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The topic of custodial vs non-custodial wallets has become increasingly relevant, especially as the cryptocurrency market continues to blossom. An influx of new users who want to venture into the decentralized finance (DeFi) world is positive for the market. But, unfortunately, it has also attracted malicious hackers who prey on exchanges and accounts that have not implemented enough security measures to protect themselves.
Proper online etiquette is one of the best ways to protect and secure your purchased cryptocurrency. Using a safe exchange is the first frontier considering some exchanges are scams, but malicious hackers sometimes target even the legitimate ones.
This is why it is essential to understand custodial vs non-custodial wallets so that you determine the best approach to protecting your wealth.
A crypto wallet is best described as a vault or account through which cryptocurrency holders can access and manage their digital assets. A crypto wallet can exist as software that holds the user's public key and private key while also acting as the bridge through which they interact with blockchains. While a regular wallet is used to carry around money, a crypto wallet facilitates the signing of cryptocurrency ownership to your particular address and balance changes.
Crypto wallets can exist as software wallets and hardware wallets. The former exists on the device on which it is downloaded (e.g. your laptop), and the latter refers to hardware devices that are also known as cold wallets (e.g. a Ledger device). Hardware wallets happen to be the safest crypto storage options and we highly suggest using them whenever possible.
There are several differences between custodial vs. non-custodial wallets. Simply put, a non-custodial wallet will put you in charge and full control of your funds, and you can always prove ownership through private keys.
If you value convenience over freedom and full-control, use a custodial wallet because it is oftentimes easier to use. However, the custodial option means trusting one platform with your digital assets, which could cause problems in the case of hackers.
Here's the breakdown between these two types of wallets that help answer some common questions our community asks.
Custodial crypto wallets are wallets that allow third parties to have custody of their user's funds. In other words, you are permitting a third party to handle all your transaction information, similar to how banks have custody over the money in their clients' accounts. Custody means the third party has a certain degree of control over the user's assets.
The best examples of custodial crypto wallets are the accounts on cryptocurrency exchanges. Most people hold crypto on those exchanges because it allows them quick entry or exit in the market. For example, they can quickly take advantage of catalysts in the market by rapidly buying some crypto. On the other side, they can exit their positions quickly if they desire to do so.
History is always a good teacher, and it has certainly taught us a lot about custodial accounts in the fiat and crypto segments. For example, banks or even exchanges can lock or freeze your funds, especially under a legal directive. Custodial accounts, therefore, give governments some leeway, which might jeopardize your funds if the government decides to exercise its power.
The FBI managed to use its persuasive authority to secure the public and private keys of the hackers responsible for the Colonial Pipeline ransom attack. In addition, the authorities managed to recover some of the Bitcoin collected as ransom because the hackers had their funds in a custodial account. In 2014, Mt. Gox, one of the largest exchanges of its time, filed for bankruptcy after a major hack where 850,000 Bitcoins belonging to its customers were lost.
The above incidents highlight the dangers of crypto custodial services. However, that does not necessarily mean that they should be avoided.
Modern exchanges have executed various measures to increase security for users. For example, Binance has implemented extra security layers such as know-your-customer (KYC) and two-factor authentication to reduce the likelihood of attacks similar to the Mr. Gox attack. It's also important to note that a third-party custodial can also be helpful when you lose access to your assets or keys. This makes the whole process of retrieving funds much more forgiving, even for the more experienced crypto holder.
Many of these wallets on custodial exchanges are making significant progress in user adoption, mainly because of an easy-to-use UI/UX; however, users demand even more control over their funds. This user demand explains why custodial services, like Coinbase, are looking to provide users full control of their funds.
Although everyone knows that the Coinbase cryptocurrency exchange is a custodial service, they might easily dismiss Coinbase's wallet services.
The Coinbase wallet allows users to have complete control of their cryptocurrencies and even hold their private keys, which is usually a mnemonic phrase or seed phrase that only the user is supposed to know. It fits the description of a completely non-custodial wallet that aligns with the doctrines of a decentralized economy where people have full control of their finances.
Coinbase is one of the few exchanges that feature non-custodial wallets. The truth is that other exchanges do feature non-custodial wallets but don't carry the same trading volume as some of the other major exchanges. It's crucial when transacting on a custodial service that it's reputable and that most customer funds are highly secured in cold storage.
A non-custodial crypto wallet is a smart wallet solution that allows users to hold and manage their digital assets without third-party interference or intervention. These wallets enable the user to have full control of their assets, which means they can move them around with little to no friction. In addition, the seed phrase privately revealed to the user when they create their account is used as a private key that can be used to seamlessly re-store their wallet on another device.
The common theme about all non-custodial wallets ensures the user has complete control over their cryptocurrencies and is usually separate from crypto exchanges. However, they can easily connect to platforms to sell or receive crypto. A non-custodial crypto wallet is also designed to facilitate easy peer-to-peer transactions. Furthermore, non-custodial wallets allow users to easily interact with many blockchain applications such as DeFi or NFT projects.
