Bitcoin Self Custody 101

The intention of this article is to explain what bitcoin self custody is, why you may consider self custodying your bitcoin, and the most critical items you should consider when implementing self custody. This is not a guide on how to take self custody, that will come in future installments. It  is important to understand that there are risks to self custodying your bitcoin. If done incorrectly, it can result in complete & permanent loss of your bitcoin. I don’t say this to sway you away from taking self custody, I do say it so that you approach self custody with the respect that it deserves. 

What is self custody?

If you’ve been around bitcoin for any length of time, you’ve probably heard the term self custody. What it means is that you are solely responsible for the management, security, and ownership of your bitcoin. 

This may sound daunting. Especially in the modern world where we interact with our current monetary system through majority digital avenues. The equivalent of self custody with fiat money (i.e. $USD) is physical cash held by you, and not sitting in a bank; or holding physical precious metals such as gold or silver. 

In order to fully describe what self custody in bitcoin means, we must first define a few terms, which are: 

• Bitcoin wallet: a physical device or service that is used to secure, manage & transact in bitcoin. It is somewhat analogous to a bank account. Examples of providers of these are Coinbase, BlueWallet or ColdCard. A bitcoin wallet stores two primary “keys” on it which are…
• Public key: a digital “key” that is used to receive payments from other people. Analogous to your Venmo, Zelle or Cash App username. If you’ve ever sent bitcoin before, this is the string of numbers & letters that start with xpub, ypub or zpub. 
• Private key: a separate digital “key” that is used to send payments to other people. Analogous to you signing a check you’re writing to someone. 

 

A wallet provider is similar to a bank, you can get a bank account from any bank, you can “get” a wallet from any wallet provider. It is important if you are going to be self custodying to select a wallet provider that will best help you accomplish your goals, which we’ll discuss in more detail below. 

 

Since the public key only allows people to send you payments in bitcoin, we aren’t as worried about it for self custody. It should be noted, however, that anyone that has access to your public keys can view the balance of bitcoin associated with those keys because bitcoin is a public ledger viewable by everyone, after all. I have written this article to address some of these privacy concerns. 

 

So, when it comes to self custody, we are most worried about the private key. Who holds it, you or someone else? If someone else holds that key, then you are trusting them to custody your bitcoin for you, because they have the key which allows money to move out of your wallet. They hold the combination to your safe, the PIN to your debit card. 

 

This begs the question, then, of “Why does it matter if someone else holds my private key?”

Why should you self custody?

Someone else holds your private key, so what? We have banks for a reason after all. Why does it matter? I’ll start by stating that self custody is not for everyone. As I discussed in the beginning, and will reiterate here, there are risks to self custodying your bitcoin, risks that could mean complete & permanent loss of your bitcoin. 

 

The most obvious answer to this question is because you can. It is a unique feature of bitcoin that you can transact in a digital manner while still maintaining custody of the asset you’re transacting in. You can’t do that with $USD or precious metals. Sure, you can use the physical representation of them to maintain custody and transact, but this is becoming less & less frequent. And beyond that, even if you transact in cash, you most likely still have a bank account to hold that “cash” when you don’t need it for spending. That is not a self custodied bank account. 

 

Further, just like a bank account, whoever ultimately controls the mechanism that allows you to spend money, controls how & when  you spend your money. Most of the time, in most places, this is not a problem. But there are some times & places where it really does. To use examples from traditional finance, think about those times when bank runs have taken place, or when bank accounts have become frozen. Folks, overnight, no longer had access to money that they worked for and had saved.

 

Even more to this point, have you heard of Mt. Gox or FTX? You know, those exchanges that were implementing shady and sometimes fraudulent practices with their customer funds, that resulted in large losses for people that trusted these exchanges with their private keys? It’s an unfortunate reality that these things happened, but the reason that they could happen is because these exchanges were the holders of the individuals private keys. Does this mean that you should be concerned about this with every exchange or every wallet provider that holds your private keys for you? No, of course not. The majority of them have excellent security & custody protocols that far exceed what some individuals could do on their own. 

 

This does show, however, that it is often difficult to discern exactly what an entity which controls your private keys is doing with the funds you have on deposit with them. Even if those things aren’t illegal, it still doesn’t mean it’s in your best interest. For example, the practices of rehypothecation or fractional reserve banking, both of which are legal, and common practice not only with bitcoin, but with many other financial assets. These practices can introduce more risk into financial markets & institutions, and could lead to the creation of artificial “paper bitcoin” which could in effect increase the supply of “bitcoin” above 21 million. There are good reasons to believe that due to the nature of bitcoin, that this paper bitcoin supply is quite limited, but that’s another topic for another day. 

 

Why should you self custody your bitcoin? First, because bitcoin allows you to; second, because you feel technically competent enough to do it; and third, because you desire to have ultimate decision making authority  over your bitcoin. 

How do you self custody?

We’ve covered what & why. Let’s now talk about the fun part – how. And because 3 is a good number and I don’t think it can be said enough: there are risks to self custodying your bitcoin, risks that could mean complete & permanent loss of your bitcoin.

