The Truth About Bitcoin Collaborative Custody

If you want to gamble with losing your bitcoin, leave it on an exchange. We can all agree after the numerous hacks and bankruptcies since 2014 that we can’t trust them with our bitcoin wealth. We’ve all heard the saying “not your keys, not your coins” and if you haven’t taken that to heart yet, you should.

And listen, I get it. There is significant fear and hesitation when it comes to taking full responsibility for your Bitcoin. Let’s just be honest, it’s nerve wracking and although wallet providers have improved tremendously on user experience, it is still good to understand what you’re doing and what’s going on behind the scenes of your wallet. Not to mention, we’ve outsourced the security of our wealth to institutions for decades, so changing that almost goes against our societal nature at this point.

The idea of being solely responsible for managing and securing our wealth is foreign to us. Even the most Bitcoin savvy will admit it can be intimidating. So that has forced many bitcoin holders into a tough position. With exchange risks ever present and self custody bringing its own difficulties and stressors, many have looked for a “happy middle” solution.

The Emergence of a New Custody Solution

This search for a sufficient middle ground has given rise to a new form of custody known as “collaborative custody.”

Collaborative custody has become a popular way for people to secure their Bitcoin without relying on an exchange or taking 100% sole responsibility for managing and securing their Bitcoin. But marketers of this new setup often tout the benefits with very little mention of potential risks and downsides. As Bitcoin financial planners, our clients pay for the advice we provide and we are unbiased towards any one solution, so it’s important for us to clearly educate them on all benefits and drawbacks. Let’s dive in…

What is Bitcoin Collaborative Custody?

For those who may not know yet, collaborative custody is where you and one or multiple third parties share the control, management, and security of your bitcoin.

This is accomplished through what’s called a multi-signature wallet. Bitcoin allows for what's known as m-of-n multisignature setups. This means that out of a total of "n" generated private keys, at least "m" are required to authorize a transaction. For example, in a 2-of-3 multisig wallet, three keys are created, and any two are needed to move funds. This flexibility lets you customize the security of your wallet based on your needs.

A 2-of-3 multisig is commonly used in collaborative custody. Typically, you hold 2 keys and a third party holds 1 key. This effectively acts as a safety net if you were to lose 1 of your 2 keys. You could still move Bitcoin using the 3rd key held by the third party. And because they only hold 1-of-3 they cannot unilaterally move your Bitcoin. Another common setup is a 3-of-5 multi-sig wallet in which 3 out of 5 keys are necessary to sign transactions.

Benefits of Collaborative Custody
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At first glance, this approach seems to offer a balanced mix of control and support. For those who find the idea of managing all aspects of Bitcoin security daunting, having a trusted service hold a key can be reassuring. So before we get to the honest downsides, let’s address the benefits.

Reduces Single Point of Failure Risk

By requiring multiple private keys to authorize a transaction, collaborative custody minimizes the risk associated with a single key being lost, stolen, or compromised. Even if one key is stolen, the thief cannot access your Bitcoin without an additional key allowing you to move it to a new wallet, reinstating full security.

Assistance with Key Management

For those who are not technically inclined or are new to Bitcoin, having a third-party hold one of the keys can provide valuable support in managing the security aspects. In the event that you lose one of your keys, the third party can help facilitate the recovery of your funds, reducing the risk of permanent loss.

Balance Between Control and Convenience

You retain significant control over your Bitcoin while having the reassurance that there's assistance available if needed. Collaborative custody can serve as a stepping stone for those not yet comfortable with full self-custody, allowing them to learn and adapt over time.

Facilitated Inheritance

In cases of incapacitation or death, collaborative custody can simplify the process for heirs to access the Bitcoin holdings. Multiple key holders ensure that the knowledge of and access to the Bitcoin are not confined to a single person.

Protect Against Coercion

In a later article, we will discuss multi-institutional, multi-signature custody setups and where they are appropriate in your Bitcoin financial plan, but for now just know that it can help protect you against coercion if you only hold 1 out of 3 or more keys to your bitcoin wallet.

Downsides of Collaborative Custody

My primary motivation for crafting this article was to address the often overlooked or unacknowledged downsides of collaborative custody. Many in the Bitcoin industry tout collaborative custody as the holy grail of Bitcoin custody without disclosing why you wouldn’t want to utilize it.

Lack of Privacy

Transaction visibility - by involving a third party, you're allowing them to monitor your total balance, see every transaction you make, and know the destination addresses you send to.
Personal data exposure - collaborative custody providers require personal identification (KYC information), linking your identity to your Bitcoin holdings and transactions.

Increased risk of data breaches - Your personal and financial data could be compromised if the provider's systems are hacked or if an insider misuses the information.

Data Tracking - apps required by providers may track your device, location, and usage, compromising your privacy. And reliance on centralized app stores (Apple App Store or Google Play) introduces the risk of app removal or censorship.

Data Sharing - Providers may share your data with advertising partners and analytics companies, further compromising your privacy. You may not be fully aware of how your data is being used or who it's being shared with.

Dependence on Third Parties

Reduced Control - while you hold the majority of keys, losing one key puts you in a vulnerable position where you need the third party's cooperation to access your funds. This situation exposes you to the potential for the third party to hold your funds hostage by delaying or refusing to co-sign transactions. Avoiding this is a big reason why we believe in and own Bitcoin in the first place.

Service Availability Risks - if the provider experiences downtime, technical issues, or goes out of business, accessing your funds could become problematic.

Government Surveillance and Coercion - third-party providers may comply with government requests to provide user data or freeze assets, compromising your financial sovereignty. Providers are unlikely to resist government coercion, which could lead to unwanted scrutiny or restrictions on your funds.

Added Point of Failure - while “eliminating single point of failure” is what everyone boasts about regarding collaborative custody, trusting a third party will always act in your best interest actually adds an additional point of failure or attack vector.

Perceived Control vs. Actual Control - collaborative custody gives the impression of full control, but reliance on a third party can introduce unforeseen vulnerabilities.

Limited Flexibility and Autonomy

Transaction Restrictions - providers may impose delays on large transactions or restrict withdrawals to certain addresses, limiting your ability to use your funds freely.

Ecosystem Lock-In - you might be forced to use specific apps, browsers, or platforms, reducing your flexibility and control over how you manage your Bitcoin.

Trust in Provider's Infrastructure - without the ability to connect to your own Bitcoin node, you must trust the provider's node for transaction verification. Relying on the provider's infrastructure undermines Bitcoin's trustless design.

Misalignment of Interests

Providers may have business interests that don't align with your personal security and privacy priorities. Or the provider could change terms of service or policies in ways that negatively affect you.

What do I want you to take away?

Let me clarify, I am not saying you should not use collaborative custody. It can be a great fit for the right person in the right financial situation.

What I am saying is that it is important to understand the benefits and risks of every decision you make in your financial situation and because collaborative custody is often held out to be risk free, I wanted to make sure you were aware of the actual risks.

In a future article, we’ll share the potential situations where multi-sig collaborative custody could be a great fit for you, your family, and your Bitcoin.

As Bitcoin financial planners, we clearly see the full picture, because we are not compensated for one specific product or strategy, we are compensated for offering our clients advice that is in their best interest.

If you’re looking for financial planning guidance and deep bitcoin expertise from fellow bitcoiners, schedule a call with us today to learn more about how we can help you.
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