Did you know that while primarily advertised as cryptocurrency trading and investment platforms, centralized exchanges (CEXs) also double as storage solutions? Today, millions of people around the world hold their crypto assets on Binance, Coinbase, Gemini, and other exchanges.
Here’s how CEXs work as a crypto storage solution. We’ll look at how CEX wallets work compared to wallets like MetaMask, Trust Wallet, Ledger, etc., why people choose them, and why many in the crypto community consider them a bad idea.
How Do CEX Wallets Work?
To understand how CEX wallets work, you must first understand how crypto wallets work. CEX wallets, at least the type you interact with as a user, are not actually wallets. They are accounts.
How Crypto Wallets Work
A real crypto wallet doesn’t actually store crypto. Instead, it stores two cryptographically linked keys: a public and a private key.
Private keys are the digital signatures of a wallet. They prove ownership of the wallet and are used to sign transactions. Public keys are the wallet addresses on the blockchain. It’s what people use to send and receive tokens.
The crypto itself lives on the blockchain as bits of data. Each bit of data has a public address associated with it. And each wallet lets you access the bits of data associated with its public address.
How CEX Accounts Work
When you join a platform like Binance, you do so by creating an account. You can then buy crypto with fiat to store in your account and/or deposit crypto from another source. You’ll be able to read your crypto balance, trade, and conduct transactions from your account.
But since it’s an account, it doesn’t store your public and private keys. These are, instead, stored in actual crypto wallets controlled by the centralized exchange.
From this information, you can see how holding crypto on a CEX works: the exchange maintains crypto wallets to store user funds. Some of these are hot wallets, and others are cold wallets. It then lets users create accounts to access and manage their funds.
In all this, the platform retains control of the private keys. So by depositing crypto in an exchange, you’re depositing it in wallets owned by the platform. You’re essentially giving your crypto to the platform to store on your behalf.
That is why CEX wallets are called custodial wallets. You give up direct custody and control of your funds to someone else, although you can still access and manage them via an account.
Platforms like Metamask and Trust Wallet are wallets in the technical sense. They store their private and public keys and give out a seed phrase. This is a phrase consisting of 12-24 randomly generated words that can be used to generate the wallet’s public and private keys.
So, by using any of these wallets, you retain control of your private keys. This gives you direct control of your assets on the blockchain. Because of this, such wallets are known as non-custodial wallets.
Features of Custodial Wallets
Many custodial wallets share the following features:
- When opening your account, you’ll be required to provide some personal information for KYC purposes. This includes your real name, a picture of your face, and a picture of your ID or driver’s license.
- You’ll also need to set a password for security. Create a strong and unique password to prevent unauthorized access.
- You can also enable two-factor authentication (2FA) to add an extra layer of security. The feature requires you to enter a code (sent via SMS to your phone number) in addition to your password when logging in.
Another way to enable 2FA is to use an authenticator app. It’s an app that generates time-based security codes that you’ll need to enter along with your password to log in.
- Some custodial wallets let you create vaults. These are meant to be more secure than standard accounts, as they typically require multiple approvals before funds can be withdrawn.
- There are also time-delayed withdrawals. When enabled, this feature requires the user to wait a specified period after requesting a withdrawal before the request is processed. The idea here is that if an unauthorized withdrawal occurs, the user will have time to cancel it.
Why People Use Custodial CEX Wallets
You’d think few people would tolerate the idea of surrendering control of their crypto to someone else. But all around the world, millions of people have done it, and many more will do it in the coming years.
Why? Convenience.
The initial account-opening process may be a little tedious due to KYC requirements, but beyond that, CEX wallets offer a lot of convenience.
For example, keeping your seed phrase safe is a huge responsibility. If it falls into the wrong hands, your funds could be drained, and if you lose it, you might lose access to your crypto forever.
Exchange wallets don’t place this responsibility on the user. The crypto exchange assumes the responsibility of securing your keys. So, you don’t have to worry about losing or securing your seed phrase. Your only duty is to set a password, which, if you lose, you can easily reset via email. In contrast, there is no way of recovering your seed phrase once you lose it.
There is also a lot of convenience when trading. CEX wallets are typically built into a large trading platform. You can easily trade cryptocurrencies and purchase/sell crypto with/for fiat.
So generally, people who use custodial CEX wallets are those who:
- Don’t want to take on the huge responsibility of securing their seed phrase and private keys
- Regularly trade cryptocurrencies
- Regularly buy or sell crypto assets for fiat
Still, many people remain unconvinced about custodial wallets. There is a good reason behind this, as explained by the phrase “not your keys, not your crypto”.
What Does “Not Your Keys, Not Your Crypto” Mean?
Custodial wallets, while convenient, entail significant counterparty risk. Giving someone else custody of your crypto can result in your losing your funds through no fault of your own.
There are several ways that this can happen:
1. The Exchange Is Hacked
The platform stores your funds and those of millions of other users in its own crypto wallets. That is billions of dollars’ worth of crypto, making them an attractive target for hackers. If any of these hacks succeeds and is big enough to collapse the platform, you stand to lose all your funds.
Today, there is little chance of this happening. But in the early years of crypto, users lost hundreds of millions of dollars to such hacks. The most infamous of these is the Mt. Gox hack of 2014, where 850,000 BTC (worth about $473 million at the time) in user funds were stolen.
More recently, ByBit was hacked for $1.5 billion. But in modern times, most exchanges can cover users in some way or recover funds from hackers.
2. Mismanagement Causes the CEX to Collapse
Storing your crypto on a custodial wallet usually gives the platform and its management power to do whatever they want with your money. Many platforms take advantage of this to engage in risky deals and investments in pursuit of bigger profits, which won’t be shared with users.
These moves can go wrong, and money is lost. If they involve a sufficiently large amount of money, the platform may collapse. An example is FTX, which was one of the largest crypto exchanges at the time of its collapse. Gross mismanagement of the CEX caused users to lose access to billions.
Usually, when an exchange collapses due to a hack or mismanagement, it pauses withdrawals because it no longer has the funds users are requesting. That’s how users lose access to their funds.
Unless the platform recovers the funds, the loss is often total and permanent. The FDIC does not insure crypto assets held by financial institutions. It is the platform’s responsibility to issue refunds to users.
If the crypto really belonged to the user, they would still have access to their assets. But by giving up control of their private keys, they effectively handed the platform control over their crypto, putting them at risk of losing it. This is the rationale behind the phrase “not your keys, not your crypto.”
Are Exchange Wallets Any Good?
Ultimately, it depends on your needs. If you’re someone who trades often or is new to crypto and not quite ready to manage your own private keys, and you’re willing to assume the counterparty risk that comes with this decision, choosing an exchange wallet isn’t a bad idea.
This type of wallet comes with many trading and security features that should serve you well. But many users get into crypto for the decentralization benefits. If that’s the case for you, then using exchange wallets just for on and off-ramping is probably your best bet.