Know Your Blockchain Wallets
Custodial vs Non-Custodial Wallet
Non-custodial wallets are commonplace throughout the decentralized finance (DeFi) community as they are essential for interacting with decentralized applications (dApps). Conversely, custodial wallets tend to be associated with a centralized exchange that takes custody of digital assets. Furthermore, custodial wallets require a certain amount of technical understanding and personal responsibility. The phrase “not your keys, not your coins” refers to the lack of control one has over their assets when stored in a custodial wallet. Plus, the phrase suggests that a custodial wallet is not sufficient for storing assets safely. This debate has led many investors to consider the differences between custodial vs non-custodial wallet offerings.
In this article, we’re going to compare the key differences between custodial vs non-custodial wallet products. We’ll discuss the security implications of each of these wallets and some of the factors to consider when deciding which is the right one for you. Plus, we’ll explore some of the different ways in which you can use each type of wallet and how to decide which one would be the best suitable choice for your needs.
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What is a Crypto Wallet?
When purchasing cryptocurrencies from a crypto exchange, you’ll need some sort of crypto wallet for holding your assets. Also, a crypto wallet is essential for interacting with blockchains and executing orders. Crypto wallets provide users with a unique address. This wallet address is an identifier that directs funds to and from the correct place whenever you interact with the blockchain and helps investors to see where their funds are.
Crypto wallets use private key cryptography. Every crypto wallet corresponds with a public key (address) that you can share with anyone to send crypto to your wallet. Also, wallets correspond with a private key. In addition, the private key functions like a password for securing funds and signing transactions. Although some software wallets will offer password protection for users to gain access to an app, the private key (or seed phrase) enables users to restore a wallet from another device.
Securing this private key can be the difference between your funds being stolen and you keeping them safe. Accordingly, some crypto wallets require users to keep their own private keys secure, while others remove the technical risks associated with self-custody.
Custodial vs Non-Custodial Wallet: A Comparison
Before deciding which wallet is the right choice for your needs, let’s first consider the key features of each wallet and the purposes they serve. Below, we break down the key distinctions between custodial vs non-custodial wallets. Plus, we discuss the pros and cons of each type of wallet to help you make an informed decision when storing your digital assets.
The majority of custodial crypto wallets are web-based exchange wallets. As such, crypto exchanges take custody of digital assets to provide a convenient solution for crypto storage. Generally, centralized exchanges such as Coinbase and Binance keep users’ private keys for security and accessibility. This enables investors to access their funds quickly and efficiently with just a few clicks.
Custodial wallets tend to offer convenient solutions for those who are unfamiliar with the technicalities of self-custody. When using a custodial wallet, the loss of private keys resulting in a loss of funds is not an issue. Even if you forget your password, lose your phone, or your computer breaks, you can usually contact somebody at the relevant exchange to recover your account.
Custodial Wallet Pros
One of the major benefits of using a custodial wallet is that it can be an effective way of avoiding high transaction fees. For example, interacting with Ethereum-based decentralized applications (dApps) during periods of high network congestion can be quite expensive. The more people that use the network, the higher gas prices become. Accordingly, higher gas fees are processed more quickly. However, many custodial wallets often offer a flat fee for transactions, or in some cases, no fee at all.
Furthermore, custodians can implement two-factor authentication (2FA) and withdrawal limits to minimize the adverse effects of potential thieves. Plus, reputable custodians tend to keep user funds in an offline cold storage hardware wallet. This, combined with the fact that centralized exchanges (CEXs) often insure losses up to a certain amount, removes a great deal of personal responsibility from investing in crypto. Moreover, for beginners and the less technically savvy, custodial wallets offer a straightforward solution for storing crypto without the technical risks associated with self-custody.
Custodial Wallets Cons
A custodial wallet associated with a centralized exchange is at risk of a single point of failure. If a rogue CEO or bad actor takes it upon themself to run away with your funds or dissolve the business, your funds may be at risk. Thus, if somebody does run away with your assets, it can be pretty challenging to retrieve your funds. Equally, if an exchange is closed down or forced to cease operations, you could lose access to your funds.
What is a Non-Custodial Wallet?
