Inheriting cryptocurrency assets presents unique challenges for heirs, including lack of access, complex probate procedures, and security risks. Custodianship services offer a viable solution by providing secure storage, streamlining the probate process, and offering expert guidance to beneficiaries. As the adoption of cryptocurrency assets continues to grow, incorporating custodianship services into estate planning becomes essential for ensuring the seamless transfer of digital wealth to future generations.
The Growth of Cryptocurrency Ownership
Cryptocurrency’s increasing presence is undeniable. As of January 2024, a whopping 40 percent of Americans own cryptocurrency, according to a study conducted by Security.org analysts. This includes almost a third of the Gen X population (people aged approximately 44–59). Most legal and financial professionals are not well-educated about cryptocurrency assets, however, and, therefore, are not able to ask their clients probing questions about ownership or even consider how to best approach such assets in estate planning.
Cryptocurrency is new and complicated, but there are options available for responsible planning without a steep learning curve. The first step in understanding how cryptocurrencies can fit into a client’s plan is understanding how they are custodied and what special considerations are needed. Then one must address the planning options available to clients, depending on how they custody their assets, as well as how to ensure fiduciaries can eventually access and distribute the cryptocurrency assets.
Cryptocurrency as a Bearer Asset
Cryptocurrencies offer unique value propositions to their holders. To begin with, they are bearer assets, as opposed to credit assets, which entitle a respective holder of such assets to all rights of ownership. This means there is no superior record title owner. Bearer assets allow their owners to remain anonymous and do not require a trusted third party to custody the assets or maintain a ledger of title. Examples of bearer assets include cash as well as gold. Should a person drop a $20 bill on the ground, as a bearer asset, whoever finds this cash can use it without requiring the need for recording a document (such as a deed) or registering it with a custodian.
Given it is a bearer asset, the benefit of ownership of cryptocurrency is that owners of it do not have to be concerned about losing cryptocurrency should it be stored by a bank that is operated by or collaborating with a custodian. That being said, the downside is that cryptocurrency can be difficult to custody. The bearer nature of cryptocurrencies is the genesis of much confusion for planners who do not want to incur the burden of custodying client assets and need to find ways to ensure fiduciaries will be able to recover the assets only once the grantor has passed away.
Storing Cryptocurrency Assets
Centralized Storage
Cryptocurrency owners are faced with two decisions when it comes to how they will store their assets: centralized v. decentralized wallet providers. Centralized storage of cryptocurrency is akin to having a bank account: They are centralized companies that users entrust with their assets. These companies custody the assets behind the scenes for the consumer and, in order for the individual to obtain an account with them, they require users to reveal their identities and go through anti-money laundering processes. Popular centralized custodians include Coinbase, Binance, Kucoin, and Kraken.
The primary advantage of centralized wallet providers is ease of use. Users do not have to be tech-savvy to hold their crypto in these wallets; the user interface is similar to a bank or e-trade account. Login occurs via email and password and can be reset at any time. Centralized platforms require users to heavily trust them, however, as misuse of customer funds or platform noncompliance is entirely dependent upon the centralized entity’s behavior. Consider the ramifications of a centralized custodian like FTX.
Because reserves have to be held in various different coins, centralized platforms have to be extremely careful about how they leverage user funds. It is also common for centralized platforms to lack strong customer service; users routinely get locked out of accounts or find themselves unable to make contributions or withdrawals. Centralized platforms also have fewer options by way of coins available for exchange and financial engineering because they are heavily regulated.
Decentralized Storage
On the other end of the spectrum is decentralized custody: If centralized custody is like a bank account, decentralized custody is similar to cash under one’s mattress. The following example of a fictional centralized wallet provider, CoinControl, illustrates the difference between decentralized and centralized crypto wallets. Should the company want to, a centralized wallet provider like CoinControl has a variety of methods by which it can steal or tamper with user funds. CoinControl can change the database recording how much of an asset a user has or it can misappropriate funds. A more common example is CoinControl’s ability to indiscriminately lock accounts for no obvious reason and require users to enter month-long verification loops in an attempt to unlock them. All ownership and account data and the actual assets are ultimately controlled by CoinControl.
Decentralized platforms mitigate these risks because there is not a single, centralized custodian. Decentralized platforms are based upon the technology of blockchain. Blockchains are databases to which data can be only appended, not deleted or modified, and whose entries are maintained by complex algorithms that do not rely on any single party. This is what makes them decentralized: The network has no external dependencies, unlike CoinControl, which holds the cryptocurrencies at the mercy of CoinControl’s employees. Decentralized wallet providers thus create a peer-to-peer financial environment that is entirely trustless, open source, and algorithmically resistant to malicious parties trying to spoof the ledger database. Decentralized cryptocurrency custody avoids all the risks inherent to centralized wallet providers. It also allows users to interact with a much wider variety of coins and technologies.
