The Problem With Cryptocurrency Custody

February 12, 2019, 9:28 PM UTC
Illustration of Edmond Dantes Discovering the Treasure of the Island of Monte Cristo
An illustration of a scene from the novel The Count of Monte Cristo by Alexandre Dumas. (Photo by Stefano Bianchetti/Corbis via Getty Images)
Stefano Bianchetti—Corbis via Getty Images

Popular myth holds that pirates of the 17th century would squirrel away bounty beneath the sands of the Caribbean, hiding treasure where no one else might find it. It was a primitive form of security: the less accessible, the better.

A reincarnation of this semi-apocryphal practice has risen, strangely, to become the dominant method for securing virtual wealth in the cryptocurrency era. People use “cold storage,” meaning they stash their private keys—the password-like secrets that grant them ownership of Bitcoin and other blockchain-based assets—offline. Investors lock these keys on computers disconnected from the Internet to ward off hackers. They write the codes on strips of paper and stash them in safety deposit boxes to discourage thieves. They even bury them inside granite mountains, a habit that hearkens to dragon-besieged dwarves in fantasy fiction.

Cold storage is imperfect—and not just because bad stewards can lose a person’s money for good, as the recent example of the Canadian cryptocurrency exchange QuadrigaCX has made painfully apparent. The approach robs cryptocurrencies of the very thing that may one day make them compelling: usability. For starters, freezing assets hinders traders from taking advantage of the market’s frequent, fleeting fluctuations. And as the technology shifts from a phase of rampant speculation to one of utility, cold storage will restrict people from participating in so-called cryptoeconomic networks, systems of financial incentives designed to support and improve blockchain projects through game-like activities. (See Ethereum’s planned update to “proof of stake” and Stellar’s inflation pools, for instance.)

Investors who fail to take up active roles in these networks will lose out. “Imagine holding traditional equities and not being able to capture dividends,” says Nathan McCauley, CEO and cofounder of Anchor Labs, a cryptocurrency custodial startup that has set out to solve just this problem. “The cold storage providers are effectively going to be dropping dividends on the floor.” (As part of the terms for a demonstration of the company’s new product in January, Fortune agreed not to reveal details about the technology; suffice it to say the service uses a clever combination of biometrics and behavioral data, multiple approvals, and human reviews to secure people’s cryptocurrency without resorting to cold storage.)

The potential wastefulness of the cold storage-status quo could eventually have legal ramifications too. As Sherwin Dowlat, an analyst with Satis Group, a digital asset advisory firm, warned in a September 2018 report, partners in investment funds may come to consider non-participation in cryptoeconomic networks as “a breach of fiduciary duty.” Leaving money on the table in this way, in other words, could be interpreted as an act of negligence.

Chris Dixon, an investor at Andreessen Horowitz, one of the earliest venture capital firms to become bullish on cryptocurrency, sees issues relating to secure storage as a fundamental obstacle to progress in the industry. “Custody is the single biggest piece of infrastructure holding back the growth of the space,” he tells Fortune. (It’s this belief that spurred Dixon to plunk down millions of dollars on Anchor a year ago.)

Given the importance of custody, it’s no surprise that so many businesses are angling for a slice of the pie. With its differentiated approach, Anchor will be taking on the likes of Coinbase, Gemini, BitGo, Xapo, and Kingdom Trust, whose cold storage options dominate the market at present. Meanwhile, warships loom on the horizon in the form of Fidelity and Bakkt, a cryptocurrency-focused subsidiary of the company behind the New York Stock Exchange, both of which plan to debut product offerings this year.

For Anchor and the rest of blockchain’s buccaneers, the hunt for buried treasure has just begun.

A version of this column first appeared in Fortune’s The Ledger, a newsletter covering the leading edge of finance and technology. Subscribe here.