Custodial Wallets vs Non-Custodial Wallets
Ever wondered where people store their crypto assets like coins and non-fungible tokens(NFTs)? True, cryptocurrencies and other crypto assets exist on the blockchain. Yet, you cannot simply go into the blockchain and pick them up as if the ledger is a room in your house. The blockchain lives in the cloud, far beyond the reach of any physical effort. If you say you own one bitcoin, where is it, then? Where is it stored?
One of the first things you would interact with if you are new to crypto is a cryptocurrency wallet. Whether you want to trade cryptocurrencies, invest, make payments with crypto, or interact with decentralized applications, you need a crypto wallet. Just as you keep cash in your leather purse, a cryptocurrency wallet is a software application that helps you store your coins and other crypto assets.
Cryptocurrencies are not like cash. You cannot simply pick them up from your wallet to make a payment. Instead, you must sign a transaction, send coins to a particular address, pay a transaction fee, and connect your wallet to an application before spending your crypto. Crypto wallets do not exactly store your coins. They hold the private keys that give you access to pay, move, and own those assets.
They work as an interface between you and the blockchain, with your private keys linking both worlds. This is why, although there are numerous crypto wallet providers with different products, you can easily import your wallet using your private keys from one app to another, and your balance will remain intact. Your coins are on the blockchain, while your wallet helps you to use them and claim ownership by putting the private keys tied to those coins in your hands.
Several blockchains exist, some with entirely different infrastructures compared to others. For instance, Bitcoin is different from Ethereum. Thus, some crypto wallets support one chain (like the Bitcoin Wallet), while others offer multichain support. Another point at which wallets differ from wallets is private key control. In this context, there are two types of cryptocurrency wallets: custodial and non-custodial.
In this article, we will explore the concepts of custodial and non-custodial wallets, how they work, compare them for strengths and weaknesses, and help you decide on the best solution for your unique needs.
How do custodial wallets work?
A custodial crypto wallet service holds your crypto assets in its custody and fully owns the private keys to which your assets are linked. You know how a bank keeps your money in its possession, and you have to trust them? The story is the same for custodial wallets. You have to trust the wallet provider to safeguard your assets and private keys, and mainly, you trade off ownership and control for a smooth user experience.
Custodial wallets employ third-party actors to hold users’ funds in custody. In the early days of Bitcoin wallets, users were entirely responsible for controlling their private keys and, by extension, their crypto assets. If private keys were lost, or if the owners passed on without disclosing them to anyone, no one would be able to access the coins in the wallet, and they would be irretrievable. Over 3 million bitcoins have been lost because their owners either misplaced their private keys or died without passing them on.
With a custodial wallet, you can avoid losing access to your coins when you lose your private keys, as you have already entrusted its keeping to a third-party custody provider. If you forget your wallet password (most crypto wallets have some security measure built into them), you can still retrieve your account by reaching out to your wallet provider’s customer support arm.
Most centralized cryptocurrency exchanges like Coinbase, Binance, and Kraken offer custodial wallet services. Also, several custodial wallet services require users to register accounts and pass a KYC verification exercise to use the service. Reliable custodial wallet providers should be regulated and have insurance policies in place in the event of a security breach that touches customers’ funds.
How do non-custodial wallets work?
Non-custodial wallets are the opposite of custodial wallets, with the responsibility of safekeeping private keys and, by extension, assets falling to the user instead of a third-party provider. If you use such wallets, you are your bank. Typical users of self-custodial wallet services store their private keys online or on paper offline, although the latter is safer.
With a non-custodial wallet, when you lose access to your keys, there is no way to recover them. The wallet provider does not have any access to your assets, nor can they help you recover your private keys. Most Bitcoin wallets in the early years employed self-custody. While it eliminates the risk of compromise on the part of the wallet or custody provider, a non-custodial wallet requires more experience to use. Also, users need to be more careful with private keys and seed phrases since wallet recovery is out of the question.
Self-custodial wallets are accessible to everyone and do not require users to register accounts or undergo KYC verification. Also, there is no cost of using the platform, and users pay transaction fees directly on the blockchain. Metamask, Trust Wallet, and Safepal are some examples of popular non-custodial crypto wallets. It would be fair to note that some crypto wallet innovations today support seed phrase recovery even with self-custody, like the Aurox Wallet.
