Custody in a Decentralized World: From Legal Protection to smart contracts Innovation

Written by: Jen Bai, Evan Lee

In business transactions, when it comes to large amounts of money or valuable assets, trust is both important and rare. How can buyers be assured that they will receive what was promised? How can sellers ensure that they will get paid after delivery? This is where the escrow mechanism comes into play—holding funds or assets by a neutral third party, which are only released after both parties have fulfilled their contractual obligations.

The application of custodial mechanisms goes far beyond simple fund storage services. It is a critical risk management tool across various industries, covering real estate, corporate mergers and acquisitions, e-commerce platforms, and even the highly volatile cryptocurrency trading sector. By utilizing a neutral and secure method of fund or asset custody, custodial mechanisms effectively reduce the probability of fraud, minimize transaction disputes, and provide reliable protection for transactions that are difficult to conduct based solely on trust.

How does the custody mechanism work?

1. Agreement on Terms - The buyer and seller negotiate and mutually confirm the terms and conditions of the transaction.

2. Sign the Custody Agreement - Both parties formally sign a legally binding custody agreement, designating a neutral custodian.

3. Funds / Assets deposited into the custody account - The buyer will deposit the agreed amount or assets into a secure custody account, ensuring that the seller cannot withdraw the funds before the agreed obligations are fulfilled.

4. Fulfillment of Obligations - The seller shall provide goods or services as agreed, and the buyer shall accept and confirm whether they meet the terms.

5. Completion of Transaction and Release of Funds / Assets - Once the conditions are confirmed to be met, the escrow agent will release the funds or assets to the seller in accordance with the agreement.

The wide applicability of the custody mechanism

Custody is not limited to cash, but can also apply to any identifiable and transferable asset, such as:

Real Estate Property Certificate

financial instruments such as stocks and bonds

Intellectual property (such as software source code)

Digital assets (cryptocurrency, NFT)

patents, contracts and other legal documents

High-value physical assets (artworks, jewelry, luxury cars, etc.)

These assets must meet identifiable and transferable conditions so that the custodian can accurately execute the release action upon completion of the verification conditions.

Legal Risks and Complexities of Custody Agreements

Although the custody mechanism can provide protection for transactions, if the structural design is not rigorous or regulatory oversight is insufficient, it may pose serious legal and financial risks. Common risks include:

1. Ambiguity in legal applicability

Custodial transactions often involve parties from different jurisdictions, such as a buyer in the United States, a seller in Singapore, and a custodian agent registered in the Cayman Islands, each with different definitions and enforcement mechanisms of contract law in their respective regions.

If the applicable law is not clearly specified in the agreement, legal conflicts may arise. The enforcement of cross-border court judgments may be limited; for example, a judgment from a Hong Kong court may not be directly enforceable in the United States. It is recommended to specify a neutral applicable law in the agreement (such as UK law or New York law) and to choose an arbitration mechanism to reduce the risk of disputes.

For example: If a custody contract does not clearly specify the applicable law, a Singapore custodian involved in a transaction dispute between a Chinese buyer and a German seller may face conflicts of procedural rules, high costs of cross-border legal consultation, and uncertain arbitration outcomes.

2. Illegal or unlicensed institutions

Not all institutions that claim to provide custodial services are legitimate and regulated. Especially in the cryptocurrency asset market or cross-border transactions, some fraudsters may impersonate legitimate platforms.

In Hong Kong, custody services can only be provided by ** authorized banks, Hong Kong law firms, or specific trust/company service providers (TCSP) **; providing custody activities by non-listed institutions is illegal.

In Singapore, custodial services are typically performed by banks, trust companies, or compliant law firms regulated by MAS; informal platforms that have not obtained a payment license or trust authorization cannot legally provide custody.

In the United States, state laws strictly require that custodial services must be performed by state-licensed custodial companies, regulated insurance/title agencies, or attorneys adhering to professional ethical standards, and the funds involved may also need to be registered as money transmission businesses.

Using unauthorized custodial services may result in:

The custody agreement cannot be legally protected.

If customers suffer from fraud, there is no regulatory agency to seek help.

Assets lost and cannot be recovered

Participants may bear civil or criminal liability for engaging in transactions while being aware of violations.

The New Era of Decentralized Custody: On-Chain Smart Contract Mechanisms

Traditional custody systems rely on intermediaries such as banks and law firms to execute custody and release, but blockchain technology has brought revolutionary changes—on-chain custody utilizes smart contracts to achieve automatic execution without the need for centralized intermediaries.

Smart contracts are self-executing code deployed on a blockchain network that can lock, release, or refund assets based on predefined conditions.

These codes are open and transparent, immutable, and both parties to the transaction can verify in advance whether the logic conforms to the agreement, and the execution costs are usually lower than traditional custodians.

For example:

The buyer transfers 1 ETH into the smart contract.

Contract Setting: ETH will only be released after a certain NFT is transferred to the buyer's wallet.

If the NFT is not delivered within the specified time, the contract automatically refunds ETH to the buyer.

Although on-chain custody has advantages such as transparency, automation, and low costs, it also carries technical risks, such as smart contract vulnerabilities and a lack of effective dispute mechanisms. Therefore, it is essential to carefully review the contract code and the platform's reputation before use.

Case Study: Hodl Hodl's Peer-to-Peer Escrow Model

Hodl Hodl is a platform that allows users to conduct peer-to-peer trading of Bitcoin or stablecoins, with a design highlight of not holding user funds, but instead relying on an on-chain multi-signature mechanism to ensure transaction security.

The operating principle is as follows:

After the transaction is initiated, the seller's cryptocurrency is locked in a multi-signature smart contract on the Bitcoin or Liquid network.

The contract adopts a 2-of-3 multi-signature structure:

A private key is held by the seller.

A holding by Hodl Hodl

The third one is held by the buyer when necessary according to the type of contract.

When a normal transaction is completed, both the seller and Hodl Hodl need to sign the contract in order to release the assets. In case of a dispute, Hodl Hodl will choose to co-sign the transaction with either the buyer or the seller based on the ruling, determining the ownership of funds. Even if the Hodl Hodl platform shuts down or encounters issues, the seller can still retrieve the funds under certain conditions because they hold their own private key. This model effectively reduces custody risks while incorporating a structured dispute resolution mechanism to ensure fair transactions.

Conclusion

When custody arrangements are properly designed and executed, they can transform trust into certainty—providing clear and reliable protection for both parties in situations where transactions may be fraught with risk. Whether it's high-value real estate transactions, cross-border business dealings, or trades on decentralized crypto platforms, the custody mechanism is the core foundation for establishing secure transaction pathways.

To truly realize the utility of custody, merely understanding its operational process is far from sufficient; all parties involved in the transaction also need to:

Strictly review whether the custody service provider is licensed and meets regulatory requirements

Clarify the applicable law and dispute resolution mechanism of the agreement

Prevent the release conditions from being ambiguous, thereby avoiding delays or ambiguities.