Since their emergence on the Ethereum blockchain, NFTs, Non-Fungible Tokens, have spread alongside an appreciation of their value and utility. But just as with other digital assets, they present problems of ownership and management that have surprising parallels in the world of traditional asset management, even as their innovative underlying technology demands unique methods of protection.
For NFTs, as for other digital assets, it’s normal for buyers to manage their own assets. But because it’s common doesn’t mean it’s best, as we’ll see. To start with, let’s look at the differences between third-party custody and managing things yourself.
Self-custody
Self-custody is the default way to hold any asset on a blockchain. You have access to your wallet, your own security information, and you manage access and transactions.
That’s for several reasons, and most of them have to do with history and people’s beliefs than with the practical realities of keeping NFTs secure.
Self-custody and decentralization
For many early adopters of NFTs, it’s another step into a digital-assets future that sees decentralization as a virtue. Nor is this without foundation: there are solid reasons to value decentralization for security reasons. It’s almost always centralized rather than decentralized exchanges that get successfully attacked, for instance.
Self-custody, access, and security
Despite the “default” nature of self-custody, it has significant downsides, even for retail investors. These include:
Hacks
Self-custody NFTs are significantly more vulnerable to hacking than those held by adequately-trained and equipped third parties. Phishing attacks are a commonly used method, and even the most technically savvy users are caught regularly. For example, in February this year, a hacker attacked OpenSea, stealing hundreds of high-value Bored Ape Yacht Club (BAYC), Azuki, and NFT Worlds NFTs.
Lost seed phrase
Seed phrases make complex cryptography human-memorable, resolving phrases of between 12 and 24 words selected from a list of 2,048 BIP39-approved words into the lengthy character strings that make up actual blockchain wallet addresses.
Because of this, they’re often an asset holder’s only way to regain access, control, and ownership of their assets—losing or forgetting them is easier than you think. About 2% to 3% of all NFT-holding wallets are chronically inactive, suggesting that their owners have locked themselves out or that they may have passed away.
Death and disability
Another problem with self-custody arises when the original owner passes away or cannot administer their affairs for some reason. Even where heirs may be aware of the value of NFT holdings, they may need correct information to access them. Being able to prove that they have a right to that wallet is insufficient since the obstacle is the possession of wallet addresses or seed phrases rather than a right of ownership. Only vesting custody in a third party can resolve this issue securely.
Taxes and regulations
The U.S. authorities have decided to view digital assets as property for tax purposes, “I think it’s almost a foregone conclusion that the IRS would do the same with NFTs,” said Tax Notes contributing editor Roxanne Bland in July.
Profits from NFTs are classed as income. However, these rules can vary in different jurisdictions, and there’s nothing to stop them from turning on a dime in the future. NFT holders could find themselves liable for big new tax bills that a trust and custody arrangement would avoid.
The benefits of third-party custody
Third-party custody is when someone else holds the private keys to your digital assets, like NFTs, Bitcoin, or an ERC-20 token. However, there’s more to it than just giving your wallet address to someone else; third-party custody has several distinct advantages.
Storage vs custody
Contrary to first impressions, custody isn’t the same as physical storage. It’s taking fractional ownership of an asset. The beneficial owner can still be you, while the legal owner can be the custodian.
This ownership structure can insulate you from risks and liabilities associated with ownership, offer more secure control of assets and give you more control over them than self-custody.
Art and collectibles
Art and collectibles are inherently non-fungible — there’s only one Mona Lisa. And while some owners want to hang their Rothko on the wall, many are concerned about preserving their investment. Typically, custodians will arrange both the physical holding of the asset and its legal management.
NFTs aren’t necessarily that different, especially when the NFT is backed by a physical artwork, like ART3.io, an OpenSea project by the British Journal of Photography that offers the physical print to the first purchaser of each NFT. A custodian is tasked with looking after the print and managing access to the NFT.
Memberships
NFTs allow businesses to transform membership experiences. They also represent an unprecedented opportunity for purchasers, granting access to online and real-life perks, including access to exclusive events and services, rewards for participation, and voting or governance rights. Such benefits make the underlying NFT more valuable and offer more reasons to explore more secure custody options. (Some third-party custody options offer accessibility equivalent to self-custody.)
Tokenization of physical asset NFTs
Tokenizing physical assets on the blockchain has several advantages, such as creating a transparent record of ownership or associating the physical object with related rights. It also offers chains of ownership and custody that might have alleviated the headaches Picasso’s intestate death caused his family.
However, whether an NFT proves ownership of a building, a work of art, a collectible or even fractionalized ownership of some real-world asset, control of the NFT is more vital than ever.
Its loss can mean the loss of voting rights, with subsequent effects on other owners of the same asset, or a valuable piece of the family legacy beyond reach or into the courts and an uncertain future.
Third-party custody of NFTs that tokenize real-world assets proceeds similarly to the custody of deeds and other proofs of ownership. This is known as a process with a long pedigree and well-established professional standards, giving its users one of the most secure forms of ownership.
Vaulting art, holding bullion
Traditionally, two types of high-value investment assets have been held by custodians: one whose value lies in fungibility and one whose value lies in infungibility.
Bullion is traditionally stored in highly-secure locations with other bullion, and its value to its owner is that a kilogram of gold is the same as any other. Art is the opposite: its value is in its uniqueness and often comes with specialized storage requirements to prevent damage and degradation to fragile materials.
Even while held securely, art can be “lost” by destruction if not held appropriately. Furthermore, bullion is (in theory) endlessly fractionizable; you can own and trade it by the gram. But you cannot sell your building a brick at a time or trade your Da Vinci by the square inch. Like NFTs, these assets aren’t valuable as an accumulation but as a whole, making them more desirable for criminal actors and investors.
NFTs are similar to art in this sense. They must be held securely, but security alone is not enough. They must be held by custodians who ensure they are not “lost while held”, and in this sense, that value may depend on accessibility. It’s important to note that not all custodians are equipped or qualified to hold NFTs.
Conclusion
NFTs present unique custody requirements and bring users unique combinations of risks and benefits. Like all digital assets, they’re subject to loss from fraud, human error, or outright theft— being housed on the blockchain doesn’t render assets invulnerable.
One of the greatest risks posed to holders of NFTs is simple loss or the difficulty of securely storing the proof of ownership over the NFT: hashes, seed phrases, and wallet addresses can be lost or forgotten.
The solution lies in adopting an NFT custody solution that fuses the best of traditional custody; integrity, privacy, and professionalism with the technological tools to effectively custody NFTs and offer rapid, secure access.
If you’d like to learn more about what that entails, please contact us — we’d love to hear from you!