Custodial vs. non-Custodial
Here’s how they compare against one another:
Pros and cons of custodial wallets
Ease of use
Custodial wallets are generally easy to use. They usually have a friendly user interface, easy for both newbies and experienced crypto users to understand.
Also, most custodial wallets offer a wide range of services like crypto-to-fiat and fiat-to-crypto services, bill payments with crypto, instant crypto trading with high liquidity, and others that make users favor them over non-custodial wallets.
Account recovery is possible
Custodial wallets give users peace of mind, knowing that when they lose their passwords, they can quickly contact support and recover their accounts. Also, there are no worries about losing private keys.
Regulations and insurance
Several custodial wallet providers have regulated bodies, which makes them easier to trust. Since they are regulated, they require users to undergo KYC verification to use their platforms. Perpetrators of frauds and scams can easily be tracked that way. Also, crypto assets stored by most custodial wallets are insured to protect against security breaches and thefts.
The foundation of the blockchain and cryptocurrencies rests upon trustless systems — eliminating middleman figures in the financial industry. Custodial wallets do not stay true to those fundamentals.
Users must trust wallet providers to play their part and store assets without malicious intent. Recently, discoveries showed how the now-defunct FTX exchange used customer funds stored in its custody wrongly. This is a powerful argument against custodial wallets.
Most custodial wallets require customers to go through identity verification exercises. Some users may not feel inclined to submit confidential information to these services, citing privacy concerns.
Pros and cons of non-custodial wallets
Users are in control of their funds
Non-custodial wallets do not accept deposits. Instead, users have complete control of their assets and need no permission to initiate withdrawals; they have no withdrawal limits and suffer no restrictions whatsoever. Also, users have full custody of their private keys. As the famous saying in crypto goes: Not your keys, not your coins.
Faster transaction speeds and lower costs
Non-custodial wallets suffer no wait times on sending and receiving cryptocurrencies since all activities happen live on-chain. There is no need to wait for anyone on the back end to approve the transaction. Also, custody fees are non-existent. Users only pay gas fees for each transaction.
Although they are not entirely private, non-custodial wallets do better at helping users buy and sell crypto without compromising their privacy. Self-custodial wallets do not require you to create an account with them, pass a KYC test, or engage in any other activity that may reveal your identity.
Lack of account recovery mechanism
Users of self-custodial wallets are their banks, meaning that if they lose access to their private keys or seed phrases, they may not be able to access the coins in the wallet anymore. Some non-custodial wallet providers do not have responsive support personnel, yet those with sufficient support channels will tell you that losing your private keys or seed phrase means losing your coins.
Less-Friendly User Experience
While custodial wallets offer a smooth user experience, non-custodial wallets have, in contrast, a less-friendly customer experience. They are not easy to use, especially for new users or people new to crypto. Although, it is essential to note that new self-custodial wallet solutions offer a user-friendly experience.
Should I choose a custodial or non-custodial wallet?
Choosing either a custodial or non-custodial wallet should depend on your needs. If you are a trader or investment company looking for markets with sufficient liquidity, custodial centralized exchange wallets would be more suitable for your needs.
Crypto users who want to buy and hold coins long-term should use non-custodial wallets and have complete control over their assets. Following the FTX saga, crypto enthusiasts have called for users to abandon custodial wallets and embrace self-custody.
Also, if you interact with dApps or build on the blockchain, you are better off using a non-custodial wallet service. If you want to access a myriad of real-world benefits like booking flights, paying bills, or converting crypto to cash, a custodial wallet would be the safer bet.
Custodial and non-custodial wallets have one significant difference: the former stores' users’ assets and private keys with a storage service, while the latter hands over the responsibility of safekeeping assets and private keys to the user.
Although custodial wallets offer incredible ease of use and a wide range of services, users need to trust them, and many have lost assets running into billions this way. Self-custodial wallets are more secure and allow people to control their fates, but they are less user-friendly, and mistakes can lead to loss of funds.
Custodial wallets must reaffirm their commitments to keeping users’ funds safe and intact. In contrast, non-custodial wallets must improve their user experience and find a way to help users recover private keys if lost.
I feel you should be convinced by now, to move your funds to a self-custodial solution. If you are looking out for a wallet, try Obvious Wallet.
Obvious is not just another wallet. It’s imagined & built from the ground up to make your crypto experience 10x better. In essence, it’s one app to rule them all — swap, bridge, NFTs, portfolio management, smart contract wallet, MPC-based wallet recovery, and many more. You can download the app from here.