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Crypto investors turn to physical storage for security

8 February 2022

Online digital wallets are potentially vulnerable to hackers. Passwords or codes can easily be lost. Christopher Barrow of Metropolitan Safe Deposits highlights a recent trend towards cold storage options, such as keeping private keys in a safe deposit box.

There are increasing reports of hackers and fraudsters successfully exploiting weak links in crypto systems. When purchasing Bitcoins or other cryptocurrencies, it is essential to safeguard the unique 16-digit “private key”, which is a password that gains access to the crypto. Two situations can lead to total loss. Cybercriminals can trick users into giving away their “hot wallet” private keys, which allows the criminals to steal the digital assets; or investors forget their private keys, which results in the permanent loss of access to their assets.

The great advantage of using digital assets and blockchain technologies is that they are designed to be more efficient and secure than paper-based or physical assets, thereby reducing administrative and physical storage costs. Ownership of digital assets, which are electronic files of data, is held securely on an electronic ledger called a blockchain, which is a distributed database that is shared among the nodes of a computer network. An important point is that, unlike traditional ledgers, the blockchain database is decentralised so that no single person or group has control.

The irony is that, whilst the blockchain database of transactions is said to be impossible to alter and therefore entirely secure, the digital assets held on the blockchain do carry security risks. Because there is no central ownership register, owners of cryptocurrencies must be extremely careful to protect their digital assets from theft or loss of access; in fact, just as much as safeguarding traditional money.

Many investors hold their digital currencies on a mobile in a virtual wallet that is kept either on an exchange or online in a hot wallet. This has the advantage of easy access for regular traders who wish to connect rapidly to exchanges. However, cryptocurrency exchanges and online virtual wallets can be vulnerable to hackers, so an increasing number of crypto investors are keeping their assets in “cold storage”. This is an electronic device that is not connected to the internet. Such devices could be physical USB keys, offline computers or sophisticated hardware wallets. A hardware wallet is a cryptocurrency wallet that stores the user’s private keys (a critical piece of information used to authorise transactions on the blockchain network) in a secure USB-like device.

The point about the hardware wallet is that it stores the private keys and not the crypto assets, which do not exist in any physical form. They are not stored in any folder. When you own cryptocurrencies, what you actually own is a private key. It is called a private key as it unlocks the right for its owner to spend or manage the underlying cryptocurrencies. Just as you are careful not to allow any stranger to find the key to your home safe, it is important that the hardware wallet containing your private key is not shared with anyone. A salutary lesson is the well-known case of James Howells from Newport, Wales, who eight years ago accidentally threw away a laptop hard drive containing his private key to 7,500 Bitcoins. Today, his Bitcoins, if the private key were to be successfully retrieved from his old hard drive (now in a landfill), would be worth around £240 million.

Many, mainly older generation, investors remain highly sceptical about the future of crypto. Equally, regulators and central banks have major concerns, especially surrounding the speculative investment risks involving retail investors. Last year, Chinese regulators imposed a crackdown on the use of digital coins and it will be fascinating to see how other major economies respond to this growing but volatile asset class. India has considered banning cryptocurrency and the Russian central bank is said to be opposed to it.

Early signs suggest that the US and Europe are adopting a more progressive approach. For example, the European Commission is looking to enact a regulatory framework called Markets in Crypto Assets (“MiCA”) by the end of this year. This will cover all possible types of blockchain-based assets and will apply uniform regulation across its 450 million EU citizens. Whether regulation and government intervention will prove a good thing or put much of the crypto industry out of business, only time will tell.

Common criticisms of early-stage crypto platforms have included clunky interfaces, the massive use of energy (in mining) and fears that they are not as decentralised as they seem. It all started with Bitcoin, which invented the creation and transfer of digital value without middlemen. The second major player was Ethereum, an asset management platform, which has evolved into the largest blockchain ecosystem in the world. Their platforms were developed based on blockchain technology that uses a mechanism called “proof of work”, where computers race to solve mathematical problems to verify transactions in return for a reward.

However, rapid technological and end-user improvements are being made, notably in decentralised finance services. Many investors have moved away from the older platforms, which suffer from having a slow and expensive process. Instead, there has been a shift towards platforms that use emerging technologies, such as the more scalable mechanism called “proof of stake”, which offers (inter alia) decentralised finance applications enabling users to trade assets, secure loans and store deposits. Another emerging process is called “sharding”, which splits the blockchain up and allows for the bundling of transactions and increases the speed and capacity of digital transactions.

Competition from cryptocurrency exchanges and the speed with which traditional assets are being digitised may lead to a substantial increase in the diversity of investable asset types in future years. This will open up a plethora of investment opportunities for institutional and retail investors. In addition to cryptocurrencies, opportunities will include digital stocks, tokenised real estate, computerised artworks, non-fungible tokens (certificates of ownership of original digital media) and even industrial equipment (akin to a leasing arrangement). This may lead to a digital transformation of capital markets, and any countries not embracing these evolving and revolutionary trends may be at risk of losing out. Banks and other financial services providers will need to adapt to this fast-changing landscape.

As Jamie Dimon of JP Morgan recognises, blockchain has become a “pivotal future technology, allowing people to move money around the globe more cheaply”. If there is widespread adoption of digital assets and services in the coming years, we come back to the fundamental issue of security risk. As already mentioned, a major security risk is that digital asset exchanges, which allow individuals to buy and sell assets such as cryptocurrencies, can be hacked by criminals. When crypto is purchased from an exchange, it is normally advisable to transfer the coins into a wallet together with the private keys that represent final control and ownership of the cryptocurrency.

Even then, cybercriminals can trick users of electronic wallets storing crypto to give away their private keys in order to steal their assets. Another risk is that users can simply forget their 16-digit private keys and lose access to their crypto, which becomes a permanent loss since there is no central ownership register. Some investors, concerned about misplacing their hardware wallets, resort to writing down their 16-digit code on a piece of paper. That is the ironic reason why businesses that offer physical safe deposit boxes have recently seen an uptick in demand from investors in digital assets.