In financial circles, custody refers to the holding of assets on behalf of a client, generally by some form of institution. The use of a custodial service can be desirable to an asset holder, as it mitigates security risks like theft or loss.
Custodians tend to differ from banks as they’re unable to leverage the assets they hold to their own ends. For their troubles, the institution will generally impose a fee for the safekeeping of the assets. This may also cover their sale at the client’s behest.
In cryptocurrency, custodial solutions are those where a third party holds the private keys to the user’s funds. They’re the only ones able to actually send and receive the user’s coins. While the owner of the cryptocurrency owns it in a legal sense, they have no ownership at the protocol level. Virtually all exchanges employ a custodial approach, as it allows them to provide a better user experience.
Where security is concerned, custodial solutions may be safer for new users that are inexperienced with key management. It should also be noted, however, that this opens users up to counterparty risk. A custodian could be compromised or shut down, leaving users with few remedies to reclaim their coins.
This isn’t to undermine the importance of these entities. Custodians play a vital role in the ecosystem, from onboarding newcomers to providing veteran users with sophisticated trading tools. A growing number of businesses exist to handle storage and management of assets at an institutional level. Some are further insured to reimburse their clients in case of loss of funds.
As a general rule for the average user, though, significant amounts of funds should be kept in cold storage if they’re not actively being used. Examples of active use include staking, trading or other forms of passive income.