Non-custodial wallets require users to take personal responsibility for the security of their digital assets. Unlike custodial wallets, non-custodial wallets give users complete control of their private keys. In cryptography, a private key is a secret number that corresponds with a public wallet address. It gives users a secure way of gatekeeping all transactions from their wallet addresses. While anyone can send cryptocurrencies to a public address, a private key is essential for removing assets from a wallet. Also, users must write down a mnemonic phrase to restore their wallets and access their funds if their device breaks or is lost.
There are two main types of non-custodial wallets. First, browser-based Web3 wallets such as MetaMask are software browser extensions. These are the wallets that most people use for interacting with decentralized finance (DeFi) protocols in a permissionless way. Second, cold storage hardware wallets are physical devices. They often look like a USB flash drive with a screen and some buttons. In addition, each of these wallets requires the owner to sign a transaction using their private keys.
Non-Custodial Wallet Pros
Whereas custodial wallets require users to complete security and identification procedures, non-custodial wallets can be created with minimal friction. You can set up multiple accounts with a non-custodial wallet provider while remaining compliant with anti-money laundering (AML) and “know your customer” (KYC) regulations. Plus, you are not required to provide any personal information to create a non-custodial wallet.
Furthermore, no central authority or malicious actor can run away with your funds or act as a single point of failure. Plus, non-custodial wallets are essential for interacting with the majority of decentralized applications (dApps) and permissionless financial protocols. In addition, the signing of transactions with non-custodial hardware wallets takes place offline within the device itself. Accordingly, malware-infected computers are resistant to hacks and attacks that could enable an intruder to sign a transaction on your behalf.
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Non-Custodial Wallet Cons
While non-custodial crypto wallets offer the most secure solution for storing crypto, some investors are not comfortable taking full responsibility for their assets. If you lose your private keys and fail to take the necessary precautions for restoring your wallet, you may lose access to your funds forever. Also, if someone gains access to your private keys, you can’t call customer service and change your password.
Other Types of Crypto Wallets
Now that we’ve made the distinction between custodial vs non-custodial wallet offerings, let’s look at some of the other types of crypto wallets. First, a paper wallet is one of the most secure types of non-custodial wallets. A wallet holder can generate a QR code that represents their public and private keys. This code can be printed on paper and stored offline to prevent potential hacks. Despite this, the nature of a paper wallet means that it is quite easy to lose or damage it.
Mobile wallets and browser-based wallet applications usually fall into the “hot wallet” category. Hot wallets are constantly connected to the internet. Although they tend to offer users self-custody, they are more vulnerable to attacks than cold storage hardware wallets that sign transactions offline.
Furthermore, desktop wallets fall into the custodial hardware wallet category. These wallets are not connected to the internet and are ideal for making frequent transactions securely. However, such wallets require users to keep protocols up to date, unlike major hardware wallet providers that often prompt users to install updates.
Custodial vs Non-Custodial Wallet: Which is the Best for You?
So, out of custodial and non-custodial wallet options, which is the best one for you? The answer to this question varies dramatically depending on how you intend to use your crypto wallet. Regardless of which option you decide to use, it’s vital that you do your own research before committing your crypto investments to any type of storage.
Furthermore, it is extremely common for crypto traders and investors to use a combination of different types of wallets. For example, some investors keep the majority of their assets in cold storage while keeping a small amount in a hot wallet for specific purposes. This could be for interacting with smart contract-based applications or decentralized gaming platforms. However, it is worth considering what type of wallet will best suit your needs for specific purposes. Also, getting to know each type of wallet and what it can do may help you to establish the best way to store your crypto assets.
Custodial vs Non-Custodial Wallet: Summary
Custodial wallets are often safer for beginners that don’t know how to safely look after their assets. However, they create a single point of failure for potential attacks. Non-custodial wallets often provide a greater degree of security and flexibility than custodial wallets, but they require a certain amount of technical understanding for safe use.
Despite the advantage custodial wallets offer in terms of usability and simplicity, some investors prefer to take extra caution when giving up custody of their assets. Exchange-traded funds (ETFs) and exchange-traded products (ETPs) offer institutional-grade security of digital assets while providing exposure to cryptocurrencies without the need for holding private keys or interacting with a blockchain directly. However, many of these products charge a premium and ongoing fees that can be much higher than usual. Also, they only tend to offer exposure to a small selection of assets.
Whatever you decide is the best option for storing your assets, make sure that you take every possible precaution for securing your funds. Both custodial and non-custodial wallets come with risks that should be taken into consideration before using them for the first time.
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