Crypto Basics Crypto Knowledge

Custodial vs Non-Custodial Wallets Explained

Custodial vs. non-custodial wallets

One of the first choices a first-time crypto user has to make is deciding what type of wallet to use for storing their crypto assets. Custodial vs. non-custodial wallets are the two main categories of cryptocurrency wallets, and they both have their advantages and disadvantages.

How much do you know about the key differences between wallets? Which type allows for easier access to your crypto or high level of security? To help you understand wallets better, let’s go over the main features of both types, compare them and share some examples.

What is a Crypto Wallet?

Before we delve into the similarities and differences between custodial vs. non-custodial wallets, let’s look at what a wallet actually is.

A cryptocurrency wallet is a digital tool that gives crypto holders ownership over their digital asset holdings, such as Bitcoin (BTC) or Ethereum (ETH). This works by using a specific digital pair of a public and a private key that each wallet generates and associates with your crypto.

The public key is the crypto address that enables you to send and receive assets, similar to a bank account number.

The private key covers the security aspect of your wallet. It acts as a digital signature confirming your ownership of your wallet’s crypto assets. Users should always keep private keys securely stored, preferably offline.

In most cases, when the user creates a new wallet, a sequence of 12, 18, or 24 words is displayed. That’s the so-called seed phrase. You can use this recovery phrase to restore your wallet in case you forget your password or something happens to the device you had your digital wallet installed on. The seed phrase should also be kept private and preferably offline. 

What are Custodial Wallets?

In the case of custodial wallets, the private keys are held by a third party and not the users themselves. In most cases, we’re talking about web-based cryptocurrency exchanges, such as Binance, Coinbase, Kucoin, Crypto.com, and Cex.io, that function as custodial wallet providers. 

Centralized exchanges protect users’ funds by employing various security measures. Once you create an account with any centralized exchange, the next step is user verification or the “Know-Your-Customer” (KYC) process. After you complete the verification, you’re ready to use fiat money to buy cryptocurrency, which you can then move to any wallet. However, if you decide to use the exchange’s wallet service for storing your crypto holdings, this crypto exchange acts as a custodian of your private key. 

The user still retains complete control over sending and receiving funds. At the same time, the exchange handles the security aspects like preventing attacks from third parties and hackers, keeping the private keys safe, and providing methods for password and account recovery without the need for a seed phrase.

In short, custodial wallets resemble a regular bank account. You keep your money in the bank account and retain full freedom to manage it, but the bank handles the security of your assets, much like a centralized exchange.

Here is a summary of the pros and cons of custodial wallets:

Custodial Wallets Pros

  • Easy-to-use and convenient for first-time crypto investors
  • Entrusting a third-party custodian to secure your wallet can prevent losing access to your crypto if you’re a newbie or not well-versed in cyber security. 
  • Most centralized cryptocurrency exchanges require your funds to be on a custodial wallet to trade.
  • Some custodial wallet providers offer a return on your cryptocurrency-based savings.

Custodial Wallets Cons

  • You have to trust a third party with access to your money.
  • Lower security level than non-custodial wallets by design since custodial wallets are centralized.
  • Higher risk of losing your funds if the wallet provider gets under a cyber attack

Technically, it all comes down to the risk of outsourcing security if you decide to use a custodial wallet. Do you trust the specific custodial wallet provider with the safety of your funds, or would you rather have complete control over your crypto?

If you prefer having complete control over your funds and assets, you should consider using a non-custodial crypto wallet.

What are Non-Custodial Wallets?

A non-custodial wallet is a blockchain wallet that gives users total control over every aspect of their crypto holdings. The user owns the private keys and the recovery phrase and is fully responsible for the security of their assets.

Non-custodial crypto wallets are generally dApps (decentralized applications). As such, they’re part of DeFi (Decentralized Finance). DApps are open-source and operate without a central authority backing them.

With this type of wallet, crypto users have “self-custody” over their funds. That’s why non-custodial wallets are sometimes also called self-custodial wallets. Both terms refer to the same type.

Non-custodial wallets can be web-based, desktop-based, or mobile wallets. Any of these are software wallets as opposed to hardware wallets, also known as “cold wallets”.

Like custodial wallets, a non-custodial wallet also supports multiple types of crypto coins, tokens, or NFTs. The benefits of staking and savings rewards depend on the stage of development of a particular wallet.

When using a non-custodial wallet, it’s absolutely essential that you never lose your private key or seed phrase. If that happens and the wallet can’t be restored, you lose the crypto assets associated with that wallet.

Popular non-custodial wallets include Trust Wallet, MetaMask, Electrum and Exodus, but new wallets are being developed all the time.

What is a Hardware Wallet?

Hardware wallets or cold wallets, as they are sometimes called, are a form of offline crypto storage. A hardware wallet stores the user’s private keys in a secure hardware device that resembles a USB drive.

A hardware wallet provides the highest level of security against hacker attacks because it operates offline. In case someone gets physical possession of your hardware wallet, they’re still prevented from stealing the private keys due to the PIN code in place. If you lose your device, you can still rely on a seed phrase to restore access to your private keys.

Currently, the most well-known hardware wallets include Trezor One, Ledger Nano X and Ledger Nano S. 

What are Paper Wallets?

Another form of offline wallet is the paper wallet. There’s only one difference between a paper wallet vs hardware wallet. A paper wallet holds the public and private keys and QR codes used to facilitate your crypto transactions on a printed piece of paper rather than on a hardware device.

Cryptocurrency holders used to rely on paper wallets mainly before crypto gained prominence. Storage technology has improved since the method was first popular, but it remains a valid way to store your keys in certain circumstances.

Here is a summary of the pros and cons of non-custodial wallets:

Non-custodial Wallets Pros:

  • Complete control of your crypto, which makes your assets much more difficult to seize
  • Making transactions without someone looking over your shoulder.
  • Different levels of security depending on your threat model
  • Access to higher levels of security through the combination of hardware and paper wallets
  • Full access to any dividends or staking rewards associated with your cryptocurrency holdings. 

Non-Custodial Wallets Cons:

  • Being in charge of your assets’ security comes with responsibility, and human error could lead to theft or accidental deletion
  • More difficult to trade your stored crypto as you need to send it to an exchange first
  • User interfaces can be more complicated to navigate

Takeaways 

Custodial vs. non-custodial wallets have their advantages depending on the way a user wants to interact with the crypto market. If you’re focused on short-term trading or day trading, perhaps it’s better to use a custodial wallet. That way your crypto is more readily accessible in case you decide to sell or exchange some at a given moment. 

On the other hand, a non-custodial crypto wallet makes for a better choice if you’re more interested in long term trading or holding onto your crypto assets. That way your funds remain safer while you enjoy full control over them. 

In the ever-expanding crypto and blockchain space, it’s important to stay informed and up-to-date on the latest developments so you can decide how to use the available software to your greatest advantage. 

Was this post helpful?

Related posts

3 pigs yellow red black w
5 Fragen zur Besteuerung von Non-Fungible Tokens (NFTs)
Non-Fungible Tokens (NFTs) sind spätestens seit einer vom Auktionshaus Christie’s durchgeführten Versteigerung in New York...
Best Crypto Wallets 2022
Ready to enter the crypto space and accumulate or trade substantial amounts of digital currency...
books with arrow
The Basics of Hard Forks Explained
Hard forks are significant changes made to a network’s blockchain. They can disrupt the crypto...