 

To start, there is no one right way to self custody. There are many variables to consider when determining how you should implement it. I am not going to cover all of this here, I will only provide an overview of the most critical things you should consider when doing this, so you should consult with one of the advisors in our directory if you want to learn more. Additionally, it is not an all or nothing decision. You can take self custody of some of your stack and leave some other part with a custodian. There are also quasi self custody solutions available that are a blend of self custody & custodial practices. I will also not cover these, though they are quite popular. 

Decision #1 – Hot or Cold?

As a reminder, a bitcoin wallet holds two primary pieces of information (or keys) on it. One is the public key, that allows you to receive bitcoin, the other the private key, which allows you to send bitcoin. When it comes to self custody, we are more concerned with the private key, the safety, management & protection of it. 

 

There are two primary ways that a bitcoin wallet can operate; connected to the internet (hot) or not connected to the internet (cold). The trade off between these is usability and security. A hot wallet will be more easy to use, as it’s normally just an app on your phone or computer, a device which is almost always connected to the internet. But because of being connected to the internet, it is also less secure. Your internet traffic could get intercepted and/or your data leaked. And because both your public and private keys are stored in your bitcoin wallet, this could mean that that information becomes revealed to a third party, who can then send your funds without your knowledge or permission. Is it likely this happens? No, but it most definitely can and has. 

 

A cold wallet then, is not connected directly to the internet. It is almost always a separate device, which sometimes looks like a thumb drive. The trade off here is higher security, but it can be less user friendly. Since it’s not connected to the internet by default, it is much less likely that your private keys would be leaked or found out by a malicious third party. In fact, with a proper cold wallet setup, they should never even have the opportunity for that to happen. 

 

Whether you should choose a hot or cold wallet generally comes down to the amount of bitcoin you’re holding. For most people, it can make sense to have one of each. Larger amounts of bitcoin are stored in cold wallets, and smaller amounts in hot wallets. With this method, you can think of a hot wallet similar to a checking account and a cold wallet similar to a savings account. 

Decision #2 – Wallet Hardware or Software

Once you’ve established if you want a hot or cold wallet (or both), you must now choose which wallet vendors you want to use. As a reminder, normally a cold wallet is a separate physical device and a hot wallet is an app on your computer or phone. So, if you decide a hot wallet is what’s best for you, then there is no need to consider hardware wallets, and vice versa. 

 

The first thing to consider when selecting a wallet is whether that wallet is bitcoin only, or it supports other cryptocurrencies. I always prefer a bitcoin specific wallet, as having support for multiple crypto’s on a wallet introduces more complexity to the software that must be run, which increases the chances that something could go wrong. There are both hardware and software wallets that are bitcoin only. A few examples of software wallets are BlueWallet, Blockstream Green or Samourai Wallet. Hardware: ColdCard, BitBox or Foundation Passport. 

 

In general, it is more preferable that a wallet (whether hardware or software) use software that is open source. Open source software (OSS) is software that is publicly viewable & auditable. It is even better if that software is also 100% free and usable, but this is not always available. The reason OSS is preferable is because you can then be more sure that there is nothing nefarious that is going on behind the scenes, without your knowledge. Although for many reasons, you can never be 100% sure of this. Again another article for another day. 

 

Decision #3 – Private Key Handling

While this may be the final item on this list, it is the most important & it requires one more definition – Seed Phrase – your seed phrase is also known as your recovery phrase, and is the list of 12 or 24 words that you are asked to write down when setting up a self custody wallet. Your seed phrase is how you can still recover your funds if you were to lose access to the wallet that you stored your bitcoin on. It contains a backup of all private & public keys that are associated with the wallet that you are using. This means that if any one were to find your seed phrase, they could also move your money without your permission. 

 

It is for this reason that I highly recommend you store your seed phrase offline, never typing it on a computer or your phone. Most of the time, writing it down on paper is not enough for proper security and storage either. In the event of a flood or fire, you no longer would be able to recover your funds with just paper. There are solutions such as punching the phrase into metal, which can work well for these purposes. 

 

At any rate, the handling and storage of your seed phrase should be treated with the utmost care. A good safe is prudent. If you have trusted family and friends, then sometimes making a copy of your seed phrase and storing it on their property can serve as a redundant backup. The one big and obvious caveat to a physical backup is the risk of physical threats. If your home gets broken into and someone finds your seed phrase, again they can access your funds without your permission.

Other Considerations

What I have described above is just the tip of the iceberg when it comes to self custody. There are many other methods that can be utilized for proper security and storage. These could be multi-signature wallets, a passphrase in addition to a seed phrase, creative seed phrase backup solutions like SeedXOR or even time locks that are implemented on the wallet, keys or both. 

 

This article also does not speak to the management of funds within the wallet, things like UTXO management (you probably need to consolidate them), use of multiple derivation paths to segregate funds even within one wallet or why running your own bitcoin node can be beneficial when you self custody. 

Wrapping Up

Self custody is one of the most powerful aspects of bitcoin. Without it, bitcoin would just replicate the traditional financial system with an inefficient blockchain. What may seem daunting at first becomes real simple very quickly. It’s like using a smartphone for the first time. A little weird a first, but you get the hang of it. You now have an idea of the what, how & why of it. If you have further questions on if self custody is appropriate for you and what would be the most prudent way to implement it, talk to any of the advisors here in the network.