature custody allows the owner to hold the majority of keys, while a trusted partner holds a minority. John Harr, managing director at Swan Bitcoin, explains that in this setup, an owner would need to simultaneously lose all physical devices and all copies of their seed phrase to be unable to recover their Bitcoin. As long as the owner can access at least one device or one seed phrase copy, they can recover their Bitcoin. This method significantly reduces the likelihood of losing all devices in an event like a natural disaster. Newman describes Casa's five-key approach: "You can spread those keys across multiple locations or even multiple countries, and you need any three of the five keys to approve a Bitcoin transaction."

Jordan Baltazor, CEO of Fortress Trust, notes that best practices used in personal life should also apply to the cryptocurrency realm, encompassing diversification of storage and risk assessment. Digital assets are no different than other data in terms of backing up to the cloud to ensure data is not lost or corrupted.

Companies like Coinbase and Block offer products attempting to balance convenience and security. Coinbase Vault adds enhanced security steps before a user can access cryptocurrency assets available for trading. Coinbase Wallet and Block's Bitkey both feature mobile applications similar to traditional wallets, convenient for moving Bitcoin, while offering the ability to pair with hardware wallets, adding cold storage-related security. Bitkey hardware requires multi-authorization of transactions for enhanced security, similar to "multi-signature wallets". Bitkey also provides recovery tools, reducing the risk of losing the code or phrase needed to recover a cold wallet. These solutions help address the convenience-security trade-off, but this likely remains a barrier to broader cryptocurrency adoption.

Beyond wildfires, natural disasters, and conflict, the greatest risk in Bitcoin self-custody remains the unexpected death of the Bitcoin owner. Inheritance is one of the most complex issues in unlocking cryptocurrency custody chains. Coinbase requires probate court documentation and specific will designations before releasing custodial funds, while physical wallets offer virtually no support, potentially locking all digital value to a single private key. Bitkey launched an inheritance solution in February, with a Bitkey executive calling it an effort to solve a problem that could trigger billions of dollars in losses.

Newman believes the industry will see a shift toward more secure storage setups following disasters or exchange collapses. "It's human nature to wait for bad things to happen to motivate people to improve their personal situation. But I think it would be better if people were more proactive. Otherwise, they might experience that bad thing, and then it's too late."