The Evolution of Custody: From Bearer Bonds to Blockchain

How we secure assets, whether they be securities, bonds or currencies, has been in a state of flux over the past century. As markets and the needs of individuals change, so do the mechanisms by which we secure and exchange assets. Central to all of this is the question of custody. How does an individual maintain control, or custody, of their assets without compromising security or the ability to access liquid markets for exchange?

How we secure assets, whether they be securities, bonds or currencies, has been in a state of flux over the past century. As markets and the needs of individuals change, so do the mechanisms by which we secure and exchange assets. Central to all of this is the question of custody. How does an individual maintain control, or custody, of their assets without compromising security or the ability to access liquid markets for exchange?

Today, the blockchain enables self-custody of assets in a way that when combined with innovative technologies like Ethos Bedrock, provides cutting edge security, rapid access to funds and liquidity in a way unrivaled by any other time in history. Understanding how this came to be is best done through examining the evolution of asset custody over the last century.

When trying to understand custody, a great place to begin are with bearer instruments, like bearer bonds, which are issued on paper (or goatskin) and can be stored by individuals in a safe, under lock and key. When one has physical possession of a bearer instrument, they gain all the beneficial ownership right associated with the asset. Thus, safeguarding these documents is vital since they are unregistered, with no records maintained of the changes of ownership or of the current owner.

Naturally, some people don’t want to keep these at home for risk of theft and have historically turned to banks for storage in a safety deposit box for safekeeping. This is referred to as custodial possession. The customer could then be given a key so they could get into their safety deposit boxes and have access to the assets. Sometimes the bank would also have a key. When two parties have a key to gain access to the underlying asset, this is referred to as joint custody.

Looking Back

As financial markets grew through the 20th century, the management and transferring of stock certificates, bearer bonds and cash became very unwieldy. In the 1960s, the New York Stock Exchange saw securities trading volume more than double over a span of just 3 years.

Adjusted for inflation, it’s estimated that billions of dollars worth of securities were stolen or lost during this era. A consequence of poor record keeping, insecure mechanisms of transfer, and theft from centralized repositories

The overwhelming trade volume marked the start of the Paper Crisis, which illuminated that the standard deployed by brokers for transferring and record keeping on securities exchanges, which at the time relied largely on paper and pen, was ill-equipped to handle the growing trade volume. This crisis led to dozens of brokerage firms going out of business and the implementation of computers, alongside professional management, to handle the high volume of trading.

Present Day

Today, custody has legally been defined as “. . .holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them” (17 C.F.R. 275.206(4)-2). This definition, while applicable to the status quo, fails to encompass custody as enabled by the blockchain, which breaks away from the inherent relinquishment of control necessitated by current standards.

The blockchain provides a revolutionary means of tracking, efficiently transacting/exchanging and securely storing assets in a decentralized fashion, in turn offering a solution that can mitigate risks associated with centralized fund storage through the self-custody of assets.

In the following section, we will provide a brief technical overview of how custody of digital assets can function in the emerging digital economy, specifically highlighting how the Ethos Universal Wallet, through Ethos Bedrock, is able to deliver safe and practical solutions to consumers and institutions through building on industry standards.


The Technology: Hierarchical Deterministic Wallet & Bedrock

As you now know, the blockchain enables self-custody of digital assets. Over the past decade, creating a wallet to store your digital assets was a complicated process, requiring individuals to manage independent public and private key pairs for every wallet they wanted to maintain. In order for someone to have 10 Bitcoin address, they would need to manage 10 private keys and 10 public keys… and if that list of lengthy alphanumeric private keys was damaged or lost, there was no simple way to regenerate those missing keys.

Now imagine if there was a way to securely generate 10 private keys and 10 public keys, all derived from and restorable with a single set of words instead of a lengthy alphanumeric string, wouldn’t that be convenient? Enter hierarchical deterministic wallets! Hierarchical deterministic wallets commonly referred to as HD wallets, allow an individual to create a multitude of private/public key pairs without the need for complex backup mechanisms or individual key management by the user.

The Ethos Universal Wallet is built 100% on Ethos Bedrock, with Bedrock being utilized as an institutional-grade custody engine. Bedrock Custody will solve the “custody trifecta” where you have your funds rapid, accessible and secure. Let’s take a dive into how all this works and examine how Ethos is building on industry standards to provide safe and secure custody solutions to consumers and institutions at scale through Ethos Bedrock.

