The crypto scene today is home to all kinds of wallets. There are core wallets like Bitcoin Core and Litecoin Core, EVM wallets like Metamask and Brave, Hardware wallets like Trezor and Ledger, and centralized wallets from exchanges like Binance and Crypto.com.
Each of these falls into one of two categories; custodial or non-custodial. And choosing between the two is one of the biggest decisions crypto users have to make.
How do crypto wallets work?
The word ‘wallet’ may suggest that crypto wallets, like regular wallets, contain your funds. But that’s not the case. Crypto assets like bitcoin (BTC), ether (ETH), and BNB are stored on their respective blockchains as bits of data. Your crypto wallet lets you access your crypto coins and tokens.
To do this, the wallet contains two types of keys; one public and the other private. The public key is the wallet’s address on the blockchain. This address is a sequence of letters and numbers that people use to send you crypto. Your wallet then sums the value of the assets associated with your address and displays it to you as your crypto balance.
On the other hand, private keys are like your bank PIN. They act as proof of ownership and are used to sign off on crypto transactions. Therefore, anyone with private keys can access the funds associated with their corresponding wallet.
The difference between custodial and non-custodial wallets arises in how these keys are stored. With custodial wallets, the user doesn’t store their private keys. Instead, someone else keeps them, essentially giving them control over the funds. On the other hand, non-custodial wallets give the user their private keys.
Here’s a closer look at each.
A custodial cryptocurrency wallet doesn’t give you your wallet’s private keys. They remain with the wallet’s creator. This means that while you can still access your crypto and conduct transactions, the wallet’s creator retains complete control of the funds in the wallet. They become the custodian.
Custodial wallets are a big feature of centralized exchanges. Binance, Kraken, Coinbase, and other centralized exchanges all use custodial wallets. So, their users trust the corporations behind the platforms with their private keys. This has its advantages and disadvantages.
Advantages of custodial wallets
Custodial wallets come with several advantages. These are:
- Convenience: Custodial wallets don’t let you manage your own private keys. Instead, the custodian shoulders this responsibility for you. This makes them a more convenient option than non-custodial wallets. Therefore, most crypto beginners tend to prefer custodial wallets.
- Recovery: A forgotten password will lock you out of your custodial wallet. Fortunately, recovery is a simple process. All you need to do is provide the custodian with your email address and they’ll help you regain access to your funds.
- Additional Services: A custodial wallet is usually one part of a bigger platform – a crypto exchange. So, users have easy access to lots of additional services. These include trading products like leverage, spot, futures, and convenient crypto swaps. Users can also buy crypto with fiat currency.
- Insurance: Some custodial wallets insure the user’s assets against hacks/exploits. This provides added peace of mind for the user.
Disadvantages of custodial wallets
Custodial wallets are not without their disadvantages.
- Lack of control: Giving a custodian your private keys means giving up control over your wallet and funds. Therefore, the custodian has the power to stop you from accessing your crypto indefinitely. This is the origin of the phrase ‘not your keys, not your crypto.’
- Counterparty risk: Since the custodian stores your crypto for you, you are exposed to counterparty risk. This means you can lose your funds in case the exchange is hacked, becomes insolvent, or some higher-ups decide to mismanage their crypto reserves. This situation has played out several times throughout crypto history.
- Censorship: Custodial wallets are typically managed by centralized organizations, which opens the door to government censorship and regulation. For example, a government may revoke an exchange’s right of operating within its jurisdiction, affecting the ability of users to access their funds. It can also order an exchange to freeze the funds belonging to a particular user.
- Privacy: Custodial wallets are required by law to complete Know Your Customer (KYC) requirements. Therefore, you have to sign up and create an account before you can use the wallet. This involves providing your personal information and pictures of your face and identification documents, which greatly limits your privacy.
Non-custodial wallets give you your private keys in the form of a phrase. This phrase is known as a mnemonic or seed phrase. It consists of 12 to 24 randomly generated words that can be used to generate your public and private keys on any device. Thus, you can use it to recover your wallet in case you lose access to your wallet. This is why it’s also called the recovery phrase.
The seed phrase is only generated once – when you first set up your wallet. Therefore, you should write it down and store it in a safe place. It will come in handy in case there’s a device failure, you forget your wallet’s password, or want to create a copy of your wallet across multiple devices.
With this phrase in your possession, you retain complete custody over your funds. As long as you’re the only one who knows it, you’re the only one who controls your wallet.
There are also core wallets, which function as their respective blockchains node clients. Examples include Bitcoin Core, Litecoin Core, Dogecoin Core, and Dash Core.
Advantages of non-custodial wallets
Using a custodial wallet comes with several advantages;
- Complete control and ownership: Non-custodial wallets give you your private keys. This allows you complete control of your wallet and all its associated funds. You have true ownership; you can deposit, withdraw, and transfer crypto whenever you want.
- No counterparty risk: Since you’re the one in control of your keys, non-custodial wallets don’t have counterparty risk. You’re not trusting a third party to keep your money safe. Therefore, you’re highly unlikely to lose your funds due to someone else’s mistakes or actions.
- Privacy: Unlike custodial wallets, non-custodial wallets are not subject to KYC laws because they are decentralized. Therefore, they don’t require you to provide any personal information or identification to use them. They are anonymous, allowing you great levels of privacy.
- Access to decentralized finance (DeFi): Most non-custodial wallets are decentralized applications (dApps) built on a blockchain. Blockchains like Ethereum and Binance Smart Chain (BSC) have robust DeFi ecosystems that you can take part in directly from your wallet.
- Free from censorship: Because they are decentralized, non-custodial wallets are free from censorship and government regulation. They are also easily accessible. All you need to create a non-custodial wallet is an internet connection.
Disadvantages of non-custodial wallets
The disadvantages of non-custodial wallets are:
- Ultimate responsibility: By giving you your private keys, non-custodial wallets put a lot of responsibility on your shoulders. It’s your duty to guard your mnemonic phrase and private keys and ensure the safety of your funds. So, if you make a fatal mistake that causes you to lose your funds, you have only yourself to blame.
- Steep learning curve: Non-custodial wallets are more technical than non-custodial wallets. This gives them a relatively steeper learning curve. Therefore, they’re not good for beginners.
- Limited customer support: Except for hardware wallets, most non-custodial wallets have limited customer support. This is because they are decentralized and therefore, there is no organization with a dedicated support team behind them.
- Hacking risk: Non-custodial wallets are a popular target for hackers, especially if they hold large amounts of crypto. Some of them store their private keys online, which creates a considerable hacking risk.
You may also be vulnerable to phishing and other social engineering attacks. These are designed to make you give up your private keys.
Which is the better option?
Your choice of wallet depends on your needs. Choose a custodial wallet if:
- You’re a beginner looking for a convenient and user-friendly option.
- You don’t want the responsibility of looking after your private keys.
- You want to reduce the risk of getting hacked or falling for a phishing scam.
- You don’t have the technical knowledge required by non-custodial wallets.
- You want a robust customer support system.
- You engage in lots of trading.
On the other hand, choose a non-custodial wallet if:
- You want full control over your funds.
- You want privacy,
- You don’t mind being responsible for your fund’s security.
- You have good technical knowledge surrounding crypto and want to participate in DeFi.
- You want to avoid counterparty risk and third-party interference from the government and other regulatory bodies.
- You’re holding large amounts of crypto for a long time. In this case, a hardware wallet will do.
Overall, both custodial and non-custodial wallets provide good ways to store cryptocurrencies. However, most experts lean towards non-custodial wallets because of the level of ownership and control they give you over your crypto.