Risks and benefits of using different types of virtual asset wallets

Virtual asset wallets are electronic wallets that store digital assets such as cryptocurrencies or tokens. They allow users to send, receive, and manage their virtual assets on various blockchain networks. 

 

Blockchain networks are decentralized systems that use cryptography to secure and verify transactions and records. Virtual asset wallets can be classified into two types: custodial and non-custodial.

 

Custodial wallets are operated by third-party service providers who have access to the user's private keys, which are secret information that gives the user control over their virtual assets.

Non-custodial wallets

Non-custodial wallets are operated by the user themselves, who have sole access to their private keys.

One of the challenges of using virtual asset wallets is how to demonstrate proof of control and ownership of the virtual assets stored in them. This is important for various purposes, such as verifying transactions, complying with anti-money laundering and countering-the-financing-of-terrorism (AML/CFT) regulations, and resolving disputes or claims. There are different methods to prove control and ownership of virtual asset wallets, depending on the type of wallet and the context of the proof.

Custodial wallets

For custodial wallets, proof of control and ownership can be demonstrated by providing evidence of the contractual relationship between the user and the service provider, such as a signed agreement, a transaction receipt, or a confirmation email.

 

The user can also request the service provider to issue a statement or a certificate that confirms the user's identity and balance in the wallet. Additionally, the user can use biometric authentication methods, such as fingerprint or facial recognition, to access their wallet and prove their identity. 

 

However, these methods may not be sufficient or reliable in some cases, such as when the service provider is hacked, goes bankrupt, or becomes unresponsive. In such scenarios, the user may face difficulties in recovering their virtual assets or proving their claims.

For non-custodial wallets, proof of control and ownership can be demonstrated by providing evidence of the possession of the private keys, such as a mnemonic phrase, a hardware device, or a paper wallet. The user can also sign a message with their private keys and verify it with a public key or an address that corresponds to their wallet. 

Furthermore, the user can use cryptographic proofs, such as zero-knowledge proofs or multi-party computation, to prove their control and ownership of the wallet without revealing their private keys or compromising their privacy. 

 

For example, zero-knowledge proofs allow the user to prove that they know a secret (such as a private key) without disclosing it or any other information. Multi-party computation allows multiple parties to jointly compute a function (such as verifying a transaction) without revealing their inputs (such as private keys) to each other. However, these methods may also have some drawbacks, such as technical complexity, human error, legal uncertainty, and regulatory compliance.

Virtual asset wallets have many potential benefits for users and society. They could make payments easier, faster, and cheaper; and provide alternative methods for those without access to regular financial products. They could also enhance financial inclusion, innovation, and competition; and foster cross-border trade and remittances. 

 

However, virtual asset wallets also pose significant risks and challenges that need to be addressed by users, service providers, regulators, and policymakers. Some of these risks and challenges include:

Money laundering and terrorist financing

Virtual asset wallets could be used by criminals and terrorists to conceal their identity, source, and destination of funds; and to transfer illicit funds across borders without detection or oversight. The Financial Action Task Force (FATF), the global standard-setter for AML/CFT efforts, has issued guidance on how to apply its standards to virtual assets and virtual asset service providers (VASPs), which include custodial wallet providers. 

 

The FATF standards require VASPs to implement AML/CFT measures such as customer due diligence (CDD), transaction monitoring (TM), record-keeping (RK), reporting of suspicious transactions (STR), and compliance with sanctions regimes. The FATF standards also require VASPs to comply with the "travel rule", which obliges them to obtain and transmit originator and beneficiary information for virtual asset transfers above a certain threshold.

Cybersecurity

Virtual asset wallets could be vulnerable to cyberattacks that could compromise the security and integrity of the private keys, transactions, and records; and result in theft, loss, or unauthorized access of virtual assets. 

 

Users and service providers need to implement adequate cybersecurity measures to protect their wallets from hackers, malware, phishing, or other malicious activities. These measures could include encryption, authentication, backup, recovery, and audit mechanisms.

Consumer protection

Virtual asset wallets could expose users to various risks and uncertainties that could affect their rights and interests as consumers. These risks and uncertainties could include volatility, fraud, scams, misrepresentation, lack of transparency, disclosure, or recourse; and operational failures or disruptions. 

 

Users need to be aware of the potential benefits and drawbacks of using different types of virtual asset wallets and choose the most suitable one for their needs and preferences. Users also need to be informed of their rights and responsibilities as consumers and the applicable laws and regulations that govern their use of virtual asset wallets.

Financial stability

Virtual asset wallets could have implications for the stability of the financial system, especially if they become widely adopted and interconnected with other financial services and markets. Virtual asset wallets could pose risks such as contagion, spillovers, systemic liquidity shortages, or market distortions; and affect the transmission and effectiveness of monetary policy. 

 

Regulators and policymakers need to monitor the developments and trends in the virtual asset sector and assess their potential impact on the financial system. They also need to coordinate their actions and responses with other jurisdictions and stakeholders to ensure a consistent and coherent approach to the regulation and supervision of virtual asset wallets.

The proof of control and ownership of virtual asset wallets can be demonstrated by various methods depending on the type of wallet and the context of the proof. These methods aim to ensure the security, integrity, and legitimacy of the virtual asset transactions and users. 

 

However, they also pose some challenges and limitations that need to be addressed by users, service providers, regulators, and policymakers. Therefore, users should be aware of the risks and benefits of using different types of virtual asset wallets and choose the most suitable method to prove their control and ownership. 

 

Service providers should comply with the applicable laws and regulations that govern their activities and operations. Regulators and policymakers should adopt a risk-based approach to the regulation and supervision of virtual asset wallets that balances innovation with stability.