Written by: Jen Bai, Evan Lee
In business dealings, when large sums of money or precious assets are involved, trust is both crucial and rare. How can the buyer be assured that they will receive what is promised? How can the seller ensure they will receive payment after delivery? This is where the escrow mechanism comes into play—holding funds or assets through a neutral third party, which are only released once both parties fulfill 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 volatile cryptocurrency trading sector. By using a neutral, 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 the custodial mechanism works
1. Reach an agreement on terms - The buyer and seller negotiate and mutually confirm the transaction terms and conditions.
2. Sign a custodial agreement - Both parties formally sign a legally binding custodial agreement, designating a neutral custodian agent.
3. Deposit funds/assets into the custodial account - The buyer deposits the agreed amount or asset into a secure custodial account, ensuring that the seller cannot withdraw funds before the obligations are fulfilled.
4. Fulfill obligations - The seller provides goods or services as agreed, and the buyer verifies and confirms compliance with the terms.
5. Transaction completion and release of funds/assets - Once the conditions are confirmed to be met, the custodian agent will release the funds or assets to the seller according to the agreement.
The wide applicability of custodial mechanisms
Custody is not limited to cash; it can also apply to any identifiable and transferable assets, such as:
Real estate title certificates
Financial instruments such as stocks and bonds
Intellectual property (e.g., software source code)
Digital assets (cryptocurrencies, NFTs)
Legal documents such as patents and contracts
High-value physical items (artworks, jewelry, luxury cars, etc.)
These assets must meet the criteria of being identifiable and transferable, so that the custodian agent can accurately execute the release action after verifying the conditions are met.
Legal risks and complexities of custodial agreements
Although custodial mechanisms can provide protection for transactions, if not designed rigorously or regulated adequately, they may pose serious legal and financial risks. Common risks include:
1. Ambiguity in applicable law
Custodial transactions often involve parties from different jurisdictions, for example, a buyer from the United States, a seller from Singapore, and a custodian agent registered in the Cayman Islands, with each region's contract law definitions and enforcement mechanisms varying.
If the applicable law is not clearly defined in the agreement, legal conflicts may arise. Enforcement of cross-border court rulings may be limited; for example, a ruling from a Hong Kong court may not be directly enforceable in the United States. It is recommended to specify a neutral applicable law (such as UK law or New York law) in the agreement and adopt arbitration mechanisms to reduce dispute risks.
For example: If a custodial contract does not clearly specify the applicable law, a custodial agent in Singapore involved in a transaction dispute between a Chinese buyer and a German seller may face procedural rule conflicts, high costs of cross-border legal consultations, and uncertain ruling outcomes.
2. Illegal or unlicensed institutions
Not all institutions claiming to offer 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, custodial services can only be performed by ** licensed banks, Hong Kong law firms, or specific trust/company service providers (TCSPs) **; any custodial activities provided by other institutions are illegal.
In Singapore, custodial services are typically performed by banks, trust companies, or compliant law firms regulated by MAS; informal platforms without a payment license or trust authorization cannot legally provide custodial services.
In the United States, state laws strictly require that custodial services be executed by state-licensed custodians, regulated insurance/title agencies, or attorneys complying with professional ethics; funds involved may also need to be registered as money transmission businesses.
Using unauthorized custodial services may lead to:
Custodial agreements cannot obtain legal protection
If customers suffer fraud, there are no regulatory bodies to turn to for help
Assets lost and cannot be recovered
Parties may bear civil or criminal liability for participating in transactions with knowledge of violations.
The new era of decentralized custody: on-chain smart contract mechanisms
Traditional custodial 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 uses smart contracts to achieve automatic execution without centralized intermediaries.
Smart contracts are self-executing codes deployed on blockchain networks that can lock, release, or refund assets based on preset conditions.
These codes are publicly transparent and tamper-proof, allowing both parties to verify the logic in advance to ensure it complies with the agreement, and the execution costs are usually lower than traditional custody.
For example:
The buyer transfers 1 ETH into the smart contract;
Contract stipulation: ETH will only be released when a specific NFT is transferred to the buyer's wallet;
If the NFT is not delivered within the specified time, the contract automatically refunds the ETH to the buyer.
Although on-chain custody has advantages of transparency, automation, and low cost, there are also technical risks, such as smart contract vulnerabilities and lack of effective dispute mechanisms. Therefore, it is essential to carefully audit the contract code and platform reputation before use.
Case Study: Hodl Hodl's peer-to-peer custodial model
Hodl Hodl is a platform that allows users to conduct peer-to-peer transactions with Bitcoin or stablecoins, with its design highlight being that it does not hold user funds but relies on an on-chain multi-signature mechanism to ensure transaction security.
The operational principles are 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:
One private key is held by the seller
One held by Hodl Hodl
The third is held by the buyer as needed based on the contract type
For a normal transaction to be completed, both the seller and Hodl Hodl must sign the contract to release the asset. If a dispute arises, Hodl Hodl will choose to jointly sign the transaction with either the buyer or the seller based on the ruling, determining the allocation of funds. Even if the Hodl Hodl platform ceases operation or encounters issues, the seller can still retrieve the funds under specific conditions since they hold their private key. This model effectively reduces custodial risk while combining a structured dispute resolution mechanism to ensure fair transactions.
Conclusion
When custodial arrangements are properly designed and executed, they can convert trust into certainty—providing clear and reliable guarantees for both parties in transactions that may be fraught with risk. Whether in high-value real estate transactions, cross-border commercial dealings, or decentralized cryptocurrency platform transactions, custodial mechanisms are the core foundation for building secure transaction pathways.
To truly realize the utility of custody, simply understanding the operational process is far from enough; all parties involved in the transaction must:
Strictly audit whether custodial service providers are licensed and meet regulatory requirements
Clarify the applicable law and dispute resolution mechanism of the agreement
Prevent ambiguity in release conditions to avoid delays or misunderstandings
