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Trust Law/Level IX · Trusts on chain/9.1 Digital assets in trust/Lesson 2

Keys, custody and the trustee’s duty of care

Why holding private keys means controlling digital assets, how self-custody and regulated custodians differ, and how a US trustee’s duties of prudence and protection apply to keeping keys safe.

Education, not legal advice. Trust law changes from country to country and state to state, and the right structure depends on your situation. Anything you sign should be drafted or reviewed by a qualified lawyer where you live.

The lean path

The cheapest, lowest-tax, simplest and most private route the law allows, best first. Each step names the rule it rests on and the condition that keeps it lawful.

  1. Cheapest compliant custody is documented self-custody: a hardware wallet with BIP 39 seed backups in separate secure places and written procedures, since UTC §809 asks only for reasonable steps to control and protect property. Catch: losing every backup can be a breach of trust.
  2. Write custody rules into the trust instrument, naming who holds keys and permitting self-custody or multisig; the terms can modify default duties. Catch: the trustee should still record why the chosen arrangement is reasonable for the amount held.
  3. A qualified custodian is mandatory only for SEC-registered advisers holding client assets (Rule 206(4)-2), so a family trustee may choose either route; a custodian charges fees but carries key-loss risk. Catch: custodian insolvency risk replaces key-loss risk.
  4. Keep seed phrases out of wills, emails and cloud notes; a written procedure naming who can act, without any secret, lets a successor take over cheaply. Catch: test recovery with a small amount and update the record whenever devices change.

MaterialsThe Uniform Prudent Investor Act (1994), especially §2, free from the Uniform Law Commission (see lesson 8.3.2)Uniform Trust Code §809, on control and protection of trust property, in a state enactment such as Maine Revised Statutes title 18-B §809SEC Rule 206(4)-2 under the Investment Advisers Act of 1940 (the custody rule), free on law.cornell.edu

Wonder

  1. If whoever holds a private key can move the coins, what does it mean for a trustee to ‘hold’ a digital asset?
  2. How can a trustee protect access to keys without creating a single point of failure?
  3. Why might a trustee use a regulated custodian rather than hold keys itself, and what new risks does that bring?

Explore

  1. On a blockchain such as Bitcoin, coins are moved by signing a transaction with a private key. Whoever can produce that signature controls the coins in practice, whatever any document says about ownership. For a trustee, holding a digital asset therefore means controlling its keys, either directly (self-custody) or through someone else who holds them, such as a custodian. If every copy of a key is lost, there is no central authority that can reset access, and the coins cannot be moved. This lesson explains concepts and recommends no product, wallet or custodian.
  2. In the US, a trustee’s investment duties come from the Uniform Prudent Investor Act (UPIA, 1994), adopted in most states (lesson 8.3.2). Under §2, a trustee must invest and manage trust assets as a prudent investor would, exercising reasonable care, skill and caution. Under Uniform Trust Code §809, a trustee must take reasonable steps to take control of and protect the trust property. Neither act mentions private keys, but applied to digital assets they point towards secure, documented arrangements for keys. The trust’s terms can modify some of these default rules, and each state’s courts apply them.
  3. Many wallets use a recovery phrase, or seed phrase: under the widely used BIP 39 standard, a list of 12 to 24 words from which the wallet’s private keys can be regenerated. Anyone who obtains the phrase can take the coins, so it is as sensitive as the keys themselves. It does not belong in a will, which may become public after probate, or in emails, cloud notes or other documents that others can read. A recovery plan can record what exists and whom to contact without recording the secret itself (lesson 9.1.3).
  4. A hardware wallet is a small dedicated device that keeps private keys inside it and signs transactions without exposing the keys to the computer it is connected to. It reduces some risks, such as malware on a computer, but a device can be lost, broken or stolen, so recovery depends on a securely kept backup. A multisignature (multisig) arrangement requires a set number of keys out of a larger group, such as 2 of 3, to approve a transaction, so no single lost or stolen key decides the outcome. Lesson 9.1.3 explains multisig and time-locks.
  5. Some trustees use a third-party custodian instead. The SEC’s custody rule, Rule 206(4)-2 under the Investment Advisers Act of 1940, requires a registered investment adviser with custody of client funds or securities to keep them with a ‘qualified custodian’, such as a bank, a registered broker-dealer, a registered futures commission merchant or certain foreign financial institutions. The rule governs advisers, not trustees generally, and how it applies to crypto assets has been debated and has changed over time. A custodian takes on the risk of losing keys but adds others, such as its own insolvency (lesson 9.1.4).
  6. Whatever arrangement is used, losing every copy of the keys means losing access to the asset, and a trustee who failed to take reasonable care could face a claim for breach of trust. Insurance may cover some losses, such as theft from a custodian, but policies differ in what they cover and exclude, and their limits may be well below the value held. A written record of custody procedures, who can act and how to reach them, kept without any keys or seed phrases, helps a successor trustee take over. The trust instrument can also set custody rules.

Key facts

  • Whoever can sign with a private key controls the coins in practice; if every copy of the key is lost, no central authority can reset access.
  • Under UPIA §2, a trustee must invest and manage trust assets as a prudent investor would, exercising reasonable care, skill and caution.
  • Under Uniform Trust Code §809, a trustee must take reasonable steps to take control of and protect the trust property.
  • Under the BIP 39 standard, a seed phrase of 12 to 24 words can regenerate a wallet’s private keys, so anyone who obtains it can take the coins.
  • A multisig arrangement requires a set number of keys out of a larger group, such as 2 of 3, to approve a transaction.
  • SEC Rule 206(4)-2 requires a registered investment adviser with custody of client funds or securities to keep them with a qualified custodian.

Exercise nine, six, three, one

9CollectList up to 9 custody risks or safeguards described in this lesson or a source you are reading (some sources give fewer), such as a lost device, a leaked seed phrase, a multisig threshold, a custodian’s insolvency or an insurance exclusion.
6ClusterSort them into 6 categories: self-custody, seed-phrase security, hardware wallets, multisig, third-party custodians, and insurance and records.
3DistillReduce the 6 categories to 3 groups: risks of losing access, risks of someone else taking the asset, and risks that depend on a third party.
1CrystallizeWrite 1 sentence explaining, in your own words, why a trustee’s duty to protect trust property applies to private keys.

Fact check

Dates, figures and claims checked against the published sources listed below.

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