It is more difficult for a user to make a decentralized wallet than to simply use a centralized wallet. Most important to note, however, is that when a user makes a decentralized wallet, a public and private key pair is created, neither of which is stored on the blockchain network.
The public key can be used to send or receive cryptocurrencies and can be given out freely. The private key (sometimes called a seed phrase), on the other hand, needs to be kept private because it is a bearer instrument: It provides access to the underlying bearer assets and cannot be changed. If a user loses the private key, the user will lose access to the cryptocurrency forever. There is no centralized entity available to recover a lost private key.
Therefore, decentralized cryptocurrency wallets come with some severe constraints: (1) The private key or seed phrase is a bearer instrument and should never be shared and (2) the private key or seed phrase cannot be recovered. Decentralized wallet providers offer users the ability to anonymously interact in a less expensive, faster, peer-to-peer environment without needing to rely on large custodians. But they must shoulder the burden of managing their private key custody.
It is helpful to consider the custodial options of centralized and decentralized as existing on a continuum. In order from left to right, Coinbase, Binance, and Kucoin are all centralized cryptocurrency platforms. To the right on the decentralized portion of the axis are Electrum, a popular decentralized wallet on the Bitcoin blockchain, and MetaMask, a decentralized wallet on the Ethereum blockchain.
Hot Versus Cold Custodial Storage
The second axis of cryptocurrency storage is the hot versus cold storage axis, or whether the wallet is connected to the internet. In the case of hot storage, the private key is stored on the user’s computer or with a centralized wallet provider’s servers and can therefore be hacked remotely if there is an internet connection to the computer. Anyone with an internet connection can theoretically hack a hot wallet. By contrast, cold storage is not connected to the internet and cannot be accessed remotely. Examples of cold storage solutions include writing a private key down on a piece of paper, using a cold storage hardware wallet (a small USB-type device), or memorizing a private key. These solutions can be hacked only by people in proximity to the user: They can steal the user’s piece of paper, hack the user’s hardware wallet, or find a way to have a user reveal a memorized private key. Cold storage is safer than hot storage, but many users still opt for hot storage because it makes trading and interaction with their coins much faster.
Adding the continuum of cold versus hot storage in a diagram, the top-left centralized and cold quadrant is Nydig. Nydig is a custodian that holds all client assets in cold storage. Nydig mainly serves very high net worth individuals who are afraid of being physically targeted for having large amounts of cryptocurrency and also want to ensure their private keys are not online and prone to hacking.
In the top-right centralized and hot storage quadrant are Coinbase, Binance, and Kucoin, which have been discussed above. It is possible for hackers to remotely access accounts on these platforms. In the bottom-left decentralized and cold quadrant are Ledger and Trezor. These are small hardware devices users can purchase to hold their cryptocurrency offline. Finally, in the bottom-right decentralized and hot quadrant are Electrum and Metamask. These wallets are decentralized but keep the private key stored in the user’s computer, which allows access by hackers when the device is connected to the internet.
Users can store assets with a centralized entity, which essentially requires users to give up their identities, trust that entity, and be bound by the policies of that entity. Alternatively, users can store their assets in a decentralized fashion and incur the burden of keeping the assets safe. Furthermore, a user can either store assets in hot storage, which allows them to use their assets more easily but also exposes the assets to hackers, or place their assets in cold storage, which limits hackers to people who can physically access the assets, but also does not allow users to use their assets as easily.
Options and Solutions: Custodial Planning
Estate planners need to help advise their clients on whether to use custodians or encourage decentralized storage. If using a custodian is an optimal consideration, the following steps should be taken: (1) contact the custodian to learn about legacy contact options, (2) use third-party software to enable planning and administration, (3) store individual user credentials with the understanding that the custodian may require verification of identification, and (4) determine if the cryptocurrency holder might be willing to switch wallet providers to use one that has more options for estate planning.
Centralized Wallet Providers—Legacy Contacts
Some wallet providers have an option to add a legacy contact. Unlike bank accounts, this contact will not receive the assets outside of probate and there cannot be multiple contacts; however, the assets will be recoverable. Currently, only Kraken and Coinbase have a legacy contact option, and although there is no clear information on how to set it up, they have telephone support lines to help with the process.
In situations where a client is using a custodial account that does not offer legacy contacts, one can plan for a transfer upon death by having users document their credentials. The concern with this, however, is that custodial crypto wallet providers are well-known for requiring random identity verification. This verification could easily lead to a fiduciary being locked out of the account.
Even with a custodial, centralized wallet provider, the crypto assets are still bearer. This means if a fiduciary obtains a grantor’s centralized wallet, the fiduciary can send the assets to an anonymous decentralized wallet. It would then be incredibly difficult to prove to whom the second wallet belongs.
