If a counterparty holds custody of your crypto or digital assets, there is no replacement for due diligence in terms of risk management, security controls, and operational processes. This is why it’s critical to design crypto operations workflows that mitigate exposure to your counterparties and minimize business continuity risks. For a quick introduction to counterparty risk and how to identify your counterparties take a look here.
The best way to minimize counterparty risk is through rigorous operational due diligence and designing operational workflows that mitigate as much as exposure to your counterparties as possible.
Here are some of the ways to mitigate digital asset and crypto counterparty risk:
1. Create a process for deposit address management
As soon as your organization handles any type of volume or begins to manage multiple counterparties’ addresses, the risk of error can increase exponentially. The main counterparty risk involved is using out-dated or incorrect deposit addresses.
The use of out-dated deposit addresses can turn a simple transaction into an operational nightmare. Address whitelisting is a best practice that leads to both efficiency gains and a reduction in manual errors.
It is important to note that whitelisting cannot prevent a rogue employee from adding their personal address to your organization’s internal whitelisting database or a fat finger error during the whitelisting process. Additionally, if either side of a trading or transactional relationship (such as paying a vendor) updates their deposit address and does not communicate this to the other party, it creates a major issue, with a possibility of losing funds.
Ideally, your wallet technology provider automatically authenticates and verifies deposit addresses. Otherwise, you want to create clear, well-documented policies for address whitelisting and the communication with counterparties of address changes.
2. Sweep funds from exchanges frequently
Trading venues, such as exchanges, can be convenient places to store your private keys. However, there are well-documented security risks with this approach – such as hacks and phishing attempts. Also, given recent market events involving inappropriate usage of customer funds, there are also serious business continuity risks with keeping funds on exchanges that could result in a total loss of those funds.
Regardless of your organizational risk appetite, we recommend keeping only “what you are comfortable losing” when it comes to third-party trading venues and lending platforms, in order to minimize this type of counterparty risk.
Operationally, ensuring that un-needed funds are consistently swept back to in-house custody is critical – and it’s best to automate this process to introduce more efficiency into your operational workflows.
3. Build a flexible custody tech stack
Qualified custodians and third party wallet technology providers are susceptible to security incidents, financial stress or acquisition. Each one of these scenarios can have severe consequences on your custodians’ ability to safeguard your digital assets or release them.
While there is no “one size fits all” digital asset custody model, we recommend building your own custody tech stack that includes a mixture of hot, warm and cold wallets.