COVER ยท RISK

Custody risk

Whoever has the key has the assets - and that is two routes with two risks

What can happen

The question is not which route is safer. The question is against whom you are protecting yourself.

Held yourselfNobody can block access, nobody can restore it. If the key is lost, the assets are permanently out of reach. If its holder is deceived, they approved it themselves.
Held for youAccess can be restored, but the assets sit with somebody else. Their solvency, care and honesty are from now on part of your own risk.

Custody by others adds a property unfamiliar from banks: it cannot be verified from outside whether the assets are really there. What the custodian displays is a figure on its own interface.

How that turns into a financial loss

With self-custody the loss arises with the holder. With third-party custody it arises with a third party - and then hits all of its customers at once.

The second case is the larger one, because a great deal concentrates there. A custodian holds the assets of thousands of people in one place. If it fails - through insolvency, misuse or an attack - it is not one account that is affected but all of them.

Anyone with a claim then has it against a company, not against the blockchain. What that is worth depends on what is still there.

A documented case

DOCUMENTED CASEInsolvency of the trading platform FTX, November 2022
On 11 November 2022 the trading platform FTX, together with over a hundred affiliated companies, filed for Chapter 11 protection. Customers could no longer withdraw the assets held there. The newly installed chief executive told the bankruptcy court a few days later that in over 40 years of experience with insolvencies he had never seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information. No smart contract and no blockchain was involved in this; the loss arose entirely beside them - in a company’s bookkeeping.

The case is included here deliberately, even though it is not a blockchain event. That is precisely the point: having assets held for you trades a technical risk for a commercial one. Whether a cover product captures that is an entirely different question from smart contract risk.

Can this be the subject of a cover?

Partly, and here for once the answer is not simply yes.

For self-custody: loss of the key and deception of the holder are often expressly excluded in cover wordings - not out of reluctance, but because the event cannot be established from outside.

For third-party custody there are products that address the failure of a custodian. They then resemble classical insurance more than a protocol cover, because the event lies entirely offchain.

THE MOST USEFUL PART

What the wording has to answer

Self-custody or third-party custody?Most products mean exactly one of the two. Which one is rarely in the name.
Is loss of the key covered?As a rule not. Where it is, only under narrow conditions - read that line closely.
Is deception of the holder covered?Whoever approved it themselves has technically consented. That is the most common exclusion.
Which custodian exactly?A product names a company, not an industry. Assets held at a different one are not meant.
What counts as failure?Insolvency, a filing, a halt on withdrawals - or only a concluded proceeding?
How long does the determination take?An insolvency proceeding takes years. Does the payment wait for it?
ASSUMED KNOWLEDGE

Terms used here

  • Wallet

    Why the key and not the money is the subject.

  • Signature

    What you actually permit when you confirm.

  • Onchain

    Why a balance at a custodian cannot be verified.