High Volumes of Crypto Assets
If an individual has a significant amount of cryptocurrency and is using a custodial wallet provider, consideration should be given to moving assets into a decentralized wallet, which could make planning simpler while safekeeping the assets. It should be noted that there are currently few custodial wallet providers that allow wallets to be titled to a trust. Coinbase Institutional has such a feature, but it requires an account minimum of $500,000. This is an option for wealthier clients; however, it is not scalable if the person has multiple beneficiaries.
License Requirements
In the United States, cryptocurrency custodians must hold specific licenses, which vary by state, and most states require custodians to have a money transmitter license. This means that an attorney, advisor, or professional fiduciary cannot take custody of a client’s assets unless licensed. Ironically, it is also causing banks to ban clients from storing their cryptocurrency wallet private key in bank boxes because this would require the bank to hold cryptocurrency licenses.
Fidelity Digital and Nydig are institutions that hold these licenses and may be able to meet some clients’ needs. Using a custodian, however, means that users cannot have direct custody of their assets. Cryptocurrency licenses also significantly constrain the tokens, NFTs, and activities that licensed parties can hold or undertake. Therefore, if an individual is holding a wide range of crypto assets and is using various staking and trading protocols throughout the decentralized finance (DeFi) ecosystem, this may not be the right solution. These specialized custodians also tend to be expensive, are fairly new, and may be limited in their service offerings.
Decentralized Wallet Options
If a user has a decentralized (noncustodial) wallet, there are two primary goals: (1) keep the private key or seed phrase safe and (2) respect the user’s custody wishes upon death. Individuals who chose to self-custody via decentralized wallets typically prefer the full range of benefits afforded by the use of blockchain technology. They likely value anonymity and alternative financial options and trust themselves to incur additional burden in order to avoid trusting centralized custodians. These users will likely be unhappy with solutions that require them to compromise their assets, even to a licensed third party.
The challenge with decentralized wallet options is that users need to ensure that upon their deaths, the fiduciary can recover the private key without compromising on security. The most common way of achieving this is by using a multi-signature scheme.
Multi-signature Scheme
A multi-signature scheme is a cryptographic solution that cuts a private key into many pieces, none of which is meaningful on its own but when put together can reconstruct the original private key. Using a multi-signature solution allows individuals to leave their private keys behind without giving indiscriminate access to their wallets to one person. Individuals can do this on their own by putting pieces of their private keys in various spots for fiduciaries or beneficiaries to eventually recover and reconstruct.
The downside to multi-signature wallets is that they do not solve the problem of giving trustees custody over a bearer asset. If a user sets up a fiduciary to receive a piece of the multi-signature key upon the user’s death, the fiduciary will effectively become the asset’s custodian. If the fiduciary is a professional without a cryptocurrency license, this poses a problem.
Furthermore, the transfer of assets into the hands of a fiduciary can still be tricky. The assets will likely remain locked if, for example, the fiduciary becomes incapacitated or dies, or the user has multiple signatories and they do not cooperate.
Companies like Gnosis or Casa provide solutions that employ a multi-signature signing scheme that allows recovery of a wallet with only one signer. This decreases the odds of assets remaining locked and decreases the trust required between fiduciaries and beneficiaries to make asset distributions.
Finally, there is no way to constrain the fiduciary’s behavior and ensure the estate plan is followed. This may be an issue if a user is using a family member or friend as a fiduciary who may deviate from the planning document.
Third-Party Options
Amid the challenges of traditional digital asset management, innovative solutions like Bequest Finance offer a streamlined alternative. Bequest Finance eliminates the need for court intervention or custodian involvement, empowering individuals to proactively manage their digital estates. By employing novel noncustodial solutions, Bequest Finance ensures seamless access to digital data after death. Through comprehensive estate planning tools and encryption technologies, Bequest Finance prioritizes privacy and security, safeguarding sensitive information while facilitating efficient asset transfer and administration without placing custodial risk on professionals.
Bequest Finance also has a software option that allows beneficiary designations on any custodial wallet to create a transfer-on-death (TOD). It is also able to hold the wallet in trust, which is aligned to the applicable TOD state law. Thus, if a user is unsatisfied with available estate planning options, Bequest Finance may be worth exploring.
Conclusion
Zev Merchant’s wife had a tremendous struggle on her hands to gain access to the nest egg left by her husband. As cryptocurrency becomes a broader asset class, and individuals increasingly rely on digital storage, the need to safeguard and manage cryptocurrency assets becomes paramount.
By incorporating digital estate planning into broader estate planning strategies, individuals can ensure their digital assets are managed and transferred seamlessly to their loved ones. From creating inventories of digital accounts to designating beneficiaries and leveraging secure custodial services, proactive digital estate planning offers peace of mind and alleviates the burden on grieving families.