The main improvement that non-custodial wallets offer over custodial wallets is that they allow users to gain access to their cryptographic keys. That way, they have sovereign control over their cryptocurrencies. The implication is that nobody else can access your cryptocurrency holdings unless they have access to your private keys - hence make sure to never share your private key or mnemonic seed phrase with anyone!
The only catch is that non-custodial wallets require users to take full responsibility for their digital assets, which means they have to deal with a slight learning curve associated with using such technology. However, on the plus side, this approach encourages users to dive deeper into knowledge regarding the crypto market and security.
Like the great Ben Parker said, with great power comes great responsibility!
When you create a wallet account on a non-custodial wallet such as Metamask or Solrise, it will prompt you to write down the mnemonic phrase or seed phrase and to keep it somewhere secure where nobody else can access it. This is because that phrase is the most critical aspect of security and recovering your account. Whoever has access to this phrase ultimately has access to your funds!
Let's say, for example, you have been using your laptop with a non-custodial wallet on it for your blockchain operations. Let’s assume that you, unfortunately, lose it or it breaks. Simply, install the wallet on another device and use the mnemonic phrase to restore your account - it’s as simple as that. If you lose your private key or mnemonic seed phrase however, then recovering your cryptocurrency can be an insurmountable challenge.
There are several types of cryptocurrency wallets, but probably the most secure is a hardware wallet. A hardware wallet is a portable device, usually the size of a USB drive, that allows you to store private keys for cryptocurrencies offline. By keeping your keys offline, it becomes less likely that someone will be able to access your funds (which is not always possible on software-only methods - also often referred to as ‘hot’ or ‘soft’ wallets). Being in charge of your own security ensures more peace of mind for crypto holders who want a higher level of protection than typical exchanges.
Hardware wallets are great because they allow you to store your crypto offline and away from threats like hackers. However, there's great responsibility when it comes to securing your assets, so taking advantage of some other benefits like being able to create backups that can be stored in a safe location or with someone else for added protection is something to consider.
We usually recommend putting the mnemonic seed phrase for your hardware wallet in a safe or another highly secure location.
Quick benefits of a hardware wallet:
There is only one downside to hardware wallets, and it's that it might cost more upfront than other wallets (~$60 - $100). But you can't put a price tag on more control, your security, and peace of mind!
As noted earlier, there are different non-custodial wallets out there. Some popular examples include Metamask, Solflare, or Trust Wallet. Hardware wallet options are the Ledger Nano S, Nano X, or the Trezor wallet. There are several options for you to choose from. The process of creating or setting up a non-custodial wallet is relatively easy.
A paper wallet is a piece of paper that contains QR codes, addresses, or keys that can facilitate receiving and sending of cryptocurrencies. Since digital currencies exist on a blockchain, the QR codes and keys highlight ownership or transfer of crypto assets.
With paper wallets, you can scan a QR code for any inbound transfers and make crypto payments. There are also QR codes that should be kept private and safe because it contains the sensitive information such as private keys that give entry into that wallet.
Making a paper wallet is relatively easy. First, visit a website that offers such services, such as walletgenerator.net or bitaddress.org.
Make sure the keys written down are safely stored to avoid loss. Losing them is equivalent to losing your crypto assets. You can also use the paper wallet to load money to exchanges or other wallets.
NFTs are operated on blockchain networks, just like cryptocurrencies. This means that you can store NFTs in wallets that support the blockchains on which those NFTs are found.
The Solflare wallet is a popular option for NFTs on Solana. Metamask is another ideal browser-based extension wallet that supports NFTs and other digital assets on Ethereum, the Binance Smart chain, and Polygon. These are just some of the many non-custodial wallets available to users.
Ever since the DeFi summer of 2020, many have come into the world of crypto with a restored faith in their financial future which has been amazing for the market. However, it is essential to maintain a sense of security and safety when investing in cryptocurrency given how nascent the industry is. This is why understanding the difference between a non-custodial vs a custodial wallet has become increasingly relevant.
Along with this rise of adoption, there are plenty of bad actors and hackers who prey on exchanges, accounts that have not implemented enough security measures to protect themselves as well as novice users. Proper knowledge of pitfalls is one of the best ways to safeguard your cryptocurrency portfolio. If you're curious to learn more or even have questions on how to manage your tokens, feel free to join our mailing list, ask us a question on our telegram channel, or visit the Staking Academy to learn more about blockchain, staking, and DeFi. If you have learned any lessons (good or bad) that might help others manage their portfolios, let us know!
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Please note that none of this is to be considered financial nor investment advice. We highly advise you to always do your own research (’DYOR’) before interacting with any of the projects or tools we write about. Crypto is a highly dynamic and fast paced environment with lots of moving parts that can quickly change.