BIP32

BIP stands for Bitcoin Improvement Proposal. A BIP is a standardized way of introducing proposals for alterations of Bitcoin, including the network protocol, block or transaction validation, and more. BIP-32 describes what HD wallets are and how they operate. An HD wallet is a system for deriving seemingly infinite private/public key pairs from a single point referred to as a seed. This creates a hierarchical tree-like structure of private/public keys.

From a mnemonic phrase, the seed is derived. That is hashed and a master key, also known as a parent key, is derived. From that parent key, you can then derive child keys underneath that. From each of the children, you can derive more child keys, and so on. Think of it as a tree branching out. This structure also allows the owner of the wallet to provide one of the branches, or sub-trees, to someone else and they can then generate more addresses further down that tree.

Deterministic wallets eliminate the need for a user to document every single private/public key because they can be regenerated at any time with the single mnemonic phrase that’s held by the wallet owner

BIP39

When creating a cryptocurrency wallet, a mnemonic phrase is sometimes generated in order to provide an easier way to remember your private key, instead of having to memorize or document a random alphanumeric string. BIP-39 provides a framework for generating that mnemonic phrase. Sometimes referred to as a “seed phrase,” it’s vital to keep this somewhere safe! The individual in possession of this set of words has full access to the assets associated with the given address, think of it as the combination to an otherwise uncrackable safe.

Under BIP-39, standardized lists of words in different languages are provided and can be used for creating a mnemonic phrase. The English language word list has 2048 words and can be found here.

For the Ethos Universal Wallet, your SmartKey is a 24-word mnemonic phrase (vs the 12-word standard used in many wallets). A single 256-bit seed, 24-word mnemonic provides master encryption for all of the private keys in each wallet you create.

Did you know the number of possible 24-word combinations of 2048 words exceeds the number of atoms on Earth!?

BIP44

BIP-44 defines a logical hierarchy for deterministic wallets and expands on the capabilities of the HD wallet as defined in BIP-32 to allow for support of different coin types (i.e., BTC, ETH, ADA) and accounts. This allows for a single mnemonic phrase SmartKey to be used to recover seemingly infinite wallet addresses that hold assets across different blockchains.

While Ethos adheres to BIP32 and BIP39, we found BIP44 as it stands would limit the ability for Ethos to provide unique solutions to our users; namely, the ability to dynamically generate addresses for users to receive payment on blockchains they haven’t used, which enables airdrops into wallets where the address has not yet been generated by the user. In considering these benefits along with additional security risks, we decided to pursue a non-standard approach to unlock use cases that will be beneficial to the overall user experience.

Ethos Bedrock utilizes “extended public keys” to securely generate addresses on our servers without having to transmit private keys. These extended public keys are used to generate all child public keys that exist below it in the derivation path – which are then transformed into addresses that follow the scheme defined by each blockchain. For a full description of the mathematics of these extended keys, see the BIP-32 / BIP-44 documentation.

Through unlocking and expanding on the capabilities of the powerful mathematical structure outlined above, consumers and institutions can now have access to industry leading custody solutions at scale.

Looking Forward

While the application of this wallet technology may be clear to our Universal Wallet users who already enjoy the benefits of self-custody and the convenience of a mobile storage solution, it’s important to note that Bedrock also enhances the custody offering for Voyager as well. Through Bedrock, we are opening up support of coins that Voyager’s existing custody partners do not support and increasing the speed to market for new coins. This enhances both the Voyager retail trading application, in addition to the Voyager institutional offering. For both businesses, Ethos helps solve one of crypto retail and institutional markets biggest problems – secure custody.

The combined Bedrock and Voyager B2B offering will enable businesses of all types to build crypto applications rooted in custody, payments, investing and more. Together, we look forward to granting Voyager’s institutional partners access to the powerful custody solutions enabled by Bedrock.

From bearer bonds to blockchain, we have arrived full circle to what the people need, true and secure asset ownership. Individuals and institutions can rest assured that Ethos is here to provide them with unprecedented security over their assets, without sacrificing ready access to rapidly transact and exchange them.